CHAPTER 3

3-1. Suppose there are two inputs in the production function, labor and capital, and these
two inputs are perfect substitutes. The existing technology permits 1 machine to do the
work of 3 workers. The firm wants to produce 100 units of output. Suppose the price of
capital is $750 per machine per week. What combination of inputs will the firm use if the
weekly salary of each worker is $300? What combination of inputs will the firm use if the
weekly salary of each worker is $225? What is the elasticity of labor demand as the wage
falls from $300 to $225?

Because labor and capital are perfect substitutes, the isoquant for producing 100 units of output
(in bold in the figure below) is linear and the firm will use only labor or only capital, depending
on which is relatively cheaper in producing 100 units of output.

The (absolute value of the) slope of the isoquant (MPE / MPK) is 1/3 because 1 machine does the
work of 3 workers. When the wage is $300, the slope of the isocost is 300/750. The isocost curve,
therefore, is steeper than the isoquant, and the firm only hires capital (at point A). To calculate
this in a different way, one machine does the work of three workers. The one machine costs
$750; the three workers cost $300 × 3 = $900. Clearly the firm should hire only machines.

When the weekly wage is $225, the isoquant is steeper than the isocost and the firm hires only
labor (at point B). To calculate this in a different way, one machine does the work of three
workers. The one machine costs $750; the three workers cost $225 × 3 = $675. Clearly the firm
should hire only workers.

Capital
Smallest isocost line that achieves 100 units of output when
the wage is $225 per week: w / r = 225 / 750 < 1/3.

Output = 100 Units Isoquant

A

Smallest isocost line that achieves 100

units of output when the wage is $300 per
week: w / r = 300 / 750 > 1/3.

B Labor

The elasticity of labor demand is defined as the percentage change in labor divided by the
percentage change in the wage. Because the demand for labor goes from 0 to a positive quantity
when the wage drops to $225, the (absolute value of the) elasticity of labor demand is infinity.

1
©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw-Hill Education.
3-2. Figure 3-18 in the text shows the ratio of the federal minimum wage to the average
hourly manufacturing wage.

(a) Describe how this ratio has changed from the 1950s to the 1990s. What might have
caused this apparent shift in fundamental economic behavior in the United States?

The ratio of the federal minimum wage to the average hourly manufacturing wage averaged about
0.5 from 1950 to 1968. That is, a manufacturing job paid about 2 times as much as a minimum
wage job. Since 1968, however, the ratio has steadily fallen. In the last quarter of the 20 th
century, the ratio approached 0.3, meaning that a manufacturing job paid about 3 times as much
as a minimum wage job.

Consider three (of the many possible) explanations for this behavior. First, although the nominal
minimum wage has risen over time, the real minimum wage fell quit a bit from 1968 to 1990.
Second, the U.S. economy has lost a lot of manufacturing jobs recently, ostensibly due to
globalization. Economic theory suggests that the jobs most likely to be lost are those with the
least productive workers (relative to foreign workers), which likely correlates to the lowest paid
manufacturing jobs. Thus, when the lowest paid manufacturing jobs are lost, the average
manufacturing wage will increase, which in turn increases the ratio presented in Figure 3-18.
Third, one might point toward the return to skills. Most low-wage, minimum wage jobs require
very little skill (and some of these jobs are becoming more and more automated). Manufacturing
jobs, however, still require skill in terms of using high-tech equipment and machines.

(b) This ratio fell steadily from 1968 to 1974 and again from 1980 to 1990, but the
underlying dynamics of the minimum wage and the average manufacturing wage were
different during the two time periods. Explain.

First, notice that over both of these periods that the federal minimum wage was unchanged.

The earlier period (1968-1974) was a time of stagflation, war, and an oil price shock. High levels
of inflation led to higher nominal wages (for those who had jobs), thus lowering the ratio of the
minimum wage to the average manufacturing wage. That is, the decreasing ratio was largely a
product of an eroding real minimum wage during an inflationary period.

