ECON480 - Labor Economics
Extra Practice
November 16, 2025
These practice questions are meant to provide you with examples for the
kinds of questions I may ask on your second midterm. It is not intended to
exhaustively list every topic that I could ask you about. Everything that
we have covered in class since after midterm #1 is fair game for a midterm
question.
1 Short Answer
1. (Note: Written in 2023, answer the question from the point of view of
someone in 2023) If President Biden finds a way to fulfill his promise of
student loan forgiveness, borrowers who have federally held loans that
were distributed on or before July 2022 will be eligible for the relief.
What do you expect this to do to the signal value of undergraduate
degrees for those who graduated before 2022? If the program is ex-
tended in such a way that it heavily subsidizes student loans to those
graduating after 2022, what do you expect this to do to the signal
value of undergraduate degrees for those who graduate after 2022?
The idea of education as a signal is that only those who are higher-
ability and willing to pay the cost of acquiring the signal will do so,
meaning that education serves as a way to distinguish workers who
are more productive. Following this logic, anyone who took on stu-
dent debt to get a college degree did so because the cost of the degree
was worth acquiring the signal. In other words, the only people who
graduated from college before 2022 who have debt would be higher-
ability workers, assuming that a college degree is at least somewhat
effective as a signal. Debt forgiveness that is purely for those who
already have degrees would not impact the effectiveness of the signal,
because it wouldn’t change who has a degree, and why those people
earned the degree On the other hand, if the loan forgiveness was ex-
tended to help those who could choose to go to college in the future,
this would reduce the value of the signal. Loan forgiveness would
serve to lower the costs of a college degree, making it more likely that
lower-ability workers would get a degree in an attempt to pool with
high-quality workers.
1
2. Sebben & Sebben Motorcycle Repair begins to offer its mechanics a
month of general training, which increases their productivity. The mo-
torcycle repair industry is perfectly competitive, and Sebben & Sebben
must pay trained motorcycle mechanics $25 a month, while they must
pay untrained mechanics who are not currently being trained $15 a
month. It costs Sebben & Sebben $5 to train a mechanic, so the
company is only willing to pay mechanics $10 a month during their
training.
Now consider Harvey, an untrained mechanic who has a discount rate
of 30%. Harvey is only planning to work for 2 more months before he
retires, including this month. Calculate Harvey’s net present value of
receiving the training. Will Harvey agree to receive general training
this month from Sebben & Sebben?
Here, Harvey has the choice to either work for 2 more months without
training, receiving $15 each month, or he can receive the training this
month to get extra money next month. If Harvey receives the training,
he would earn an extra $10 next month, but he would receive $5 less
this month. Thus, the net present value of the training for Harvey is
$10
− $5 = 7.69 − $5 = $2.69
1.3
Thus, Harvey will agree to receive the training.
3. Consider the McCall search model that we covered in class, where we
discovered that the reservation wage must satisfy the condition that
β X
w̄ = z + [pr(w)(w − w̄)]
1−β
w≥w̄
In this formula for the reservation wage, the right-hand size represents
the benefits of rejecting the reservation wage and continuing to search
in the future. Explain what the terms on that side of the equation
mean, and explain how they contribute to the benefit of continued
search.
First and most directly, z represents the unemployment insurance that
a worker receives each period. It is a direct monetary benefit that a
worker only gets if they continue searching. The other, bigger term, is
β
connected to the value of searching in the future. 1−β is a reflection
of the fact that the worker is discounting the future. (Going into it in
1
a bit more detail than we mentioned in class, recall how 1−β showed
up when we calculated the value of getting a certain wage forever. So,
β
1−β is capturing the P value of getting a certain wage forever, starting
tomorrow.) Finally, w≥w̄ [pr(w)(w − w̄)] is the expected additional
wage that the worker gets if a future wage offer is above the reservation
wage. Or in plain language, this summation shows how much extra
wage the worker expects to get if they wait for a better offer than the
reservation wage. So altogether, the benefit of searching again is (1)
the direct monetary assistance from unemployment insurance, plus (2)
the extra wage the worker expects to get if they search for something
better, discounted because it’s in the future.
2
4. A computer programming firm that writes software for other compa-
nies is attempting to motivate its workers to program more quickly, so
that it can sell more code. In order to do so, the firm is considering
implementing a piece-rate: an employee will be compensated a flat
rate for every line of code that they write. Do you think this strategy
will be effective for the firm? Explain your answer.
This strategy is likely to increase the amount of code that workers
write, but unlikely to be truly effective for the firm. Piece rates in-
centivize workers to make as much of the thing that the piece rate is
based on. So in this case, the firm’s computer programmers will be
motivated to write as many lines of code as possible. If the firm just
wants lots of lines of code, this strategy could be effective. However,
assuming that the firm wants its employees to produce good computer
programs, incentivizing workers to just write a bunch of lines is not
necessarily ideal. At the extreme, you could imagine the workers just
copy-pasting the same line of code again and again to increase the
amount they are being paid. Even if the firm takes steps to verify that
the lines of code or programs work, workers will still have an incen-
tive to pretend that writing code is harder than it is, or that longer
computer programs with more lines are necessary. So, this strategy is
unlikely to be effective for the firm at increasing profit or improving
productivity.
