Model Answer
0 min readIntroduction
The Classical model of employment, developed by economists like David Ricardo and John Stuart Mill, posits that the economy self-corrects towards full employment through flexible prices and wages. This model assumes perfect competition and rational expectations. A key tenet is that wages adjust to equate labor demand and supply, ensuring equilibrium. However, real-world economies often exhibit wage rigidity, where wages do not readily adjust downwards even in the face of excess labor supply. This rigidity, often due to factors like labor contracts and minimum wage laws, can significantly alter the outcomes predicted by the Classical model. This answer will explore how equilibrium employment and real wages change in a classical model when an increase in the supply of labor occurs, but money wages are rigid.
The Classical Model: A Foundation
The Classical model assumes a perfectly competitive labor market. Labor supply is determined by the willingness of individuals to offer their labor at different wage rates, generally upward sloping. Labor demand is derived from the marginal product of labor, and is downward sloping. Equilibrium is achieved where labor supply equals labor demand, determining both the equilibrium wage and the level of employment. Crucially, the Classical model assumes that wages are fully flexible, meaning they can adjust quickly and efficiently to changes in supply and demand.
Increased Labor Supply with Flexible Money Wages
If the supply of labor increases in a classical model with flexible wages, the initial impact is an excess supply of labor at the existing wage rate. This excess supply puts downward pressure on money wages. As money wages fall, firms find it cheaper to hire labor, leading to an increase in labor demand. Simultaneously, the lower wage rate discourages some workers from offering their labor, decreasing labor supply. This adjustment process continues until a new equilibrium is reached where labor supply equals labor demand.
In this scenario:
- Employment increases: Although some workers are initially displaced, the fall in wages stimulates enough demand to absorb a larger workforce overall.
- Real wage decreases: Since money wages fall and prices are assumed to be constant in the simplest Classical model, the real wage (money wage adjusted for price level) decreases.
- The economy returns to full employment: The flexibility of wages ensures that the economy self-corrects and returns to its initial level of full employment.
Increased Labor Supply with Rigid Money Wages
Now, consider the same increase in labor supply, but with the crucial difference that money wages are rigid. This rigidity could be due to factors like collective bargaining agreements, minimum wage laws, or efficiency wage theories. Because wages cannot fall, the initial excess supply of labor persists. Firms are unwilling to hire more workers at the existing wage rate, as the marginal product of labor is now lower than the wage.
The consequences are:
- Employment decreases: Firms respond to the excess supply of labor by reducing employment. Some workers are laid off, leading to unemployment.
- Real wage increases: Although money wages are fixed, the price level may fall due to decreased aggregate demand (as employment and income fall). This fall in the price level leads to an increase in the real wage.
- Persistent unemployment: The economy does not self-correct to full employment. The rigid money wage prevents the necessary adjustment in the labor market.
Graphical Representation
Imagine a labor market diagram. An increase in labor supply shifts the supply curve to the right. With flexible wages, the intersection of the new supply curve and the demand curve determines a lower equilibrium wage and a higher level of employment. However, with a rigid wage line, the new supply curve intersects the demand curve at a point representing unemployment. The quantity of labor supplied exceeds the quantity demanded at the fixed wage.
Long-Run Implications
In the long run, the persistence of unemployment due to wage rigidity can have significant consequences. It can lead to hysteresis effects, where prolonged unemployment reduces the skills and motivation of the workforce, making it even harder to return to full employment. Furthermore, it can necessitate government intervention in the form of unemployment benefits and active labor market policies.
| Scenario | Money Wage | Employment | Real Wage | Unemployment |
|---|---|---|---|---|
| Increased Labor Supply - Flexible Wages | Decreases | Increases | Decreases | None (Full Employment) |
| Increased Labor Supply - Rigid Wages | Constant | Decreases | Increases | Increases |
Conclusion
In conclusion, the Classical model predicts that an increase in labor supply will lead to lower wages and increased employment under conditions of wage flexibility. However, when money wages are rigid, the increase in labor supply results in unemployment and a higher real wage. This highlights the crucial role of wage flexibility in the Classical model’s self-correcting mechanism. The persistence of wage rigidity in real-world economies often necessitates government intervention to mitigate the negative consequences of unemployment and maintain economic stability. Understanding these dynamics is vital for formulating effective labor market policies.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.