Demonstration Lecture 5: Suggested Solutions 1. True.

The analysis underpinning the economy-wide short run aggregate supply curve is based on the derivation of the relevant supply curve for an individual firm. The first point to note is that an individual firm will produce up to the point where price of the product or service equals its relevant marginal cost. This is the firms profit-maximising condition. It also follows that in a perfectly competitive market that price will equal marginal revenue. aving established those criteria! the next step is to consider the individual firms production function in the short-run. "ssuming that the production function comprises a variable labour input! a fixed capital stock input! and a fixed level of technology! the marginal physical product of labour is the extra output that a firm can produce by adding an extra unit of labour input. The latter is presumed to show diminishing returns! or have a diminishing marginal physical product of labour for a given factor price #or money wage rate say per hour of labour$. %tudents should refer to pages 1&-1'! (hapter )! in the *rooks manuscript to see the relevant diagrams illustrating these relationships. The law of diminishing returns implies that the individual firms marginal cost #of production$ curve will be upwards sloping. In effect the latter curve is the individual firms supply curve! and so upwards sloping indicating that higher prices will induce higher levels of output in the short-run. +. True. The answer to this question builds on the previous answer. The key point to note is that one can establish a relationship between the marginal physical product of labour #,--.$! the individual firms marginal cost of production #,($! and the money wage rate #/$. "ssuming a constant or fixed money wage rate in the first instance! ,( 0 /1 ,--.. 2ext ! note that the profit-maximising criterion for an individual firm is to produce up to that level of production where ,( 0 -rice. Therefore - #or price$ 0 ,( 0 /1 ,--.. If - 0 /1 ,--.! it follows that by re-arranging the equation that ,--. 0 /1-. .ogically one can say that the ,--. is equivalent to a firms demand for labour schedule. 3urthermore a firm will be more likely to hire more labour when /1- #or the real wage$ is lower rather than higher. The demand for labour curve is therefore downwards sloping! as shown in the first of three diagrams on page 14 of (hapter ) of the *rooks manuscript. *y determining varying levels of labour demand at different levels of real wages #/1-$! it then possible to see what levels of output! 5! are achievable given the specification of the original production function.! as shown in the second diagram on page 14. 3inally by plotting the various price levels from the labour demand curve against the output levels from the production function! the third and final %6"% curve is obtained. 2ote that the latter is constructed for a given money wage7 a given level of capital stock7 and a given technology level. These are all shift parameters of the %6"%. &. True. In a competitive world the "8 and %6"% curves intersect so as to determine the price level. In turn the money wage rate! /! responds to that price level to determine a market-clearing real wage rate! /1-. "s flexible wages and prices! in time! provide a full-employment outcome! then it follows that the price outcome determined in the product market must be consistent with "8 and the %6"% being equal at the full-employment level. (ompetition should lead to simultaneous balance in both the labour and product markets. In turn this implies the existence of a vertical .6"% at the full-employment level of output. 3or a useful illustration of this relationship students should examine the + diagrams in %ection ).+.& of the *rooks manuscript. ). True. The .6"% is vertical at the full-employment level of output. %tudents should refer to the pair of diagrams located in %ection ).+.) of the *rooks manuscript! page +1. (ommencing at the short-run equilibrium point " #with an equilibrium real wage of /o1-o$! a fiscal expansion will lead to a rightward shift of the "8 curve from "89 to "81. Therefore the price level increases form -o to -1! and so movement to point ( results. The higher price level of -1 will lead to disequilibrium in the labour market! as it now produces a real wage result of /o1-1! which is the same as a reduction in the real wage rate. The latter produces a situation whereby demand for labour will exceed the supply of labour at that specific real wage rate. :ventually money wage rates will have to increase! and so /1 results. This however will move the %6"% from its original position to %6"%#/1$! and so a reduced level of 5 results! together with a higher price level. "gain labour market disequilibrium will result! and eventually a higher money wage rate will be needed to clear the labour market. This process will continue until point ; is reached and that is consistent with a price level of -x and the full-employment level of 5o. %imultaneous labour and product market equilibrium are achieved. <nce again it demonstrates that the .6"% is vertical at the full-employment level of output.

'. True. The key point to note in answering this question is to be able to understand the difference between the effect upon the %6"% of a change in the price level! and the effect upon the %6"% and the .6"% of a change in the overall supply of labour. The initial change in price! assuming a given money wage rate! will cause disequilibrium in the labour market! which will only be resolved by an eventual increase in the money wage rate. This will shift the %6"% back to the left. <n the other hand an increase in the supply of labour will move the labour supply curve to the right! within the labour market. This would in turn lead to a change in the money wage rate causing a shift of the %6"%. owever! because the total labour supply has changed! a new fullemployment level would result. .ogically this would lead to the .6"% shifting as well. 4. True. %tudents should refer to the appropriate definitions in =ordon! > th edition! page +19. #or if you are using the 4th edition! refer to page 14&$