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Examiners’ commentaries 2015

Examiners’ commentaries 2015


EC3015 Economics of labour

Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 2014–15. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading


references
Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2011). You should always attempt to use the most
recent edition of any Essential reading textbook, even if the commentary
and/or online reading list and/or subject guide refers to an earlier
edition. If different editions of Essential reading are listed, please check
the VLE for reading supplements – if none are available, please use the
contents list and index of the new edition to find the relevant section.

General remarks

Learning outcomes
At the end of this course, and having completed the Essential reading and
activities, you should be able to:
• explain, on the supply side, the factors that affect the decision of an
individual:
to work
to choose a particular job or a career path
to acquire education and on-the-job training to provide effort in a
particular job.
• Explain also how governments’ policies could affect the decisions of the
individual.
• Explain, on the demand side, the factors that affect the decision of a
firm:
to hire and fire workers
to offer jobs with different characteristics (amenities and training
for example)
to discriminate among different workers
to choose particular compensation policies and to offer different
career paths.
• Explain also how government policies and institutions (such as the
unions) can affect the decisions of the firm.

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EC3015 Economics of labour

Introduction
EC3015 Economics of labour is intended to give you a wide-ranging
introduction to contemporary labour market issues, the theoretical
techniques and skills needed to analyse these issues, and the ability to
interpret data as they might appear in journal articles or as part of a
statistical investigation of labour market events. To this end, the course
requires you to build up a good working knowledge of labour market
theory as well as the ability to explain theory using a combination of
graphical and mathematical analysis to be able to display sound reasoning
using essay-based analysis. The examination reflects all these aspects of
the course.

Format of the examination


Section A is intended to test your ability to apply simple mathematical,
statistical and diagrammatic analysis used by economists to analyse labour
market issues. Candidates should provide a brief explanation rather than
just a number or an unaccompanied diagram.
Section B requires you to provide two essay-based answers from a choice
of four questions. You should be able to write around three to four pages
of text in response to your chosen questions. It is important that what is
written applies directly to the question. Memorising whole sections of the
textbook and writing these verbatim in the examination does not gain
additional marks. A good answer should also be accompanied by relevant
diagrammatic and mathematical exposition. References to relevant
journal articles would increase the marks awarded as would relevant
descriptive statistics that you can supply (for example, the OECD average
unemployment rate is currently 8 per cent).
Since the individual questions in Section A and B carry unequal marks, but
the two sections are each worth 50 per cent of the total, you should take
care to allocate your time accordingly for each question.
The examination scripts in the 2015 cohort demonstrated a good standard
overall. Two-fifths of candidates scored either a first or a 2:1. Above all,
the examiner is searching for evidence of understanding of issues,
methods and approaches. Since the examination is intended to test
understanding, candidates should expect to see some questions that differ
somewhat in format from questions that have been used in previous
examinations and you should therefore seek to become confident with the
material in the subject guide and the main textbooks so that you can apply
this competently even when the format of the question is unfamiliar.

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Examiners’ commentaries 2015

Examination revision strategy


Many candidates are disappointed to find that their examination
performance is poorer than they expected. This may be due to a
number of reasons.  The Examiners’ commentaries suggest ways of
addressing common problems and improving your performance. One
particular failing is ‘question spotting’, that is, confining your
examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious
consequences.
We recognise that candidates may not cover all topics in the syllabus in
the same depth, but you need to be aware that examiners are free to
set questions on any aspect of the syllabus. This means that you need
to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the Course information sheet in the
section of the VLE dedicated to each course. You should read the
syllabus carefully and ensure that you cover sufficient material in
preparation for the examination.  Examiners will vary the topics and
questions from year to year and may well set questions that have not
appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus.  So, although past papers can be
helpful during your revision, you cannot assume that topics or specific
questions that have come up in past examinations will occur again.
If you rely on a question-spotting strategy, it is likely
you will find yourself in difficulties when you sit the
examination. We strongly advise you not to adopt this
strategy.

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EC3015 Economics of labour

Examiners’ commentaries 2015


EC3015 Economics of labour – Zone A

Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 2014–15. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading


references
Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2011). You should always attempt to use the most
recent edition of any Essential reading textbook, even if the commentary
and/or online reading list and/or subject guide refers to an earlier
edition. If different editions of Essential reading are listed, please check
the VLE for reading supplements – if none are available, please use the
contents list and index of the new edition to find the relevant section.

Comments on specific questions


Candidates should answer SEVEN of the following NINE questions: all
FIVE of Section A (50 marks in total) and any TWO from Section B (25
marks each). Candidates are strongly advised to divide their
time accordingly.

Section A
Answer all five questions from this section.

