The labour market and unemployment

Question 1

What are the three determinants of profits in this simplified labour market model?

Answer 1

Nominal wage (actual wage paid in currency).

Price of goods sold.

Average output per worker per hour (productivity).

Question 2

Why must firms pay above-reservation wages?

Answer 2

To create employment rent, ensuring workers:

Fear job loss → work hard.

Accept the job over unemployment (cost of job loss > 0).

Question 3

How does high employment in the economy affect wages?

Answer 3

Workers can easily find jobs if fired → weaker incentives.

Firms must pay higher wages to motivate effort (shifts wage-setting curve up).

Question 4

What trade-off do firms face when setting prices?

Answer 4

Higher price: More profit per unit but lower sales (due to demand curve).

Lower price: More sales but less profit per unit.

Goal: Choose markup that maximizes profits (balances these effects)

Question 5

What is the real wage, and how is it determined?

Answer 5

Real wage = Nominal wage ÷ Price level.

Depends on:

Wages set by firms.

Prices charged by firms.

Question 6

What is the wage-setting curve?

Answer 6

Shows the real wage needed at each employment level to:

Incentivize worker effort (via employment rent).

Downward-sloping: Higher employment → higher wages needed (easier to find jobs).

Question 7

What is the price-setting curve?

Answer 7

Shows the real wage firms actually pay when they:

Set profit-maximizing prices (markup over costs).

Hire workers based on productivity.

Typically horizontal: Real wage is stable if markup and productivity are constant.

Question 8

How do the wage-setting and price-setting curves determine equilibrium?

Answer 8

Intersection of the two curves gives:

Equilibrium real wage.

Equilibrium employment level.

Unemployment exists if employment < labour force.

Question 9

Why is there involuntary unemployment in equilibrium?

Answer 9

Firms won’t lower wages below wage-setting curve (would kill effort).

Price-setting curve limits jobs firms can profitably offer.

Result: Some workers can’t find jobs even if willing to work at current wages.

Question 10

What are the key components of the labour market diagram?

Answer 10

Labour force: Vertical line (rightmost), shows working-age population participating.

Employment rate: Vertical line (left of labour force), shows actual employed workers.

Unemployment rate: Gap between employment and labour force lines.

Inactive workers: To the right of the labour force (not seeking work).

Question 11

Why is the wage-setting curve upward-sloping?

Answer 11

Low unemployment (e.g., 5%): Workers have bargaining power → need higher wages to incentivize effort (reservation wage rises).

High unemployment (e.g., 12%): Workers fear job loss → accept lower wages (reservation wage falls).

Question 12

How does unemployment rate shift the best response curve?

Answer 12

Higher unemployment (12%): Shifts curve LEFT (lower reservation wage, e.g., point F).

Lower unemployment (5%): Shifts curve RIGHT (higher reservation wage, e.g., point B).

Question 13

What is the Nash equilibrium wage?

Answer 13

The wage W at employment rate X where:

Employers maximize profits (set optimal wage).

Workers provide effort (best response to wage).

Question 14

How does the simplified model (work/shirk) represent effort?

Answer 14

Working: Provides firm’s required effort (like machine “on”).

Shirking: Zero effort (machine “off”).

Wage-setting curve: Boundary between work (above curve) and shirk (below curve).

Question 15

What shifts the wage-setting curve DOWN?

Answer 15

Lower unemployment benefits: Reduces reservation wage.

Better monitoring: Raises fear of being caught shirking.

Reduced disutility of work: Effort becomes less costly.

Question 16

Why does higher unemployment weaken worker bargaining power?

Answer 16

Longer job search if fired → lower reservation wage.

Firms can pay lower wages to maintain effort (employment rent still effective).

Question 17

Compare Point A (12% unemployment) and Point B (5%) in the diagram

Answer 17

Point A: Low wage (workers desperate, high effort).

Point B: High wage (workers secure, need incentive to work).

Question 18

In the simplified firm model, what determines output and hiring decisions?

