Chapter 3

The Demand for Labor

„ Answers to Even-Numbered Review Questions

2. Assume that wages for keyboarders (data entry clerks) are lower in India than in the United States.
Does this mean that keyboarding jobs in the United States will be lost to India? Explain.
Answer: Indian data entry clerks will be substituted for American ones only if the ratio of their
wage to their marginal productivity is lower. Thus, it is not wage alone that affects the
incentives to substitute; marginal productivity is also critical.

4. Suppose that prisons historically have required inmates to perform, without pay, various cleaning and
food preparation jobs within the prison. Now suppose that prisoners are offered paid work in factory
jobs within the prison walls, and that the cleaning and food preparation tasks are now performed by
non-prisoners hired to do them. Would you expect to see any differences in the technologies used to
perform these tasks? Explain.
Answer: When inmates were required to work without pay, their wage was essentially zero—and we
would expect that prisons to have adopted labor-intensive technologies (using the argument
inherent in Equation 3.8c). When wages rise, the cost of expanding output using labor
becomes greater, and we expect prisons to adopt the use of more capital in the production
process.
 Chapter 6 Supply of Labor to the Economy: The Decision to Work 33

6. Suppose the government were to subsidize the wages of all women in the population by paying their
employers 50 cents for every hour they worked. What would be the effect on the wage rate women
received? What would be the effect on the net wage employers paid? (The net wage would be the
wage women received less 50 cents.)
Answer: Consider a simple competitive labor market in which the demand and supply of women
are both expressed in terms of the wage received by women (which, in the absence of any
subsidy, is assumed to be equal to the wage paid by employers). Given the demand curve, D0,
and the supply curve, S0, market clearing wage and employment levels will be W0 and E0,
respectively.

Suppose the government now subsidizes employers by paying them 50 cents for every hour
women work. Viewed in terms of the wage received by women, the employers’ demand
curve will shift up by exactly 50 cents (reflecting the fact that this amount will be paid by
the government). At the old market clearing wage received by women, W0, the number of
women employers want to hire, E2, exceeds the number who are willing to work, E0. This
puts upward pressure on the wage received by women, and this wage rises until the excess
demand for labor is eliminated. This equilibrium occurs at the wage rate W1, and the
employment level E1.
It is clear from the figure that the wage received by women increases by less than 50 cents
as long as the supply of labor curve is not vertical (i.e., as long as labor supply is responsive
to wages). Indeed, the more responsive labor supply is to the wage rate, the less the women’s
wage will rise. Since the wage paid by employers now equals the wage women receive
less the 50-cent subsidy, it is also clear that the wage paid by employers declines (by 50 cents
minus the increase in the wage women receive).
It is important to stress to students that one would reach identical conclusions if one analyzed
the subsidy in terms of the wage employers pay. If supply and demand curves are drawn in
terms of this variable, a 50-cent-an-hour subsidy for women would shift the female labor
supply curve down by 50 cents. At the old wage paid by employers, the supply of female
labor would now exceed the demand. Downward pressure would be placed on the wage paid
by employers and it would fall by less than 50 cents (as long as labor supply was responsive
to the wage). As a result, the wage received by women would rise by 50 cents less the fall
in the wage paid by employers.
34 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Eleventh Edition

8. If anti-sweatshop movements are successful in raising pay and improving working conditions for
apparel workers in foreign countries, how will these changes abroad affect labor market outcomes
for workers in the apparel and retailing industries in the United States? Explain.
Answer: If increased labor costs abroad are not accompanied by increases in marginal productivity,
then there will be incentives to substitute for these foreign workers (with capital or workers
elsewhere, including the United States). However, increased costs of manufacturing university
apparel also would be expected to reduce sales and the scale of output, which will put
downward pressure on employment in the American apparel and retailing industries. The
presence of both substitution and scale effects—working in opposite directions—implies
that the ultimate effect on American workers in these industries cannot be predicted by
theory alone.

„ Answers to Even-Numbered Problems

2. The marginal revenue product of labor in the local saw mill is MRPL = 20 − 0.5L, where L = the
number of workers. If the wage of saw mill workers is $10 per hour, then how many workers will
the mill hire?
Answer: The mill will hire workers until MRPL = W.20 − 0.5L = 10 when L = 20 workers.

4. The output of workers at a factory depends on the number of supervisors hired (see below). The factory
sells its output for $0.50 each, it hires 50 production workers at a wage of $100 per day, and needs to
decide how many supervisors to hire. The daily wage of supervisors is $500 but output rises as more
supervisors are hired, as shown below. How many supervisors should it hire?

