Macro Unit 1 Flashcards
What is the supply side of the economy and what is it made up of?
Supply side - activities that produce the economy’s output
It is made up of labour and product markets
To model a simple economy, we consider 3 main actors; firms, households and the government
Firms provide goods and services for households, and provide goods, services and tax for the government.
Firms also hire workers in the labour market.
Households provided firms with labour and the government with labour and tax.
The government uses taxes to provide public services and implement laws and policies. They also provide grants to households in the form of unemployment benefits and pensions.
Explain the participants in the labour market.
- Consider the entire population. Distinguish who is of working age and who isn’t (children and 64+)
- From those of working age, the labour force is made up of those who are employed or wish to be employed. Those who are of working age but are not employed and don’t wish to be are economically inactive.
- Only members of the labour force can be considered employed or unemployed. Those with a job are employed and those without are unemployed.
Participation rate = labour force/population of working age
Unemployment rate = unemployed/labour force
Employment rate = employed/population of working age
What is an index?
An index is used to compare trends and measure things like prices, nominal wages and real wages.
First a baseline year is chosen, assigning it a value of 100. The index measures changes by converting figures for other years to index values relative to the baseline.
Ie in year 1 the nominal wage is 100 (baseline), and in year 2 the nominal wage is 102, therefore the nominal wage has increased by 2%.
The consumer price index (CPI) is an index used to measure price changes by tracking prices of a shopping basket of commonly bought goods
What is the nominal and real wage?
Nominal wage - the actual amount of money per unit time received in payment for work.
Real wage - the actual purchasing power that workers have from their earnings, thus taking into account changes in prices (real wage adjusted for inflation)
If nominal wages is W per week, and the price of one unit of output in the same currency is P, your wage can buy W/P units of output per week. Nominal wages depends on the currency used, real wages don’t.
Real wage index = (nominal wage index/consumer price index) x 100
If prices grow faster than nominal wages, the real wage is falling. If the nominal wage grows faster than prices, real wage is rising.
Outline the mode of the supply side of the economy
- Two actors, owners of firms and households
- The model excludes people who are self employed or out of the labour force
- Employees and firms produce, and households buy, units of output
- Differences between wages, levels of output, type of work and products produced are ignored
- Total amount of output produced is Y
- Price of one unit of output is P
- Real wage, w, is W/P
- Total employment is N
- unemployment rate is u
- All workers earn the same nominal wage W
- average product of labour (output per worker) is assumed to be constant (Y/N)
Explain the diagram used in the supply side model of the economy.
On the horizontal axis is employment, N. This can be divided into the number of employed, the number of unemployed and the number of inactive.
On the vertical axis is output per worker (lambda), productivity and real wage. From 0 to lambda is output per worker. Real wage, w, is between 0 and lambda.
Wherever real wage lies, w-0 = real wage (money to workers) and lambda - w = real profit per worker (money to firms)
Who are the actors in these markets?
Within a firm there are different actors:
- owners who hire and fire managers, own property, capital and receive profits
- managers who direct daily activities, are paid salaries and sometimes earn profits
- employees who work under the direction of managers in return for wages
Human Resources (HR) makes decisions relating to the labour market, ie setting wages
Marketing department makes decisions relating to the product market, ie setting prices
In the labour market, we focus on the relationship between employers and workers and how wages are set by HR departments
In the product market, we focus on the relationship between firms and customers and how prices for goods/services are set by marketing departments
What is the wage-setting curve?
An upward sloping relationship between aggregate employment and the real wage.
The HR departments determines the nominal wage, W, that is sufficient to recruit, retain and motivate the firm’s desired number of workers.
Given the aggregate price level, P, in the economy, this determines the firm’s real wage.
The WS curve gets increasingly steep as unemployment shrinks to 0. This shows that there is always unemployment in the economy.
What is the price-setting curve?
Another relationship between the real wage and the level of employment, but from the product market and marketing department of firms.
The marketing department sets the price, P, of the firm’s output to maximise profits which depends on production costs, ie the nominal wage, W, and labour productivity, lambda, as well as competition.
In this model we assume labour productivity doesn’t change with the level of employment, and the level of competition remains constant.
Each firms sets a price, P, that is proportional to the nominal wage, W, and P is the same regardless of employment level.
Each firm sets this wage which is a ratio between W and P which is an aggregate real wage, w.
The price setting curve is a horizontal line at real wage, w.
What is the WS-PS model of the macroeconomy?
This combines the wage and price setting curves of the labour and product market.
