Solow Model

Question 1

Solow Condition

Answer 1

A profit maximising firm chooses the nominal wage where the elasticity of effort with respect to the real wage is 1.

Question 2

What does the Solow condition imply?

Answer 2

Real wage rigidity and involuntary unemployment.

Question 3

Describe the e(w) function verbally and draw the diagram.

Answer 3

Near the origin, the curve isn’t very steep, because the worker is on subsistence wages and can only afford food. Above a certain point, wages induce more effort, as the cost of job loss increases.

But as the wage rises, the rate at which the worker provide effort slows. The worker either can’t or is unwilling to work much harder.

Question 4

How much would a profit maximising firm pay a worker?

Answer 4

At the tangency point between the e(w) function and the steepest ray from the origin.

Output per worker is maximised here.

Question 5

Assumptions for Solow Condition

Answer 5

Firm is price taker in goods marker and wage setter in labour market.

Prices are equal to 1 and outputs are homogenous.

Question 6

Draw the solow condition graphically

Answer 6

Downward sloping labour demand curve intersecting with the efficiency wage, which is a straight line above the competitive wage, also a straight line.

Gap between aggregate labour supply and Labour market equilibrium = involuntary unemployment.