L9 - The Determination of Wage, Price and Supply Flashcards
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/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
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<p> Real Wages fall
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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