Where the two curves intersect, the real wage on the WS curve is equal to the real wage on the PS curve. Only at this intersection are the decisions of wage and price setters amongst the economy consistent. This is called the Nash or supply side equilibrium of the economy. Only at this equilibrium do owners have no incentive to change wages or prices. This is a long run equilibrium ie what we would expect on average in the economy over a long run period.
Explain the reservation wage curve
We assume the firm hires only from unemployment and makes a take it or leave it offer to jobseekers
The jobseeker’s decision on whether or not to take the job depends on their next best alternative option, to remain unemployed and seek another job.
The overall value of this option is the worker’s reservation wage which depends on:
- income while unemployed (benefits)
- net utility of unemployment
- how many weeks they expect to remain unemployed before receiving a job offer
- how good they expect the job offer to be.
The reservation wage is the minimum wage jobseekers would accept, and it has the same value as the next best alternative
Because workers have differing reservation wages, they can be ordered by ascending reservation wage, hence forming the reservation wage curve with real wage, w, on the Y axis and employment on the X axis
As the real wage offered increases, the more workers will accept
Explain the no-shirking wage
Once hired, HR also needs to ensure workers are motivated to exert the required amount of effort.
This is because at the reservation wage, the worker is indifferent between working or not and therefore will shirk.
HR does this by offering a wage above the reservation wage (employment rent), so that the worker has something to lose if they were to be caught shirking and fired.
The NSW depends on:
- the cost of effort ie tiredness, boredom of working hard
- the chance of getting caught shirking
- the chance of being fired if caught shirking
We assume these factors are the same for all workers and hence the additional amount that workers earn to work hard is the same for each.
Therefore there is a constant vertical distance between the NSW and reservation wage curve.
What shifts the NSW?
Factors that improve the opportunities available to an unemployed jobseeker increases the reservation wage which pushes NSW up:
- an increase in unemployment benefit
- an improvement in the prospective employee’s quality of life without the job relative to with the job
- other employers increasing their demand for labour, reducing the unemployment rate
- other employers raising their wages
Also (NSW only):
- increased difficulty to monitor the effort of workers
- increased cost of firing a worker caught shirking
- employees find it more difficult to meet HR’s work standard
How is the NSW for a firm related to unemployment in the economy?
Every firm sets its wage to recruit and motivate their desired number of workers and these collective decisions affect the overall demand for labour and hence the unemployment rate which affects the NSW.
Combining the NSW curve and wage setting curve:
When unemployment, u, is high, firms set the real wage on the WS curve accordingly. This wage corresponds to the real wage set on the NSW.
If u is at a medium level, aggregate employment is higher so NSW shifts up. On this higher NSW, the real wage is higher and hence this higher real wage is accounted for on the WS curve.
When u is low, NSW is shifted upwards proportionally more, and hence the real wage has increased again.
In this way, the WS curve can be derived from the NSW.
Thus, a change in unemployment causes a shift of the NSW and movement along the WS curve.
What shifts the WS curve?
These factors shift WS upwards
- increased unemployment benefit
- improvement in the prospective employee’s quality of life without the job relative to the quality of life with the job
- it becomes more difficult for the employer to monitor the effort of workers
- it becomes more costly for the employer to fire a worker caught shirking
- employees find it more unpleasant to meet HR’s work standard, which increases the disutility of work.
(Same as shift factors for NSW except that the unemployment rate and wages offered by other firms are built into the WS model already)
How does competition impact the price setting curve?
The price setting curve shows the split between wages and profits that arises when firms set their prices to maximise profits.
If a firm faces little competition in the product and labour markets, they have more market power and will set a higher price which increases their profit margins and pushes the real wage down. The PS curve is lower and workers get a lower share of output per worker.
If a firm faces high competition, the profit margins will be lower and the real wage higher.
How does the marketing department set its profit maximising price?
First it considers the demand for the product. The price it chooses will determine how many items it can sell and hence the firm’s revenue.
Once the quantity of output is known, the production costs can be calculated by determining how many workers are needed to produce that amount of output and the wage that will be required.
The firm can then work out how much profit will be made at a given price and can then choose its profit maximising price.
What is PED?
Price elasticity of demand measures the relative responsiveness of demand to a change in the price of a product.
Demand is elastic if an increase in price leads to a more than proportional fall in demand and inelastic if it leads to a less than proportional fall in demand.
The more competition the firm faces, the more elastic its demand will be.
Explain the concepts marginal cost, profit margins and markup
The additional cost of producing one more unit of output is the marginal cost.
