Principles of Economics II Homework 4

Dr. Hoang Khieu

Question 1
Please explain the following statements are true, false, or uncertain.

● The unemployment rate tends to be high in recessions and low in expansions.

-> True: During economic recessions, the unemployment rate tends to rise as
businesses hire fewer workers. Conversely, in economic expansions, the
unemployment rate tends to decrease due to increased job opportunities
● Most workers are typically paid their reservation wage.
-> False: Workers are typically paid more than their reservation wage, which
is the lowest wage they are willing to accept. Employers generally offer
competitive wages to attract and retain employees.
● Workers who do not belong to unions have no bargaining power.
-> False: Workers who are not union members can still possess bargaining
power in negotiations, influenced by factors such as labor market conditions,
skill level, and demand for their expertise.
● It may be in the best interest of employers to pay wages higher than their
workers’ reservation wage.
-> True: Employers may find it beneficial to pay wages higher than their
workers' reservation wage to attract skilled and motivated employees, leading
to increased productivity and lower turnover.
● Workers’ reservation wage does not depend on their skills.
-> False: Workers' reservation wage varies based on factors like skills,
experience, education, and individual financial circumstances. Highly skilled
workers often command higher reservation wages.
● The natural rate of unemployment is unaffected by policy changes.
-> False: The natural rate of unemployment can be influenced by policy
changes, including labor market policies, fiscal policies, or monetary policies.
● An increase in the markup causes equilibrium wage to fall.
-> True: An increase in the markup, representing the difference between
prices charged by employers for goods and workers' wages, can lead to a
decrease in the equilibrium wage. Employers may pass some cost savings to
workers, affecting the equilibrium wage.

Question 2 − The natural rate of unemployment

Suppose that the markup of goods prices over marginal cost is 5%, and that the
wage-setting equation is:

W =P(1−u)

where u is the unemployment rate.

● What is the real wage, as determined by the price-setting equation?

Real wage: W/P
 -> we'll divide both sides by P:
W/P = (P/P)(1 - u)
W/P = (1 - u)
So, the real wage, as determined by the price-setting equation, is equal to (1 -
u).
● What is the natural rate of unemployment?
The natural rate of unemployment occurs when the real wage is equal to the
markup (M) of goods prices over marginal cost. In this case, the markup is
5%.
We have (1 - u_natural) = M:
1 - u_natural = M
=> 1 - u_natural = 0.05
=> u_natural = 1 - 0.05
=> u_natural = 0.95
-> The natural rate of unemployment is 0.95, or 95%.
● Suppose that the markup of prices over costs increases to 10%. What
happens to the natural rate of unemployment? Explain the logic behind your
answer.
With a 10% markup increase (M_new = 0.10), we can determine the new
natural rate of unemployment (u_natural_new) using the same approach as
previously explained.
1 - u_natural_new = M_new
=> 1 - u_natural_new = 0.10
=> u_natural_new = 1 - 0.10
=> u_natural_new = 0.90
So, when the markup increases to 10%, the natural rate of unemployment
(u_natural_new) decreases to 0.90, or 90%.
-> As the markup rises, firms raise prices relative to production costs. This
alters the real wage required to preserve workers' purchasing power. With a
higher markup, workers require a lower real wage (1 - u) to maintain their
buying power. Consequently, the natural rate of unemployment drops
because fewer workers need to demand higher nominal wages to sustain their
real wages amidst price increases.

Question 3 − Bargaining power and wage determina- tion

Even in the absence of collective bargaining, workers do have some bargaining
power that allows them to receive wages higher than their reservation wage. Each
worker’s bargaining power depends both on the nature of the job and on the
economy-wide labor market conditions. Let’s consider each factor in turn.

Compare the job of an economics professor and a computer network administrator.

In which of these jobs does a worker have more bargaining power? Why?

● For any given job, how do labor market conditions affect a worker’s bargaining
power? Which labor-market variable would you look at to assess labor-market
conditions?
-> In a low unemployment rate scenario, firms struggle to find suitable
 replacements, giving workers stronger bargaining positions, potentially
resulting in higher wages. Conversely, in high unemployment situations, firms
find it easier to hire, while workers face challenges finding new jobs,
weakening their bargaining power and potentially accepting lower wages.
● Suppose that for given labor-market conditions [the variable you identified in
part (b)], worker bargaining power throughout the economy increases. What
effect would this have on the real wage in the medium run? in the short run?
What determines the real wage in the model described in this chapter?
When worker bargaining power increases due to favorable labor market
conditions (e.g., a lower unemployment rate), the impact on the real wage can
differ in the short run and the medium run:
->
- In the short term, higher worker bargaining power can prompt immediate
wage hikes through better negotiations, leading to a higher nominal wage (W).
However, firms may respond to increased labor costs by raising prices (P) to
protect profits. This could result in a temporarily higher or stable real wage
(W/P), depending on the scale of wage and price adjustments.
- In the medium term, the impact on the real wage is intricate. If firms can
adapt to higher labor costs through productivity or other means, the real wage
may sustain gains, benefiting workers. However, if firms struggle to adjust,
they might cut hiring or investments, potentially increasing unemployment. In
such cases, the medium-term effect on the real wage could be less favorable.
Moreover, if increased worker bargaining power lacks matched productivity
gains, it might drive up prices (inflation), potentially eroding the real wage over
time.

The impact of enhanced worker bargaining power on real wages hinges on

factors such as wage-price adjustments, productivity shifts, and overall
economic conditions. While short-term gains are possible, the medium-term
results rely on how the labor market and firms respond to these shifts.

Question 4 − The existence of unemployment

● Suppose the unemployment rate is very low. How easy is it for firms to find
workers to hire? How easy is it for workers to find jobs? What do your
answers imply about the relative bargaining power of workers and firms when
the unemployment rate is very low? What do your answers imply about what
happens to the wage as the unemployment rate gets very low?
-> In a situation of very low unemployment:
1. Firms Finding Workers: Firms face difficulties in locating available workers
for hiring. With low unemployment, many people are already employed or
easy to switch jobs, reducing the pool of potential hires for companies.
2. Workers Finding Jobs: Workers find it easier to secure employment. In a
low unemployment environment, job opportunities are plentiful, and employers
are more inclined to hire, making it relatively straightforward for job seekers to
find work.
3. Relative Bargaining Power: Workers typically possess greater bargaining
power when the unemployment rate is very low. With a limited pool of
available workers, firms may need to offer higher wages and improved
benefits to attract and retain employees. Workers can leverage this tight labor
 market to negotiate for better conditions.
4. Wage Impact: As the unemployment rate drops, competition for labor
intensifies. In their efforts to attract and retain employees, firms may offer
higher wages and enhanced benefits. This results in upward pressure on
wages, which is a common outcome of a very low unemployment rate.

● Given your answer to part (a), why is there unemployment in the economy?
(What would happen to real wages if the unemployment rate were equal to
zero?)
-> Unemployment exists in the economy for various reasons, including job
transitions, skill mismatches, economic cycles, seasonal fluctuations, and
institutional factors. If the unemployment rate were zero, it could lead to
inflationary pressures, labor shortages, reduced worker mobility, and potential
skills mismatches. A small, nonzero unemployment rate is considered normal
for a well-functioning economy as it helps maintain labor market flexibility and
prevents excessive inflation.