The later period (1980-1990) is generally characterized as a time of economic growth and
prosperity. Thus, while inflation was largely in check, wages were increasing substantially as a
result of productivity growth. This productivity growth (and in turn wage growth) resulted in a
lower ratio.

(c) What has been happening to the ratio of the federal minimum wage (nominal) to the
average hourly manufacturing wage from 1990 to today?

More or less, it has been holding steady between 0.3 and 0.4, depending on the timing of
legislative increases in the minimum wage.

2
©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw-Hill Education.
3-3. Firm would hire 20,000 workers if the wage rate is $12 but will hire 10,000 workers if
the wage rate is $15. Firm B will hire 30,000 workers if the wage is $20 but will hire 33,000
workers if the wage is $15. The workers in which firm are more likely to organize and form
a union?

The union will be more likely to attract the workers’ support when the elasticity of labor demand
(in absolute value) is small. The elasticity of labor demand facing firm A is given by:

%E (20,000  10,000) 20,000

A    2 .
%w (12  15) 12

The elasticity of labor demand facing firm B is given by:

%E (33,000  30,000) 33,000

B    0.45
%w (15  20) 15

Workers at Firm B, therefore, are more likely to organize as |-0.45| < |-2|.

3-4. Consider a firm for which production depends on two normal inputs, labor and capital,
with prices w and r, respectively. Initially the firm faces market prices of w = 6 and r = 4.
These prices then shift to w = 4 and r = 2.

(a) In which direction will the substitution effect change the firm’s employment and capital
stock?

Prior to the price shift, the absolute value of the slope of the isocost line (w/r) was 1.5. After the
price shift, the slope is 2. In other words, labor has become relatively more expensive than
capital. As a result, there will be a substitution away from labor and towards capital (the
substitution effect).

(b) In which direction will the scale effect change the firm’s employment and capital stock?

Because both prices fall, the marginal cost of production falls, and the firm will want to expand.
The scale effect, therefore, increases the demand for both labor and capital as both are normal
inputs.

(c) Can we say conclusively whether the firm will use more or less labor? More or less
capital?

The firm will certainly use more capital as the substitution and scale effects reinforce each other
in the direction of using more capital. The change in labor hired, however, will depend on
whether the substitution or the scale effect dominates for labor.

3
©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw-Hill Education.
3-5. What happens to employment in a competitive firm that experiences a technology
shock such that at every level of employment its output is 200 units/hour greater than
before?

Because output increases by the same amount at every level of employment, the marginal product
of labor does not change (and hence, the value of the marginal product of labor does not change).
Therefore, as the value of the marginal product of labor will equal the wage rate at the same level
of employment as before, the level of employment will not change.

3-6. Consider each of the following, and explain why it is or is not a valid instrument for
estimating labor supply elasticity and/or labor demand elasticity in the United States. (1)
Variation in state income tax rates. (2) Variation in state corporate tax rates. (3) Changes
in federal income tax rates over time.

A valid instrumental variable for estimating labor supply elasticity must be something that shifts
labor demand but not labor supply. Similarly, a valid instrumental variable for estimating labor
demand elasticity must be something that shifts labor supply but not labor demand. For each of
the options above:

(1) State income taxes affect labor supply (because income taxes affect the wage), and
therefore variation in state income taxes would be a valid instrument for estimating the
elasticity of labor demand but not for estimating labor supply.

(2) State corporate taxes affect labor demand (because corporate taxes affect profits and the
value of marginal product of labor), and therefore variation in state corporate taxes would
be a valid instrument for estimating the elasticity of labor supply but not for estimating
labor demand.

(3) Changes in the federal income tax rate over time is not a valid instrument for estimating
either elasticity. The goal is to estimate either elasticity for the United States. Therefore,
one needs something that changes within the United States for different workers or firms.
One cannot use a nation-wide variable to do this. Moreover, using time as the variation is
dangerous as it requires assuming everything else is constant over time, which likely is
not the case.

