Question

2. Draw a graph of the labor market that shows the impact of reduction in labor demand for two cases (a) wages are perfectly flexible, and (b) wages are perfectly inflexible (do not change). Show what happens to labor hours in both cases, and to wage in both cases. Label everything clearly.

Answer 1

(b) The second diagram shows the fall in labor demand when the wages are inflexible in the labor market.Inflexible wages are also known as the sticky wages as these wages will not change according to the changes in demand and supply of labor in the labor market.In the figure when there is reduction in the labor demand from d¹ to d² the firms cannot the reduce real wages .The real wages will remain at w¹.There are various reasons for the stickiness of wages such as trade unions ,employment contracts ect..When there is contract between the employers and employees even if the labor demand decreases the workers will resist the wage cut.This sticky wages will lead to a large fall in the employment level.Employment level reduces from E² to ȳ.The fall in employment under sticky wages are more than fall in employment under flexible wages.Sticky wages causes disequilibrium in the labor market.

Thus to conclude when the wages are flexible a reduction in labor demand will lead to cut in the real wages and firms will employ laborers for less hours.

When the wages are sticky when there is a reduction in labor demand the wages are not reduced.