Question

Referring to the scale and substitution effects, explain why an increase in the wage rate will generate more of a negative employment response in the long run than in the short run. (Assume there is no change in productivity or nonlabor input prices

Answer 1

When the wage rate increases,the firms isocost will rotate in and the firm now maximizes profirs by choosing a lower level of output and employing fewer units of labor.

The firm will choose to lower output when an increase in the wages shifts the firms marginal cost curve higher and as a result,the industry's supply curve shift left and the prices rises.The new equilibrium is at the point when each firm has reduced its output.The amount of labor will decrease as the wage increases because of scale and substitution effect-

Substitution Effect-

Capital becomes relatively cheaper and the firms substitutes away from labor so, N falls while K rises.

Scale Effect-

The firm reduces its scale of operation and so, N and K both decreases.

Overall,amount of labor demanded falls and amount of capital demanded is indeterminate.

The substitution effect allows the prices to change but hold ouput constant

• Substitute away from labor (N0-N1)

The scale effect hold prices fixed at new levels but allow output to change

• Reduces labour requirements (N1-N2)

In the short run,the capital is fixed therefore there is no substitution effect and the labor demand is downward sloping because of scale effect and diminishing marginal product of labour.

In the long run the firm has more flexibility to change its inputs and so there is added substitution effect, therefore,the response to a wage change will be larger in the long-run.