3-7. Suppose a firm purchases labor in a competitive labor market and sells its product in a
competitive product market. The firm’s elasticity of demand for labor is 0.4. Suppose the
wage increases by 5 percent. What will happen to the amount of labor hired by the firm?
What will happen to the marginal productivity of the last worker hired by the firm?

Given the estimates of the elasticity of labor demand and the change in the wage, we have that

% E %E
  0.4 =>  0.4 => % E  2% .
% w 5%

4
©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw-Hill Education.
Thus, the firm hires 2 percent fewer workers when wages increase by 5%. Furthermore, because
fewer workers are hired, under normal conditions the marginal productivity of the last worker
hired will increase. (More formally, because the labor market is competitive, the marginal
worker is paid the value of his marginal product. As the product market is competitive, we also
know that the output price does not change so that the marginal productivity of the marginal
worker increases by 5 percent as well.)

3-8. A firm’s technology requires it to combine 5 person-hours of labor with 3 machine-

hours to produce 1 unit of output. The firm has 15 machines in place when the wage rate
rises from $10 per hour to $20 per hour. What is the firm’s short-run elasticity of labor
demand?

Unless the firm shuts down (i.e., goes out of business in the short run), it will combine 25 persons
with the 15 machines it has in place regardless of the wage rate. Therefore, employment will not
change in response to the movement of the wage rate, and the short-run elasticity of labor demand
is zero.

5
©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw-Hill Education.
3-9. In a particular industry, labor supply is ES = 10 + w and labor demand is ED = 40  4w,
where E is the level of employment and w is the hourly wage.

(a) What is the equilibrium wage and employment if the labor market is competitive? What
is the unemployment rate?

In equilibrium, the quantity of labor supplied equals the quantity of labor demanded, so that
ES = ED. This implies that 10 + w = 40 – 4w. The wage rate that equates supply and demand is $6.
When the wage is $6, 16 persons are employed. There is no unemployment because the number
of persons looking for work equals the number of persons employers are willing to hire at the
going wage rate of $6 per hour.

(b) Suppose the government sets a minimum hourly wage of $8. How many workers would
lose their jobs? How many additional workers would want a job at the minimum wage?
What is the unemployment rate?

If employers must pay an hourly wage of $8, employers would only want to hire ED = 40 – 4(8) =
8 workers, while ES = 10 + 8 = 18 persons would like to work. Thus, 8 workers lose their job
following the minimum wage as 16 workers used to be employed but now only 8 are; and 2
additional people enter the labor force following the minimum wage as 16 workers used to want a
job but now 18 do. Under the minimum wage, the unemployment rate would be 10/18, or 55.6
percent.

3-10. Suppose the hourly wage is $10 and the price of each unit of capital is $25. The price
of output is constant at $50 per unit. The production function is

f(E,K) = E½K ½,

so that the marginal product of labor is

MPE = (½)(K/E) ½ .

If the current capital stock is fixed at 1,600 units, how much labor should the firm employ
in the short run? How much profit will the firm earn?

The firm’s labor demand curve is its value of marginal product curve, VMPE, which equals the
marginal productivity of labor, MPE, times the marginal revenue of the firm’s product. But as
price is fixed at $50, MR = 50. Thus, we have:

1 1600 1,000

VMPE  MPE  MR      50  .
2 E E

Now, by setting VMPE = w and solving for E, we find that the optimal number of workers for the
firm to hire is 10,000 workers (i.e., 1000/sqrt(E) = 10 solves as E = 10,000). The firm then makes
(1,600)½(10,000)½ = 4,000 units of output and earns a profit of

π = 4,000($50) – 1,600($25) – 10,000 ($10) = $60,000.

