Question

Problem 6 Due to the collapse of the housing bubble in 2007-2008 there was a financial crisis that led to rampant unemployment. Draw a best resonse curve (BRC) for each of the following years and explain what it illustrates 1. the pre-crisis period (2006) 2. the crisis years (20078) 3. the post-crisis year (2009) Your diagram should show that firms would be able to lower costs during the crisis by offer ing a lower wage however, there is empirical evidence that this did not happen. One reason cause is that firms thought that lowering wages in such a tough time would lower morale and workers to spitefully exert less offort. To show how this can be seen in our model draw a new best response curve that shows a decrease in workers morale and show that lowering the wage can actually increase costs This is going to be complicated so I will try to walk you through it a bit. You should draw two BRC that are identical but shifted due to lower reservation wage (caused by unemployment), then you should draw 3 isocost lines (2 optimal ones for the BRC you just drew and 1 that. goes through the point representing the firm giving same wage during crisis). Then draw another BRC of low morale employees who are enduring the crisis and given a lower wage (hint this will be a rotation not a shift!). Now draw an isocost line through the optimal point on this new BRC and note how its slope compares to the slope of the isocost line you drew through the point where the firm paid the employee a higher than optimal wage 7 Probl Problem 6 Due to the collapse of the housing bubble in 2007-2008 there was a financial crisis that led to (BRC) for each of the following years rampant unemployment. Draw a best response curve and explain what it illustrates: 1. the pre-crisis period (2006) 2. the crisis years (20078) 3. the post-crisis year (2009) Your diagram should show that firms would be able to lower costs during the crisis by offer- ing a lower wage however, there is empirical evidence that this did not happen. One reason is that firms thought that lowering wages in such a tough time would lower morale and cause workers to spitefully exert less effort. To show how this can be seen in our model draw a new best response curve that shows a decrease in workers morale and show that lowering the wage can actually increase costs. This is going to be complicated so I will try to walk you through it a bit. You should draw two BRC that are identical but shifted due to lower reservation wage (caused by unemployment), then you should draw 3 isocost lines (2 optimal ones for the BRC you just drew and 1 that goes through the point representing the firm giving same wage during crisis). Then draw another BRC of low morale employees who are enduring the crisis and given a lower wage (hint this will be a rotation not a shift!). Now draw an isocost line through the optimal point on this new BRC and note how its slope compares to the slope of the isocost line you drew through the point where the firm paid the emplovee a higher than optimal wage. 7

Answer 1

1. In the pre recession period the housing sector was booming. Booming means more and more jobs were being created in the market. Therefore, there will be less unemployment in the market.

2. In the year of crisis (2008), employees were being sacked down. As businesses were closing down because if the crisis, and the businesses were incurring losses. So employees were being sacked down. This period has seen an increased rate of unemployment.

3. In the year of post crisis (2009), again jobs were created as the economy tried to recover from the crisis. Hence, again the rate of unemployment will be lower.