Answer 18

Output depends on sales, which depends on price (demand curve).

Hiring depends on output (1 worker-hour = 1 unit output).

Profit-maximizing choice: Point where demand curve is tangent to highest isoprofit curve (Point B).

Question 19

What is the slope of the isoprofit curve, and what does it represent?

Answer 19

Slope = (P - W) / q = Marginal rate of substitution.

Shows trade-off between price and quantity for constant profit.

Question 20

How does the markup affect the division of revenue?

Answer 20

Markup = (P - W)/P = 1 - (W/P).

Higher markup (less competition) → larger profit share, smaller wage share.

Question 21

What is the price-setting curve, and why is it horizontal?

Answer 21

Shows real wage (W/P) consistent with profit-maximizing markup.

Horizontal: Real wage is constant across employment levels (determined by markup/productivity).

Question 22

What happens if the real wage is above (Point A) or below (Point C) the price-setting curve?

Answer 22

Point A: Wage too high → firms raise prices, reduce output → employment falls.

Point C: Wage too low → firms lower prices, expand output → employment rises.

Question 23

What two factors determine the height of the price-setting curve?

Answer 23

Competition: Less competition → higher markup → lower real wage (curve shifts down).

Labour productivity: Higher productivity → higher real wage (curve shifts up).

Question 24

Why is there always involuntary unemployment in equilibrium?

Answer 24

Zero unemployment → no employment rent → workers shirk.

Wage-setting curve must be left of labour supply to incentivize effort.

Equilibrium (Point X) requires unemployed workers to maintain discipline.

Question 25

How does reduced competition affect the labour market equilibrium?

Answer 25

Higher markup → lower price-setting curve. New equilibrium: Lower real wage, higher unemployment (intersection moves left).

Question 26

What is the Nash equilibrium in the labour market?

Answer 26

Firms: Set profit-maximizing wages/prices (on wage- and price-setting curves). Workers: Provide effort (due to employment rent). Unemployed: Cannot find jobs even if willing to work at current wages

Question 27

Why can’t policies eliminate unemployment entirely?

Answer 27

Near-full employment → wages must rise to unsustainable levels (exceeding productivity). Firms would earn zero profits and shut down.

Question 28

What is demand-deficient (cyclical) unemployment?

Answer 28

Unemployment caused by low aggregate demand (e.g., recession). Shown by point B in the labour market model, where unemployment exceeds Nash equilibrium (point X).

Question 29

How does equilibrium unemployment (X) differ from cyclical unemployment (B)?

Answer 29

X (Nash equilibrium): "Normal" unemployment due to employment rent incentives. B (Cyclical): Extra unemployment from low demand. Workers would accept jobs below current wage but can’t find them.

Question 30

Why is point B not a Nash equilibrium?

Answer 30

Firms could lower wages (still above wage-setting curve) and increase profits. Workers would still work (due to fear of job loss), but wages/prices adjust slowly.

Question 31

What adjustments would occur if the economy is stuck at B?

Answer 31

Firms cut nominal wages → lower costs. Firms then cut prices (to restore markup). Lower prices → higher sales/employment (moving toward X).

Question 32

What problems can block the return to equilibrium (X)?

Answer 32

Worker resistance: Wage cuts reduce morale/strike risk. Deflationary spiral: Falling prices → delayed spending → lower demand. Lower wages → reduced consumer spending → weaker demand.

Question 33

How can government policy reduce cyclical unemployment?

Answer 33

Fiscal policy: Increase spending/cut taxes to boost demand. Monetary policy: Lower interest rates to encourage borrowing/spending. Shifts aggregate demand right, moving economy from B → X.

Question 34

Why are policy interventions faster than wage/price adjustments?

Answer 34

Wages/prices are sticky downward (slow to fall). Policies directly increase demand, bypassing deflation risks.

Question 35

What happens to isoprofit curves when wages fall?

Answer 35

Steeper slope: (P - W)/q increases (higher profit per unit). Firms maximize profits by lowering prices, expanding output (B → X).

