Problem Set No.

Instructor: Costanza Naguib

Teaching Assistant: Clemente Pignatti

Instructions: Solutions to the problem set must be submitted on Moodle by 22 October 2020 at 16:15 at the latest,

before the virtual class will start. No late submissions will be accepted.

LONG QUESTIONS (GRADED)

1. (10 points) Use data from Eurostat to produce a table reporting the overall unemployment rate (i.e. age group

15 to 74) in the 27 countries of the European Union for the year 2019. Is the overall unemployment rate generally

higher or lower than the youth unemployment rate (i.e. the latter corresponding to the unemployment rate for

the age group 15 to 24)?

Solution: The Eurostat database can be easily accessed online. In order to find the unemployment rate,

from the main page the easiest path is to select Population and social conditions, then Labour market and

finally look within Employment and Unemployment (Labour force survey). Dowloading the data from 2019

for the 27 countries of the European Union will produce the desired table. In 2019, the youth unemployment

rate was higher than the overall unemployment rate in all the countries of the European Union.

2. Consider the following short-run production function:

3
Y = 30L − L2
2

(a) (2 points) Compute the marginal product of labour.

Solution: Simply take the derivative of the production function with respect to the only input (in the

short run), labour:

∂Y
M PL = = 30 − 3L
∂L

(b) (4 points) How much labour would be demanded in a perfectly competitive market where the consumption

price of the final good were 2 and the market wage were 30?
Labour Economics Problem Set N.1

Solution: Employers demand labour up to the point where the marginal revenues, computed as the

product of M PL and the price, equal the marginal cost, which in perfect competition is equal to the

wage:

MR = MC

P · M PL = w

2 · [30 − 3L] = 30

L = 5

3. Consider a firm using capital (K) and labour (L) according to a generic production function Y (K, L). Assume

all markets are perfectly competitive (i.e., the labour market, the capital market and the product market). Let

w be the prevailing wage rate and c the cost of renting capital. The firm sells its product at the market price P .

(a) (2 points) Write down the profit function for this firm.

Solution:

Π = P · Y (K, L) − wL − cK (1)

(b) (2 points) Derive the optimality conditions for the maximisation of profits when the firm can adjust both

labour and capital.

Solution: Take the derivatives of equation 1 with respect to labour and capital:

P · M PL − w = 0

P · M PK − c = 0

Combining these two conditions yields the following optimality condition:

w M PL
=
c M PK

Meaning that the ratio between the cost of labour and the cost of capital needs to equalize the ration

between the marginal products of the two inputs.

4. Consider a perfectly competitive labour market with the following labour demand (LD ) and labour supply (LS ):

LD = 200 − w
1
LS = 50 + w
2
Labour Economics Problem Set N.1

where w is the market wage. Assume the selling price of the firms’ output is equal to 1.

(a) (5 points) Compute the equilibrium wage and the equilibrium level of employment.

Solution: The equilibrium is reached when the demand equals the supply:

LD = LS
1
200 − w∗ = 50 + w∗
2
3 ∗
150 = w
2
w∗ = 100

Replace this into either the supply or the demand equation to equilibrium employment: L∗ = 100.

(b) (5 points) Assume now that the workers’ wages are subject to a lump sum tax of 50. Compute the new

equilibrium wage and employment. How much of the tax is effectively paid by the workers (i.e. comparing

the take-home income obtained here with the equilibrium wage obtained in the previous point)?

Solution: If the workers have to pay 50 in taxes their labour supply becomes:

1
LS = 50 + (w − 50)
2

The equilibrium is derived as usual by equating supply and demand:

1
200 − w∗ = 50 + (w∗ − 50)
2
3 ∗
175 = w
2
w∗ = 116.67

Eventually the tax is paid partially by the workers and partially by the employers. In particular, firms

will pay workers a wage of 116.67. Workers will pay 50 to the state and take home 116.67-50=66.67.

The amount of tax effectively paid by the workers is equal to 100-66.67=33.33. The remaining part of

the tax is paid by the employer via higher wages (i.e. 116.67-100=16.67). The higher wage, however,

leads to lower employment: L∗ = 83.33 (obtained by replacing the new equilibrium wage into either the

demand or the new supply equations).

(c) (5 points) Assume now that the same tax of 50 is levied on the employers instead of the workers. In other

words, employers are required to pay 50 to the state for each worker they hire. Compute the equilibrium

and discuss how it differs from the one obtained in the point above. How much of the tax is effectively paid

by the employer?
Labour Economics Problem Set N.1

Solution: Now the equation for labour supply is unchanged and it is the demand of labour that changes

as follows:

LD = 200 − (w + 50)

The equilibrium is derived as usual by equating supply and demand:

1
200 − (w∗ + 50) = 50 + w∗
2
3 ∗
100 = w
2
w∗ = 66.67

For each worker employers will pay 66.67 in wage directly to the worker and 50 to the State. Overall the

labour cost for the employers will be 66.67+50=116.67 and hence their labour demand will be equal to

83.33. Note that the equilibrium is exactly the same as in the case when the tax is levied on the workers,

the only difference is in the formal requirement to pay. In particular, employers wll still effectively pay

only 16.67 of the tax while the remaining part is paid by workers via lower wages (i.e. 100-66.67=33.33).

