L9 - The Determination of Wage, Price and Supply

Question 1

What are the basic assumptions for the Aggregate Supply Curve?

Answer 1

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

Question 2

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

Answer 2

• Labour

Question 3

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

Answer 3

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

Question 4

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

Answer 4

• 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)

Question 5

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

Answer 5

• Multiple both sides by (P^e/P)
• (W/P^e)(P^e/P)=(P^e/P)f(N,z)
• 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

Question 6

How does the real price level affect real wages?

Answer 6

• 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<p> Real Wages fall

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Question 7

What does the Wage Setting relationship graph look like?

Answer 7

• 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)

Question 8

What is the Price-Setting Equation?

Answer 8

• 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

Question 9

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

Answer 9

• 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

Question 10

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

Answer 10

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

Question 11

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

Answer 11

• 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)

Question 12

What does the Complete Labour Market Diagram look like?

Answer 12

• 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

Question 13

How can you interpret the Complete Labour Market Diagram?

Answer 13

• 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

Question 14

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

Answer 14

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

Question 15

How can you translate the level of employment into output?

Answer 15

• Using a Production Function

Question 16

What is the Production Function?

Answer 16

• 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

Question 17

What is the Marginal Product of Labour?

Answer 17

• 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.

Question 18

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

Answer 18

• 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

Question 19

What does the Aggregate Supply Curve say?

Answer 19

• 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

Question 20

How do you derive SRAS Curve?

Answer 20

• 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

Question 21

How can the SRAS curve be affected?

Answer 21

• 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

Question 22

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

Answer 22

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