Question 1
The Fluffy Yellow Corporation produces tennis balls at its factory. Its labour,
capital and product markets are all competitive. Wages are £12 per hour and
tennis ball producing equipment rents for £4 per hour. The production function is
q = 40K0.25L0.75, where q = boxes of tennis balls per week, K = hours of tennis ball
producing equipment used, and L = hours of labour.
a. Determine the cost minimising capital-labour ratio at this firm.
b. How would this change if the rental rate of capital increased to £6 per hour?
c. What can you say about the firm’s overall long-run demand for labour when
capital becomes more expensive?
Reading for this question
Subject guide, Chapter 3.
Borjas, G.J. Labor economics. (Boston, MA; London: Irwin/McGraw-Hill, 2009)
fifth edition [ISBN 9780070172708] Chapter 3.
Ehrenberg, R.G. and R.S. Smith Modern labor economics: theory and public
policy. (Reading, MA: Pearson Education, 2008) tenth edition [ISBN
97803211538963] Chapters 3, 4 and 5.

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Examiners’ commentaries 2015

Approaching the question


This question requires an understanding of the way that the optimal
capital-labour ratio is calculated, thus the formula W/MPL = R/MPK is
key. You must first be able to differentiate the production function to find
MPL and MPK. and then correctly substitute in the values for wage and the
rental rate of capital to find the optimal capital-labour ratio for that firm.
Part (c) requires an understanding of the scale and substitution effects that
comprise total change in the long-run demand for an input.
a. The production function is q = 40K0.25L0.75, where q = boxes of tennis
balls per week, K = hours of tennis ball equipment used, and L = hours
of labour, marginal factor products are given by MPL = 30K0.25L–0.25 and
MPK = 10K –0.75L0.75
To minimise cost, the firm chooses K and L so that W/MPL = R/MPK,
where R is the rental cost of capital. Rearrange this to W/R = MPL/MPK
and substitute in the information from the problem:
12/4 = 30K0.25L–0.25/10K –0.75L0.75
3 = 3K/L
K=L
This is a capital-labour ratio of one labour hour for each hour of
equipment used.
b. If the rental rate of capital increased to £6 per hour,
12/6 = 30K0.25L–0.25/10K –0.75L0.75
2 = 3K/L
K = (2/3)*L
Since capital has become more expensive, the capital-labour ratio will
decrease – the firm will now use less capital relative to the number of
workers (two hours of equipment use for every three labour hours).
c. The firm’s demand for labour will increase relative to its demand for
capital, as the firm substitutes between inputs to achieve the most
efficient production method. However, it is unclear whether the
demand for labour will increase overall, since the increased rental
rate of capital represents an increased marginal cost to the company,
which would lead them to decrease their overall production, requiring
less capital and also fewer workers. These effects are known as the
substitution and scale effects, and it is not clear a priori which will
dominate.

Question 2
Teenagers under age 18 in Century City are prohibited from working more than
8 hours a day, except if they work as babysitters or work with their parents in
a family-business. This is called the ‘underage workers hours restriction law’.
Consider a 16-year-old whose primary household work in the summer is to learn
a foreign language and practice a musical instrument, but who also has two
options for paid work. She can work for $5 per hour with a cleaning service
(limited to 8 hours per day), or work for $4 per hour as a babysitter (with no
limitations on hours worked).
a. On a single graph, draw the daily budget constraints for each of her paid-
work options, assuming she can work either for the cleaning service or as a
babysitter but not both; and also that she needs 8 hours per day for sleep
and personal care.

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EC3015 Economics of labour

b. Next, analyze the possible labour supply decisions this 16-year old can make
depending on her preferences. In particular, you should refer to the effects of
the ‘underage workers hours restrictions’ law on her overall utility and her
hours of household work.
Reading for this question
Subject guide, Chapter 2.
Borjas, Chapter 2.
Ehrenberg and Smith, Chapters 6 and 7.
Approaching the question
In part (a), it is important to calculate the correct intercepts on the
y-axis ($40 and $64) as well as on the x-axis (16 hours). Furthermore,
the position involving cleaning work should have a kink in the budget
constraint at 8 hours. In part (b), you could illustrate the 16-year-old’s
preferences using indifference curves of varying steepness and find the
points of tangency of these curves with the budget constraints. Although
the question does not ask you to draw these curves, you may find it helpful
to do so to assist you to develop your answer to the question. It may also
help to extend the budget constraint from the cleaning job to show what
would have been possible without the state law. You need to discuss the
implications of her various options on her overall utility and hours of paid
work/household work, with reference to the effects of the state law.
a.

Since the teenager requires eight hours per day for sleep and personal
care, the maximum amount of time available to her for paid or
household work is 16 hours. If she works for 16 hours as a babysitter
she can earn $64. If she works the maximum possible as a cleaner
(eight hours) she can earn $40. The budget constraint facing this
teenager is shown above, with line ABC representing the constraint
associated with her job as a cleaner and AD the constraint as a
babysitter. You should make note of the intercepts on both axes. It is
also important that the line ABC shows a clear kink and the hours of
work at which this occurs is clearly marked.
b. The value of her income, on the one hand, and her language learning
and practising, on the other, would be shown by indifference curves,
with more steeply sloped curves indicating a greater value being placed
on household work rather than paid employment (i.e. with steeper
indifference curves she requires a higher wage to sacrifice home time
than if her indifference curves were flatter). If she places a high value
on her household activities, she will either not work (corner solution
at point A) or choose to work as a cleaner along constraint AB. In
this case the state law has no effect. With a flatter indifference curve,
however, she may maximise utility at point B (cleaning job) or along

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Examiners’ commentaries 2015

ED (babysitting). If she ends up at point B, unless this is the point of


tangency to her highest indifference curve, the state law reduces her
earnings and her utility, but would mean she spends more time at home
than she would if unconstrained. Along ED, the state law also reduces
her earnings and her utility but the effects on her hours at home are
unclear, since the income and substitution effects of the law work in
opposite directions.