6
©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw-Hill Education.
3-11. Several states set their own minimum hourly wage above the federal minimum wage.
To offset higher minimum wages, many of these states offer firms tax incentives that lower
the cost of borrowing and/or lower the firm’s tax liability on profits. In general, how do
these kinds of state policies (i.e., higher minimum wages and lower taxes) distort the firm’s
profit-maximization decisions? Why might we expect to see such policies attract firms in
“high tech” industries?

High minimum wages provide an incentive to hire fewer low-skilled workers than the firm would
otherwise choose to hire if it faced the lower federal minimum wage. Similarly, receiving tax
incentives that lower the cost of borrowing or the firm’s tax liability provides an incentive for
firms to invest more in non-labor inputs, such as capital and technology. As “high tech” firms
tend to hire very skilled workers (paid well in excess of the minimum wage) and employ a lot of
capital/technology while employing very little minimum wage labor, it is exactly these kinds of
firms that would find a state that offered these kinds of tax incentives appealing (and who don’t
really care about the higher minimum wage).

3-12. How does the amount of unemployment created by an increase in the minimum wage
depend on the elasticity of labor demand? Do you think an increase in the minimum wage
will have a greater unemployment effect in the fast food industry or in the lawn
care/landscaping industry?

The elasticity of demand (for low-skill workers) is the percent change in labor demanded over the
percent change in the wage. When this is low (in absolute value), labor demand is not very
responsive to increases in the (minimum) wage. In this case, there will be very small
unemployment effects from increasing the minimum wage. When the elasticity of demand is
large in absolute value, however, there will be substantial unemployment effects when the
minimum wage is increased.

It is probably likely that the unemployment effect from an increase in the minimum wage would
be more pronounced in the fast food industry than in the lawn care/landscaping industry. The fast
food industry has witnessed a large amount of automation (and even outsourcing), and could
experience more. Such possible reactions make labor demand more elastic. In contrast, the lawn
care/landscaping industry requires workers to cut lawns, install sprinklers, etc. Such reliance on
labor, therefore, may result in more inelastic demand for labor.

7
©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw-Hill Education.
3-13. Which one of Marshall’s rules suggests why labor demand should be relatively
inelastic for public school teachers and nurses? Explain.

Public school teachers and nurses both help produce a good that is price inelastic – in the United
States, at least, society will always purchase education and health care. Likewise, education and
healthcare do not face strong competition from substitute goods. Finally, the production
processes for education and healthcare both require teachers and nurses. And though these talents
can be substituted for to some degree by other forms of labor or capital, both are crucial to the
production process. Thus, other inputs (computers, doctors, etc.) cannot readily replace teaching
or nursing services, and therefore the supply elasticity of other factors of production is not very
elastic for teachers or nurses. For all three of these rules, therefore, the labor demand for public
school teachers and nurses is likely fairly inelastic.

As an aside, however, we can make a distinction between teachers and nurses. These two
occupations likely differ in Marshall’s fourth rule. Public school teacher salaries are estimated to
be between 50% and 80% of all expenditures on primary and secondary education. In contrast,
expenditures on nursing are a much lower percentage of the total cost of heath care. For this rule,
therefore, the demand for nurses is likely to be even more inelastic than is the demand for public
school teachers.

3-14. Many large cities have recently enacted living wage ordinances that require paying a
minimum wage that is higher than the state or federal minimum wage. Moreover,
sometimes living wage ordinances state two different minimum wages – one for workers
who also receive employer-paid health insurance and one for workers who do not receive
health insurance.

(a) Why would living wages distinguish between workers based on their health insurance?
In particular, what “problem” might the local government be trying to solve?

