73-200 Fall 2010

73-200 Problem set 2

Due September 17 2010

From the Syllabus:

1. Turning in Homework: Homework must be turned in on the day it is due in class. Do
NOT leave it under my office door. Late homework will NOT be accepted unless you
are sick and have a doctors note.
2. Homework regrading: If you believe a question has been incorrectly graded, please take
your homework to your TA, stating what you think to be wrong, within 2 weeks of it
being returned.
3. Working in groups: You may work in groups of up to 4. BUT: You MUST put names
of other group members on your homework. You MUST write up your own set of
answers. Do NOT simply copy some other persons work.
4. TYPE your work. Long equations may be hand written.
5. Buy a stapler!
6. Write your first and last name on the title of each graph. Graphs may be hand drawn.
7. Carefully explain your work.

This version: September 8, 2010

Prof. Nicolas Petrosky-Nadeau

73-200 Fall 2010

Problem 1: The household (35 points)

This question will have you explore the central elements of consumer behavior with a particular functional form for preference.
1. Assume preferences over consumption and leisure take the functional form
U (C, L) = ln(C) +

L1
1

with 0 < < 1.

(a) Derive the marginal utility of consumption and the marginal utility of leisure:
(b) Show that there are decreasing returns to consumption and leisure:

2. The household finances consumption through wage (w) earnings and dividends () from
firms. The government finances its expenditure with a proportional tax 0 < < 1 on
labor income. Normalizing the available time during the day to 1 (i.e. h = 1), write
the households budget constraint:

3. Household maximization:
(a) Write the households constrained optimization problem of consumption and leisure
(use the earlier form for preferences)
(b) What are the first order conditions to this problem?
4. Using the first order conditions for consumption and leisure, equate the marginal rate of
substitution between leisure and consumption to the wage. Can you give an economic
interpretation of this optimality condition?
5. Assume for now that the parameter on leisure in the utility function = 1 (this will
be the same as assuming U (C, L) = ln(C) + ln(L)).

This version: September 8, 2010

Prof. Nicolas Petrosky-Nadeau

73-200 Fall 2010

(a) Write the optimal ratio of consumption to leisure as a function of the tax rate
and the wage using your answer to point 4.:
(b) What is the effect of an increase in the tax rate on the consumption-leisure bundle?
is this an income or a substitution effect? why?

6. For the rest of this homework, assume that preference take the form U (C, L) = C + L
where > 0
(a) Restate the optimality condition for the household obtained in part 5 with these
new preferences:
(b) What does the labor supply curve look like now? plot the curve in (N s , w) space.
Can you provide an intuition for the supply curve in this special case?

Problem 2: The firm (15 points)

The representative firm is assumed to have access to the Cobb-Douglas production technol1
ogy: Y = zN d K , where Y is output of the firm, z is the level of Total Factor Productivity
(TFP), N d the demand for labor, K the firms stock of capital and the parameter 0 < < 1.
1. Firm maximization:
(a) Set up the firms maximization problem:
(b) What is the first order condition for labor demand?
(c) Show that the labor demand schedule is downward sloping in (N d , w) space. Plot
labor demand.

This version: September 8, 2010

Prof. Nicolas Petrosky-Nadeau

73-200 Fall 2010

Problem 3: General equilibrium (20 points)

1. Combine the households optimality condition for the consumption-leisure bundle with
the firms first order condition for labor demand:
2. Express the equilibrium amount of hours N as a function of the parameters , , , z
and the capital stock K:
3. What effect would an increase in total factor productivity z have on the equilibrium
quantity of hours in this economy? Explain, in your words, what happens when z
increases

Problem 4: Policy questions (30 points)

You now have a model to explore the quantitative effects of a proposed change in the income
tax rate.
1. Assume = 1, z = 1, = 1/3 and K = 2. At present, households face a 25% income
tax rate. Calculate the value of N .
2. It is proposed that additional spending should be financing through a raise in income
taxes, from 25% to 32%.
(a) What would the new equilibrium quantity of hours worked N be after this change?
(b) What are the values the equilibrium wage before and after the reform?
(c) Will there be any change in aggregate output? why?
3. It has been suggested that differences in hours worked between Europe and the United
States (more hours worked in the US relative to Europe) are explained by differences
in income tax rates.
(a) Is that assertion consistent with this model? why?
(b) Can you use this model to suggest another explanation for the differences? Discuss.

This version: September 8, 2010

Prof. Nicolas Petrosky-Nadeau