Question

Suppose that the mythical country of Moricana has a downward rigid wage. Moricana is in a recession; capacity utilization in the economy is at an all-time low, and surveys show that firms do not expect economic conditions to improve in the coming year.

      a.    Firms in the country are cutting back on capital spending and investment. Use a graph to show how this would affect the labor demand curve (ignore the effects of multipliers).

      b.    How would the economy move along the aggregate production function curve?

      c.    Is unemployment in Moricana likely to be classified as voluntary or involuntary? Explain your answer.

Answer 1

Due to the downward rigid wage, firms will not be able to reduce wages. Instead, they will cut down on the number of workers hired at all wage rates.

a) Since firms are cutting down on capital investment, and wages are downward rigid, they will also have to cut down on employees. The labor demand curve will shift to the left:

Effectively this reduces the wage rate, as the existing workers will have to work more than earlier.

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b) There will be a leftward movement along the aggregate production function curve, towards lower levels of output and capital. This will also happen for output per worker and capital per worker.

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c) The unemployment that results is involuntary unemployment.

The workers wanted to work, but it was too costly for the firm to continue with a higher number of workers.

Though the wage rate didn't change due to rigidity, workers were laid off by firms, to control the total labor cost.