Question

the labour market model

a. Take a look at figure 9.12, the labour market model. Describe position B. Explain why B is not a Nash equilibrium. What would happen?

b. In a. you’ll describe an adaptation process. However, that might not take place. For what reasons?

Labour supply Average product of labour Real wage Price-setting curve Equilibrium unemployment Demand-deficient or cyclical unemployment, at B Wage-setting curve Total involuntary unemployment, at B Employment, N The Nash equilibrium At point B, total involuntary unemployment is given by the sum of cyclical and equilibrium unemployment. Point X is the Nash equilibrium of the labour market, which means that all actors are doing the best they can, given the actions of the other actors. No worker or firm can improve their position by changing their actions. Figure 9.12 Equilibrium and demand-deficient (cyclical) unemployment.

Answer 1

a) At B, at a given real wage set by firms, there is a higher unemployment. So, firms could hire labor at a much lower cost. So, they will shift their price setting real wage down. It will keep on cutting prices till price setting curve intersects with wage setting curve.

b) The adaptation process can face following problems:

1. resistance from workers from cutting down nominal wages

2. If firms keep cutting the prices of their products, their will be deflation. If consumers predict more price cuts in the future, they may actually refrain from spending. Hence, sales and profit of the firm might become stable or actually fall down.

So, firms may not be ready to cut nominal wages.