Eco 370 Hw Solution

Answers to Homework 2 (30) 1. Continuing from the Question 4 on Homework 1, suppose the following Earned Income Tax Credit (EITC) scheme is put in place. For those whose earned income (i.e. labor income) is less than \$100 per week the government gives 20 cents on every dollar earned. For those who earn more than \$100 the government gives them \$80 per week. Based on the answers to question 4(d) of the first homework, how does this affect the labor supply and earnings of Shelly? Explain your answers. From homework 1, Shelly will work 32 hours. We expect her to be on the flat part of the EITC schedule. This is equivalent to an increase in her non-labor income, V, of \$100 per week. So tangency implies ; The budget constraint is C = 320 + 5(168 – L) + 80. So 320 + 5(168 – L) + 80 = 5L – 200 and L = 144(hours), h = 24(hours) > 20(hours), C = \$520. Therefore, Shelly would work 24 hours per week and get \$520 of total income, i.e. she would work less when there is EITC. Both consumption and leisure increase for her. With the lumpsum subsidy, she would get more consumption with the same leisure; therefore, there is pure income effect; hence she will be less willing to provide labor.

(20) 2. Explain why a lump sum government transfer can entice some workers to stop working (and entices no one to start working) while the earned income tax credit can entice some people who otherwise would not work to start working (and entices no one to stop working). A lump sum transfer is associated with an income effect but not a substitution effect, because it doesn’t affect the wage rate. Thus, if leisure is a normal good, a lump sum transfer will likely cause workers to work fewer hours (and certainly not cause them to work more hours) while possibly enticing some workers to exit the labor force all together. On the other hand, the Earned Income Tax Credit raises the effective wage of low-income workers by 40 percent (at least for the poorest workers). Thus, someone who had not been...