Department of Economics, CSUS Name:_____________________

Economics 130
Spring 2005 Course Number:_____________
Problem Set 1 Solutions
Due Tuesday February 15th at the beginning of lecture

Draw all graphs and write your answers neatly in the space provided. Show all of your work. You may discuss
questions you have with other students, but your answers need to be in your own words. Answers that appear to be
copied from another student will receive a grade of zero.

Income and Substitution Effects of a Change in Wage

In this exercise, you will describe the effect of an increase in the wage on hours worked, and
decompose the change in hours into income and substitution effects.

1. First draw a budget constraint and indifference curve diagram with hours of leisure on the
horizontal axis and income on the vertical axis. Assume the maximum hours of labor or
leisure in a day is 16 hours (8 hours are reserved for sleep). The horizontal axis measures
leisure, but any choice of leisure is also a choice of labor because (hours of labor=16 - hours
of leisure). Assume the wage rate is $10 an hour. With this information you should be able to
draw a budget constraint. (Hint: Consider total hours of leisure in a day if earnings are zero,
and total earnings if leisure is zero to obtain the endpoints of the budget constraint. Leave a
lot of room at the top of your graph, since you will have to draw a new budget constraint with
a higher wage for part 3.)
Earnings $320

9*20 = $180
$160

$100

67 16 Leisure

10 hours of labor

2. Draw an indifference curve tangent to the budget constraint. On your graph, what are
approximate hours of leisure, hours of labor, and earnings? Illustrate on your graph where
you observe ‘hours of labor’.

On this graph, hours of leisure are 6, hours of labor are 10, and earnings are 10*10 = 100.

3. Now consider a decrease in wage, to $10 an hour. Draw the new budget constraint and a
tangent indifference curve. What are approximate hours of leisure, hours of labor, and
earnings?
Department of Economics, CSUS Name:_____________________
Economics 130
Spring 2005 Course Number:_____________
The new budget constraint and indifference curves are shaded light. Hours of leisure are now 7,
labor is 9, and earnings are $180.

4. Income and substitution effects play a role in determining the new labor/leisure decision.
When describing these two effects, we discuss leisure as a “good” which is bought just like
any other good purchased, with price equal to the wage rate, or foregone wages. Buying
leisure has the coincident effect of reducing hours of work and income.
 The income effect says that when wage falls, the worker is poorer, so he will buy fewer
goods, including leisure, and hours of work rise.
 The substitution effect says that when wage falls leisure is relatively less expensive so the
worker will buy more leisure and work less.
On a new graph, illustrate the separate income and substitution effects. On your graph, which
effect is larger?

The income effect is larger than the substitution effect, so the overall effect of the increase in
wage on hours of work is negative. The income effect moves the worker from 6 hours of
leisure to 10 hours of leisure, on the dotted line parallel to the original budget constraint, but
tangent to the new indifference curve. The substitution effect moves the worker from 10
hours of leisure to 7 hours of leisure, along the new indifference curve.

Earnings $320

9*20 = $180
$160

$100

67 10 16 Leisure
Income effect
Substitution effect

5. Empirical research has found that, in general, hours of work fall as wages fall, and vice versa.
What would this imply about the relative magnitude of the income and substitution effects?
(Which effect dominates?) The labor supply curve shows the relation between the quantity of
labor supplied and wage. Draw the labor supply curve.

Since hours of work rise as wage rises, the substitution effect must dominate.
Department of Economics, CSUS Name:_____________________
Economics 130
Spring 2005 Course Number:_____________
w S labor

L
Other empirical research has determined that as the wages of professional middle-aged men rise,
hours of work falls. What would this imply about the relative magnitude of the income and
substitution effect? The result is a ‘backward bending’ supply curve for this particular group.

The income effect must dominate for there to be a backward bending labor supply curve.

API Test Score Regression Results and Class Size Reduction

The API (Academic Performance Index) is a score between 0 and 1000 given to every school in California,
based on student test scores. An ordinary least squares regression of API score on school characteristics and
class size provides the following coefficients. The dependent variable is API score.

R Squared 0.757
Observations 4601

Coefficients t Stat
Intercept 691.989 16.367
Average Class Size K-3 2.780 4.449
Average Class Size 4-6 0.937 2.629
Percent Credentialed Teachers -0.138 -0.794
Percent Emergency Credentials -0.479 -2.559
Percent Receiving Free Meals -0.792 -19.490
Percent White 0.706 1.922
Percent African American -2.264 -6.012
Percent American Indian -5.780 -11.454
Percent Asian 0.990 2.640
Percent Filipino 1.514 3.486
Percent Hispanic -2.624 -7.115
Percent Pacific Islander -3.043 -3.366

1. What do the coefficients on Average Class Size imply about the effect of class size on API test
scores? Are these coefficients statistically significant?

Both coefficients are positive and statistically significant. Increasing class size by one student in grades K-
3 would increase test scores by 2.78. Increasing class size by one students in grades 4-6 would increase test
scores by 0.94.

2. What does the coefficient on percent of students receiving free meals imply? Is this coefficient
significant?
Department of Economics, CSUS Name:_____________________
Economics 130
Spring 2005 Course Number:_____________
The coefficient on free meals is negative and significant. Increasing the percent of students receiving free
meals by 1 reduces test scores by 0.79.

3. What can we infer from the coefficient on percent Hispanic? Is this coefficient significant?

The coefficient on Hispanic is negative and significant. Increasing the share of students who are Hispanic
by 1 percent would reduce test scores by 2.6.

4. Do you think this is a valid way to analyze the effect of class size on student outcomes? What other
data could help you decide whether reducing class size improves student outcomes?

Other research has not consistently found a positive effect on test scores from reducing class size. There
could be potential problems with this regression analysis because of the level of aggregation of the data.
Data are provided at the school level, so we can’t track student or class level performance. We can only
look at the school as a whole. It would be better to have student level or teacher level data. Since we
obtained positive, significant coefficients on class size, it is possible that reducing class size actually
lowers test scores. But since this is counterintuitive, the question should receive more attention by
researchers.