Question

Please show your work

2.(4 pt) In September 1992, The Wall Street Journal reported that the Internal Revenue Service (IRS) was planning to cut 414 positions at the same time it was going to expand its auditing, collection, and taxpayer assistance, and education programs. The increase in output was to be made possible by expanding its computer system. Assume that the explanation of the computer system was triggered by a reduction in the price of computers a. Based on these facts, what can you say about the size of the substitution and scale effects at the IRS? Which one had a larger effect? Explain. b. What would be the overall effect on the labor demand curve? Will this cause the labor demand curve to shift left or right? Explain.

Answer 1

I guess the question is about determination of the impact substitution effect and scale effect have on the demand for labour at IRS. Let's look at them one by one. Since IRS is going to expand its auditing, collection and taxpayer assistance, and education programs, it amounts to IRS increase the scale of 'production', which should result in the demand for all its factors of production going up. This would result in the number of positions it has going up. So the scale effect should have a positive impact on the demand for labour at IRS.

On the other hand, with computers becoming less expensive, it is turning out more profitable for the IRS to employ more computers by removing labour. This is the substitution effect at work. It is negative for the demand for labour at the IRS.

Since there is a net reduction in the number of positions at IRS (demand for labour) it is clear that the substitution effect is larger than the scale effect.

As a result of the substitution effect, the demand curve for labour at IRS would shift towards left (i.e., it employs fewer people for the same wages).