Pub Aff 111 Problem Set 2

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PA 111 – Microeconomics: Market failures and inequality Professor R. Jisung Park Problem Set 2 1. True/False/Uncertain : Mobile banking apps (e.g. automated check deposit via smartphone) represent technological changes that have made capital a better substitute for some types of labor and a better complement to others over the long run. (3pts, 1 for answer, 2 for explanation) True; mobile banking apps are capital that can substitute some types of labor, such as bank tellers, but they complement the jobs of the people operating the bank, as well as jobs of people on the run, providing more efficient and accessible options for banking—the apps improve profits of those that own the bank and increases efficiency for all the customers. 2. Short Answer : If technological change reduces the per unit rental rate of capital (e.g. assembly line robots) in the manufacturing industry, we would expect a manufacturing firm to face steeper isocost curves in the long run (assume K is on the y-axis and that wages have not changed). Explain and illustrate graphically. (3pts) The manufacturing firm would face steeper isocost curves in the long run because the reduced cost of capital means the firm will adopt the use of more capital over labor. The steep slope represents the fact that the firm pays more in wages for labor relative to rent for capital. 3. Multiple Choice: Suppose labor and capital are imperfect substitutes in production, and that perfectly competitive firms are choosing how much labor and capital to employ for a given production target (for a given product). A decline in the relative price of capital will most likely lead in the long run to (choose one): (3pts) a. Firms choosing to employ more labor than before. b. Firms choosing to produce using a higher capital/labor ratio (K/L) than before. c. Firms paying a higher rental rate (r). d. A decline in the relative price of labor (w).

Applied problem: Labor Market Mobility Consider the market for labor. Here, note that individual workers are “suppliers” and firms “demand” labor services. Specifically, consider the market for non-college educated (non-BA) workers, as depicted below. Basics a) Why might the labor supply curve be upward sloping? (2pts) The labor supply curve in this scenario is upward sloping because as wages in this market increase, more individuals are willing to work in this labor market. b) Could the labor supply curve ever be downward sloping (i.e. “backward bending”)? If so, why? (4pts) The labor supply curve could be downward sloping in some scenarios when wages increase beyond a point at which people will decide to substitute paid work time for leisure, decreasing the amount of hours some people will work. This would lead to a part of the labor supply curve to be downward sloping, but not the entire curve. Automation c) Fast-food restaurants are an important source of employment for low-skill labor (they represent labor “demand” in this case). Suppose a new food processing technology allows fast-food restaurants to produce the same products with fewer workers. How might this affect the demand curve for non-BA labor? Explain the intuition and draw the new curve. (3pts) A new technology that allows fast-food restaurants to produce the same products with fewer workers will shift the demand curve for low-skill labor to the left. In other words, as it is cheaper to invest in capital and reduce the amount of labor in the market for fast-food restaurants, the demand for low-skill labor in the market decreases.

d) How might this affect the realized wage and level of employment for these workers? Explain the intuition and label the new equilibrium. (3pts) The shift of the demand curve to the left results in new equilibrium wage and amount of labor. The shift as a result of the new technology decreases the realized wage and decreases the level of employment in this market. Education policy e) Suppose many low-skilled workers are on the margin of deciding to work versus go to college. If a change in policy (e.g. Federal student loan expansion) leads to lower total costs of college education, how might this affect the supply curve for low-skill labor? Explain the intuition and draw the new curve. (3pts) Policy change that leads to lower total costs of college education would decrease the supply of low-skill labor, or shift the supply curve to the left. This is because more individuals will decide to go to college as a result of the policy rather than get a low-skill job. f) If nothing else about the market changes (from parts a and b), how might this affect the realized wage and level of employment? Explain the intuition and label the new equilibrium. (3pts)

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This would increase wages and decrease the amount of labor in the market with the shift of the supply curve to the left. This is because the jobs are more valued when there is lower supply, but the same amount of demand. g) Are there potential market failures in the market for college education? If so, what specific forms might they take? How does this affect your assessment of the desirability (or not) of such a policy? (3pts) There are potential market failures in the market for college education. There is a positive externality of getting a college education, meaning some benefits of getting an education will not be internalized, leading to a less than socially optimal amount of people getting a college education. The policy will result in more people being able to afford college, and therefore encouraging a more socially optimal amount of people to get an education. This increases the desirability of a policy that leads to lower total costs of college education. Import competition h) Suppose that, due to massive rural-urban migration within the Chinese labor force, the cost of manufacturing tradable goods in China declines. If nothing else about the market changes (from parts a and b), how might this affect supply and/or demand for low-skilled labor in the US? Explain and be sure to list your assumptions. (3pts) Decreased manufacturing costs in China will decrease the cost of importing more goods to the US which will increase the amount of goods imported. Assuming the imported goods are substitutes for some goods manufactured in the US, fewer goods will be manufactured in the US which will decrease the demand for low-skilled labor in the US. i) Show the effect on the non-BA US labor market graphically, specifically for trade exposed industries. (3pts)

