3 = Labour Supply = Wage determination

Question 1

Why would a firm pay wage higher than market clearing wage?

Answer 1

incentivizes workers to work harder - more effort = better productivity

• nutrition
• more required effort
• lower turnover rate = dont want to lose job
• attract high skilled workers

Question 2

Describe the model of shirking
- firm and worker
- imperfect monitoring

Answer 2

Firm has to set a wage rate and minimum efficiency level
- up to the worker if they want to obey the minimum efficiecny or shirk
- shirk e<e* –> e=0 (reduced strategy space)
- work e>= e* –> e=e*

• when the worker exhibits effort there is a cost = loss in welfare = convex
• but infrequent monitoring of shirking - so can get away with it

Question 3

What does V mean?

Answer 3

V = unemployment
- the gain from the outside option
- unemployment benefits or another outside job

Question 4

If a worker chooses to put in no effort what does this mean?

Answer 4

they are indifferent between the outside option and the reservation wage

WR (amount earning from nothing) = V

= indifferent between employment and unemployment

Question 5

How does wage setting play an important role in shirking or not

Answer 5

• if wage is high enough i wont shirk
• will put in the minimum effort
• dont want to lose my job
• employment > unemployment

Question 6

How will firms set their prices?

Answer 6

Set the lowest wage that will satisfy the incentive compatibility
- make sure benefit to workers working > shirking
- make them indifferent = lowest wage

Question 7

What is the payoff to worker for shirking

Answer 7

(1-p(checking)w + vp(checking)

• if they dont check i get wage
• if they check i get fired

Question 8

What is the payoff to worker for exerting effort?

Answer 8

w - cost(effort)

wage - the cost of effort

Question 9

How do firm make sure the wage is incentive compatible?

• when will the worker exhibit effort

Answer 9

w - cost(effort) >= (1-p(checking)w + vp(checking)

w - cost(effort) = (1-p(checking)w + vp(checking)
- bind it - because cheapest way

Question 10

What happens to wage when V increases
(higher outside options)?

Answer 10

wage increases

Question 11

What happens to wage when cost of effort increases?

Answer 11

wage increases

Question 12

What happens to wage when probability of being caught increases?

Answer 12

wage decreases

Question 13

So what are the implications of this for a high paying job
V , C(e) , p

Answer 13

• lots of vacancies - lots of outside options = strong labour demand for workers - need workers
• hard work - requires lots of effort
• its hard to track effort/work

Question 14

How do firms set wage and effort levels that maximise profits - while making sure workers put in required effort?

Answer 14

want to maximise profits =
output - cost
- output is an increasing function in effort

Question 15

what is the optimisation problem - max profits subject to workers working

Answer 15

objective function
- max (f(e) - w)
subject to
compatibility constraint
- w - c(e) = (1-p)w + vp

Question 16

What is the sequential game
- how firms set profit maximising w and e

Answer 16

1. firms set w and e
2. workers choose to shirk or work

Question 17

what is the sequential game
- trade unions want to maximise workers welfare

Answer 17

1. trade union sets a wage that they demand
2. firm chooses to accept or reject

Question 18

How can TU max welfare (WL)?

Answer 18

maximise welfare subject to firm accepting their offer

Question 19

What is the firm side problem - trade unions

Answer 19

firms want to maximise their profits subject to their production function
- they will only accept trade unions offer if they make positive profits
- they the choose how many people to hire at this wage to increase profits

Question 20

What is the firm side problem - trade unions
what is the equation

Answer 20

max profits = p(q)*q - wl
subject to
production function = q(l)

Question 21

How do you work out this optimisation problem
- firm side

• firm and union

Answer 21

1. firm - want to find profit maximising as a function of w
   - substitute pf into objective function
   - FOC
   - L* - sub back in to get a function of w
   - firm will only accept if the profit maximising number is positive
   - find the wage strategy when will the accept and reject

Question 22

How do you work out this optimisation problem
- union side

Answer 22

• take the wage that makes the firm indifferent

maximise welfare = wl
subject to
L* = the L that the firm will hire L(w)
- FOC
- find w* = max total income of workers