Supervisors Output (units per day)

0 11,000
1 14,800
2 18,000
3 19,500
4 20,200
5 20,600

Answer: The firm needs to compare the marginal cost to the marginal revenue of hiring an
additional supervisor. The marginal cost is always $500 for each extra supervisor. The
marginal revenue is the number of additional units produced times the price of output.

Number of Supervisors MC MR
1 $500 $0.50 × 3800 = $1900
2 $500 $0.50 × 3200 = $1600
3 $500 $0.50 × 1500 = $750
4 $500 $0.50 × 700 = $350
5 $500 $0.50 × 400 = $200

The firm will hire three supervisors since the marginal revenue generated from hiring the
third supervisor exceeds $500 but the marginal revenue generated from hiring the fourth
supervisor is less than $500.
 Chapter 6 Supply of Labor to the Economy: The Decision to Work 35

6. The table below shows the number of cakes that could be baked daily at a local bakery, depending on
the number of bakers.

Number of Bakers Number of Cakes

0 0
1 10
2 18
3 23
4 27

a. Calculate the marginal product of labor.

b. Do you observe the law of diminishing marginal returns? Explain.
c. Suppose each cake sells for $10. Calculate the marginal revenue product of labor.
d. Draw the marginal revenue product of labor curve, which is the demand curve for bakers.
e. If each baker is paid $80 per day, how many bakers will the bakery owner hire, given that the
goal is to maximize profits? How many cakes will be baked and sold each day?
Answer: a.

Number of Bakers Number of Cakes MPL MRPL

0 0 — —
1 10 10 100
2 18 8 80
3 23 5 50
4 27 4 40

The marginal product of labor (MPL) is calculated in the third column, using the
following formula:

MPL = Δ(Number of cakes)/ΔL

b. Yes, the marginal product of labor declines as more bakers are hired.
c. The marginal revenue product of labor (MRPL) is calculated in the fourth column,
using the following formula:

MRPL = MPL × P
36 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Eleventh Edition

d. The demand for labor is the MRPL curve:

e. If each baker is paid $80 per day, 2 bakers would be hired and 18 cakes would be
baked and sold daily.

8. The demand curve for gardeners is GD = 19 − W, where G = the number of gardeners and W = the
hourly wage. The supply curve is GS = 4 + 2W.
a. Graph the demand curve and the supply curve. What is the equilibrium wage and equilibrium
number of gardeners hired?
b. Suppose the town government imposes a $2 per hour tax in all gardeners. Indicate the effect of
the tax on the market for gardeners. What is the effect on the equilibrium wage and the equilibrium
number of gardeners hired? How much does the gardener receive? How much does the customer
pay? How much does the government receive as tax revenue?
Answer: a.
 Chapter 6 Supply of Labor to the Economy: The Decision to Work 37

To calculate the equilibrium wage and equilibrium quantity:

GD = GS
19 – W = 4 + 2W
15 = 3W
W = 5 [equilibrium wage]
Next solve for equilibrium quantity:
GD = 19 − W = 19 − 5 = 14 [equilibrium quantity]
b. With the imposition of the tax on gardeners, the new supply is GS = 4 + 2(W − 2).
To calculate the equilibrium wage and equilibrium quantity:
GD = GS
19 − W = 4 + 2(W − 2)
19 − W = 2W
3W = 19
W = 19/3 = 6.33 [equilibrium wage]
Next solve for equilibrium quantity:
GD = 19 − W = 19 − 6.33 = 12.67 [equilibrium quantity]
With the imposition of the tax, the customer pays $6.33 per hour to the gardener. The
government collects the tax of $2.00 per hour, the gardener keeps $4.33 per hour, and
total tax revenues are $25.34 ($2 per hour from 12.67 gardeners).

„ Suggested Essay Questions

1. Retirees often have limited incomes but live in homes on which the property tax liabilities are
relatively high; as a result, they often have to sell their homes and move to smaller, cheaper housing.
A town in New York State recently decided to allow senior citizens the option of working for the
town, at an implicit wage of $7 per hour, as a way of paying their property taxes; as a part of this
program, the town pledged not to assign such seniors to jobs performed by regular employees.
Assume that the lowest wage paid to any regular employee of the town is $10, and that the town
government seeks to make the most of its resources. Use economic theory to analyze the worth to the
town of the tasks that will be performed by seniors. Is the loss of tax revenues likely to be offset by
the labor provided?
Answer: The town will seek to hire workers until the marginal revenue product of labor (MRPL)
equals the wage paid. Regular employees will be hired until their MRPL equals $10. Seniors
will be hired to perform tasks that have an MRPL of at least $7 per hour, but because they
will not compete with regular workers, their MRPL will be less than $10. The city will lose
revenues of $X, which were formerly spent buying labor services that were worth at least
$10 per hour, and instead will now be using that $X to purchase services worth between
$7 and $10 per hour.
38 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Eleventh Edition

