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Using a Labor Market Model
Econ 103
Principles of Macroeconomics
1. Using a standard labor market model, present an analysis that explains why
deflation can cause economic problems, at least in the short term.
2. Using a standard labor market model, present an analysis where you identify the
expect long term economic impacts of running out of natural resources like oil,
which are currently important inputs in many production processes. (In
performing your analysis, assume the loss of any productive input will decrease
labor productivity.)
3. By examining the impact of population growth in a standard labor market model,
explain why it is not reasonable to measure the economic health of a nation by
counting jobs.
Answers to Homework 4
1.In the labor market diagram below, the economy is initially in equilibrium. The
employment level is the labor level where labor supply equals labor demand, identified as
L1s  L1d in the figure. Deflation, by definition, is a decrease in the economy’s general
price level. That is, the prices of products on average are decreasing. In this situation,
the wage any worker receives will buy more. Thinking of the nominal average wage
level as the variable W , a decrease in the price level P implies that the real wage W / P
increases. An increase in the real wage implies that people get more out of working. We
assume that this leads more people into the workforce (i.e. more start looking for work
when the real wage increases). In the figure, the increase in the real wage increases the
number of people looking for work from L1s to Ls2 . At the same time, a decrease in the
price level makes business less profitable for producers. At the price P1 , our assumption
was that employers were maximizing profits by hiring labor up to the point where the last
worker hired was just producing enough value to cover the wage paid. The deflation
therefore means that the last worker hired would no longer be producing enough value to
cover the wage. So, the deflation would encourage employers to layoff workers until
labor productivity increased to a point where the wage could be covered. In the figure,
the deflation causes a decrease in labor demand from L1d to Ld2 . Overall, then, the
deflation creates a labor surplus equal to the gap Ls2  Ld2 , as shown in the figure. The
employment level would at least temporarily drop from L1d to Ld2 . The labor surplus
would create pressure for a decrease in the nominal wage level, which would eliminate
the surplus and move the employment level back to its original level. However, in the
short term, the deflation would be expected to cause pain in the form of unemployment
and lost production.
Ls, Ld
Ls
Ls2
L1s  L1d
Labor Surplus
Ld2
Ld
W1 / P1 W1 / P2
W/P
2. In the labor market diagram below, it is assumed that the economy initially has an
employment level that is at the level where L1s  L1d , while the real wage level is
initially W1 / P1 . When the loss of a productive input decreases labor
productivity, employers will be encouraged to layoff workers. (This is because
the last worker hired will no longer be producing enough value to cover his or her
wage.) In the figure, this loss in the willingness to hire is captured by the
decrease in labor demand from L1d to Ld2 . The labor supply remains unchanged,
meaning a labor surplus is created equal to Ls2  Ld2 , as shown in the figure. This
puts a downward pressure on the nominal wage. In the short term, the nominal
wage may be “sticky” and not adjust downward, meaning the unemployment
created by the loss of the productive input could persist for some time. However,
by definition, in the long run the labor surplus must be eliminated by wage and
price adjustments. Thus, in the long run, the impact of the loss of a productive
input is to decrease the employment level and decrease the real wage. In the
figure the real wage decrease is from W1 / P1 to W2 / P1 , and this means that the
standard of living of the average worker is reduced. The ultimate decline in
employment is from the level where L1s  L1d to the level where Lss  Lds . The
decrease in employment, along with the assumption that labor productivity
declines, means that the nation’s output would also decrease (i.e., a recession
would be experienced.
Ls, Ld
Ls
L1s  L1d  Ls2
Ls3  Ld3
Labor Surplus
Ld2
d
2
L1d
L
W2 / P1
W1 / P1
W/P