The decrease in the demand for low skilled labor in the US as a result of decreased manufacturing costs in China will shift the demand curve to the left, decreasing the equilibrium wage and level of employment. j) Suppose that relocating from one industry to another involves substantial “labor market frictions”. How, in your view, does the presence or absence of such frictions affect the case for or against government intervention to support trade-displaced workers? (5pts) The presence of such frictions supports the case for government intervention to support trade-displaced workers. It is more economically efficient and increases GDP to have workers employed where they are needed. The government should intervene to reduce these frictions associated with increased imports from China. Applied Problem: Income Inequality The net-of-tax or retention rate of income is defined as: Income retention rate = (1-τ) In other words, the proportion of taxable income that remains after taxes. The elasticity of taxable income η (“eta”) is defined as follows: η = %Δ𝑧 %∆ 1−τ ( ) where z denotes reported income, and (%“delta”) denotes percentage changes. %∆ a) In your own words, what potential margins of adjustment might the elasticity of taxable income represent? Name at least 3 margins. (3pts) The elasticity of taxable income reflects adjustments made to decrease reported income for the purposes of paying smaller portions of income in taxes. This can be reducing hours to choose leisure over increasing income, not putting in as much effort to get a higher paying job, and tax evasion or not reporting all the income one actually makes. b) In 2 sentences or less, explain why might be an important parameter for policy? (Hint: For η instance, in estimating how much revenue might be raised by increasing top income tax rates. 3pts) This measure of elasticity might be important for policy because it reflects how much revenue will be made from an income tax in reality compared to how much a tax could make theoretically. In other words, higher taxes might increase tax revenue, or if the elasticity is high, then higher taxes might reduce how much people make and therefore reduce efficiency and tax revenue.

The President/Prime Minister of Unequaland is concerned about the rise in income inequality in his/her/their country. A proposal has been put forth to increase marginal taxes on the highest income earners. Unequaland, unequal as it is, nevertheless already has a progressive income tax system. c) In two sentences or less, explain what it means for a society to have a “progressive” tax system. (3pts) A progressive tax system means that the more money you make, the greater percentage of your income you have to pay in taxes. Currently, the top marginal tax rate in Uequaland is 30%. d) What is the net-of-tax rate for top earners in Unequaland? (2pts) 70% The new proposal would raise the top marginal tax rate to 80%. e) What would the net-of-tax rate be if the proposal were implemented? (2pts) 20% Your team has been tasked with estimating the potential revenue raised by this policy. Suppose that the policy would apply to everyone with incomes above $1,000,000 per year. All other tax rates would remain unchanged. Suppose there are approximately 1,000 millionaires in this country, with an average income of $2,000,000. f) Assuming, probably naively, that , how much additional revenue would you estimate from η = 0 this policy? Note that we are interested in the change in revenue, not total revenue. (5pts) previous revenue = 30% of $2B = $600M new revenue from policy = 80% of $2B = $1.6B change in revenue = $1.6B - $600M = $1B The President and his/her/their constituents are greatly excited by the prospect of using this revenue to fund sorely needed public investments, including infrastructure, education, and health care. Cognizant of the long-term costs of populism (despite short-term political gain), He/She/They are committed to delivering on campaign promises. As such, they insist on probing the robustness of the policy to alternative assumptions. You note that economists have attempted to estimate the potential responses to a change in top marginal taxes, including possible tax-evasion and reduced economic activity in Unequaland, and published many studies on potential values of Across a range of studies, you note that has been estimated to be η. η between and 0.4. η = 0. 2 g) Assuming that , how much revenue would you estimate will be raised by this policy? η = 0. 4 (Be sure to show your work. For simplicity, assume that no current millionaires are induced to earn less than $1m due to the policy: that is, assume for simplicity that everyone above $1m earns $2m before the proposed policy. 5pts)

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h) Is the expected revenue figure smaller or larger? By how much? Explain why these two estimates are so different. (3pts) The expected revenue figure is smaller than the previous estimate by $896 million. The estimates are so different because the latter factored in the tendency of people to change their behavior as a result of heavy income taxes. This includes (but is not limited to) working less and spending more time on leisure, reducing effort devoted to obtaining income, and evading taxes. Factoring in the elasticity in the second estimation took these tendencies into account. A member of your team notes that, in neighboring Ruleoflawland, a recent measure that increased funding for tax enforcement reduced tax evasion by 50%. Suppose that half of all changes in reported income due to increased taxes arise from tax evasion, and that implementing a similar tax enforcement policy in Unequaland would cost $10m. i) Would you recommend implementing such a policy? Be sure to support your answer with an estimate of the cost-effectiveness of the tax enforcement policy. Assume that represents η = 0. 4 the best-guess for Unequaland without any changes in tax enforcement. (5pts) I would recommend implementing the policy to reduce tax evasions because if half of all changes in reported income were due to tax evasion and the policy would reduce half of tax evasions, then likely a quarter of the original decrease would not decrease due to tax evasion. The revenue would be about 14% of the original $1.6 billion, which is $224 million. This significantly outweighs the $10 million that the tax enforcement policy would cost.

Pub Aff 111 Problem Set 2

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