Question 3
Bernice’s utility function is U = √Y, where Y = annual income. She has to decide
between two job offers. The first is in an industry where there are no layoffs
and the annual pay is £40,000. In the other industry, there is uncertainty about
layoffs. One quarter of the years are bad years and layoffs would push Bernice’s
annual pay down to £22,500. The other years are good years.
a. How much would Bernice need to earn in the good years in this job to
compensate her for the high risk of layoffs? How much extra pay does
Bernice require (on average) to compensate her for the layoff risk?
b. If the second job paid £45,000 in the good years, which job would Bernice
prefer?
c. Suppose Bernice has a friend called Philip whose utility function is U = Y2.
Which job will Philip prefer under the same conditions as part (b), i.e. if the
first job always pays £40,000 and the second pays £22,500 one quarter of
the years and £45,000 in the other years? What can you say about Philip’s
attitude to risk?
Reading for this question
Subject guide, Chapter 5.
Borjas, Chapter 5.
Ehrenberg and Smith, Chapter 8.
Approaching the question
In part (a), the correct answer can be found using: √40,000 = ¼ √22,500
+ ¾ √X. If the fractions are included together with the wage inside the
square root sign, the answer will be incorrect. This applies in the same
way for part (c) and is particularly important in part (c), because it leads
to a false conclusion about which job Phillip would prefer. Including the
fractions together with the wage and squaring both leads to a conclusion
that Philip will prefer the safe job. However, this is incorrect. A common
mistake arose because candidates didn’t pay attention to consistency –
some candidates recognised that Phillip is risk-loving based on his utility
function, but their calculations falsely showed you that he prefers the
safe job. If you arrive at an answer that doesn’t make sense, check your
calculations because they might be incorrect! The answer will also be
incorrect if candidates only pay attention to the wage and does not use
the utility functions. Remember you need to compare the utility from each
job, so it is important to use the utility functions. You need to calculate
expected utility, not the utility of expected value.
a. E(UA) = E(UB)
√40,000 = 0.25√22,500 + 0.75√X
X=£46,944.44
Bernice would require £46,944.44 in the good years
Expected earnings from job B:
0.25 * 22,500 + 0.75 * 46,944.44 = £40,833.33
Compensating extra pay = £833.33
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EC3015 Economics of labour

b. In this case, the first job gives expected utility of √40,000 = 200. The
second job gives expected utility of 0.25* √22,500 + 0.75 * √45,000
= 196.599. Since the first job gives Bernice higher expected utility, she
would prefer the first job.
c. Philip would prefer the second job, where his expected utility E(U2) is
equal to ¼ * (22,500)2 + ¾ * (45,000)2 = 1,645,312,500 compared to
E(U1) = (40,000)2 = 1,600,000,000 from the first job. He is risk-loving,
since the expected payoff from the second job is lower, but his expected
utility is higher.

Question 4
Suppose that at the beginning of the month, the number employed, E, equals
180 million; the number not in the labour force, N, equals 50 million; and the
number unemployed, U, equals 20 million. During the course of the month, the
flows indicated below occurred:
4.0 million – moved from employment into unemployment (EU)
1.5 million – moved from employment to not being in the labour force (EN)
2.2 million – moved from unemployment into employment (UE)
2.7 million – unemployed people dropped out of the labour force (UN)
0.3 million – moved from not being in the labour force directly into employment
(NE)
1.8 million – moved from not being in the labour force into unemployment (NU)
a. Assuming that the population has not grown, calculate the unemployment
and labour force participation rates at the beginning and end of the month.
b. Excluding movements into and out of the labour force, calculate the rate of
job loss (j), and the rate of hiring (h).
c. For each of these 6 figures, give a brief explanation to demonstrate your
understanding of this flow, relating the magnitude of the number either to a
stage in the business cycle, or else to some personal motivation of the people
making this transition.
Reading for this question
Subject guide, Chapters 2 and 10.
Borjas, Chapters 2 and 12.
Ehrenberg and Smith, Chapter 14.
Approaching the question
Part (a) requires you to calculate unemployment and labour force
participation rates from the basic formulas given in Chapter 2 of the
subject guide (or Chapter 2 of Borjas). Part (b) requires you to calculate
the rates of job loss and hiring from the definitions and formulas in
Chapter 10 of the subject guide (or Chapter 12 of Borjas). Part (c) requires
you to demonstrate deeper understanding of flows between employment,
unemployment and inactivity by interpreting the six flows given in the
question.
a. The millions terms are dropped for ease of calculation.
Initial unemployment rate = 100 * U/(U+E)
= 100 * 20/(180 + 20)
= 10 per cent

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Examiners’ commentaries 2015

