FHCE 3150 Final Exam Study Guide

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Adverse selection is the process by which

"undesirable" members of a particular market are more likely to participate in exchange

An individual who is considering consumption between two time periods (year 1 and year 2) has an endowment of $20,000 in year 1 and $15,000 in year 2. If the interest rate is 5%, what is the maximum appropriate amount that can be spent on consumption in year 1?

$34,285

The model of intertemporal choice illustrates 3 things:

(1) the budget constraints faced by consumers, (2) their preferences between current and future consumption, and (3) how these two conjointly determine households' decisions regarding optimal consumption and saving over an extended period of time.

A gamble in which you win D dollars if the coin comes up heads, but lose D dollars if the coin comes up tails has an expected value of

0

Say, Anna's utility function was given by UA = (MA)(MM), where MA is Anna's wealth and MM is Marie's wealth. Initially, Anna has 160 units of wealth and Marie has 40. When Anna maximizes her utility level is equal to

10,000

Seth could consume $120 next year if he saved all his current earnings. He expects to earn nothing next year. The intermporal budget constraint for Seth is given by the equation C2 = 120 - 1.2*C1, where C1 = possible consumption in year 1 and C2 = possible consumption in year 2. Assume that C1 is on the horizontal axis and C2 is on the vertical axis. What is the present value of the total consumption available?

100

In Figure 17-1, if the reference time period is one week, N equals _______ hours.

168

Suppose Microsoft stock will provide either a return of 10 or 20 percent over the next year and that the probability of the former outcome is 0.25 while the probability of the latter is 0.75. The expected return on Microsoft stock over the next year is thus __________

17.5

_________ will causes the budget line in figure 17-1 to rotate from NY2 to NY3.

A rise in the wage rate

The labor demand curve is downward sloping due to:

A substitution effect and a scale effect

An increase in the wage rate makes leisure more expensive

True

Measuring Unemployment Rate

UR = U/LF

Giving consumers more options to choose from makes consumers worse off.

Uncertain

In the income-leisure model, the worker is seeking to maximize ____________

Utility

If borrowing and lending is possible at a positive interest rate and if there is present and future income, then the intertemporal budget constraint

Will be a straight line with a slope steeper than -1

Suppose you receive Y1 of your income this period and Y2 of your income in the next period. If you can either borrow or lend at an interest rate r, what is the most you can consume in the future period?

Y1 (1 + r) + Y2

Fred is considering consumption between two periods and is earning an income of $1,000 in both periods. If the interest rate is 8%, Fred borrows $500, but if the interest rate rises to 18%, Fred saves $500. Is this behavior economically reasonable?

Yes, the higher interest rate will raise the cost of current consumption, including him to cut back current consumption. He could cut back so much that he becomes a saver.

Suppose there are two individuals, each with an income $10,000 this year and next year. Frank consumes $10,833 the first year and $9,000 the second, while Michelle consumes $9,167 the first year and $11,000 the second. Is this market for loanable funds?

Yes. Because the supply of loanable funds to the demand since the amount that one person wants to borrow is equal to the other amount a person wants to save.

For a signal between two adversaries to be credible, it must

be costly to fake or duplicate

Suppose leisure is shown on the horizontal axis and weekly income is shown on the vertical axis, an increase in the wage rate will cause the budget line to:

become steeper

An individual is considering consumption in two periods. He has decided to borrow $1,000 in period 1, given his endowment and the interest rate. Other things remaining the same, if the interest rate increases, he will:

borrow less than $1,000

If an impatient and a patient consumer face the same intertemporal budget constraint, have the same first-year income, and if their indifference curves are both normally shaped, then

both will have the same marginal rate of time preference at equilibrium unless one or the other is at a corner solution

For a risk-loving individual with return on the x-axis and total utility on the y-axis, the slope of the total utility curve:

increases at an increasing rate

Velma starts a business for $150,000 that gives her a 50% change of losing and a 50% change of gaining an expected annual return of $75,000. John is content with a job that pays him $75,000 per year with near certainty; there is only about a 1% chance of losing his job each year. Suppose risk is on the horizontal axis and return on the vertical axis. Velma's indifference curve for risk and return:

is flatter than John's

A risk-neutral consumer

is indifferent between accepting and refusing a fair gamble

The Kahneman-Tversky value function shows that a gain of $100

is valued less than two gains of $50

The "self-interest theory" considers an act to be rational if

it efficiently promotes the ongoing material interest of the person who performs it without the requirement that social justice be achieved

For an individual who is saving for a specific purpose, say a car, an increase in the interest rate is most likely to

lead to lesser saving in the current period have a stronger substitution effect than income effect

