L9 - The Determination of Wage, Price and Supply Flashcards Preview

18ECA001 - Principles of Macroeconomics > L9 - The Determination of Wage, Price and Supply > Flashcards

Flashcards in L9 - The Determination of Wage, Price and Supply Deck (22):

What are the basic assumptions for the Aggregate Supply Curve?

1- The economy is assumed to have a unique long-run macro equilibrium that occurs when GDP is at its potential level
2- The market prices of all goods and service and all inputs are assumed to be flexible
3- Technology and potential GDP are assumed to be constant --> growth is slow enough to be ignored for short term analysis


What is seen as the Variable Input in the Production Process in the Short Run?

- Labour


What is the problem with Labour being the only variable input in the production process in the short run?

- The problem is that it is not really sensible to treat it as a competitive market given the institutional feature e.g. trade unions


What factors are likely to influence the level of money wage rates?

- Labour market in aggregate are not very competitive, the following however will likely influence the level of money wage rates (W):
- The level of Employment (N) --> when employment levels are high, the demand for labour is high, so wages are increased as firms try to recruit more staff and retain existing staff
- The Price Level (P) --> influence wage bargaining as workers attempt to maintain the purchasing power of their real wage rate
-When wage bargains are struck, the actual future level of P is not known, so wage bargains are struck on the basis of the expected future price level (P^e):
- As P^e rises so the money wage rate is expected to rise
- Institutional factors: trade unions or unemployment benefit payment (z) may positively influence wages independently of labour market conditions
- So we can write the expected real wage rate as:
- W/Pe=f(N,z)


How do we convert the expected real wage rate to the actual real wage rate?

- Multiple both sides by (P^e/P)
- w=W/P=(P^e/P)f(N,z)
- So the real wage rate (w) is a positive function of both employment and institutional factors e.g. trade union pressures
- As well as of the ratio of the expected future price level to the actual price level
- Thus Unexpected rises in the price level reduce the real wage rate


How does the real price level affect real wages?

- If Expected Price Level (P^e) is greater than the actual Price Level (P) so there was an overestimation of Price Levels --> Real Wages will increase
- If there is an underestimation whereas Pe

Real Wages fall


What does the Wage Setting relationship graph look like?

- Employment (N) on the x-axis
- Real Wage rate (w or W/P) on the y-axis
-Positive 45 degree line of (P^e/P) f(N,z)


What is the Price-Setting Equation?

- Firms are assumed to operate in imperfectly competitive markets and set prices as a mark-up on average prime costs --> P=(1+µ)W
- Where prices area constant mark up (µ) on money wage costs (W) Since µ > 0 then prices exceed unit costs by the extent of the mark-up
- This says that firms’ prices are set independently of demand – which is fairly close to what happens in practice


How does Price Levels and Wages relate to a business making a profit or loss?

- Total Cost (TC) = Money Wage (W) x Employment (N)
- Average costs = TC/N = W ≈ P
- Therefore P ≥ W or the business is making a loss


How can you relate the Price-Setting Equation to Real Wage Rates?

- P=(1+ µ)W
- P/W=(1+ µ)
- W/P=w=1/(1+ µ)
- Therefore real wages is the reciprocal of mark-up


How does the Price-Setting Equation look on a graph?

- If Employment (N) is on the x-axis and Price Levels (P) is on the y-axis--> Will be a horizontal line with the equation (1+µ)W
- If Employment(N) is on the x-axis and Real Wage Rate (W/P(0) or w) on the y-axis --> Will be a horizontal line with the equation (1/1+µ)


What does the Complete Labour Market Diagram look like?

- With Employment (N) on the x-axis and Real Wage Rate (w or W/P) on the y-axis
- A 45 degree line of (P^e/P), f(N,z)
- A straight horizontal line of 1/(1+ µ) crossing the y-axis at W/P(0)
- Equilibrium employment is when these two lines cross


How can you interpret the Complete Labour Market Diagram?

- The level of employment, N(0), is that level of employment that is consistent with firms’ price-setting behaviour and worker wage bargaining. This is sometimes called the natural level of employment
- Price-setting decisions determine the real wage paid by firms. An increase in the mark-up leads firms to increase their prices given the wage they have to pay; equivalently it leads to a decrease in the real wage
- Alternatively, suppose the firm you work for raises its mark-up. The effect on your real wage would be close to zero, since you only consume a few of the goods produced by your company. But if all firms raised their mark-ups your real wage would decline. Hence a rise in μ reduces the real wage rate


What have the Price-Setting and Wage-Setting Behaviour’s determined?

- The level of the real wage rates and the level of employment


How can you translate the level of employment into output?

- Using a Production Function


What is the Production Function?

- The standard Neo-Classical production function links the level of output to the levels of the inputs of capital (K) and labour (N)
- With capital (K) fixed in the short run, and assuming a linear production function, such that Y=ΦN, then Φ is the (constant) marginal product of labour (ΔY/ΔN) which is often called productivity – output per head


What is the Marginal Product of Labour?

- The marginal product of a factor of production is generally defined as the change in output associated with a change in Labour, holding other inputs into production constant.


How can we relate the Wage-Setting relationship to Aggregate Supply?

- Inverting the production function gives N=Y/Φ then sub into the wage-setting relationship:
- W/P=(P^e/P)f(Y/Φ,z)
- Real wage rate is directly related to the level of output produced
- Substituting for W/P, using the price-setting relation and re-arranging give:
- 1/(1+μ)=(P^e/P)f(Y/Φ,z) or P=P^e(1+μ) f(Y/Φ,z)
- This is the relationship for aggregate supply


What does the Aggregate Supply Curve say?

- The price level and output are positively related for given levels of P^e, μ, Φ and z
- An increase in μ or z (or a fall in Φ) will lead to the AS-curve shifting up, as P rises at each level of output
- If P=P^e then the level of output is at the natural or potential level and independent of the price level. This will be the LRAS curve


How do you derive SRAS Curve?

- Draw the complete Labour Market diagram with Employment (N) on the x-axis and Real Wage Rates (w) on the y-axis.
- Draw underneath a graph with Output (Y) on the x-axis and Price-Level (P) on the y-axis
- Draw various line of P^e /P f(.) at various price levels, at the point they intercept the 1/(1+ μ) draw down to the graph below a dotted line for each point of output
- At each level of output make a point of its corresponding price level
- By connecting these points, we create the SRAS curve


How can the SRAS curve be affected?

- Because the AS curve relates real GDP to P, changes in P which shift the wage-setting line cause movements along the AS curve
- Along the AS curve wage-setting and price-setting behaviour are consistent for a given expected future price level
- A rise in the mark-up, indicating greater monopoly power of firms in the goods market, leads to an upward shift the SRAS curve
- A rise in productivity – Φ – will lead to a fall in P and a downward shift of the SRAS curve
- A rise in z – perhaps due to an increase in unemployment benefits, also leads to an upward shift in the SRAS curve


What is the Short-Run AD-AS Model equilibrium?

It is now time to put both the AD and AS curves together to give the equilibrium level of output (Y{0}) and price level (P{0}) - only at this point are desired spending (AE) and desired production (supply) activities consistent
- If P > P{0} then desire (and actual) spending is consistent with a level of GDP that is greater than the desired output of firms
- if P > P{0} then desired (and actual) spending is consistent with a level of GDP that is less than the desired output of firms