Initial labour force participation rate = 100 * (U + E)/(U + E + N)


= 100 * (180 + 20)/ (180 + 20 + 50)
= 80 per cent
New number unemployed = 20 + 4.0 –2.2 – 2.7 + 1.8
= 20.9
New number employed = 180 – 4 – 1.5 + 2.2 + 0.3
= 177
New number not in the labour force = 50 + 1.5 + 2.7 – 0.3 – 1.8
= 52.1
New unemployment rate = 100 * 20.9/(20.9 + 177)
= 100 * (20.9/197.9)
= 10.6 per cent
New labour force participation rate = 100 * (20.9 + 177)/
(20.9 + 177 + 52.1)
= 100 * (197.9/250)
= 79.2 per cent
b. Rate of job loss = (EU)/(E) [people losing employment
/number employed initially]
= (4.0)/(180)
= 2.2 per cent
Rate of hiring = (UE)/(U) [people gaining
employment/number unemployed
initially]
= (2.2)/(20)
= 11.0 per cent
c. This question is asking you to demonstrate understanding of the six figures
given in the question. You should demonstrate a general understanding of
each flow and also interpret the magnitude of the number given. This is an
important skill that economists need in the real world.
EU – this is the largest number; it indicates there is a downturn in economic
activity, with many people losing their jobs.
EN – this may also be related to the downturn in economic activity. Many of
these people may be older workers who feel they have little hope of finding
employment again once the economy recovers and chose to move into
retirement. It could also be that many have lost their jobs due to structural
changes in the economy and have decided to move into full-time education
and retrain.
UE – a substantial number of unemployed workers also found employment.
Even in a downturn, there are firms and sectors which continue to grow and
hire new workers. Also, in an economic downturn, many firms will lay-off
full-time workers and hire consultants or contract workers.
UN – this is called the discouraged worker effect. These may be people who
have been unemployed for quite some time and have given up hope of finding
work. This is quite a large number so it may indicate the economy is in a
recession and has been there for some time.
NE – this figure is the lowest number. Since people who are actively seeking
work are classified as unemployed, this group consists of people who found
work although they were not officially actively looking. This group is most
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EC3015 Economics of labour

likely to consist of students who just finished secondary school or


university and immediately found a job without spending any time in
unemployment.
NU – this is larger than those moving from unemployment into
employment. When people join the labour force they would generally
start with a period of unemployment while they seek work. This flow
could have been motivated by an increase in unemployment benefit,
for example.

Question 5
Suppose that the demand for shop assistants in retail stores in a small city is LD
= 1200 – 40W, where L = the number of shop assistants and W = the wage in
pounds per hour. The equilibrium wage is £8 per hour, but the government puts
in place a minimum wage of £10 per hour.
a. What will happen to employment in these retail stores? Draw a graph
showing labour demand and the original and new levels of employment.
b. Suppose that in the city described above, there is an uncovered sector where
LS = –400 + 160W and LD = 1200 – 40W, before the minimum wage is put
in place. Suppose further that all the workers who lose their jobs as shop
assistants when the minimum wage is introduced seek work in the uncovered
sector. What will happen to wages and employment in that sector? Draw a
graph showing the effects on both wages and employment in the uncovered
sector.
c. Can you think of any reasons why the assumption in part (b) that all the
workers who lose their jobs as shop assistants when the minimum wage
is introduced seek work in the uncovered sector may be unrealistic? If it is
unrealistic, what might be the consequences?
Reading for this question
Subject guide, Chapter 4.
Borjas, Chapter 4.
Ehrenberg and Smith, Chapters 3, 4 and 5.
Approaching the question
A common mistake in part (b) was to simply add the 80 workers who
lost their jobs in the covered sector to the 880 initially employed in the
uncovered sector. This is incorrect. Instead, the labour supply curve shifts
horizontally by 80. You need to use the new labour supply curve and the
unchanged labour demand curve to calculate the new equilibrium wage
and employment level in the uncovered sector. The diagram should clearly
show a rightward shift in the labour supply curve as well as the initial and
new equilibrium wages and the initial and new employment levels.

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Examiners’ commentaries 2015

a.
The higher wage will cause a movement along the demand curve, and
the level of employment will decrease from 880 (= 1200 – 40 * 8) to
800 (= 1200 – 40 * 10) workers.

b.

The initial equilibrium wage in the uncovered sector is $8 per hour


with employment at 880. The labour supply curve shifts by 80 (the
people who lost their jobs when the minimum wage was introduced)
such that the labour supply curve is now LS = –320 + 160W. The new
equilibrium wage is £7.60 per hour and employment is 896 workers.
c. Some of the displaced workers may ‘queue’ in the covered sector to get
minimum wage jobs. Some workers may also move from the uncovered
sector to queue for these jobs. So there could be unemployment as
a consequence of the minimum wage even though there is market
clearing in the uncovered sector.

Section B
Answer two questions from this section.
Question 6
Theoretical models relating to the labour market predict outcomes which are
supported by empirical evidence to varying degrees. Describe the theoretical
model of the effects of immigration on the labour market, and then evaluate
how well the predicted effects are supported by empirical evidence.
Reading for this question
Borjas, Chapter 4.
Ehrenberg and Smith, Chapter 10.

