Question

Suppose that households’ wealth substantially increases.

a. Using the labor market diagram, show the effects of this change on demand for and supply of labor. Explain what happens to the equilibrium labor input and real wage rate.

b. Using the capital market diagram (which shows the desired capital stock), show the effects of the change in wealth on MPK (demand for capital) and the user cost of capital (supply of capital).

Answer 1

a. The intial equilibrium in the labor market occurs at point E1. Increase in the wealth of the households will lead to domination of income effect over substitution effect and this will reduce the supply of labor in the labor market. This will shift the labor supply curve leftwards to Ls' and thus new equilibrium in the labor market occurs at point E2 where real wage rate has increased to Ow2 and employment or equilibrium labor input in the economy has decreased to L2. This can be depicted in the diagram as:

b. In the capital market as labor becomes expensive, some of the labor is substited for capital and this increases the demand for capital in the capital market and this leads to rightward shift of the demand for capital in the capital market. This rightward shift of the capital demand will lead to increase in the rate of interest in the capital market.