Question

The “worker misperception model” focuses on labor supply (workers offering their labor for hire) and sticky expectations about the price level (Pe). Explain how expected real wages

(expected by labor suppliers) ultimately determines the equilibrium amount of labor hired.

Illustrate with a labor market graph.

Answer 1

Under the worker misconception model, it is assumed that the wages adjust themselves freely to equilibrate in the market.

Under the model, the demand for the labor depends upon the real wages, while the supply of labor depends on the expected real wage, as the workers are not fully aware of the real wages, they suffer from the money illusion. When they see a hike in the nominal wage, they assume it as a rise in the real wage.

Ld=f(W/P)

Ls=h(W/Pe)

where W/Pe is the expected real wage. The W/Pe can be written as W/P*P/Pe where P/Pe is the workers' misconception about the price level. This will be greater than 1 when P>Pe and vice versa. So we can say that the supply of labour depends on the real wage and the misconception of workers about the price level in the economy.

In this illusion, the workers are expected to supply more of labour at the initial real wage. This cause the supply of labor curve to shift to the right which leads to the decline in the real wge and increases the demand for labour. The result is the new equilibrium at the lower real wage rate and higher employment which got transformed into higher output level.