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EC3015 Economics of labour

Approaching the question


This question is asking about the effects of immigration on the labour
market rather than about the personal decision whether or not to migrate.
You could use a supply and demand framework with immigrant workers
as either substitutes or complements to native born workers. For example,
when immigrants and natives are perfect substitutes, in the short-run,
immigration will increase the supply of labour, resulting in lower wages
and a higher overall employment level, with a lower employment level
for native born workers. In the long-run, the capital stock will increase as
firms take advantage of the cheaper workforce, leading to an increase in
the demand for labour – where the aggregate production function displays
constant returns to scale, in the long-run, wages will return to their initial
levels. If the two groups are complements, immigration increases the
marginal product of native workers, increasing demand for their labour
and leading to an increase in their wages and employment. You could also
discuss the economic benefits of immigration and the immigration surplus.
An important part of this question is to discuss how well the theoretical
predictions are supported by empirical evidence. For example, you could
use the example of the Mariel boatlift discussed in Borjas, Chapter 4. Extra
marks are awarded for reasons why the empirical evidence doesn’t always
match up with theory (also discussed in Borjas, Chapter 4).

Question 7
Why do people invest in education? Present two alternative models and for each
model, discuss the decisions made by individuals and the implications for policy
makers.
Reading for this question
Subject guide, Chapter 6.
Borjas, Chapter 6.
Ehrenberg and Smith, Chapter 9.
Approaching the question
A good answer will provide detail on both the human capital/schooling
model and the signalling model. For each model, you should give an
explanation of the decisions made by individuals, using diagrams or
equations where appropriate. For the human capital model, you could
use present value calculations, the stopping rule and discuss the impact
of different discount rates and ability levels. For the signalling model, you
should set up a model in terms of the proportion of workers who have
low and high productivity, and show how firms determine the minimum
amount of education they will require as a signal of high productivity
and how this affects the education decisions of low and high productivity
workers. It is far better to write a reasonable amount about both models
than to write every possible detail about one and almost nothing about
the other. In terms of implications for policy makers, there is a reason to
subsidise education under the human capital model, because it increases
productivity; however, there is little reason for the government to do this
under signalling because under this model, education doesn’t increase
productivity – it just signals it (although governments may place some
value on improved matching through signalling, this is likely to be
minimal compared to the value placed on increased productivity). To make
this point, you could explain the difference between private and social
rates of return to schooling.

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Examiners’ commentaries 2015

Question 8
Union membership in the UK fell from around fifty percent of the workforce in
1980 to around thirty percent of the workforce in 2003. Discuss the potential
advantages for workers of belonging to a union as well as some possible
reasons for the decline of unionisation in the UK.
Reading for this question
Subject guide, Chapter 9.
Borjas, Chapter 10.
Ehrenberg and Smith, Chapter 13.
Approaching the question
Potential advantages for workers include: higher wages, more secure
employment and non-wage benefits such as better working conditions. On
the other hand, if unions trade off higher wages for lower employment
some workers may lose their jobs, although if unions can take firms
beyond their labour demand curve (under what circumstances could
this happen?) there may not be a trade-off. In terms of theory/models,
you could use the workers’ budget constraint and indifference curves to
illustrate the decision to join a union, and/or the efficient contract curve
for negotiations between the union and the firm. Possible reasons for
the decline in unionisation include: changing structural factors such as
a decline in manufacturing and the increased participation of women,
increased foreign competition, deregulation, weakened government
support for collective bargaining (and other policies regulating the power
of unions) and anti-union resistance by management.

Question 9
Various theories have been suggested to explain the increase in income
inequality which has been observed in several developed economies over recent
decades. Use theory, supported by historical/empirical evidence, to discuss this
increase.
Reading for this question
Subject guide, Chapter 7.
Borjas, Chapter 7.
Ehrenberg and Smith, Chapter 15.
Approaching the question
Possible reasons for the increase in income inequality include changes
in relative demand and supply of skills, skill-biased technological
change, globalisation and changes in institutions such as the decline in
unionisation and the erosion in the real value of minimum wages. You
should use a demand-and-supply framework to demonstrate these effects.
It is important to support your arguments with historical/empirical
evidence, relating each point to real-world facts (as per the discussion in
the core texts). Citing statistics that demonstrate the increase in income
inequality also gains extra marks.

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EC3015 Economics of labour

Examiners’ commentaries 2015


EC3015 Economics of labour – Zone B

Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 2014–15. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading


references
Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2011). You should always attempt to use the most
recent edition of any Essential reading textbook, even if the commentary
and/or online reading list and/or subject guide refers to an earlier
edition. If different editions of Essential reading are listed, please check
the VLE for reading supplements – if none are available, please use the
contents list and index of the new edition to find the relevant section.

Comments on specific questions


Candidates should answer SEVEN of the following NINE questions: all
FIVE of Section A (50 marks in total) and any TWO from Section B (25
marks each). Candidates are strongly advised to divide their
time accordingly.

Section A
Answer all five questions from this section.