Question 36

How does lower competition affect cyclical unemployment?

Answer 36

Higher markups shift price-setting curve down. Worse cyclical unemployment: Equilibrium moves left (higher natural unemployment).

Question 37

What happens to the wage-setting curve when labor supply increases (e.g., immigration)?

Answer 37

Shifts downward: More unemployed workers → higher job loss threat → firms can pay lower wages for same effort. Short-run: Wages fall (point B), unemployment rises. Long-run: Profits rise → firms hire more → wages recover (point C).

Question 38

How does immigration affect wages and employment in the long run?

Answer 38

Short-run: Wages drop (B), unemployment rises (U′). Long-run: Higher profits → expanded employment → wages return to initial level (C), unemployment falls (U″).

Question 39

What is the union bargained wage-setting curve?

Answer 39

Lies above standard wage-setting curve. Reflects wages negotiated by unions via strikes/threats. Union power depends on ability to block replacement workers during strikes.

Question 40

How do unions alter the labor market equilibrium?

Answer 40

Bargaining effect: Higher wages → lower employment (if wage > price-setting curve). Voice effect: Better worker morale → lower disutility of effort → wage-setting curve shifts down. Net effect: Depends on which effect dominates (e.g., point Y vs. X).

Question 41

Compare union vs. non-union labor markets.

Answer 41

Non-union: Firms set profit-maximizing wage (point A). Union: Higher wage (point C) but lower profits (flatter isocost). With voice effect: Potential for higher employment (point Y).

Question 41

What is the union voice effect?

Answer 41

Unions improve worker-employer relations → effort feels less costly. Shifts best response curve up: Workers provide more effort at same wage. Can raise employment if strong enough (point D).

Question 42

Why might unions reduce employment?

Answer 42

If bargaining effect > voice effect: Wages rise above price-setting curve → firms hire fewer workers.

Question 43

How do unions impact firm profits?

Answer 43

Without voice effect: Lower profits (higher wages, same effort). With voice effect: May offset losses (higher effort compensates for wage hikes).

Question 44

How does education/training affect the price-setting curve?

Answer 44

↑ Labor productivity → ↑ real wages (same markup). Price-setting curve shifts up → higher employment & wages in equilibrium.

Question 45

What is the effect of a wage subsidy?

Answer 45

Lowers firm costs → firms cut prices (restore markup). ↑ Real wages (price-setting curve shifts up). Result: Higher employment + higher wages.

Question 46

How do unemployment benefits shift the wage-setting curve?

Answer 46

Higher benefits → ↑ reservation wage → wage-setting curve shifts right. Equilibrium: Higher unemployment (e.g., 12% vs. 5% at lower benefits).

Question 47

What policies increase labor supply (e.g., for women/minorities)?

Answer 47

Subsidized childcare, anti-discrimination laws. Effect: ↑ Job seekers → wage-setting curve shifts down → lower wages short-run, but long-run employment may rise.

Question 48

Compare supply-side (labor market) vs. demand-side (multiplier) models.

Answer 48

Supply-side: Determines long-run equilibrium unemployment (wage/price-setting curves). Demand-side: Explains short-run fluctuations (aggregate demand shifts → cyclical unemployment).

Question 49

What is cyclical unemployment?

Answer 49

Unemployment due to low aggregate demand (e.g., point C). Gap between actual employment and labor market equilibrium (point A).

Question 50

How does a boom (high AD) affect unemployment?

Answer 50

AD shifts up → employment rises above equilibrium (point B). Cyclical employment: Unemployment < natural rate (e.g., 3% vs. 5%).

Question 51

Why is the multiplier model short-run but the labor market model medium-run?

Answer 51

Multiplier: Assumes fixed wages/prices (short-run). Labor market: Allows wage/price adjustment (medium-run). Disequilibrium: Short-run AD shifts ≠ labor market equilibrium.

Question 52

What is the normal level of output?

Answer 52

Output at labor market equilibrium (point A, 5% unemployment). Any other output level implies cyclical employment/unemployment.