When A Minimum-Wage Law Forces The Wage To Remain Above The Equilibrium Level, The Result Is?

When A Minimum-Wage Law Forces The Wage To Remain Above The Equilibrium Level, The Result Is
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  • The non-comprehensive part of the final will be over the unemployment chapter and the inflation chapter
  • I. who should be unemployed
  • On the surface this seems easy—those that do not work
  • But what about stay at home moms—individuals what are not willing to work for low wages at available jobs
  • Unemployment can be divided into two categories.

A. The economy’s natural rate of unemployment refers to the amount of unemployment that the economy normally experiences.B. Cyclical unemployment refers to the year-to-year fluctuations in unemployment around its natural rate. II. Identifying Unemployment A.

  • How Is Unemployment Measured? 1.
  • The Bureau of Labor Statistics (BLS) surveys 60,000 households every month.2.
  • The BLS places each adult (age 16 or older) into one of three categories: employed, unemployed, or not in the labor force.3.
  • Definition of labor force :,4.
  • Definition of unemployment rate :.5.

Definition of labor-force participation rate : the percentage of the adult population that is in the labor force,a. Women ages 20 and older have lower labor-force participation rates than men, but have similar rates of unemployment.b. Blacks ages 20 and older have similar labor-force participation rates to whites, but have higher rates of unemployment.c.

Teenagers have lower labor-force participation rates than adults, but have higher unemployment rates.B. Definition of the natural rate of unemployment :.C. Definition of cyclical unemployment :,F. Does the Unemployment Rate Measure What We Want It To? 1. Measuring the unemployment rate is not as straightforward as it may seem.2.

There is a tremendous amount of movement into and out of the labor force.a. Many of the unemployed are new entrants or reentrants looking for work.b. Many unemployment spells end with a person leaving the labor force as opposed to actually finding a job.3.

There may be individuals who are calling themselves unemployed to qualify for government assistance, yet they are not trying hard to find work. These individuals are more likely not a part of the true labor force, but they will be counted as unemployed.4. Definition of discouraged workers :.a.

These individuals will not be counted as part of the labor force.b. Thus, while they are likely a part of the unemployed, they will not show up in the unemployment statistics.H. Why Are There Always Some People Unemployed? 1. In an ideal labor market, wages would adjust so that the quantity of labor supplied and the quantity of labor demanded would be equal.2.

However, there is always unemployment even when the economy is doing well. The unemployment rate is never zero; it fluctuates around the natural rate.a. Definition of frictional unemployment :.b. Definition of structural unemployment :.c. Three possible reasons for structural unemployment are minimum-wage laws, unions, and efficiency wages.

III. Job Search A. Definition of job search : the process by which workers find appropriate jobs given their tastes and skills,B. Because workers differ from one another in terms of their skills and tastes and jobs differ in their attributes, it is often difficult for workers to match with the appropriate job.C.

Why Some Frictional Unemployment Is Inevitable 1. Frictional unemployment often occurs because of a change in the demand for labor among different firms.a. When consumers decide to stop buying a good produced by Firm A and instead start buying a good produced by Firm B, some workers at Firm A will likely lose their jobs.b.

New jobs will be created at Firm B, but it will take some time to move the displaced workers from Firm A to Firm B.c. The result of this transition is temporary unemployment.d. The same situation can occur across industries and regions as well.2. This implies that, because the economy is always changing, frictional unemployment is inevitable.

Workers in declining industries will find themselves looking for new jobs, and firms in growing industries will be seeking new workers.D. Public Policy and Job Search 1. The faster information spreads about job openings and worker availability, the more rapidly the economy can match workers and firms.2.

Government programs can help to reduce the amount of frictional unemployment.a. Government-run employment agencies give out information on job vacancies.b. Public training programs can ease the transition of workers from declining to growing industries and help disadvantaged groups escape poverty.3.

  • Critics of these programs argue that the private labor market will do a better job of matching workers with employers and therefore the government should not be involved in the process of job search.E.
  • Unemployment Insurance 1.
  • Definition of unemployment insurance :.2.
  • Because unemployment insurance reduces the hardship of unemployment, it also increases the amount of unemployment that exists.