Question 1
Suppose that the demand for shop assistants in retail stores in a small city is
LD = 1200 – 40W, where L = the number of shop assistants and W = the wage in
pounds per hour. The equilibrium wage is £8 per hour, but the government puts
in place a minimum wage of £10 per hour.
a. What will happen to employment in these retail stores? Draw a graph
showing labour demand and the original and new levels of employment.
b. Suppose that in the city described above, there is an uncovered sector where
LS = –400 + 160W and LD = 1200 – 40W, before the minimum wage is put
in place. Suppose further that all the workers who lose their jobs as shop
assistants when the minimum wage is introduced seek work in the uncovered
sector. What will happen to wages and employment in that sector? Draw a
graph showing the effects on both wages and employment in the uncovered
sector.
c. In part (b) there is an assumption that all the workers who lose their jobs
as shop assistants when the minimum wage is introduced seek work in the
uncovered sector. Can you think of any reasons why this assumption may be
unrealistic? If it is unrealistic, what might be the consequences?

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Examiners’ commentaries 2015

Reading for this question


Subject guide, Chapter 4.
Borjas, Chapter 4.
Ehrenberg and Smith, Chapters 3, 4 and 5.
Approaching the question
A common mistake in part (b) was to simply add the 80 workers who
lost their jobs in the covered sector to the 880 initially employed in the
uncovered sector. This is incorrect. Instead, the labour supply curve shifts
horizontally by 80. You need to use the new labour supply curve and the
unchanged labour demand curve to calculate the new equilibrium wage
and employment level in the uncovered sector. The diagram should clearly
show a rightward shift in the labour supply curve as well as the initial and
new equilibrium wages and the initial and new employment levels.
a.

The higher wage will cause a movement along the demand curve, and
the level of employment will decrease from 880 (=1200 – 40 * 8) to 800
(=1200 – 40 * 10) workers.
b.

The initial equilibrium wage in the uncovered sector is $8 per hour


with employment at 880. The labour supply curve shifts by 80 (the
people who lost their jobs when the minimum wage was introduced)
such that the labour supply curve is now LS = –320 + 160W. The new
equilibrium wage is $7.60 per hour and employment is 896 workers.
c. Some of the displaced workers may ‘queue’ in the covered sector to get
minimum wage jobs. Some workers may also move from the uncovered
sector to queue for these jobs. So there could be unemployment as
a consequence of the minimum wage even though there is market
clearing in the uncovered sector.
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EC3015 Economics of labour

Question 2
A researcher studying the wages of tree-branch cutters who work in tall trees
investigates the relationship between the distance they work above the ground,
the wage they receive as compensation for their effort and the dangers they
face. Chances of injury are greater for workers who work higher above the
ground. The researcher discovers the following relationship: Wi = 10 + 2Di where
W = the wage in pounds per hour and D = the distance above ground at which
workers work, in feet. Based on this information:
a. Draw the market wage curve with distance above ground on the horizontal
axis.
b. Draw possible indifference curves for two tree-branch cutters, Paul and
Anthony: Paul works at a height of 15 feet (around 5 meters) and Anthony
works at a height of 25 feet (around 8 meters). Explain why you have drawn
the indifference curves as they are.
c. At their current wages and distances above the ground, what is the trade-off
(keeping utility constant) that each worker is willing to make between hourly
wages and a one foot change in distance?
d. Which worker has a greater willingness to pay for reduced distance at 15
feet above the ground?
Reading for this question
Subject guide, Chapter 5.
Borjas, Chapter 5.
Ehrenberg and Smith, Chapter 8.
Approaching the question
This question on compensating wage differentials requires you to draw
and interpret indifference curves where one good is a bad and where
workers have different degrees of risk aversion.
a.

(Diagram for parts a and b)


The market wage curve is an upward sloping straight line with a slope
of £2 per foot of distance above the ground and an intercept of £10.
b. The curves are upwards sloping since distance above the ground is a
‘bad’. Each indifference curve is tangent to the wage curve at the height
at which the relevant worker works. Paul’s wage at 15 feet is 10 +
2 * 15 = £40 per hour. At 25 feet, Anthony’s wage is 10 + 2 * 25 =
£60 per hour. Paul’s indifference curve is steeper than Anthony’s, as
this indicates Paul is more risk averse and therefore works at a lower
height.

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Examiners’ commentaries 2015

c. Both indifference curves are tangent to the same straight line, so both
must have the same slope at their points of tangency; therefore both
workers are willing to pay (or receive) £2 per hour for reduced (added)
distance of one foot.
d. Paul, who chooses to work at 15 feet, has a steeper indifference curve
(a greater willingness to pay for reduced distance above the ground) at
each height; that is why Paul chooses to work at a lower height.

