10%

B. Employer Collusion
Suppose there are four fast food franchises hiring workers. The marginal product of labor for each is:

Employer Marginal Product of Labor ($)

McDonalds 18
Wendy's 20
Burger King 10
Chipotle 15
Meanwhile, there are four potential workers, each with a willingness-to-accept as in this table:

Worker Willingness-to-accept ($)

Carlos 10
Alan 15
Grace 20
Esther 8
1. Suppose there is a competitive labor market.

To solve this question let's line employers (consumers) in descending order of their marginal product of
labor, and workers (producers) in ascending order of their willingness to accept:

Employer Marg. Prod. Of Labor Worker Willingness-to-accept

Wendy's 20 Esther 8
McDonalds 18 Carlos 10
Chipotle 15 Alan 15
Burger King 10 Grace 20

At a wage of $15 the number of workers willing to work equals the number of employers willing to hire.

a. What is the equilibrium wage?

$15
b. How many workers are hired?
3 workers
c. What is consumer surplus?
(20-15) + (18-15) + (15-15) = $8
d. What is producer surplus?
(15-8) + (15-10) + (15-15) = $13
e. What is total surplus?
$8 + $13 = $21
2. Now suppose the owners of the four restaurants are good friends. They have an agreement that
none of them will offer a wage higher than $10. (This is called collusion or the formation of a
purchasing cartel.) Hint: Is this situation similar to Part 1 from Homework 2? Does the
collusive agreement look like bid-rigging?
a. How many workers are hired?
The collusive agreement looks like a price ceiling. At a wage of $10 only Carlos and
Esther are willing to work, meaning 2 workers are hired. Wendy's and McDonalds are
 able to hire them, while Chipotle and Burger King are unable to hire (despite being
willing to hire).
b. What is consumer surplus?
(20-10) + (18-10) = $18
c. What is producer surplus?
(10-8) + (10-10) = $2
d. What is total surplus?
$18 + $2 = $20
e. Given your answers to 1c and 2c, explain why employers might be willing to collude
Collusion clearly raises employers' surplus (consumer surplus) at the expense of both
workers' (producer) surplus and total surplus.
3. Suppose that the collusive agreement from Question 2 is in effect. The government, responding
to complaints from workers that wages are too low, sets a minimum wage of $15.
In this case the minimum wage actually returns us to the equilibrium wage. The following
answers are the same as for Question 1.
a. How many workers are hired?
3 workers
b. What is consumer surplus?
$8
c. What is producer surplus?
$13
d. What is total surplus?
$21
e. Compare your answers to 3a and 3d to your answers to 2a and 2d. Did the minimum
wage create unemployment and reduce surplus, as predicted by the model of labor
markets covered in lecture? Why or why not?
It did not because it was counter-acting the effect of the collusive agreement between
employers. Collusion was holding the wage below the equilibrium level, and the
minimum wage moved the prevailing wage back to the equilibrium.
f. Many empirical studies have found little or no evidence that minimum wages increase
unemployment. Does your answer to the previous questions suggest one explanation
why that might be?
The standard model of labor markets assumes there is competition between employers
for each worker. If that assumption is false and employers are able to collude or are
large enough to hold down wages themselves, then a minimum wage may move the
economy towards rather than away from the efficient outcome.
What Caused the Great Recession?
Assessing Two Explanations
In this assignment you will take our model to the data to understand what might have been the cause of
the Great Recession.

A. Was it Caused by a Real Shock?

Suppose that the long run aggregate supply curve is given by

3 1
⃑𝐿 = 𝐴+ 𝐾
𝑌 ⃑
4 4

⃑ = 0. Suppose the money supply is growing at a rate of 5 percent per year, and the
Initially, 𝐴 = 2, 𝐾
velocity of money does not change.

1. Derive the aggregate demand curve and the long-run aggregate supply curve

2. Solve for the initial equilibrium.

a. What is real GDP growth? What is the rate of inflation?
 b. Draw an aggregate supply-demand diagram. Make sure to label your axes, the curves,
equilibrium inflation and GDP growth, and vertical intercepts.

