Question

1. Preferences or Policy? Europeans work fewer hours than Americans. There are many reasons for this fact. You will consider two different reasons in this question. (a) Suppose that both the utility functions and before-tax real wages are the same in the US and Europe. However, labor income tax is higher in Europe. In a single carefully labeled diagram, show how it can be the case that Europeans work fewer hours than Americans. Provide an explanation for your graph. (b) Suppose that both before-tax and after-tax real wages are the same, but the utility func- tions are different. In a single carefully labeled diagram, show how it can be the case that Europeans work fewer hours than Americans. Provide an explanation for your graph. (c) Regarding part (b) above, which of the following statements is (are) correct? Briefly explain. i. If u(c.l-All-α, then the value of Q ls bigger for Europe. Assume 0 < α < 1 ii. Îf u(e,l)-(e +1*) , then the value of σ įs bigger for Europe. Assume σ < 1.

Answer 1

Ans (a) The utility function and real wage are same in both the countries but the tax rate is higher in Europe then in America, i.e the income tax is higher as a result the supply of labour in Europe will increase because now the available workers will work less then before as they are getting less income then before because of increase in labour tax however in America the supply of labour will same as well as income because their working hour are more then Europe

As shown in figure the European supply of labour will shift to S' ,on the vertical axis it is salary is shown at the equilibrium point the salary is S where as after tax the salary received by labour is shown by Sr as this point cuts the original supply curve so the workers will prefer leisure more then work because of increase in labour income tax.

Ans (b) Both the before tax and after tax real wages are same in both countries but the utility of both countries are different .

S10 2

As shown in diagram M1 shows the slope of European workers and M2 shows the American workers IC1 shows the satisfaction level or utility function of European labour whereas IC2 shows the utility function of American labour. As slope of American labour (w') is greater then European labour (w) because in Europe labour prefer leisure more then work in comparison with the Americans so their slope is also less then Americans.

Ans (c) (i ) is true in this context because of cobb Douglas production function the sum of both the elasticity of production will be 1 and at this level the economy will produce at optimal level.