Chapter 10/General Equilibrium and Economic Welfare



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Figure 10.3

2) Suppose that the minimum wage covers all sectors of the economy; however, for unionized laborers, the minimum wage is ineffective. That is, the union wage is already above the minimum wage. Analyze the impact of an increase in the minimum wage on both the unionized and non-unionized labor markets. (Assume that the higher minimum wage is still ineffective in the unionized sector and that union and nonunion labor are substitutable.)


Answer: See Figure 10.3. The higher minimum wage from min1 to min2 reduces the quantity demanded of nonunion labor from L1 to L2. This causes a rightward shift of the demand curve for union labor from D1 to D2. The equilibrium union wage rises from w1 to w2. This explains why unions typically support increases in the minimum wage even though it does not directly affect their members.

Diff: 0


Topic: General Equilibrium
3) Explain why having different marginal rates of substitution is necessary for trade to

occur.
Answer: The marginal rate of substitution is the rate at which a person is willing to trade one good for another. If these rates are not equal for all people, trade can occur. With different marginal rates of substitution at least one person gains by trading. When the marginal rates of substitution are the same for everyone, everyone is willing to trade goods at the same rate, so no one can gain by trading.

Diff: 1

Topic: Trading Between Two People


4) Explain why Robin Hood’s practice of stealing from the rich to give to the poor is never Pareto-efficient.
Answer: When Robin steals from the rich, those people are made worse off. This cannot be Pareto-efficient.

Diff; 1


Topic: Competitive Exchange
5) Consider a society consisting of just a farmer and a tailor. The farmer has 10 units of food but no clothing. The tailor has 20 units of clothing but no food. Suppose each has the utility function U = F * C. Derive the contract curve.
Answer: Let F and C denote the farmer’s final allotment of food and clothing. Setting MRS's equal yields F/C = (10 - F)/(20 - C) or F/C = 1/2. The contract curve is a ray from the origin with a slope of 1/2 (assuming food is on the vertical axis).

Diff: 2


Topic: Trading Between Two People


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