2. A December 2007 issue of The Economist contained the following quote in an article about Germany:
“The government has just chopped the payroll tax that finances unemployment insurance, which
should encourage employment.” Comment on this statement, using economic theory.
Answer: Cutting the payroll tax will shift the labor demand curve (when stated in terms of employee
wages) to the right, but how this rightward shift affects employment depends on the shape
of the labor supply curve. The steeper the supply curve, the smaller will be the employment
gains and the larger will be increases in the wages paid to workers. If the supply curve is
vertical, all of the shift will show up as a wage gain, and there will be no employment
increases.
 Chapter 6 Supply of Labor to the Economy: The Decision to Work 39

Chapter 6
Supply of Labor to the Economy:
The Decision to Work

„ Answers to Even-Numbered Review Questions

2. Evaluate the following quote: “Higher take-home wages for any group should increase the labor force
participation rate for that group.”
Answer: This quotation is correct, because for labor force participation decisions, the substitution
effect dominates the income effect. The strength of the income effect is relatively weaker
when the initial hours of work are smaller. When initial hours of work are zero—as is the
case when a person is out of the labor force—then the income effect is zero if leisure is a
normal good (increased resources cannot induce one to increase the consumption of leisure,
since leisure hours are already at their maximum).

4. The way the workers’ compensation system works now, employees permanently injured on the job
receive a payment of $X each year whether they work or not. Suppose the government were to
implement a new program in which those who did not work at all got $0.5X but those who did work
got $0.5X plus workers’ compensation of 50 cents for every hour worked (of course, this subsidy
would be in addition to the wages paid by their employers). What would be the change in work
incentives associated with this change in the way workers’ compensation payments are calculated?
Answer: This change in workers’ compensation has two effects. First, it reduces the subsidy for
people who do not work from $X to $0.5X. This reduction in income by itself would produce
an income effect that tends to induce the injured worker to work more (he or she is poorer
if not working than under the previous workers’ compensation system). On the other hand,
for those who work, the wage rate is increased by 50 cents an hour. (We assume here that
the change in workers’ compensation payments is not so large as to influence market
wages.) The increased wage by itself would tend to induce injured workers to work more
because the cost of leisure has risen by 50 cents an hour; however, the eventual outcome is
theoretically unclear.
The effects of these changes can be seen in the figure below.
40 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Eleventh Edition

Along segment DE there is a clear-cut strengthening of work incentives. Segment DE

has a steeper slope than the previous budget constraint (BQ) and it also lies to the
southwest of BC. Thus, along segment DE there is a substitution effect inducing more work
and an income effect that also induces more work. To the left of Point E, however, along
segment EF, there are income and substitution effects that work in opposite directions.
Along segment EF the 50-cents-an-hour increase in the wage rate is sufficient to increase
the injured worker’s income under workers’ compensation, thereby creating an income
effect that reduces work incentives, other things equal. However, the substitution effect of
the increased wage continues to exert an increase in work incentives, and the outcome of
the two effects is not predictable in advance.
Thus, if the tangency point between the worker’s indifference curve and the full budget
constraint used to be along BC but to the right of Point E, the worker faces a clear-cut
strengthening of work incentives under the new program. If, however, the worker’s
tangency point along BC was to the left of Point E, the new program would have an
unpredictable effect on work incentives.

6. In 2002, a French law went into effect that cut the standard work week from 39 to 35 hours (workers
got paid for 39 hours even though working 35), while at the same time prohibiting overtime hours
from being worked. (Overtime in France is paid at 25% above the normal wage rate.) (a) Draw the
old budget constraint, showing the overtime premium after 39 hours of work. (b) Draw the new
budget constraint. (c) Analyze which workers in France are better off under the 2002 law. Are any
worse off? Explain.
Answer: In the drawing below, the old (pre-2002) constraint is ABC, where slope of BC is 25%
greater (in absolute value) than the slope of AB. The constraint created by the new law
is ADE, where earnings at D are equal to those at B, and the slope of DE is horizontal
(workers cannot get paid for more than 35 hours of work).

Workers who used to work 39 hours per week are clearly better off under the new law.
Those who worked more than 39, but whose tangency point was close to B, will also be
better off if their original utility-maximizing indifference curve passed below Point D.
However, for those whose original utility-maximizing indifference curves passed above
Point D (almost surely the case for most of those with original tangencies along BC),
utility will fall under the new law.

