Unemployment is one of the major macroeconomic issues that concern policy makers. Some economists have argued...

Unemployment is one of the major macroeconomic issues that concern policy makers. Some economists have argued the main reason for a rise in unemployment during the great recession 2008/09 is a drop in labour demand.

Show the effects of a drop in labour demand curve using the labour supply and labour demand curves in the competitive equilibrium with perfect information. Can it predict a rise in unemployment?
Suppose now there is imperfect information, e.g. firms cannot perfectly observe workers’ effort. Explain how your answers to part (a) are changed.
Another reason why a drop in labour demand can imply a higher unemployment rate is the minimum wage law. Explain how it works using labour supply and labour demand curves. Can this be a main cause of the rise in aggregate unemployment during the great recession for the United States?

Solutions

Expert Solution

a) See diagram below.

Initially, equilibrium is obtained in the labor market at point E1 with wage rate w1 and labor demand-supply equal to L1. With a drop in labor demand, the labor demand curve shifts leftwards. At wage rate w1, labor demand is L3 (in correspondence to point A) and labor supply is L1 (in correspondence to point E1). There is excess of labor supply as L1>L3. People are willing to work at less wages now to get jobs.

In case of perfect information, firms reduce the wages accordingly and labor demand rises while labor supply falls till equilibrium is obtained at E2. There is no unemployment.

b) See above diagram. In case of imperfect information, firms do not have the information that labor supply is more than demand. They continue demanding at point A while labor supply is as per initial point E1. Here, (L1 - L3) represents unemployment.

c) See diagram below.

If minimum wages wM and imposed, there is excess labor supply in the labor market. As a result, there is unemployment equal to labor supply (L3) minus labor demand (L1).

Rahul Sunny answered 1 year ago

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