Question 3
The Swoosh Corporation produces frisbees at its factory. Its labour, capital and
product markets are all competitive. Wages are £12 per hour and frisbee making
equipment rents for £4 per hour. The production function is q = 40 K0.25L0.75,
where q = boxes of frisbees per week, K = hours of frisbee equipment used, and
L = hours of labour.
a. Determine the cost minimising capital-labour ratio at this firm.
b. How would this change if the rental rate of capital increased to £6 per hour?
c. What can you say about the firm’s overall long-run demand for labour when
capital becomes more expensive?
Reading for this question
Subject guide, Chapter 3.
Borjas, Chapter 3.
Ehrenberg and Smith, Chapters 3, 4 and 5.
Approaching the question
This question requires an understanding of the way that the optimal
capital-labour ratio is calculated, thus the formula W/MPL = R/MPK is
key. You must first be able to differentiate the production function to find
MPL and MPK. and then correctly substitute in the values for wage and the
rental rate of capital to find the optimal capital-labour ratio for that firm.
Part (c) requires an understanding of the scale and substitution effects that
comprise total change in the long-run demand for an input.
a. The production function is q = 40K0.25L0.75, where q = boxes of frisbees
per week, K = hours of frisbee equipment used, and L = hours of
labour, marginal factor products are given by MPL = 30K0.25L–0.25 and
MPK = 10K–0.75L0.75
To minimise cost, the firm chooses K and L so that W/MPL = R/MPK,
where R is the rental cost of capital. Rearrange this to W/R = MPL/MPK
and substitute in the information from the problem:
12/4 = 30K0.25L–0.25/10K–0.75L0.75
3 = 3K/L
K=L
This is a capital-labour ratio of one labour hour for each hour of
equipment used.
b. If the rental rate of capital increased to £6 per hour,
12/6 = 30K0.25L–0.25/10K –0.75L0.75
2 = 3K/L
K = (2/3) * L
Since capital has become more expensive, the capital-labour ratio will
decrease – the firm will now use less capital relative to the number of
workers (two hours of equipment use for every three labour hours)

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EC3015 Economics of labour

c. The firm’s demand for labour will increase relative to its demand for
capital, as the firm substitutes between inputs to achieve the most
efficient production method. However, it is unclear whether the demand
for labour will increase overall, since the increased rental rate of capital
represents an increased marginal cost to the company, which would lead
them to decrease their overall production, requiring less capital and also
fewer workers. These effects are known as the substitution and scale
effects, and it is not clear a priori which will dominate.

Question 4
a. Use budget constraints and indifference curves for different wage levels to
derive a backward bending labour supply curve for an individual worker and
explain why the curve is backward bending.
b. On a separate graph, draw a simple upward sloping aggregate supply curve
for the labour market as a whole. Explain why it is possible for the aggregate
supply of labour to increase as wages increase, even if most workers are on
the backward bending parts of their own labour supply schedules.
Reading for this question
Subject guide, Chapter 2.
Borjas, Chapter 2.
Ehrenberg and Smith, Chapters 6 and 7.
Approaching the question
In part (a), good answers will include a detailed diagram as well as an
intuitive explanation. In part (b), the diagram is very simple, but excellent
answers will provide a detailed explanation of the different effects of a
higher wage and the likely relative size of these effects. Good answers will
indicate that a higher wage is likely to encourage non-participants to enter
the labour force, resulting in an increase in the labour supply.
a.

The individual labour supply curve is backwards bending because of


income and substitution effects at different wage levels – at high wage
levels, the income effect tends to outweigh the substitution effect, while
at low wage levels, the opposite is the case. Good answers will include
a detailed diagram as well as an intuitive explanation of this result.

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Examiners’ commentaries 2015

b.

For workers on the backward-bending section of their labour supply


schedules, an increase in wages reduces the number of hours worked
– this would reduce aggregate work hours. However, this reduction
would be offset by two effects. First, current labour force participants
who are on the positively sloped sections of their labour supply
schedules would increase the number of hours they work. More
importantly, the wage increase would cause some current non-
participants to enter the labour force. The labour supply schedules of
current participants are relatively inelastic (i.e. the demand for leisure
doesn’t change much following a change in the wage), so the second
work-enhancing effect of a wage increase on the behaviour of
nonparticipants would play a key role, and could lead to a positively
sloped aggregate labour supply schedule.

Question 5
At the competitive wage of £25 per hour, two firms A and B both hire 5,000
workers (each working 2,000 hours per year). The elasticity of demand for labour
is –2.3 and –0.7 at firms A and B respectively. Workers at both firms unionise and
negotiate a 10% wage increase. Assume any decrease in employment results in
an even reduction in weekly hours worked across a firm’s workforce (rather than
layoffs).
a. What is the employment effect at firm A? How has each worker’s total
income changed?
b. What is the employment effect at firm B? How has each worker’s total
income changed?
c. Which firm is more likely to unionise? Assuming firm A is a representative
firm in industry AA and firm B is a representative firm in industry BB, what
factors might lie behind the different labour demand elasticities in each
industry?
Reading for this question
Subject guide, Chapters 3 and 9.
Borjas, Chapter 10.
Ehrenberg and Smith, Chapter 13.
Approaching the question
For parts (a) and (b), the calculation of the change in employment
should be applied directly to the number of hours (effectively ignoring
the number of workers). For part (c), the second part of the question
requires identifying the factors as per Marshall’s laws of derived demand.
Better answers would demonstrate understanding of this by applying it to
industry AA and industry BB.

