Question

Suppose that laws are passed banning labor unions and that resulting lower labor costs are passed along to consumers in the form of lower prices.
(a) Identity the type of shock. Demand shock or supply shock? Favorable or adverse? Explain. (0.5 points)

(b) Use the aggregate demand–aggregate supply model to illustrate graphically the impact in the short run and the long run of this shock. Be sure to label: i. the axes; ii. the curves (LRAS, SRAS and AD); iii. the initial equilibrium values (initially, all three curves intersect at a point, say A); iv. the direction the curves shift; v. the short-run equilibrium values; and vi. the long-run equilibrium values. (3 points)

(c) According to your answer in part (c), what is the new equilibrium prices and output in the short run and the long run. Explain in words. (1 point)

Answer 1

a) As labor unions are banned , the costs of labor declines . This causes the production costs to decline . So this is a supply shock or a favourable supply shock . This is because the costs fall and production increases .

b) In the short run the aggregate supply curve shifts rightwards causing fall in price level and increase in real GDP . Eventually in the long run wages will rise . This will cause the unit cost of production to increase . So the SRAS will shift back to its original position .

c) In the short run new equilibrium prices and output were P1 and Y1 . In the long run it is again Y0 at P0 . In long run the wages slowly increases because increase in production would mean higher demand for labor which increases the wage . In the long run the SRAS moves back till all 3 curves intersect at equilibrium .

LRAS SRAS SRAS 山B