3. Here is a list of possible changes in the economy:

i. The growth rate of the capital stock increases to 3 percent per year
ii. The growth rate of the money supply falls to -4 percent per year
iii. The growth rate of productivity falls to -5 percent per year
iv. The growth rate of real consumption spending increases to 2 percent per year

Of the real shocks1 in this list, which of these changes is most likely to have caused the Great
Recession? Explain why your answer is right, and why each of the other three answers is not.

4. Suppose the answer you chose in Question 3 actually happened. Solve for the new equilibrium.

1
Shocks to the long-run aggregate supply curve, as compared to demand shocks, which move aggregate demand.
 a. What is real GDP growth? What is the rate of inflation?

b. Add the new equilibrium to your aggregate supply-demand diagram from A.2.b, making
sure to shift any curves as necessary.

5. We have talked about several possible shocks that Real Business Cycle theory predicts would
cause a recession. But it seems implausible that there was a massive destruction of physical or
human capital. It also seems unlikely that there was technological regress.

The article shows that there was a seize-up in the financial system. Why might this cause the
change that you chose in Question 3? (Hint: Think back to our discussion of the role of the
financial market in the economy. What would happen if the financial system stopped working?)

B. Was it Caused by a Demand Shock?

Suppose that the AD and LRAS curves are exactly as you derived in Part A.1.

1. What is the short-run aggregate supply curve?

2. Solve for the initial equilibrium.

 a. What is real GDP growth? What is the rate of inflation?

b. Draw an aggregate supply-demand diagram. Make sure to label your axes, the curves,
equilibrium inflation and GDP growth, and vertical intercepts. (Unlike your diagram for
A.2.b, this one will have the short-run aggregate supply curve.)

3. Now suppose that the growth rate of the money supply falls to -4 percent per year.
a. What is the new aggregate demand curve?

b. Solve for the new short-run equilibrium (that is, before expectations have shifted).
What is real GDP growth? What is the rate of inflation?
 c. Add the new short-run equilibrium to your aggregate supply-demand diagram from
B.2.b, making sure to shift any curves as necessary.

4. Assume the change in the growth rate of money is permanent. Also assume that neither
Congress nor the Federal Reserve take any action to address this shock.
a. In words, explain why, in the long run, the short-run aggregate supply curve will shift.
Why does this return to long-run equilibrium?

b. Solve for the new long-run equilibrium. What is real GDP growth? What is the rate of
inflation?

c. Write down the new short-run aggregate supply curve.

 d. Add the new long-run equilibrium to your aggregate supply-demand diagram from
B.2.b/B.3.b, making sure to shift any curves as necessary.

5. Based on the article, does the shock from B.3 seem like the real cause of the Great Recession?
Why or why not?

6. Suppose instead that our setup is exactly as it was in B.2 (before the money supply fell). Now
suppose that the velocity of money is 𝑣 = 5𝐶 + 2𝐼 + 3𝐺 + ⃑⃑⃑⃑⃑⃑
𝑁𝑋. Suppose that a crash in the
prices of houses reduces the wealth of consumers. They respond by spending less, causing 𝐶 to
fall to -1. Meanwhile, turmoil in the financial market makes it hard for firms to borrow, causing a
decrease in investment. 𝐼 falls to -3. Everything else remains unchanged.
a. What is the new aggregate demand curve?

b. Solve for the new short-run equilibrium. What is real GDP growth? What is the rate of
inflation?
 C. Which Explanation Does Better?
Now let's take the predictions of these two theories and assess which one is more accurate. This will
help us decide which of the two perspectives is more useful.

1. Look back at your answers to Part A. How does the model predict a real shock will affect
inflation in a recession? (That is, when GDP falls?)

2. Look back at your answers to Part B. How does the model predict a demand shock will affect
inflation in a recession? (That is, when GDP falls?)

3. The figure below shows what actually happened to inflation and real GDP growth during the
Great Recession. Which of the two predictions best matches the data? What does that imply is
the most likely cause of the Great Recession?

This diagram better matches the prediction made when there is a demand shock. Only a demand
shock causes both inflation and GDP to decrease (inflation and GDP move together). By contrast, a
real shock causes inflation to rise whenever GDP falls.

Inflation and Real GDP Growth During the Great

Recession
10
8
6
4
2
0
-2
-4
-6
-8
-10
-12

Inflation Real GDP Growth