8. The Tax Reform Act of 1986 was designed to reduce the marginal tax rate (the tax rate on the last
dollars earned) while eliminating enough deductions and loopholes so that total revenues collected by
 Chapter 6 Supply of Labor to the Economy: The Decision to Work 41

the government could remain constant. Analyze the work incentive effects of tax reforms that lower
marginal tax rates while keeping total tax revenues constant.
Answer: Reducing the marginal tax rate has the effect of increasing the wage rate, because workers
are allowed to keep more from any extra hours worked. Keeping tax revenues constant
suggests that workers’ after-tax incomes also remain constant. Thus, the Tax Reform Act
tended to increase the wage while keeping workers’ incomes constant—creating a pure
substitution effect that tended to increase hours of work.

10. Assume that the current Disability Insurance (DI) benefit for those who are unable to work is $X per
day, and that DI benefits go to zero if a worker accepts a job for even one hour per week. Suppose
that the benefit rules are changed so those disabled workers who take jobs that pay less than $X per
day receive a benefit that brings their total daily income (earnings plus the DI benefit) up to $X. As
soon as their labor market earnings rise above $X per day, their disability benefits end. Draw the old
and new budget constraints (label each clearly) associated with the DI program, and analyze the work
incentive effects of the change in benefits.
Answer: The old constraint is ABC in the below diagram; the new one is BADC.

There is no change in the incentives to work (as long as indifference curves slope down).

„ Answers to Even-Numbered Problems

2. Nina is able to select her weekly work hours. When a new bridge opens up, it cuts one hour off
Nina’s commute to work. If both leisure and income are normal goods, what is the effect of the
shorter commute on Nina’s work time?
Answer: When the new bridge opened, Nina’s budget constraint shifted to the right in a parallel
fashion as the amount of available time for either work or leisure (as opposed to
commuting) was increased. This shift in her constraint created an income effect (she can
now work more and consume more leisure). Because both income and leisure are normal
goods, both would increase. The only way income can increase in this case is for her to
work more, so we must conclude that her extra hour per day from the shorter commute is
divided in some way between more work and more leisure. Therefore, she works more.
4. The federal minimum wage was increased on July 24, 2007 to $5.85 from $5.15. If 16 hours per day
are available for work and leisure, draw the daily budget constraint for a worker who was earning the
minimum wage rate of $5.15 and the new budget constraint after the increase.
Answer:
42 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Eleventh Edition

6. Stella can work up to 16 hours per day at her job. Her wage rate is $8.00 per hour for the first 8 hours.
If she works more than 8 hours, her employer pays “time and a half.” Draw Stella’s daily budget
constraint.
Answer:

Stella’s earnings are equal to the following:

[Number of hours (within first 8 hours) × $8] + [Number of hours (among next 8 hours) × $12].
The budget constraint for the first 8 hours of work is the segment to the right of the dotted
vertical line at 8 hours. The budget constraint for subsequent hours of work is the segment
to the left of the dotted vertical line at 8 hours.

„ Suggested Essay Questions

1. Currently, the U.S. Department of Transportation has a rule that allows commercial truck drivers to
drive up to 90 hours per week; after 40 hours per week, drivers’ hourly pay goes up by 50%. A
proposed rule would reduce this limit to 60 hours per week. Assume truck drivers currently drive
more than 60 hours per week. Ignoring the safety aspects of the proposed rule, use economic theory
to analyze the likely effects of this new rule on the utility of truck drivers. Use a graph to support
your analysis.
 Chapter 6 Supply of Labor to the Economy: The Decision to Work 43

Answer: The constraint created by this new law looks like the one below. Anyone with a utility-
maximizing point along the more steeply-sloped segment and above the horizontal line
(that is, anyone working⎯by choice⎯more than 60 hours per week) will be made worse
off by this new regulation.

2. Suppose a country passes a law that cuts the standard work day from 8 to 7 hours. Overtime (hours
worked per day beyond the “standard” workday) in this country is paid at 50% above the normal
wage rate. Please answer the following questions related to the work incentives facing workers in this
country:
a. Draw the old budget constraint (in leisure/income space), showing the overtime premium after
8 hours of work per day.
b. On your diagram in (a), draw in the new budget constraint.
c. Use your diagrams in (a) and (b) to analyze the change in work incentives facing workers in this
country as a result of this new law.
Answer:

For those already working overtime, there will be pure income effect reducing overtime
hours. For those working between 7 and 8 hours before, there will be a wage increase,
producing both income and substitution effects; these effects will tend to work in opposite
directions, producing an ambiguous prediction for hours of work (except for those working
exactly 7 hours before; for them, the substitution effect dominates and more hours of work
will be offered).
For those working a bit less than 7 hours before, some will now work overtime (more than 7 hours);
others working less than 7 hours may have such steep indifference curves that their labor supply
behavior will be unaffected.
44 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Eleventh Edition

