Problem Set No.

Instructor: Michele Pellizzari

Teaching Assistant: Eleonora Brandimarti

Instructions: Solutions to the problem set must be submitted on Moodle by the beginning of class on

18/11/2021 at the latest, before the problems will be solved. Your solution should be comprised of

one single, labelled .pdf file (well-organized hand-written solutions are accepted). No late submissions

are accepted.

Exercise 1 in this problem set can be solved with any statistical software (e.g. Excel, Stata, R).

QUESTIONS

1. (10 points) Using data from the OECD labour force statistics (stats.oecd.org) and the software of

your choice, produce a graph of the annual unemployment rates over the period 2010-2020, separately

for men and women and for the following countries: Germany, Switzerland and the United States.

You are free to choose the specific format of the graph (e.g. you could have multiple panels for

the different countries or different panels by gender) but in general you should put years on the

horizontal axis and the unemployment rates on the vertical axis. Describe your data and the overall

process of generating your graph if relevant.

Solution: One example of a possible solution:

Figure 1: Unemployment rates by country and gender

Germany Spain
10 15 20 25 30
Unemployment rate

Unemployment rate
3 4 5 6 7

2010 2012 2014 2016 2018 2020 2010 2012 2014 2016 2018 2020

Women Men Women Men

Switzerland United States

5.5

8 10 12
Unemployment rate

Unemployment rate
4.5 5

4 6
4

2010 2012 2014 2016 2018 2020 2010 2012 2014 2016 2018 2020

Women Men Women Men

Labour Economics Problem Set N.2

2. Consider a labour market characterised by the following labour demand and labour supply schedules:

LD = 160 − 2w

LS = −120 + 2w

(a) (10 points) Compute the equilibrium wage and employment under the assumption that the

market is perfectly competitive.

Solution: The equilibrium wage is the wage at which supply and demand are equal:

−120 + 2w∗ = 160 − 2w∗

w∗ = 70

Now replace this equilibrium wage into either the supply or the demand to find the equi-

librium level of employment. For example, replacing w∗ into labour demand yields:

L∗ = 160 − 2 · 70 = 20

The perfectly competitive equilibrium is represented graphically in the picture below:

(b) (10 points) Suppose now that the demand side of the market is dominated by a single monopson-

istic employer. Compute the equilibrium wage and employment level and represent it graphically

(assume the price of the consumer good is 1).

Labour Economics Problem Set N.2

Solution: In a monopsonistic labour market the equilibrium is at the intersection of the

marginal profit and the marginal cost associated with the hiring of additional labour. The

marginal profit is equal to the marginal product of labour and we know that the labour

demand function describes precisely the relationship between the marginal product of labour

and total employment:

L = 160 − 2 · M PL
1
M PL = 80 − L
2

The marginal cost of labour is the cost to the firm of employing the marginal unit of labour.

To derive this, first write the total cost function to the firm (abstracting from other inputs,

that we assume to be constant):

T C = w(L) · L

where the wage is expressed as a function of employment to indicate the fact that the

monopsonist cannot disregard the supply schedule. The monopsonist can lower the wage

but must take into account that by doing so there will be fewer persons willing to be

employed (and symmetrically for wage rises). Hence, the actual functional form of the

relationship between the wage commanded by the monopsonist and the available labour is

given by the supply function:

L = −120 + 2 · w(L)
1
w(L) = 60 + L
2

Then replace this into the total cost function to obtain a simple function of L and take the

first derivative to obtain the marginal cost:

 
1
TC = 60 + L · L
2
∂T C
M CL = = 60 + L
∂L

Now, we can compute the equilibrium level of employment by solving for M CL = M PL :

1
60 + L = 80 − L
2
40
L∗∗ = ≈ 13.33
3
Labour Economics Problem Set N.2

Replacing this employment level into the supply function we find the wage required to

mobilise this exact amount of labour supply:

1 400
w∗∗ = 60 + L∗∗ = ≈ 66.67
2 6

The graphical representation of the monopsonistic equilibrium is in the picture below:

3. Consider an efficient bargaining model where the representative firm is characterized by the following

production function
1
y = αL − βL2 .
2

(a) (5 points) Derive the firm’s labour demand as a function of wage and other parameters.