The firm’s profit margins is the difference between price and marginal cost, P-MC
The markup is the profit margin as a proportion of the price, markup = P-MC/P
When a firm sets its price at the profit maximising level, the markup is inversely proportional top the PED, P-MC/P = 1/PED
Because we assume competition is constant, PED does not vary with output so 1/PED (markup) can be seen as a constant mu
Rearranging mu = P-MC/P gives P=1/1-mu MC, thus the profit maximising price is proportional to the marginal cost of production
The factor 1/(1-mu) is a number greater than 1. If the firm faces little competition, the demand elasticity is low and so the markup, mu, is high and the price is a higher multiple of marginal cost.
Explain what the price setting real wage is
The price setting real wage, w, = W/P
Another expression for it is w = (1+mu)/(1+eta) * lambda
Where mu = P-MC/P (markup), eta = markdown, ie how much the firm has to raise the wage to increase employment, lambda = output per worker
Explain how output per worker is shared amongst the firm and its workers
We know that the real wage, w = 1-mu/1+eta * lambda, therefore the real wage is a fraction of output per worker
Output per worker, lambda, is split into two fractions
One goes to workers in the form of real wages (wage share = 1-sigma)
The other goes to the firm in the form of profits (profit share = sigma)
The price setting real wages can therefore be written as w = (1-sigma) * lambda
Ie the firm sets its price so that each worker is paid a real wage that is a constant share of the output per worker, and the remaining share goes to the firm
The higher the competition in the market, the profit share is lower and wage share is higher
What are the expressions for average and marginal cost in the WS-PS model?
AC = total cost of labour/output = WN/Y = W/lambda
Thus AC is proportional to the wage
To increase output, the firm must hire more workers and pay a higher wage to their workers
MC = (1+eta) * W/lambda
Where eta is a constant that measures how much wages have to be increased to increase employment
Eta depends on competition but competition is constant too
Eta is called the mark down which indicates how far the wage is marked down so that wage cost per unit, W/lambda, is below marginal cost
What shifts the price setting curve?
Anything that improves output per worker or reduces the profit share leads to a higher real wage:
- Higher labour productivity - this reduces costs and firms cut their prices, resulting in a higher real wages
- More competition in the product market - reduces the markup firms can set, lower share of profits and real wages rise
- More competition in the labour market - reduces the markdown in the wages firms set, lower profit share and higher wage share so real wages rise
What determines the height of the price setting curve?
- Labour productivity: for any given markup and markdown, the output per worker determines the real wages on the price setting curve. The greater the level of labour productivity (lambda), the higher the real wages that is consistent with a given profit share
Higher labour productivity pushes the PS curve up, keeps the shares the same so real wage increases - Competition: increased competition means a lower markup, thus lower prices across the economy and higher real wages. This pushes PS curve upwards. Additionally, the firm has less labour market power, so set a lower markdown and so the wage us higher and PS curve shifts up.
More competition means workers get a bigger share
Why is there always some unemployment at Nash equilibrium?
- if there was 0 unemployment, the cost of job loss would be 0, as a worker who loses their job can instantly find a new one, so there is no employment rent
- therefore workers would not fear being fired if caught shirking and would be indifferent between working hard or not
- if workers are not motivated to work hard, there will be no output and nothing for the employer to sell, hence no profits
- therefore some unemployment is necessary as it means the employer can motivate workers to provide effort on the job
- thus at any equilibrium where WS=PS, there must be unemployed people (structural unemployment)
What is involuntary unemployment?
A person is involuntarily unemployed if they are seeking work and willing to accept a job at the going wage but are unable to secure employment.
Diagrammatically, it is the difference in employment between the WS curve and reservation wage curve
A person is voluntarily unemployed if they are seeking a job but unwilling to accept a wage at the going rate
Structural unemployment = voluntary + involuntary unemployment
Explain how the WS-PS model always reverts to Nash equilibrium following changes in real wage
Suppose a higher real wage, w’, is paid to recruit and motivate workers.
This real wage is higher than the price setting real wage, w
At w’ the profit share shrinks given that output per worker stays constant
This is not profit maximising for firms, and since competition has not changed and production has become more costly, firms will raise their prices and reduce output and employment, so the economy will move back towards the equilibrium point.
Suppose a lower real wage, w” is paid to workers. Now making higher profits, the firm would want to produce more. To sell more they would reduce prices. The economy would move back to the Nash equilibrium with employment and real wages rising.