Chapter 8
Compensating Wage Differentials
and Labor Markets

„ Answers to Even-Numbered Review Questions

2. Statement 1: “Business executives are greedy profit maximizers, caring only for themselves.”
Statement 2: “It has been established that workers doing filthy, dangerous work receive higher
wages, other things equal.” Can both of these statements be generally true? Why?
Answer: Both statements can be simultaneously true. If workers are informed about job hazards
and have a choice about the jobs they take, their behavior will force even the most greedy
executives to pay higher wages for filthy, dangerous work. Even the greediest profit
maximizer must obtain a work force, and to do so must pay a wage that workers will
accept. If workers have alternative job offers that pay the same wage but offer better
working conditions, they will accept those offers and turn down work at the more
dangerous or filthy workplaces. Their behavior then will force owners to either pay the
compensating wage differentials or clean up the workplace.

4. A recent article stated, “Workers in low-wage jobs lack the basic security, the health benefits, and the
flexibility in their work lives that most American workers take for granted.” Assuming this statement
is true, do these facts contradict the theory of compensating wage differentials?
Answer: The theory of compensating differentials predicts that, other things equal, jobs with low
non-wage benefits would have to pay higher wages. This statement is implicitly comparing
those in low-skilled jobs with those in high-skilled jobs, where clearly “other things” are
not comparable. Thus, the facts in this statement do not contradict the theory of compensating
wage differentials.
 Chapter 6 Supply of Labor to the Economy: The Decision to Work 45

6. Suppose Congress were to mandate that all employers had to offer their employees a life insurance
policy worth at least $50,000 in the event of death. Use economic theory, both positively and
normatively, to analyze the effects of this mandate on employee well-being.
Answer: From the perspective of positive economics, mandating that employers offer at least
$50,000 in life insurance will obviously have no effect on those who are already offering
that much or more, but it will add to the costs of those who were previously offering less.
To be competitive in the labor market, those previously offering less must have been
compensating their workers in some other way (to make their jobs as attractive as those of
their competitors). It is thus likely that low-insurance employers were paying higher wages
than those offering more insurance. To now compete with their competitors in the product
market, the affected employers must reduce their wages (to keep overall costs in the
competitive range). Thus, the wages in firms previously offering less insurance will
decline. Of course, if wages do not, or cannot, decline by enough to fully offset the added
costs of more insurance, then employment among these employers will fall.
From the perspective of normative economics, we would like to know if this mandate
improves the welfare of the workers affected. If the labor market is perfectly functioning,
workers are able to obtain the combination of wages and life insurance that maximizes
their utility. If the mandate forces them to take some other mix, then their utility will
decline. If the market is not allowing workers to “buy” (in the form of lower wages) the
life insurance they want, then mandating increased insurance could improve the welfare
of affected workers (as long as the mandate does not require workers to buy more than they
are willing to pay for).

8. “The concept of compensating wage premiums for dangerous work does not apply to industries like
the coal industry, where the union has forced all wages and other compensation items to be the same.
Because all mines must pay the same wage, compensating differentials cannot exist.” Is this statement
correct? (Assume wages and other forms of pay must be equal for dangerous and non-dangerous
work and consider the implications for individual labor supply behavior.)
Answer: This statement is not correct. To understand how the market would adjust, let us assume
that we have a set of relatively safe coal mines and a set of relatively dangerous coal mines.
Both sets of mines must pay the same wage rate and offer the same fringe benefits.
They both advertise for help and, assuming workers quickly find out which mines are
safe and which are dangerous, the safe mines receive many more applications than the
dangerous mines. The safe mines can thus be highly selective about the applicants they
choose, and they will tend to hire the most dependable, hardest working, most motivated
employees. The dangerous mines, with very few applicants, will have to take who they
can get (those workers not chosen to work in the safe mines). Safe mines will have high
quality, highly productive workers getting wage $X, while the dangerous mines will have
lower quality workers obtaining the same wage. Thus, workers of unequal productivity
would receive the same wage, and this is tantamount to the receipt of a compensating
wage differential.
Put differently, the theory of compensating wage differentials says that people of equal
skill will receive different wages when working conditions differ. But a natural corollary
of this is that, when working conditions differ, people of different skills might receive the
same wage. In both cases workers in less desirable circumstances receive higher wages
than they would otherwise receive.
46 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Eleventh Edition

10. In 2005, a federal court authorized United Air Lines (UAL) to terminate its pension plan. The
government will take over pension payments to retired UAL employees, but this action means that
pension benefits will be less than promised by UAL to both its current retirees and current workers.
What future labor-market effects would you expect to occur from this sudden and unexpected
reduction of pension benefits?
Answer: If the labor market is working well, a compensating wage differential will arise to
compensate for the reduced pension benefits; thus wages will tend to rise. The effects on
employment levels are ambiguous. The labor demand curve (expressed in terms of wages)
will tend to shift to the right as employee benefits are reduced, while the labor supply curve
will shift left at each given wage rate.