Solution: First, derive the marginal productivity of labour and set it equal to the wage:

∂y
MPL = = α − βL = w.
∂L

Rewrite the function in terms of L to obtain the labour demand function LD :

α 1
LD = − w
β β

(b) (5 points) Consider the following labour supply function LS = δw. Find the perfectly compet-

itive equilibrium values w∗ and L∗ .

Labour Economics Problem Set N.2

Solution: Perfect competition implies that in equilibrium, LD = LS :

α 1
− w = δw.
β β

Solving for w and L entails the following equilibrium levels:

α
w∗ =
βδ + 1

αδ
L∗ = .
βδ + 1

(c) (10 points) Now consider a monopolistic union withan utility function U = wγ L1−γ .

ˆ Derive equilibrium wages and labour with a monopolistic union. [Hint: think of the labor

demand function as the budget constraint of the model.]

ˆ Is there unemployment in equilibrium? Why? Which parameter(s) governs the presence of

unemployment? Can you derive a condition which only depends on the parameters of the

model which – if met – guarantees that there is unemployment in equilibrium?

Solution: First, find the marginal rate of substitution between wages and labour.

M UL
MRS = −
M Uw

M UL = (1 − γ)wγ L−γ , M Uw = γwγ−1 L1−γ

1−γ w
⇒ MRS = −
γ L

In equilibrium, the marginal rate of substitution must be equal to the slope of the budget

constraint (labor demand):

1−γ w 1−γ
=β ↔ βL = w
γ L γ

we can plug this back into the labor demand function found in part a) in order to obtain

equilibrium wages and employment with monopolistic unions:

1−γ α
w =α−w → w∗∗ = αγ, L∗∗ = (1 − γ)
γ β
Labour Economics Problem Set N.2

Unemployment. In equilibrium, there will be unemployment if the monopolistic union

wage w∗∗ is greater than the competitive equilibrium wage w∗ . This is because when wages

are higher than what they would be in the competitive equilibrium, more people are willing

to work at that rate than vacancies. This implies that

1
U > 0 if w∗∗ > w∗ ⇒ γ >
βδ + 1

If γ is greater that the previously found inequality, this means that the union has a suffi-

ciently strong preference for wages γ which generates unemployment in equilibrium.

(d) (10 points) Solve the efficient bargaining model and derive the contract curve. [Hint: derive

the profit function and normalize the price level to 1.]

Solution: First, derive the profit function with prices p = 1:

1
Π = py − wL = αL − βL2 − wL
2

The contract curve is then the set of points at which the slope of the isoprofit curve is equal

to the slope of the indifference curve.

The slope of the isoprofit curve is then given by the marginal rate of substitution between

labour and wages with respect to the profit function.

∂Π ∂Π M ΠL α − βL − w
= α − βL − w, = −L ⇒ =−
∂L ∂w M Πw L

We set this equal to the marginal rate of substitution with respect to utility to obtain

α − βL − w γ−1w
=
L γ L

We rewrite it in terms of w to obtain the contract curve:

αγ βγ
w= − L
2γ − 1 2γ − 1

(e) (10 points) Consider α = 0.3, β = 0.7, and γ = 0.7. Plot the contract curve and labour

demand curve and comment. What can you say about the contract curve? Is it upward sloping

or downard sloping, to the left or to the right of the demand curve? What is the best wage that
Labour Economics Problem Set N.2

the union can reasonably try to bargain? What is the best wage from the point of view of the

firm? [Hint: You can use software or a graphic calculator to plot the curves if you want to.]

Solution: Plot:

The contract curve (red) is always to the right of the labor demand curve (blue) and they

meet when w=0, hence equilibrium employment with a monopolistic union is always greater

than under perfect competition.

Best wage for the union: w moving upward along the contract curve (red line).

Best wage for the firm: w moving downward along the contract curve.