Question

Question 2 (5 marks) The wage setting relation W = PF(u, z) developed in lectures and in Blanchard, for the situation where P = Pe can be drawn in real wage/unemployment space as follows: W/P WS (Wage setting relation) u (a) (b) Explain why an increase in the unemployment rate would be associated with a lower real wage rate. Explain what effect an increase in the unemployment benefit rate would have on this wage setting relation Explain the effect an increase in firms' markup would have on the natural rate of unemployment. C)

Answer 1

2.(a)

The increase in unemployment rate increases the amount of unemployed labor in the industry or economy. This makes abandond labor cheaply available to the firm. The unemployed workers are close substitutes of the employed ones. this weakens the bargaining power of the employed. On the other hand, this makes the firm to bargain for a lower wage easily, hence, the higner unemployment rate is associated with lower real wage rate.

(b)

The increase in unemployment benefit increases the catch all variable z in the WS function. The increase in z shifts the WS curve to the right. This is at any real wage rate the natural rate of unemployment increases in the economy. This is because the increase in unemployment benefit increases the disincentive to work and labor try to remian unemployed for a longer time. Hence, the increase in z increases unemployment at each (W/P).

(c)

The increase in firm mark up makes the firm less competitive. That is the market power of the firm rises with mark up. This increases the firms bargaining power in the labor market. The increase in market power makes more people unemployed as firm offer less real wage rate. Therefore, the markup increases natural rate of unemployment.