5. Suppose there are two types of people, high-ability and low-bility.
High-ability workers have productivity of $25,000, while low-ability
workers have a productivity of $9,000. A firm is trying to find a way
to separate these two types. A certain certification program costs a
high-ability person $8,000, and costs a low-ability person $15,000. Can
this certification be used as an effective signal of type? Explain your
answer briefly.
For this certificate to be an effective signal, high-ability workers need
to want it, and low-ability workers need to not want it. Assuming
that markets, are competitive, if the certificate is a good signal that
distinguishes high-ability types, the firm would need to pay $25,000
to anyone with the certification. For low types, this would mean they
could incur the $15,000 cost, and receive $25,000. This would give
them a net benefit of $10,000, which is preferable to revealing them-
selves as low-ability types and getting $9,000. So, low-types will always
want to get the certificate, and it will not be an effective signal.
2 Long-Answer
1. Consider the McCall search model that we covered in class, where we
discovered that the reservation wage must satisfy the condition that
β X
w̄ = z + [pr(w)(w − w̄)]
1−β
w≥w̄
Consider a worker who will receive a job offer every year. The wage
distribution, F ()w), is shown in the following table:
3
Wage level Probability
50,000 0.25
75,000 0.5
100,000 0.25
they have a 25% chance of receiving an offer with a $50,000 wage,
a 50% chance of receiving an offer with a $75,000 wage, and a 25%
receiving an offer with a $100,000 wage. Imagine that the worker has
access to unemployment of $20,000 each year, and their discount rate
is β = 0.8.
(a) What is the expected wage the worker should expect to be of-
fered?
The expected wage is
.25(50, 000)+.5(75, 000)+.25(100, 000) = 12, 500+37, 500+25, 000 = $75, 000
(b) Showing your work, calculate the worker’s reservation wage. First,
let us assume that the reservation wage is between $50,000 and
$75,000. Then:
.8
w̄ = 20, 000 + [.50($75, 000 − w̄) + .25($100, 000 − w̄)]
.2
w̄ = 20, 000 + 4[.50($75, 000 − w̄) + .25($100, 000 − w̄)]
w̄ = 20, 000 + 2($75, 000 − w̄) + 1($100, 000 − w̄)
w̄ = 20, 000 + $150, 000 − 2w̄ + $100, 000 − w̄
w̄ = $270, 000 − 3w̄
4w̄ = $270, 000
4w̄ = $67, 500
So, we see that this assumption was correct. The reservation
wage was in the range we assumed, so we are done.
(c) Suppose that a major economic expansion causes the job market
to improve, such that the chance of drawing a $100,000 wage rises
to 60%, the chance of drawing a $75,000 wage falls to 20%, and
the chance of drawing a $50,000 wage falls to 20%. What will the
workers reservation wage be now?
Given what we’ve learned, our intuition should be that the reser-
vation wage goes up. So let’s check first if it has risen above
$75,000.
.8
w̄ = 20, 000 + [.25($100, 000 − w̄)]
.2
w̄ = 20, 000 + 4[.6($100, 000 − w̄)]
w̄ = 20, 000 + 2.4($100, 000 − w̄)
4
w̄ = 20, 000 + $240, 000 − 2.4w̄
w̄ = $260, 000 − 2.4w̄
3.4w̄ = $260, 000
3.4w̄ = $76, 470.59
So, we see that this intuition was correct. The reservation wage
has risen to the level that the worker will hold out for the $100,000
wage.
(d) Briefly explain the economic logic behind your answer to part (c).
Why does the labor market improvement cause the change you
found in part (c)?
When the labor market improves, the chance of receiving a good
wage offer in the future rises. This means that the value of con-
tinuing to search rises, because that search is more likely to yield
the $100,000 wage. Or said differently, once the labor market
improves, the worker will no longer be willing to give up the high
chance at a $100,000 wage for only $75,000.
(e) Suppose that the government wants to keep reservation wages
where they were before the economic expansion. What could
they do to unemployment insurance to ensure this? Be as precise
as you can.
We know that now the worker values continuing to search much
more due to the better labor market. To get them to reduce their
reservation wage back to $67,500, we would need to make them
more desperate by lowering unemployment insurance. To figure
out exactly how much we need to lower z, we can set w̄ equal
to $67,500, and solve for z. But we do need to be careful, if the
reservation wage falls back to 67,500, then we need to have both
75,000 and 100,000 in our reservation wage formula. So, what we
need to solve is:
w̄ = z + 4[.2($75, 000 − w̄) + .6($100, 000 − w̄)]
I’m going to simplify a bit, then substitute in w̄ = 67, 500
w̄ = z + .8($75, 000 − w̄) + 2.4($100, 000 − w̄)]
w̄ = z + $60, 000 − .8w̄ + $240, 000 − 2.4w̄
4.2w̄ = z + $300, 000
Now, substituting in $67,500 for the reservation wage:
4.2(67, 500) = z + $300, 000
283, 500 = z + $300, 000
−16, 500 = z
That is, the job market has gotten so good that the government
would have to penalize people $16,500 a year for being unemployed
in order to get this worker to return to their previous reservation
wage. (Note that this isn’t a very realistic policy, but it is what
our math tells us. On an exam, I would most likely not give you
a question with such a non-realistic answer.)