„ Answers to Even-Numbered Problems

2. Consider the conditions of work in perfume factories. In New York perfume factories, workers
dislike the smell of perfume, while in California workers appreciate the smell of perfume, provided
that the level does not climb above S *. (If it rises above S *, they start to dislike it.) Suppose that there
is no cost for firms to reduce or eliminate the smell of perfume in perfume factories and assume that
the workers have an alternative wage, W *.
Draw a diagram using isocost and indifference curves that depicts the situation. (The New York and
California isocost curves are the same, but their indifference curves differ.) What level of perfume
smell is there in the New York factories? In the California factories? Is there a wage differential
between the California and New York workers?
Answer: See the figure below. The California workers are paid exactly the same as the New York
workers. This wage equals W *. The level of smell in California is S *; in New York it is 0.
 Chapter 6 Supply of Labor to the Economy: The Decision to Work 47

4. The following two figures represent the labor market for two industries that require workers with the
same skills and experience; however, Industry B is characterized by much noisier working conditions
than Industry A. What is the compensating wage differential between the two industries?

Answer: The equilibrium wage in Market A is $6.00. The equilibrium wage is Market B is $7.00.
Market B, which is characterized by noisy working conditions, needs to offer a higher
wage in order to attract workers. The compensating wage differential is $1.00 per hour.

6. The demand for labor in Occupation A is LD = 20 − W, where LD = number of workers demanded

for that occupation, in thousands. The supply of labor for Occupation A is LA = −1.25 + 0.5 W.
For Occupation B, the demand for labor is similar but the supply of labor is LB = −0.5 + 0.6 W, which
is indicative of a more pleasant work environment associated with that occupation in comparison
with Occupation A. What is the compensating wage differential between the two occupations?
Answer: a. Occupation A:
LD = LA
20 – W = –1.25 + 0.5W
21.25 = 1.5W
$14.17 = W
Occupation B:
LD = LB
20 – W = −0.5 + 0.6W
20.5 = 1.6W
$12.81 = W
The compensating wage differential is $1.36 per hour ($14.17 − $12.81).
48 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Eleventh Edition

„ Suggested Essay Questions

1. Currently, the U.S. Department of Transportation has a rule that allows commercial truck drivers to
drive up a limit of 90 hours per week; after 40 hours per week, drivers’ hourly pay goes up by 50%.
A proposed rule would reduce this limit to 60 hours of driving per week. One supporter of the
proposal said this: “Almost no drivers are choosing to work 90 hours per week; drivers will welcome
the added time away from the job.” Suppose that the proposal passes, and a subsequent study shows
that after the new limit took effect, the straight-time wages of truck drivers rose, other things equal.
Using economic theory, comment on this finding in the context of the quotation above; explain fully.
Answer: If drivers were working 90 hours a week because they were compelled to, the new
regulation would make them better off, and they should be attracted to the job at lower
wages. If, however, drivers were working 90 hours a week by choice, cutting their hours
to 60 would represent a reduction in their utility (they could have chosen 60 hours of work
before, but chose 90 instead). The job would thus become less attractive to them, and to
attract drivers, trucking firms would have to raise wages. Thus, the increase in wages
would indicate that the truckers were working more than 60 hours a week by choice.

2. Courts in Japan have recently begun to make awards to the families of workers who have been judged
to have been “worked to death.” That is, employers have been increasingly required by courts to make
large financial payments to the heirs of workers whose hours of work have been so long that they are
judged to have played a role in causing their death. How is the growth in these awards likely to affect
wages in occupations or industries that require long hours of work? Why?
Answer: From the perspective of workers, the attractiveness of jobs requiring very long hours of
work rises with these awards, which can be thought of as a form of life insurance. Thus,
this new “benefit” provides an added inducement to enter these jobs, and the compensating
wage differential needed to attract workers into these jobs should fall. On the demand side
of the market, employers requiring long hours of work will want less labor at each potential
wage rate, which will move the labor demand curve to the left. The rightward shift of supply
and leftward shift in demand will serve to reduce wages, but its effects on employment in
long-hour jobs is ambiguous.
 Chapter 6 Supply of Labor to the Economy: The Decision to Work 49

