2 - The Supply Side Flashcards
What is meant by labour market clearing
The labour market clears when the wage is such that there is neither excess supply of, nor demand for labour.
Real wage = W/P
The market clears at the real wage where the labour demand curve intersects the labour supply curve.
Why is labour market clearing not observed in real world labour markets
Firms prefer to offer EFFICIENCY WAGES, wages that contain a premium over and above the market clearing rate.
-efficiency wages motivates the worker to exert greater effort. Creates incentives for workers to value their jobs and work conscientiously that results in greater efficiency (increased productivity and lower costs of hiring and training workers).
Why is the wage setting curve upwards sloping?
As unemployment falls, the probability of getting another job rises and the efficiency wage rises to deter workers from leaving: the wage setting curve is upwards sloping.
The wage rises and unemployment falls.
Why are workers unhappy when they are unemployed?
Workings entails a dis utility for workers, but provides access to consumption which the worker values.
The loss of income when unemployed is often associated with mental distress and loss of skills.
Derive the price-setting curve
A firm maximises profit when MR=MC
MC=W/MPL
MR=P(1-1/n)
P(1-1/n)=W/MPL
P = (1+u)*W/MPL
price setting equation
What are the inflationary consequences of an upswing in Aggregate Demand?
An upswing in aggregate demand moved the economy away from the medium run equilibrium where the WS and PS curves intersect, opening a positive output gap.
An expansion in aggregate demand pushes output and employment above equilibrium and raises wage and price inflation.
In the WS-PS model
Wages at equilibrium unemployment are higher than workers would be willing to accept (efficiency wages). This means there is involuntary unemployment.
Phillips Curve
Current inflation = lagged inflation + output gap
Inflation and output
Explain how unemployment can be above equilibrium due to Aggregate Demand being too low
May be due to a negative demand shock, either arising from lower autonomous investment or decreases autonomous consumption.
-this shifts the IS curve to the left
-output and unemployment are below their equilibrium values
The negative demand shock opens a negative output gap that implies a fall of inflation.
Demand and supply shocks
A positive DEMAND shock will shift the IS curve to the right.
- output increases above equilibrium
- positive output gap results in increasing inflation
- employment rises at the expense of higher inflation (Phillips curve shifts upwards)
A positive SUPPLY shock (labour reforms) shifts WS curve downwards, raising equilibrium output and employment.
-real wage falls, nominal wage stays constant, inflation decreases, Phillips curve shifts downwards
Ability of firms to make supernormal profits.
The ability of firms to make supernormal profits is associated with the mark up u, which will be equal to 0 in case of perfect competition.
Provide two different explanations for why the PS curve may be flat.
- The Marginal Product of Labour (MPL) and the mark-up are constant.
- Firms set their prices using a rule of thumb, basing their average costs over the business cycle.
