Question

Answer both questions completely, yet concisely. Make sure that you provide explanations of the underlying economic behavior of agents.   Your completed extra credit is due by 11:59 PM on Monday October 19^th. Late submissions will not be accepted. Please submit your work as either a Word of PDF file to the drop box provided.

1. Why, when the prevailing wage rate is above the equilibrium wage rate, will wages fall back to the equilibrium?

2. Why, when the prevailing wage rate is below the equilibrium wage rate, will wages rise to the equilibrium wage rate?

Answer 1

Answer 1:

When the previaling wage rate in the labor market is above the equilibrium wage rate, there is surplus of labor in the labor market.. Thi can be depicted in the labor market diagram below where initial equilibrium in labor market occurs at point E and equilbrium wage rate is w*. Since previaling wage rate is equal to W' where amount of labor demanded is L1 but amount of labor supplied is L2 and thus there is surplus of labor in the labor market ny L1L2. This surplus of labor will cause the wages to decrease until they fall to the equilibrium level where labor demanded is equal to labor supplied and the market is in equilibrium.

Answer 2:

In the secind diagram, the previaling wage rate depicted by red line is below the equilibrium wage rate in the labor market. AT this wage, labor demanded exceeds labor supplied and there is shortage of labor. To eliminate this shortage , the wage rate will increase until quantity demanded is equal to quantity supplied and labor market is again in equilibrium.