The income effect of a wage rate typically assumes that:

leisure is a normal good

What is a secondary labor market?

low wages and unstable employment relationships

Labor force:

non-institutionalized individuals aged 16 or above who are either working or actively seeking work

Rational individuals always prefer

to increase the quantity or quality of the goods and services they consume.

income =

total compensation + unearned income (or income = earnings + unearned income)

Say Anna's utility function was given by UA = (MA)(MM), where MA is Anna's wealth and MM is Marie's wealth. Initially, Anna has 160 units of wealth and Marie has 40. In order to maximize her utility Anna should:

transfer 60 units to Marie

earnings =

wage x hours

When a job applicant discloses information that could be seen as favorable by potential employers, other job candidates who do not disclose information:

will be seen as more unfavorable by potential employers

Labor market participants

workers, firms, the government

Industry demand for labor

• An industry's demand for labor consists of the total demand for a particular type of worker in a given industry. (An industry consists of all of the firms that produce a given type of output.) • An industry's labor demand curve is determined by adding together the labor demand curves for all of the firms in the industry.

Slope of labor demand curve

• Both the substitution and scale effects result in a reduction in the quantity of labor demanded when the wage rate rises. • A change in the wage changes the quantity of labor demanded, but does not affect labor demand. Labor demand changes only if the labor demand curve shifts in some manner (as discussed below).

Measurement Issues

• Labor Force measurement relies on subjectivity and likely understates the effects of a recession • The added worker effect refers to an increase in the labor supply of for example married women when their husbands become unemployed. • EPR is a better measure of fluctuations in economic activity than the UR

Market demand for labor

• The market for a given category of labor consists of all of the firms that might hire a given type of labor, regardless of the industry in which the firm operates. • The market demand for labor is determined by adding together all of the industry demand for labor curves.

The scale effect associated with a wage increase involves the following steps:

• higher wages result in higher average and marginal costs of production, • leading to an increase in the equilibrium price of the product, • leading to a reduction in the quantity of the product demanded, • leading to a reduction in the use of all inputs used to produce the product.

Labor demand may shift due to changes in:

• the demand for the product, and • the prices of other resources.

Standard rational choice theory accepts which of the following?

People are creatures of reason

Which statement is true?

An increase in the interest rate will always cause a reduction in current consumption

Behavioral economics studies behavior, but neoclassical economics does not.

False

Workers will always work fewer hours when the wage rate increases.

False

According to the rational choice model which of these two events should be valued more by rational consumers: A). gift mug valued at %10 B). finding the mug you thought was lost, which cost you $10 to purchase

Both events should have the same value

We had two boxes of candy on the counter. Both were identical, except one was a 10-pound box and the other was only a 1-pound box. Because it was Christmas, I rationalized that four pieces a day would be okay, but I always felt better when I took candy out of the large box instead of the small one. This tendency is an illustration of

Fear of losing options

Labor Market Participants: Firms

Demanders of labor (aggregate individual decisions to derive a downward-sloping labor demand curve) Goal: Strive to maximize profits subject to constraints Determine: • How many workers to employ • Which workers to hire • How much to pay each worker • Whether to hire additional workers • Whether to fire workers• How much capital to employ • Working conditions • Length of the work week

Measuring Employment Rate

Employment: Population Ratio (percent of population that is employed) EPR = E/P

For a risk-averse individual, with return on the x-axis and total utility on the y-axis, the slope of the total utility curve:

increases at a decreasing rate

Consider a two-year period where a consumer has an income of $10,000 in year 1 and $8,000 in year 2. The consumer can borrow or lend at an interest rate of 10 percent. If the consumer decides to save $1,000 in year 1, it means:

He will have a higher consumption in year 2 than in year 1

Suppose there are two individuals, each with an income $10,000 this year and next year. Frank consumes $10,833 the first year and $9,000 the second, while Michelle consumes $9,167 the first year and $11,000 the second. What is the interest rate? What does saving equal? Borrowing?

IR = 20% Savings = $833 To solve this --> $833(1 + r) = $1,000

Which of the following gambles should be considered more attractive?

If heads, you win $9; if tails, you lose $6

If the interest rate increases, the price of current consumption

Increase relative to the price of future consumption

Measuring the Labor Force Participation Rate

LFPR = LF/P P = civilian adult population 16 years or older not in institutions

Measuring the Labor Force

Labor Force = Employed + Unemployed Does not tell us about intensity of work

An increase in the interest rate

Makes borrowers worse off (shift away current consumption) The income effect will be negative for a net-borrower

An increase in the interest rate

Makes savers better off because they are able to reach a higher level of utility (the IR is making current consumption is more expensive, so cut current consumption and encourages saving even more). The sub effect and income effect work in opposite directions for a net-saver (income, positive and sub, negative).