5. Consider an economic agent with the following utility function:

U = C 2/3 + L2/3 (2)

where C is consumption and L is leisure. Assume that the price of the consumption good is p = 3, the wage is

w = 6 and the total endowment of time is T = 24.

(a) (5 points) Write down the budget constraint of the agent assuming she does not have any non-labour income.

Represent this budget constraint graphically, indicate its slope and vertical intercept, and explain their

economic meaning.

Solution: The budget constraint is:

pC = w(T − L)

pC + wL = wT

And in the specific case of this exercise:

3C + 6L = 6 · 24

C = −2L + 48

−w
Graphically, the budget constraint is a downward sloping line on the space L-C with slope p = −2,

horizontal intercept equal to 24 (the maximum number of hours of leisure that can be consumed) and
Labour Economics Problem Set N.1

vertical intercept equal to T wp = 48 (maximum consumption if working 24 hours).

(b) (10 points) Compute the marginal rate of substitution between consumption and leisure and graphically

represent the map of indifference curves.

Solution: The marginal rate of substitution is:

M UL
M RSC,L = − (3)
M UC

Given the utility function in this problem:

∂U 2
M UL = = L−1/3
∂L 3
∂U 2
M UC = = C −1/3
∂C 3
L−1/3 C 1/3
M RSC,L = − −1/3 = − 1/3
C L

Graphically the indifference curves are as follows:

Labour Economics Problem Set N.1

This reminds us of the properties of indifference curves: (i) utility increases as we move out of the origin;

(ii) they are downward sloping; (iii) they are conves; (iv) never intersect.

(c) (10 points) Derive the demand of consumption goods, the demand of leisure and the labour supply of the

agent. Represent the optimal choice graphically.

Solution: The optimal consumption choice is at the tangency point between the budget constraint and

the map of indifference curves, where utility is maximised given the budget constraint:

w
M RSC,L =
p
C 1/3
= 2
L1/3

In the optimum then

C =8·L

and replacing this into the budget constraint yields

L = 4.8

C = 38.4

Hence, H = T − L = 24 − 4.8 = 19.2. Graphically:

Labour Economics Problem Set N.1

(d) (5 points) Assume now that the agent also has some non-labour income equal to v = 12 per day. Write

down the new budget constraint, represent it graphically and compare it to that of question a.

Solution: The budget constraint is now parallel to the previous one but shifted outwards:

pC = w(T − L) + v

pC + wL = wT + v

3C + 6L = 6 · 24 + 12

C = −2L + 52

(e) (10 points) Derive the new optimal choice of consumption and labour supply under the new budget constraint
Labour Economics Problem Set N.1

in question d and compare this with the previous one (question c).

Solution: The optimal choice is always at the tangency of the budget constraint and the map of indif-

ference curves and the slopes of the two curves has not changed. Hence, in the optimum we still have

that C = 8 · L. However, when we plug this into the budget constraint we get different optimal levels of

C and L:

L = 5.2

C = 41.6

Then optimal labour supply is then H = T − L = 24 − 5.2 = 18.8. Graphically:

So the individual now both works less and consumes more as a result of the introduction of non-labour

income.

(f) (5 points) Compute the minimum level of the daily non-labour income that would induce the agent to

withdraw from the labour force.

Solution: We have just seen that labour supply changes when non-labour income changes. Now we

need to compute the level of v such that H = 0 or L = 24. We know that in the optimum C = 8 · L so
Labour Economics Problem Set N.1

we can rewrite the budget constraint at the optimum, setting L to 24 and solving for v:

pC = w(T − L) + v

pC + wL = wT + v

3C + 6L = 6 · 24 + v
1
C −2L + 48 + v
=
3
1
10L = 48 + v
3
1
240 − 48 = v
3
v = 576

6. Consider a labour market characterised by the following labour demand and labour supply schedules:

LD = 160 − 2w

LS = −120 + 2w

(a) (5 points) Compute the equilibrium wage and employment under the assumption that the market is perfectly

competitive.

Solution: The equilibrium wage is the wage at which supply and demand are equal:

−120 + 2w∗ = 160 − 2w∗

w∗ = 70

Now replace this equilibrium wage into either the supply or the demand to find the equilibrium level of

employment. For example, replacing w∗ into labour demand yields:

L∗ = 160 − 2 · 70 = 20

The perfectly competitive equilibrium is represented graphically in the picture below:

Labour Economics Problem Set N.1

(b) (15 points) Suppose now that the demand side of the market is dominated by a single monopsonistic em-

ployer. Compute the equilibrium wage and employment level and represent it graphically (assume the price

of the consumer good is 1).

