Suppose that Charlie’s Pizzeria in Boston, employs 10 workers at a wage level of
ID: 1124528 • Letter: S
Question
Suppose that Charlie’s Pizzeria in Boston, employs 10 workers at a wage level of $8 per person. All other costs (ovens, rent, advertising, return to capital) total $40 per hour, and the pizzeria sells 12 pizzas per hour at a cost of $10 per pizza. Suppose the state of Massachusetts mandates health coverage that can only be covered at a cost of $1 per hour, if it is offered at all. Charlie finds that if he offers insurance, he could maintain production by letting one worker go and running his pizza overs a little hotter, leading to costs of $45 per hour.
(a) What are Charlie’s original profits?
(b) What is Charlie’s elasticity of demand for labor? How is this calculated?
(c) What will happen to Charlie’s profits in the short run if he chooses to pay for mandated insurance?
(d) What will Charlies’ long-run decision be? Why?
Explanation / Answer
(a) Originally,
Total revenue (TR) = Price x Quantity = $10 x 12 = $120
Total cost (TC) = Other costs + Labor cost = $40 + 10 x $8 = $40 + $80 = $120
Profit = TR - TC = $120 - $120 = 0
(b) With health insurance, Wage rate = $8 + $1 = $9
When Wage = $8, workers = 10
When Wage = $9, workers = 9
Elasticity of labor demand = (Change in workers / Average workers) / (Change in wage / Average wage)
= [(9 - 10) / (9 + 10) / 2] / [$(9 - 8) / $(9 + 8) / 2]
= [- 1 / (19 / 2)] / [1 / (17 / 2)] = (- 1 / 9.5) / (1 / 8.5)
= - 0.89
(c) After insurance,
TC = $45 + 9 x $9 = $45 + $81 = $126
Profit = TR - TC = $120 - $126 = - $6 (loss)
However, since price ($10) is higher than unit variable cost (new wage rate of $9), he will continue producing in short run.
(d) Since Charlie is making a short run loss, he will exit the market in long run.
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