Chapter 9
Investments in Human Capital:
Education and Training

„ Answers to Even-Numbered Review Questions

2. “The vigorous pursuit by a society of tax policies that tend to equalize wages across skill groups will
frustrate the goal of optimum resource allocation.” Comment.
Answer: As indicated in Chapter 1 and elsewhere, the optimum allocation of resources requires that
all mutually beneficial transactions be accomplished. If wages are forced toward equality
by government fiat, potentially beneficial human capital transactions may be discouraged.
That is, because the acquisition of training and education is costly, human capital investments
will not be undertaken unless there is a future return to them. These returns normally are in
the form of higher wages paid to those with the higher skill levels, and if these higher wages
cannot be paid, human capital investments that might have been made will be discouraged.
Thus, the pursuit of wage equalization across skill levels will discourage human capital
investment and may result in too few workers entering skilled occupations.

4. When Plant X closed, Employer Y (which offers no training to its workers) hired many of X’s employees
after they had completed a lengthy, full-time retraining program offered by a local agency. The city’s
Equal Opportunity Commission noticed that the workers Employer Y hired from X were all young, and
it launched an age-discrimination investigation. During this investigation Employer Y claimed that it
hired all of the applicants from X who had successfully completed the retraining program, without
regard to age. From what you know of human capital theory, does Y’s claim sound credible? Explain.
Answer: Y’s claim is consistent with human capital theory in two respects. First, its own hiring and
training costs appear to be negligible (we are told that it offers no training on its own, and
that its hiring standards consist of taking successful graduates of another program).
Because it makes no major investments in its workers, it therefore has no reason to prefer
younger workers. Second, because the retraining program to which X’s former employees
had access was “lengthy,” it may well be that only the younger workers from X decided to
invest in this retraining. All workers have to decide whether a human capital investment
opportunity will have expected benefits (properly discounted to the present) that are at least
equal to the costs, and a shorter period over which benefits are received reduces these
benefits. Thus, older workers are less likely to have decided to invest in retraining⎯with
the result that only the younger workers became qualified to apply to Employer Y.

6. A study shows that, for American high school dropouts, obtaining a General Equivalency Degree
(GED) by part-time study after high school has very little payoff. It also shows, however, that for
immigrants who did not complete high school in their native countries, obtaining a GED has a
relatively large payoff. Can signaling theory be used to explain these results?
Answer: Graduating from high school is more or less the expectation for American students, and
those who drop out may be viewed as having a low aptitude (or low tolerance) for learning,
even if they later obtain a GED. Immigrants may come from countries in which high
schools are either more demanding or less available, so dropping out may not send the
same signal of low aptitude or tolerance. If, though a GED, these immigrants are certified
as knowing the equivalent of American high school graduates, employers may prefer them
to American GED recipients, other things equal.
50 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Eleventh Edition

8. Many crimes against property (burglary, for example) can be thought of as acts that have immediate
gains but run the risk of long-run costs. If imprisoned, the criminal loses income from both criminal
and non-criminal activities. Using the framework for occupational choice in the long run, analyze
what kinds of people are most likely to engage in criminal activities. What can society do to reduce
crime?
Answer: Committing a crime like burglary is essentially the mirror image of a human capital
investment, because with an investment costs are borne in the present and the returns come
later. Characteristics that tend to reduce the expected costs of committing a crime are a
high discount rate (a “present orientation”) and relatively poor earnings prospects in the
labor market (less to lose by being jailed).
To reduce crime, society needs to reduce the immediate benefits or increase the expected
future costs of committing a crime. Reducing the benefits could be accomplished by
installing protective devices that make burglaries less likely to succeed. Increasing the
costs can be done by increasing the likelihood of catching thieves, increasing the length of
incarceration, or raising the labor-market earnings potential of those currently with the least
to lose.
 Chapter 6 Supply of Labor to the Economy: The Decision to Work 51

10. The following statement was overheard at a party: “It is just not right that Joe, who never went to
college, makes more than Ken, who has a master’s degree. People with higher degrees deserve to
earn more!” Use human capital theory to comment on this quotation.
Answer: Earnings are influenced by many factors other than education, including experience,
compensating wage differentials for job characteristics or employee benefit levels, and
luck. Those who make educational investments expect a return, in terms of either money or
utility, and they will not invest if the expected returns are too low. However, actual returns
are subject to both demand and supply forces, which cannot be perfectly anticipated.
Expectations, then, are not always realized. Thus, Ken may make less than Joe for a variety
of reasons. In any event, human capital theory addresses the issue of what is required for an
investment to be made, not what people “deserve” in some moral sense.

