EC201 Macroeconomics 2, Spring 2016

University of Warwick
Thijs van Rens

Labour markets
Seminar questions - part I

Standard labor market model

1. In the standard competitive labor market model, the labor demand curve is
derived from the prot maximization problem of rms. Suppose rms produce
according to a production function f (K; L) = AK L1 , where A is total factor
productivity, K is capital, which rms may rent at a rate r, and L is labor input,
which is hired at a wage rate w.
(a) Derive the labor demand curve, which is a relation between labor demand
L and the wage rate w.
(b) Calculate the slope of the labor demand curve. As we would expect, this
curve is downward/upward sloping.
2. Again in the standard competitive labor market model, the labor supply curve
is derived from the labor-leisure choice of workers. Suppose workers utility
function is given by u (c; L) = c + 1 1 (1 L)1 , where c is consumption and L
is labor supply, which is measured as a fraction of total time available, so that
0 < L < 1. Workers face a budget constraint, c = wL, which states they cannot
consume more than they earn.
(a) Derive the labor supply curve, which is a relation between labor supply L
and the wage rate w.
(b) Calculate the slope of the labor supply curve. As we would expect, this
curve is downward/upward sloping.
3. Solve for the equilibrium level of employment, which is given by the intersection
of the labor demand and supply curves. Does employment increase or decrease
with productivity? Explain why?
4. What is meant by the intensive and extensive margins of labor adjustment?
What do we know about the importance of each in the data?
5. What is inactivity and how does it relate to unemployment?
6. What is the Barro critique to wage rigidity? Why does this critique not apply
in a labor market model with search frictions?
7. What are the two main problems of the competitive labor market model that
make this model not very suitable to analyze unemployment?

Introduction to the search model

In the lecture, we derived the Bellman equations for the value of an employed worker
W . To test your understanding of how this equations was derived, we will see how it
changes if we modify the assumptions of the model.
1. When a worker looses her job, the rm needs to pay her a severance payment
in the amount of 3 months wages.
2. When a worker gets hired, she initially gets a temporary contract. That means
the probability she looses the job again is high: H per month. With probability
, the worker gets promoted to a permanent position, which she looses only with
a low probability L < H per month.
3. When a worker becomes unemployed, initially she receives unemployment benets in the amount of a fraction of her last earned wage w. However, with
probability , these unemployment benets run out and she receives only welfare
benets b < w.