Advanced Macroeconomics (MSc Economics) Spring term - Class I

Giovanni Melina Birkbeck College, University of London March 2, 2010

The Shapiro-Stiglitz model - Problem 9.3

Describe how each of the following aect equilibrium employment and the wage in the Shapiro-Stiglitz model: Recall the no-shirking condition (NSC): L w=e + + b L NL and the labour demand curve: w = Ae F ( eL) (2) Equation (2) states that rms choose L so that the marginal product of eective labour equals the marginal cost of eective labour, where w is set to satisfy (1). (a) An increase in workers discount rate, . e q (1)

Figure 1: The eect of an increase in or b NSC shifts up. Intuitively, since workers discount the future more, it matters less to them if they are caught shirking, are red, and have to go through a period of unemployment. Thus, at a given level of employment, rms must pay a higher wage to deter shirking. The labour demand curve is unaected. Equilibrium employment falls and the equilibrium wage rises. (b) An increase in the job breakup rate, b. 1

Same gure as above. Intuitively, since workers are more likely to lose their job anyway, the value of being employed is lower. Thus workers are not as concerned about being caught shirking and red. The labour demand curve is unaected. Equilibrium employment falls and the equilibrium wage rises. (c) A positive multiplicative shock to the production function (that is, suppose the production function is AF (L), and consider an increase in A.

Figure 2: The eect of an increase in A The rise in A shifts the labour demand curve to the right. The NSC is unaected. The equilibrium wage rises as does the level of employment. . (d) An increase in the size of the labour force, L

Figure 3: The eect of an increase in L The vertical position of the vertical supply curve shifts to the right. The labour demand curve N L is now higher. Thus, at is unaected. The NSC shifts down. Intuitively, at a given N L, L a given level of employment, if workers become unemployed, they are likely to stay unemployed longer. The cost of shirking is greater for a worker and thus rms can get away with paying a lower wage. Equilibrium wage falls and employment rises.

The fair wage-eort hypothesis (Akerlof and Yellen, 1990) - Problem 9.5
Suppose there are a large number of rms, N , each with prots given by F (eL) wL, F () > 0, F () > 0. L is the number of workers the rm hires, w is the wage it pays, and e is the workers eort. Eort is given by e = min[w/w, 1], where w is the fair wage; that is if workers are paid less than the fair wage, they reduce their eort in proportion to the shortfall. Assume that there are L workers who are willing to work at any positive wage. (a) If a rm can hire workers at any wage, what value (or range of values) of w minimizes the cost per unit of eective labour, w/e? For the remainder of the problem, assume that if the rm is indierent over a range of possible wages, it pays the highest value in this range. The value of w that minimizes w/e is the one that solves the prot maximization problem of the rm: max F (eL) wL s.t. e = min[w/w, 1], Q = eL The FOC wrt L implies: F (Q)e = w. Hence: if w w F (Q) = w and e = w/w (Assume w = w) if w > w F (Q) = w and e = 1. Hence if the rm is free to set wage freely, it will set the fair wage. (b) Suppose w is given by w = w + a bu, where u is the unemployment rate and w is the average wage paid by the rms in the economy. Assume b > 0 and a/b < 1. (i) Given your answer to part (a) (and the assumption about what rms pay in cases of indierence), what wage does the representative rm pay if it can choose w freely (taking w and u as given)? As above, if the rm is free to set wage freely, it will set the fair wage. In this case w = w = w + a bu. (ii) Under what conditions does the equilibrium involve positive unemployment and no constraints on rms choice of w? (Hint: In this case, equilibrium requires that the representative rm, taking w and u as given, wishes to pay w .) What is the unemployment rate in this case? In order rms to be unconstrained, there must be a positive rate of unemployment. In this case, all rms choose to pay the fair wage (nothing more). Since this is true for all rms, w = w and w = w + a bu implies u = a/b. As long as a > 0 there will be positive unemployment in equilibrium. (iii) Under what conditions is there full employment? In order u = 0, it must be that a 0. If a = 0, the fair wage will simply be equal to the wage which in turn equals the marginal product of the full-employment labour force. If a < 0, the perceived fair wage is always less than the average wage for any value of unemployment. Since workers are willing to work at any positive wage, rms need only pay slightly above zero to get workers to be willing to work, even with zero unemployment. (c) Suppose the representative rms production function is modied to be F (Ae1 L1 + e2 L2 , A > 1, where L1 and L2 are the numbers of high-productivity and low-productivity workers the rm hires. Assume that ei = min[wi /wi , 1], where wi is the fair wage for type-i workers. wi is given by wi = [(w 1 + w 2 )/2] bui , where b > 0, w i is the average wage paid to workers of type workers of each type. i, and ui is their unemployment rate. Finally assume there are L (i) Explain why, given your answer to part (a) (and the assumption about what rms pay in cases of indierence), neither type of workers will be paid less than the fair wage for that type. 3

Take FOCs wrt L1 and L2 : F (Q) =

F (Q) = w /A if w1 w1 1 if w1 > w1 F (Q) = w1 /A

w1 1 e1 A

F (Q) =
F (Q) = w if w2 w2 2 F (Q) = w if w2 > w2 2

w2 e2

(ii) Explain why w1 will exceed w2 by a factor of A. Combine FOCs: F (Q) = w1 /A = w2 w1 = Aw2 (iii) In equilibrium, is there unemployment among high-productivity workers? Explain. (Hint: If u1 is positive, rms are unconstrained in their choice of w1 .) We have seen that w1 > w2 . As all rms are equal, we also have that w1 = w 1 and w2 = w 2 . Thus: w1 + w2 w1 = bu1 2
w2 =

w1 + w2 bu2 2

Note that:

w1 + w2 > w2 2 , it must be that u < 0, which is impossible. Thus w > w and u = 0. Hence, if w1 = w1 1 1 1 1 w1 > Suppose there is no unemployment among the low-productivity workers. Then, the fair wage for them would be: w1 + w2 w2 = > w2 2 This cannot be true, because we have shown that the rm will not pay a wage below the fair . wage. Hence there must be some positive unemployment rate u2 > 0 such that w2 = w2

(iv) In equilibrium, is there unemployment among low-productivity workers? Explain.