Living wage ordinances came about (largely in the 1990s) as advocates argued that people could
not live in the city on the federal minimum wage. Therefore, these advocate groups tried to
change the discussion from an hourly wage issue to discussing what it takes to actually live –
wages, housing, education, healthcare, etc. When making these arguments, it quickly becomes
clear that there is a huge difference between people with healthcare insurance and those without.
Therefore, in recognition of this difference, living wage advocates started proposing a policy of ,
say, $18 per hour if health insurance is not provided and $15 per hour if health insurance is
provided, in order to remain true to their goals. Put differently, without this provision it isn’t a
stretch to think that many firms would stop providing health insurance in order to save money
now that they are being asked to pay a much higher minimum wage.
,
(b) Sometimes living wage ordinances apply only to the city government, meaning that the
city is required to pay all city workers a high minimum wage while private firms are only
subject to state or federal minimum wages. In this case, the living wage creates a covered
sector and an uncovered sector. Which workers are in the covered sector? Which workers
are in the uncovered sector? What might city officials, who have to manage to a budget, do
in response to a living wage ordinance that only applies to city workers?

The covered sector are all city workers. The uncovered sector is everyone else working in the
city. City officials who are trying to make the budget work out may decide to lay-off any city
worker whose job can be replaced with contracted work. For example, a city may hire 1,000

8
©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw-Hill Education.
landscapers at $10 per hour to maintain all of the natural patches of grass, trees, and flowers
throughout the city. But should it be forced to pay a minimum wage of $18 per hour, the city
could (optimally) respond by firing those 1,000 workers and rather contract out landscaping
work. These 1,000 workers then flow to the uncovered sector where they are paid $10 per hour
(or even less if the flow of labor competes down the wage.) In response to this shift by the city,
some living wage ordinances apply to all city workers as well as to all firms that do business with
the city. This doesn’t completely prevent the labor migration issue discussed in this paragraph,
but it is thought to reduce the abuse somewhat.

As a side note, many colleges and universities have done exactly the same thing (though not due
to a formal living wage ordinance but rather due to accusations of paying staff way too little).
Thus, many campuses now contract out food preparation, janitorial services, and lawn care.

3-15. Consider a production model with two inputs–domestic labor (EDom) and foreign labor
(EFor). The market is originally in equilibrium in that

MPEdom MPEfor
 .
wdom w for

(a) Suppose a shock occurs that increases the marginal product of foreign labor. Assuming
no changes in domestic or foreign wages, explain what will happen to domestic and foreign
labor in order to restore the above condition.

We are told that the marginal productivity of foreign labor has increased. Therefore, before labor
adjustments, we will have a situation in which

MPEdom MPEfor
 .
wdom w for

As we are further told that wages don’t adjust, the only way to restore the original equation is to
have MPEdom increase and/or MPEfor to decrease. And these changes occur through labor
mobility. In particular, for MPEdom to increase, we need EDom to decrease; and similarly for MPEfor
to decrease we need EFor to increase. Therefore, to answer the question, following a positive
shock to the marginal product of foreign labor, firms will respond by employing fewer units of
domestic labor and more units of foreign labor.

(b) In the years following the shock, what are three (significantly different) policies that the
domestic country could employ if it wanted to reverse the outflow of labor?

In order to reverse the outflow of labor, there are generally two things that can be done:

 Reverse the change in relative wages, which requires the domestic wage to decrease
relative to the foreign wage.

 Reverse the previous change in relative marginal products, which requires domestic
marginal product to increase relative to foreign marginal product.

9
©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw-Hill Education.
The first, therefore, requires lowering wDom or increasing wFor. The second requires increasing
MPEdom or decreasing MPEfor. Of these four options, the only one the domestic country probably
would not pursue is decreasing MPEfor. To provide an example using the United States, the
government could:

 Decrease wdom by allowing the minimum wage to be eroded by inflation, by reducing

hiring rules and regulations, by allowing firms to cut medical benefits, by offering hiring
subsidies, etc.

 Increase wfor by lobbying the WTO and UN to have developing countries adopt minimum
wage laws, environmental standards, child labor laws, etc.

 Increase MPEdom by improving K – 12 and university education in the United States. (In
words, the standard economic argument here is that outsourcing would stop if American
workers became more productive.)

10
©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution
permitted without the prior written consent of McGraw-Hill Education.