Solution: In a monopsonistic labour market the equilibrium is at the intersection of the marginal profit

and the marginal cost associated with the hiring of additional labour (i.e. MPL=MCL for p=1). The

marginal profit is equal to the marginal product of labour and we know that the labour demand function

describes precisely the relationship between the marginal product of labour and total employment:

L = 160 − 2 · M PL
1
M PL = 80 − L
2

The marginal cost of labour is the cost to the firm of employing the marginal unit of labour. To derive

this, first write the total cost function to the firm (abstracting from other inputs, that we assume to be

constant):

T C = w(L) · L

where the wage is expressed as a function of employment to indicate the fact that the monopsonist

cannot disregard the supply schedule. The monopsonist can lower the wage but must take into account

that by doing so there will be fewer persons willing to be employed (and symmetrically for wage rises).

Hence, the actual functional form of the relationship between the wage commanded by the monopsonist
Labour Economics Problem Set N.1

and the available labour is given by the supply function:

L = −120 + 2 · w(L)
1
w(L) = 60 + L
2

Then replace this into the total cost function to obtain a simple function of L and take the first derivative

to obtain the marginal cost:

 
1
TC = 60 + L · L
2
∂T C
M CL = = 60 + L
∂L

Now, we can compute the equilibrium level of employment by solving for M CL = M PL :

1
60 + L = 80 − L
2
40
L∗∗ = ≈ 13.33
3

Replacing this employment level into the supply function we find the wage required to mobilise this exact

amount of labour supply:

1 400
w∗∗ = 60 + L∗∗ = ≈ 66.67
2 6

The graphical representation of the monopsonistic equilibrium is in the picture below:

Labour Economics Problem Set N.1

MULTIPLE CHOICE QUESTIONS (NOT GRADED)

Exercice 1
The following are labour market indicators for Austria, Germany and Greece for the year 2018

Which are the correct values for the letters A to F?

(a) A=4.5, V=4.4%, C=41.9, D=4.4%, E=4.1, F=1

(b) A=4.5, B=4.4%, C=41.9, D=3.4%, E=4.1, F=1

(c) A=4.5, B=6.4%, C=41.9, D=3.4%, E=3.6, F=1.5

(d) A=4.1, B=4.4%, C=44.9, D=3.4%, E=3.6, F=1.5

(e) A=4.1, B=5%, C=44.9, D=4.4%, E=4.1, F=1.5

→ Answer (b)

Exercice 2

Which of the following definitions best describes a panel database?

(a) An individual is observed repeatedly over time

(b) The same group of individuals is observed repeatedly over time

(c) A group of individuals is observed once

(d) Different groups of individuals are observed at different points in time

(e) None of the above

→ Answer (b)
Labour Economics Problem Set N.1

Exercice 3

Consider a firm with the following production function

1
Y = 2L 2

with the price of the final good being equal to 2 and the wage equal to 1/2. What is the profit maximizing level of

labor demand?

(a) 12

(b) 4

(c) 16

(d) 8

(e) 20

→ Answer (c)

Exercice 4

How would your answer to question (3) change if the wage level increases to 3?

(a) 4/9

(b) 8

(c) 12

(d) 2

(e) 1/3

→ Answer (a)
Labour Economics Problem Set N.1

Exercice 5

In a perfectly competitive economy, LD =160-10w and LS =-40+10w. What are the equilibrium levels of employment

and wage?

(a) W=40, L=60

(b) W=10, L=40

(c) W=60, L=10

(d) W=10, L=60

(e) W=0, L=60

→ Answer (d)

Exercice 6

How would your answers to the previous question change if a lump sum tax of 10 is now levied on the worker?

(a) W=15, L=10

(b) W=15, L=15

(c) W=10, L=15

(d) W=10, L=10

(e) W=20, L=20

→ Answer (a)

Exercice 7

Consider now that the labour demand is completely inelastic, with LD=160. Compute the wage levels that would

arise in equilibrium under the settings of questions (5) and (6)

(a) Without tax: W=20. With tax=W=20

(b) Without tax: W=30. With tax=W=30

(c) Without tax: W=20. With tax=W=20

(d) Without tax: W=30. With tax=W=20

(e) Without tax: W=20. With tax=W=30

Labour Economics Problem Set N.1

→ Answer (e)

Exercice 8

Consider an economic agent with utility function

U = C 1/2 L1/2 (4)

facing a price of goods p=2 a wage w=10 and with time endowment T=20. What is her optimal choice of consumption

(C), leisure (L) and labour supply (H)?

(a) L=10, C=40, H=10

(b) L=15, C=75, H=5

(c) L=10, C=50, H=10

(d) L=10, C=50, H=14

(e) L=5, C=25, H=15

→ Answer (c)

Exercice 9

How would your answers to the previous question change if she now has some non-labour income equal to 100?

(a) L=10, C=50, H=10

(b) L=15, C=75, H=5

(c) L=15, C=60, H=5

(d) L=15, C=75, H=9

(e) L=10, C=75, C=5

→ Answer (b)
Labour Economics Problem Set N.1

Exercice 10

Most of a payroll tax is eventually paid by

(a) Employers if the supply of labor curve is very inelastic

(b) Employers if the labor demand curve is very elastic

(c) Workers if the supply of labor curve is very inelastic

(d) Workers if the supply of labor curve is very elastic

(e) The burden of payroll taxes is always equally divided between the employers and the workers

→ Answer (c)