Final Exam Review Questions

Chapter 18 – Factors of Production
1. Explain why the labor demand curve is the value of the marginal product curve for labor
2. Explain why the labor supply curve is usually upward sloping
3. Explain why a competitive firm maximizes profit when it hires labor to the point where the wage equals the value of the marginal product of labor
4. Demonstrate the similarity between the labor market and the market for other factors of production
5. Explain why the change in the supply of one factor alters the value of the marginal product of the other factors

Chapter 19 – Earnings and Discrimination
1. Explain why an economics professor earns less than a corporate economist of similar age, background, and training
2. Explain the differing impact of policies aimed at increasing the educational attainment of all workers under the signaling and the human-capital view of education
3. List the characteristics of a market where superstars can arise
4. List three reasons why a wage can rise above the equilibrium wage
5. Explain why differences in wages among groups does not by itself say anything about how much discrimination there is in the labor market
6. Explain why competitive employers are unlikely to discriminate against groups of employees unless the customers or the government demands it

Chapter 20 – Distribution of Income
1. Explain how the women’s movement has affected income distribution in the United States
2. Name some factors that cause the measurement of income distribution to exaggerate the degree of income inequality
3. Compare and contrast utilitarianism, liberalism and libertarianism
4. Explain the concept of a negative income tax

Chapter 21 – Theory of Consumer Choice
1. Draw a budget constraint on a graph if you are given the value of income and the prices of the good
2. Explain why indifference curves must slope downward in the two products considered are ‘goods’
3. Explain the relationship between the relative prices and the marginal rate of substitution between two goods at the consumer’s optimum
4. Shift the budget constraint when the price of a good increases
5. Demonstrate the income and substitution effect on a graph using indifference curves and budget constraints
6. Show why someone’s labor-supply curve might be backward sloping

Chapter 22 – Frontiers
1. Describe the information asymmetry in the labor market
2. Explain why insurance companies screen potential customers
3. Generate an example of the Condorcet voting paradox
4. Explain why people are willing to sign contracts that require them to contribute a portion of their paychecks to a retirement savings program.

Questions for Monday's Section

Solutions to class question 3

Solutions to class question 2

Solutions to class question 1

Capital Supply

The expressed consumer preferences between consumption today and consumption tomorrow (alternatively, when young and when old) is precisely what defines the supply of financial capital in our stylized market. The important thing to note here is that the difference between the two consumption periods, essentially the gap between what is spend today and what will be spend tomorrow, is equal to the amount that households save today plus any interest rate on that amount.

Therefore, we may ask: "How do interest rate changes affect household saving (and thus the supply of capital) in the market?

1. If the substitution effect of a higher interest rate is greater than the income effect, then households save more.

2. If the income effect of a higher interest rate is greater than the substitution effect, then households save less.

The two possible effects are shown in the diagram above. With a similar thinking that we applied to derive the backward-bending labor supply curve, you may infer that we are going to be faced with a backward-bending savings supply curve.

Labor Supply

We assume that the individual will try to maximize their utility, within a fixed number of hours (24 hours a day). This means, there is a trade off (opportunity cost) between how many hours a person works and the hours spent on leisure.

The opportunity cost involved in working - forgone hours of leisure - give a backward bending supply of labor curve for the individual (see Figure 1).

The key to understanding the principle is the concept of utility. For example, if the consumer is in equilibrium, then the utility they get purchasing goods with the income they earn in the last hour will equal the utility they would gain from the last hour leisure time. (i.e. the Marginal Utilities per dollar spent on each of the activities are equal, exactly at the consumption optimum).

If the wage rate increased from W1 to W2 then due to a higher income the individual would have a greater utility, hence, they would be willing to increase their hours worked per day to L2. Over this section of the curve the substitution effect is positive, the income effect is negative, but the substitution effect is greater than the income effect. Therefore, the increase in the real wage rate will cause an increase in the number of hours worked.

However, if the wage rate increased from W2 to W3, then the number of hours worked per day would fall from L2 to L3. This is because the income effect is greater than the substitution effect.

The processes involved in the decision to work more or less hours is termed the income and substitution effects. The higher wage means that the individual could work fewer hours to maintain the same consumption patterns of goods and services. Therefore, the income effect would mean that an individual would work fewer hours. However, the substitution effect is that the higher wage will mean the utility gained from the last hour work is greater than the utility gained from an hour of leisure. This is because the higher wage means the individual can purchase more goods. Consequently, the individual will substitute work for leisure until the utilities equal (i.e the consumer is back in equilibrium between work and leisure).

An interesting issue is that individuals have different characteristics and utilities. Hence the degree of trade off between the utility of an hour worked and the utility of an hour of leisure will be different. This implies that the elasticity of substitution between leisure and consumption will vary. It is likely that the low income households will tend to be less responsive to wage changes than higher income groups due to the high substitution effect.