„ Answers to Even-Numbered Problems

2. (Appendix) Suppose the supply curve for optometrists is given by Ls = −6 + 0.6W, while the demand
curve is given by Ld = 50 − W, where W = annual earnings in thousands of dollars per year and
L = thousands of optometrists.
a. Find the equilibrium wage and employment levels.
b. Now suppose that the demand for optometrists increases and the new demand curve is Ld′ = 66 − W.
Assume that this market is subject to cobwebs because it takes about 3 years to produce people
who specialize in optometry. While this adjustment is taking place, the short-run supply of
optometrists is fixed. Calculate the wage and employment levels in each of the first three rounds
and find the new long-run equilibrium. Draw a graph to show these events.
Answer: a. Initial equilibrium W = $35, L = 15. (Find this by setting Ls = −6 + 0.6W = Ld = 50 − W
and solving for W.)
b. First round: L is still 15, so W = $51. This is Point A in the figure below. (Find W by
plugging L = 15 into the new Ld equation.)
52 Ehrenberg/Smith • Modern Labor Economics: Theory and Public Policy, Eleventh Edition

Second round: Labor supply reacts to first round wage, L = 24.6, but this pushes W
down to $41.4 (at Point C). Find this by plugging W = $51 into the Ls equation to find
L = 24.6, and then plugging L = 24.6 into the new Ld equation.
Third round: Labor supply reacts to second round W, L = 18.84, but this pushes W up
to $47.16 (see Point E). Find this by plugging W = $41.4 into the Ls equation to find
L = 18.84 and then plugging L = 18.84 into the new Ld equation.
Long-run equilibrium, W = $45, L = 21. (Find this by setting Ls = −6 + 0.6W = Ld =
66 − W and solving for W.)

4. Prepaid college tuition plans, also known as Prepaid Education Arrangements (PEAs), allow you to
prepay college tuition at present-day prices. The value of the investment is guaranteed by the state to
cover college tuition, regardless of its future cost. You are considering the purchase of an education
certificate for $25,000, which will cover the future tuition costs of your 8-year old daughter. You
expect the tuition cost of your daughter’s bachelor’s degree to be $50,000 in 10 years. What would
your personal discount rate need to be in order for it to be worthwhile for you to make the investment
and purchase the certificate?
Answer: For a PEA to be worthwhile, its present value to you now must be at least $25,000.
In 10 years, the PEA will be worth $50,000, and its present value to you now is
$50,000/(1 + r)10, where r is your personal discount rate. Thus,

$50,000 /(1 + r )10 = $25,000, or

$50,000 / $25,000 = (1 + r )10
2 = (1 + r )10
(1 + r ) = (2)1/10
(1 + r ) = 1.0718
r = 0.0718

Your personal discount rate needs to be 7.18% or less for the PEA to be worth investing in.

„ Suggested Essay Questions

1. A recent report by the “Lisbon Council” concluded that eastern European (formerly Communist)
countries were experiencing a significant “brain drain,” with university-educated workers migrating
from the east to western European countries. The report also noted that these eastern countries were
investing less in human capital than countries in the west, and it concluded that the eastern countries
should substantially increase their investments in university education. Using economic theory,
comment on the consistency between these two conclusions, explaining your reasoning in detail.
Answer: If workers in eastern Europe are leaving for western Europe, it is likely that the returns to
educational investments captured by workers (the “private” returns) are lower in the east.
As noted in Chapter 9, societies will want to invest their scarce capital resources in projects
that yield the highest returns, and if educational investments are yielding relatively low
returns, higher levels of investment are not indicated. Thus, unless the “private” returns to
education are much less than the overall (“social”) returns, the Lisbon Council’s
recommendation is not justifiable.
 Chapter 6 Supply of Labor to the Economy: The Decision to Work 53

2. Some politicians in countries that are the recipients of large numbers of immigrants advocate adopting
laws requiring immigrants to learn the local language within a specified period of time. One economist,
commenting on such a proposed law, said the following: “These laws are unnecessary, as the market
provides incentives to learn the local language.”
Use economic theory to describe the likely mechanism provided by the labor market to learn the local
language. Analyze the characteristics of immigrants who are most likely to learn the new language.
Answer: Learning a new language requires an investment. Costs (of tuition, books, effort, and time)
are spent in the present and the benefits are realized later. These benefits are most likely to
be in the form of higher wages (as more occupations become open to the immigrant),
although there are other gains from being able to communicate for social or consumption
purposes. The immigrants likely to realize the largest benefits are those who want to be in
jobs requiring more than just simple communication with natives.
Using human capital theory, we can theorize that immigrants more likely to invest in
learning the language are those for whom the yearly benefits are larger (those living and
working outside of immigrant enclaves), those who intend to remain in their new country,
those who are younger, those who learn more quickly, and those who have a lower
personal discount rate.