Economics 151A

Professor David Neumark

Problem Set 1
Due Thursday, January 24, in class

1. In the bivariate regression model Yi =  + X i +  i , the error term ε captures influences

on Y that are not included in the model.

a. What has to be true about the relationship between ε and X for the estimate of β to
be unbiased?

b. Suppose a new pizza shop owner is trying to decide how much to charge, by
collecting data on prices of pizzas (X) and quantities sold (Y) from local pizza shops.
Give an example of something that might be included in ε and bias the estimate of β.
Give an example of something that might be included in ε that would probably not
bias the estimate of β.

c. Suggest a multivariate regression that the pizza shop owner should run to get a
better answer to the question of how the price she charges is likely to affect quantities
sold. (Remember that a multivariate regression can have many included variables,
not just two.)

2. Between 1996 and 2004, California raised its minimum wage from $4.75 to $6.75. In that
period, total employment grew from 14.3 million to 16.5 million. A policymaker arguing in
favor of a minimum wage increase argues that evidence demonstrates that raising the
minimum wage does not reduce employment, but rather increases it. How would you
evaluate this argument, and how would you propose using data to study this question?

3. Suppose a firm uses labor L and capital K to product output y, with the production function
y = L1 / 2 K 1 / 2 . Suppose the firm sells its output in a competitive labor market at price p, and
buys labor in a competitive market at price w, and assume the firm maximizes profits.

a. Let the level of capital be fixed at K in the short-run. Provide an expression for
the demand curve for labor.

b. Using your answer for part a, how does L change with w, p, and K ? Explain why
each of these changes makes sense.

4. Suppose a firm uses only one input (L) to produce output y, with the production function
y = L1 / 2 . Suppose the firm sells its output in a competitive market at price p, and buys labor
in a competitive market at price w.

a. Write an expression for the profits of the firm as a function of w, p, and L.

b. What is the marginal cost of hiring an additional unit of labor? Graph the marginal
cost of labor curve.

c. What is the marginal revenue from hiring an additional unit of labor? Graph the
marginal revenue curve on the same graph as in part b.
 d. Assume the firm maximizes profits. How much labor should it hire as a function
of the real wage w/p? Find the solution for L, and also display it on the graph.

e. Does the firm hire more or less labor as p increases? Why?

5. Assume everything is the same as in Problem 4, except that the firm is a monopolist, and
faces downward sloping demand curve p(y) = a −by.

a. Write an expression for the profits of the firm as a function of w, p, and L.

b. What is the marginal revenue from hiring an additional unit of labor? Graph the
marginal revenue curve and the marginal cost curve (which is the same as in 5.b).

c. Assume the firm maximizes profits. How much labor should it hire as a function
of a, b, and w? Find the solution for L, and also display it on the graph.

d. Why is the equation for the profit-maximizing choice for L in this case not a
function of p?

e. Show that labor demand declines if the wage increases.

f. Show that labor demand increases if demand for the firm’s product increases.

6. Suppose a firm’s production function is Q = L + 2∙K.

a. Graph isoquants for Q = 6, 9, and 12.

b. Suppose w, the price of labor, and r, the price of capital, both equal 1. Draw the
isocost lie for C (the cost) = 6. What combination of inputs L and K does the firm
choose?

c. Now suppose w = 1 and r = 3. Draw the isocost line for C = 6. What combination
of inputs L and K does the firm choose.

d. When r goes from 1 to 3, what is the magnitude of the substitution effect for L?
What is the magnitude of the scale effect for L (defined for staying on the same
isocost line)?

7. Suppose a firm’s production function is Q = min(L,K). (This means the level of Q

produced is the smaller of L and K.)

a. Graph some isoquants for this firm.

b. Let w = 2, r = 1, and suppose the firm’s expenditures are C = 12. What are the
firm’s demands for L and K? What is the share of labor in the cost of output?

c. Now let w rise to 3. What are the firm’s new demands for L and K?
d. Now suppose instead that the production function is Q = min(L,2K). Draw some
isoquants for this firm.

e. Again, let w = 2 and r = 1, and suppose the firm’s expenditures are C = 12. What
are the firm’s demands for L and K? What is the share of labor in the cost of output?

f. Now let w rise to 3. What are the firm’s new demands for L and K?

g. Why does labor demand fall more in part f than in part c? (Hint: Use one of
Marshall’s Laws.)