Question

Consider the markets for low-skilled and high-skilled labor.

a. Suppose the government introduces a subsidy to the employment of low-skilled workers physically paid to firms. (For simplicity, assume the government pays firms some amount for each low-skilled worker they hire.) How will the subsidy affect the employment of low-skilled workers, the wage low-skilled workers receive, and the netof-subsidy wage for low-skilled workers paid by firms? Will this policy tend to increase, decrease, or have no effect on income inequality (or is it not possible to tell)?

b. Suppose some low-skilled workers get more education, and so become high-skilled workers. How will this development affect the employment and wages of low-skilled and of high-skilled workers? Will it tend to increase, decrease, or have no effect on income inequality (or is it not possible to tell)?

Answer 1

a. When government introduces a subsidy to the employment of low skilled workers which is being paid to the firms, then this will reduce the cost of hiring low skilled workers of the firm. As the cost of hiring low skilled workers of the firm decreases, the demand for low skilled workers will also increase in the labor market. The diagram is depicted below:

The initial equilibrium in the labor market occurs at point E1 where demand for and supply of low skilled workers intersect. The provision of subsidy will shift the demand curve for low skilled workers rightwards to D'D' and this shifts the equilibrium from point e1 to point e2 where equilibrium wage rate has increased to Ow2 and level oif employment has increased to L2.The net of-subsidy wage for low-skilled workers paid by firms will decrease to ow' in the labor market as depicted in the diagram above. The policy will aim to decrease income inequality as wages of low skilled workers will increase along with increase in their employment. Thus, gap between high skilled and low skilled workers will decrease in the economy.

b.When low-skilled workers get more education and become high skilled workers, this will reduce the supply of low skilled workers in the labor market for low skilled workers. In the high skilled labor market, the change will increase the supply of high skilled workers. Thus, it can be seen in the diagram below, in the labor market for low skilled workers wages will increase and employment decrease and in the labor market of high skilled workers the real wage rate will decrease and employment of high skilled workers will increase.

This will reduce the gap between wage rate of high skilled and low skilled workers and thus help in reduction of income inequality in the economy.