Suppose it costs K dollars per year to pay for childcare. Suppose the government introduces a subsidy that reduces the cost to K’.

a) Graph the budget constraint without the policy (without the cost subsidy), illustrating on the graph the role of K (the daycare cost), the weekly market wage rate w, weekly hours and assume the individual already possesses a yearly non labour income YN and it is positive. On the same graph, illustrate the change in the budget constraint once the subsidy is introduced.

b) Show graphically if and how the subsidy will affect the labour supply. Make sure you provide a complete answer including considerations of labour supply at the extensive and intensive margins (corner and interior solutions) before and after the daycare subsidy.

Q2

Pam has a weekly unearned income of $200 (which comes from winning a beauty contest). She works 30 hours a week (out of a maximal 100 hours in the week) at a wage rate of $10. Her wage increases to $14/hour. Pam has a compensated wage elasticity of 0.4 and an income elasticity of –0.5 for labor supply.

a) Find the percentage increase in Pam’s wage rate and in her wealth due to this wage change.

Write down the formula for calculating an uncompensated wage elasticity from the compensated wage elasticity and the income elasticity.

b) Calculate Pam’s uncompensated wage elasticity. Is it positive or negative? What does this say about the relative sizes of the income and substitution effects?

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