Question

2.       Economists argued that temporary labor wage differentials tend to be eroded by labor mobility. Consider the two markets for sheet-iron workers and steel-pipe workers in the same region. Suppose both markets are competitive. We begin in a situation in which both sheet-iron workers and steel-pipe workers earn $20 per hour. Assume that workers can switch easily between the two jobs.

a.       Draw diagrams showing the supply and demand for labor in each market.

b.      Now suppose there is a sharp increase in the demand for steel pipe. Explain what happens in the market for steel-pipe workers.

c.       If the employment of steel-pipe workers increased in part (b), explain where the extra workers came from.

d.      What effect does the event in part (b) have on the market for sheet-iron workers?

e.      What is the long-run effect of the shock on the relative wages in the two types of jobs?

Answer 1

Q2) a) Take a look at fig 1 and 2 showing the labour market for sheet-iron(SI) and steel-pipe (SP) respectively. Labourers in both the markets earn wages of $20/hour. This is the equilibrium wage.

b) When there is a sharp increase in the demand for steel pipes, there will be an increase in the demand for steel-pipe workers. So, there will be a rightward shift of the demand curve in the steel pipe labour market. This will lead to increase in the equilibrium wage rate to W' as well as increase in the output to Q_L'. This is a positive demand shock. This increases the aggregate demand function of steep pipes, this will increase the output in the short run. So, steel-pipe factories will start hiring more labour, to meet the increased demand. However, the prices will also increase, leading to an increase in inflation. Take a look at fig 3.

c) Now, as the employment of steel-pipe workers increased due to the positive demand shock, the extra workers came from the iron sheet market as there is perfect labour mobility in the economy. So, iron-sheet workers entered the steel-pipe labour force and accounted for the increase in employment.

d) Now, as sheet iron workers changed their jobs and shifted to making steel-pipes, the supply of labour in the Sheet iron labour market fell. So, the supply curve underwent a leftward shift. This pushed up the wages in the sheet-iron labour market and output fell as now less workers are available to make iron sheets, So, the wages in this market increased as well due to a temporary negative supply shock.Take a look at fig 4.

So, we see the temporary wage differential or difference in the wages between steel-pipe and iron-sheet workers was quickly dissipated due to the presence of labour mobility.

e) Now, both the positive demand shock and the temporary negative supply shocks are corrected in the long run due to the self-adjustment mechanism of the economy. Let us see how!

So, first let us talk about the demand shock to the steel-pipes market, as the aggreaget demand increases, the output increases, which increases the price of teh goods and a general increase in inflation. This inflation spike leads to a fall in the real wages, workers will demand higher wages, increasing cost of labour, which will cause the short run aggreaget supply to fall, expectations regarding future inflations and increase in prices causes firms to produce less and charge more. This leads to fall in output, increase in unemployment, fall in wages, and rising prices which continues till real GDP is back to the full employment level of output. The unemployment rate is back to the natural rate, but the price level is permanently higher.

Now, when we talk about the temporary supply shock to the iron-sheets market, there is a decrease in the short run aggreagate supply (SRAS), output goes down, and both inflation and unemployment increases. The rise in unemployment will push down wages as there is less competition for labour, so firms have no need to compete for higher wages, once wages have adjusted, the fall in the price of labour input will increase the SRAS and output will return back to the full employment level output.

So, both the wages will be pushed down in the long run due to the self-adjustment nature of the market. So, the relative wages will undergo no effect in the long run and both the wages will be back at the equilibrium level. Even if prices rise in the long run due to inflation, the relative real wages will remain the same.