A risk-averse individual who owns a $200,000 house and faces the prospect that the house will burn down with the probability 0.05 in any given year will be willing to pay how much of an annual premium to fully insure against such a loss?

More than $10,000

In Figure 17-1, assume the worker is initially in equilibrium at point A. Weekly earnings and work hours are __________ respectively.

OY1 and NL2

Labor Market Participants: The Government

Regulations determine ground rules in the labor market • Taxes on earnings • Training subsidies • Payroll taxes • Affirmative action laws • Minimum wages • Worker condition regulations • Immigration laws

If you were to behave according to the typical rational choice model when confronted with a loss of $100 on the same day in which you receive an unexpected gift of $125 you would

See the net gain of $25 and consider yourself better off

Labor Market Participants: Workers

Suppliers of labor (aggregate individual decisions to derive an upward-sloping labor supply curve) Goal: Strive to maximize well-being (utility) subject to constraints Determine: • Whether or not to work • How many hours to work • Which skills to acquire • Whether or not to quit a job • Which occupation to work in • Whether to join a union • How much effort to put forth at work

Point A represents my endowments for today and tomorrow, the real interest rate is r, and you observe that I consume at point M. From this information what do you know about me?

That I need to borrow in order to finance my higher consumption planned tomorrow.

Which of the following statement is correct for a typical worker?

The substitution effect of a higher wage encourages more work, and the income effect encourages less work

A fundamental axiom of rational choice theory is

choices should be independent of irrelevant alternatives

A reduction in an individual's future income will cause

consumption to fall in both time periods because consumption in both years are normal goods

According to Keynes' absolute income hypothesis,

current consumption depends only on current income.

The labor force participation rate rises

during an expansion and falls during a recession

total compensation =

earnings + fringe benefits

As a result of the substitution effect of a lower wage, hours of work will:

fall due to a lower opportunity cost of leisure time

primary sector (agricultural) employment

has declined as a share of the labor force

secondary sector (industrial) employment

has declined slightly as a share of the labor force, but only in the past few decades

tertiary sector (service sector) employment

has increased as a share of the labor force

What is a primary labor market?

high wages and stable employment relationships

As a result of the substitution effect of a wage increase, a worker will:

increase his work hours

wage =

payment per unit of time

fringe benefits =

payments-in-kind + deferred compensation

Discouraged workers or Hidden unemployed

persons who have left the labor force, giving up in their search for work

A risk-averse individual ___________

prefers a sure return to an uncertain prospect generating the same expected return

Other things remaining the same, in the intertemporal consumer choice model a change in the endowment point:

produces a parallel shift in the consumer's budget line

The Kahneman-Tversky value function is

risk-averse in gains, risk seeking in losses

If you were to behave according to the rational choice model when confronted with a loss of $25 on the same day in which you receive an unexpected gift of $25, you would:

see the two events as exactly offsetting and thereby no consequences in your overall welfare.

When the size of the potential loss is small, most people will

self-insure because they can afford it and the expected loss is less than the insurance premium

The Kahneman-Tversky value function is

steeper in losses than in gains

substitution effect

substitution of other resources for a resource that becomes relatively more expensive

Say one morning you are considering whether to take UBER or riding the train to work. Both mediums would cost you about $4, but you have already paid in advance for the train (since you pay a flat fee at the beginning of the month). If the UBER would take slightly less time than the train ride, and you are mostly concerned with the time it takes you to get to work, you should:

take the cab (take the UBER)

The income-leisure model of work is based on the assumption that:

the worker is able to choose how many hours to work

In the income-leisure model of work, leisure is the portion of time when:

the worker is not receiving compensation from an employer

Unemployed:

those who are not working but are "actively seeking work"

In a two-year period, if a higher interest rate causes consumption in year 1 to rise:

the income effect associated with the higher interest rate is greater than the substitution effect

An individual's labor supply curve will bend backward when

the income effect of a higher wage is greater than the substitution effect

Refer to figure 17-1. If the number of leisure hours is OL1 after a change in wage rate, it implies that:

the income effect of the wage change is less than the substitution effect

In the intertemporal consumer choice model, an increase in ________ will alter the slope of the budget line

the interest rate

The more the people consume in the current period (today or the current year) and the less they save,

the less they will be able to consume in the next period (tomorrow or next year).

Expected return/value is defined as __________

the summed value of each possible rater of return weighted by its probability

The expected utility from an investment is defined as ____________

the summed value of each possible utility weighted by its probability

An increase in the number of discouraged workers causes

the unemployment rate to fall


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