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1 Subsidies and Incidence (2014 PS3) 1. Consider the labor market for high skill workers characterized by the following supply and demand: S(w) = -50 + 5w D(w) = 1000 - 10w (a) Calculate the equilibrium wage in this market. Draw the supply and demand curves on a graph, and calculate worker and employer surplus. [4 points](b) There is another group of workers who may be high skilled, but have not been tested. The government institutes a free testing service which verifies workers as being skilled. The result is that a second, identical group of high skilled workers join the workforce, doubling the supply of high skilled labor. What is the new supply equation that the employer faces? Draw the new supply curve on your previous graph (and verify that at each level of wage the supply of labor doubled). What is the new equilibrium wage? [4 points](d) The original group of workers rightfully views this new development as a wage decrease for themselves. Associated with this wage decrease is a transfer of wealth to the employer (since each working employee is now getting paid less) as well as a loss of welfare from workers who were productive but no longer have a job. On your graph label the areas associated with the transfer and job loss. What is the sum of the two areas? [3 points]2. Return to our original market for labor S(w) = -50+5w D(w) = 1000 - 10w Suppose that the government implements an earned income tax credit. Any worker in the market that is employed gets a government subsidy of 4, so our new labor supply is S( w) = -50 + 5(w + 4). (@) For subsidies, we are often interested in the incidence, which describes how much each party gains from the subsidy. To calculate this, find the the new equilibrium wage. What is the difference in the amount the worker gets paid? What is the difference in the amount the employer pays? The ratio of the difference for the worker and the employer is the incidence. This also the ratio of the elasticities of supply and demand. What is this value? [4 points] 3(b) Imagine instead that the labor supply curve was S (w) = -400+ 10w. Recalculate the incidence as in part (a) and compare to your answer above. Explain intuitively why the incidence of the subsidy on equilibrium wages is higher or lower in this case. [4 points] 42 General Equilibrium in an Exchange Economy (2014 PS3) Romeo is an MIT undergraduate who lives in East Campus. Juliet is a Wellesley student. Suppose Romeo has utility up ( R, C) = Rogl-a where R are roses and C are chocolates. Juliet has utility u; (R, C) = RBC]-B with a e (0, 1) and B e (0, 1). Initially Romeo and Juliet do not know each other, and so are unable to trade the roses and chocolates they own, only consuming their own endowment. Romeo begins with 1 rose and 9 chocolates (R. = 1, C, =9), Juliet begins with 1 chocolate and 9 roses (C; = 1, R, = 9). 1. What are the initial utility levels of Romeo and Juliet? [2 points]2. Suppose that Romeo bumps into Juliet at Toscanini's and after talking about life over ice cream, they decide to enter into a trading agreement. Draw an Edgeworth box and show clearly all feasible allocations of chocolates and roses for Romeo and Juliet. Draw Romeo and Juliet's indifference curves within the box you can assume a = 3 = : for this part if you would like, but the indifference curves need not be completely accurate] and mark the endowment allocation. Shade in the allocations which would be Pareto improvements over the endowment allocation. [5 points]