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EC3015 Economics of labour

a. Elasticity of labour demand = % change in labour demanded/%


change in wage
–2.3 = % change in labour demanded/10%
% change in labour demanded = –23%
Hours per worker before the wage change: 2000
Change in hours due to the wage change: –23% * 2000 = –460
The percentage change in employment is –23%, which is equal to
460 fewer hours per worker. At a new wage of £27.50, each worker
now earns (£27.50 * 1540 = £42,350) compared to what they earned
before the pay increase (£25 * 2000 = £50,000).
b. At firm B, the percentage change in employment is –7%, which is equal
to 140 fewer hours per worker. At a new wage of £27.50, each worker
now earns (£27.50 * 1860 = £51,150) compared to what they earned
before the pay increase (£25 * 2000 = £50,000).
c. Workers at firm A would be less likely to unionise because any
negotiated increase in wages would lead to a substantial fall in
employment and potentially a fall in total income per worker. Workers
at firm B would be more likely to unionise. Following Marshall’s
four rules of derived demand, elasticity of demand for labour would
depend on the elasticity of the output demand, the share of labour in
the cost of output, the elasticity of substitution between labour and
capital, capital’s supply elasticity. Thus it is likely that industry AA has
at least some of the following characteristics: more elastic demand for
output, higher share of labour in the cost of output, greater elasticity of
substitution between labour and capital, and a greater supply elasticity
of capital.

Section B
Answer two questions from this section.

Question 6
Various theories have been suggested to explain the increase in income
inequality which has been observed in several developed economies over recent
decades. Use theory, supported by historical/empirical evidence, to discuss this
increase.
Reading for this question
Subject guide, Chapter 7.
Borjas, Chapter 7.
Ehrenberg and Smith, Chapter 15.
Approaching the question
Possible reasons for the increase in income inequality include changes
in relative demand and supply of skills, skill-biased technological
change, globalisation and changes in institutions such as the decline in
unionisation and the erosion in the real value of minimum wages. You
should use a demand-and-supply framework to demonstrate these effects.
It is important to support your arguments with historical/empirical
evidence, relating each point to real-world facts (as per the discussion in
the core texts). Citing statistics that demonstrate the increase in income
inequality also gains extra marks.

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Examiners’ commentaries 2015

Question 7
Why do people invest in education? Present two alternative models and for each
model, discuss the decisions made by individuals and the implications for policy
makers.
Reading for this question
Subject guide, Chapter 6.
Borjas, Chapter 6.
Ehrenberg and Smith, Chapter 9.
Approaching the question
A good answer will provide detail on both the human capital/schooling
model and the signalling model. For each model, you should give an
explanation of the decisions made by individuals, using diagrams or
equations where appropriate. For the human capital model, you could
use present value calculations, the stopping rule and discuss the impact
of different discount rates and ability levels. For the signalling model, you
should set up a model in terms of the proportion of workers who have
low and high productivity and show how firms determine the minimum
amount of education they will require as a signal of high productivity
and how this affects the education decisions of low and high productivity
workers. It is far better to write a reasonable amount about both models
than to write every possible detail about one and almost nothing about
the other. In terms of implications for policy makers, there is a reason to
subsidise education under the human capital model, because it increases
productivity; however, there is little reason for the government to do this
under signalling because under this model, education does not increase
productivity – it just signals it (although governments may place some
value on improved matching through signalling, this is likely to be
minimal compared to the value placed on increased productivity). To make
this point, you could explain the difference between private and social
rates of return to schooling.

Question 8
Theoretical models relating to the labour market predict outcomes which are
supported by empirical evidence to varying degrees. Describe the theoretical
model of the effects of discrimination on the labour market, and then evaluate
how well the predicted effects are supported by empirical evidence.
Reading for this question
Subject guide, Chapter 7.
Borjas, Chapter 9.
Ehrenberg and Smith, Chapter 12.
Approaching the question
In terms of theory, you could discuss the impact of discrimination on
firms’ profits and on wage inequality, using diagrams to illustrate these
effects. Becker’s theory also implies segregated workplaces (not supported
by evidence). An important part of this question is to discuss how well
the theoretical predictions are supported by empirical evidence. For
example, several experiments that have been conducted to try to measure
discrimination are described in Borjas, section 9-7.

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EC3015 Economics of labour

Question 9
Describe two strategies firms can use in relation to how they pay workers
in order to maximise the effort the workers put into their work. Discuss the
problems of implementing these strategies in practice.
Reading for this question
Subject guide, Chapter 8.
Borjas, Chapter 11.
Ehrenberg and Smith, Chapter 11.
Approaching the question
Possible strategies include piece-rates, efficiency wages, bonuses,
profit-sharing, tournaments and delayed compensation. Problems with
implementation may include, for example:
• for piece rate schemes: monitoring costs, difficulties in measuring
output, team work and free-riding, emphasis on quantity rather than
quality
• for bonuses: free-riding; for tournaments: collusion or sabotage.
As is asked in the question, you should focus on two strategies and discuss
each one and its specific implementation challenges in detail.

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