IV. Minimum-Wage Laws A. Unemployment can also occur because of minimum-wage laws.B. The minimum wage is a price floor.1. If the minimum wage is set above the equilibrium wage in the labor market, a surplus of labor will occur.2. However, this is a binding constraint only when the minimum wage is set above the equilibrium wage. When A Minimum-Wage Law Forces The Wage To Remain Above The Equilibrium Level, The Result Is a. Most workers in the economy earn a wage above the minimum wage.b. Minimum-wage laws therefore have the largest affect on workers with low skill and little experience (such as teenagers).C. FYI: Who Earns the Minimum Wage? 1. In 2006, the Department of Labor released a study concerning workers who reported earnings at or below the minimum wage.a.

  • Of all workers paid an hourly rate in the United States, about 2% of men and 3% of women reported wages at or below the minimum wage.b.
  • Minimum-wage workers tend to be young, with about half under the age of 25.c.
  • Minimum-wage workers tend to be less educated.
  • Of those workers ages 16 and over with a high school education, only 2% earned the minimum wage.d.

The industry with the highest proportion of workers with reported wages at or below the minimum wage was leisure and hospitality.e. The proportion of workers earning the prevailing minimum wage has trended downward since 1979.D. Anytime a wage is kept above the equilibrium level for any reason, the result is unemployment.1.

  • Other causes of this situation include unions and efficiency wages.2.
  • This situation is different from frictional unemployment where the search for the right job is the reason for unemployment.V.
  • Unions and Collective Bargaining A.
  • Definition of union :.B.
  • Unions play a smaller role in the U.S.
  • Economy today than they did in the past.

However, unions continue to be prevalent in many European countries.D. Are Unions Good or Bad for the Economy? 1. Critics of unions argue that unions are a cartel, which causes inefficiency because fewer workers end up being hired at the higher union wage.2.

  1. Advocates of unions argue that unions are an answer to the problems that occur when a firm has too much power in the labor market (for example, if it is the only major employer in town).
  2. In addition, by representing workers’ views, unions help firms provide the right mix of job attributes. VI.
  3. The Theory of Efficiency Wages A.

Definition of efficiency wages :.B. Efficiency wages raise the wage above the market equilibrium wage, resulting in unemployment.C. There are several reasons why a firm may pay efficiency wages.1. Worker Health a. Better-paid workers can afford to eat better and can afford good medical care.b.

This is more applicable in developing countries where inadequate nutrition can be a significant problem.2. Worker Turnover a. A firm can reduce turnover by paying a wage greater than its workers could receive elsewhere.b. This is especially helpful for firms that face high hiring and training costs.3. Worker Quality a.

Offering higher wages attracts a better pool of applicants.b. This is especially helpful for firms that are not able to perfectly gauge the quality of job applicants.4. Worker Effort a. Again, if a firm pays a worker more than he or she can receive elsewhere, the worker will be more likely to try to protect his or her job by working harder.b.

This is especially helpful for firms that have difficulty monitoring their workers. INFlATION I. The inflation rate is measured as the percentage change in the Consumer Price Index, the GDP deflator, or some other index of the overall price level.A. Over the past 100 years, prices have risen an average of about 4% per year in the United States.

The last 20 years have been far below that average. II. The Classical Theory of Inflation A. The Level of Prices and the Value of Money 1. When the price level rises, people have to pay more for the goods and services that they purchase.2. A rise in the price level also means that the value of money is now lower because each dollar now buys a smaller quantity of goods and services.3.

If P is the price level, then the quantity of goods and services that can be purchased with $1 is equal to 1/ P,B. Money Supply, Money Demand, and Monetary Equilibrium 1. The value of money is determined by the supply and demand for money.2. For the most part, the supply of money is determined by the Fed.a.

This implies that the quantity of money supplied is fixed (until the Fed decides to change it).b. Thus, the supply of money will be vertical (perfectly inelastic).3. The demand for money reflects how much wealth people want to hold in liquid form.a. One variable that is very important in determining the demand for money is the price level.b.

  • The higher prices are, the more money that is needed to perform transactions.c.
  • Thus, a higher price level (and a lower value of money) leads to a higher quantity of money demanded.4.
  • In the long run, the overall price level adjusts to the level at which the demand for money equals the supply of money.a.

If the price level is above the equilibrium level, people will want to hold more money than is available and prices will have to decline.b. If the price level is below equilibrium, people will want to hold less money than that available and the price level will rise. When A Minimum-Wage Law Forces The Wage To Remain Above The Equilibrium Level, The Result Is 5. We can show the supply and demand for money using a graph.a. The left-hand vertical axis is the value of money, measured by 1/ P,b. The right-hand vertical axis is the price level ( P ). Note that it is inverted—a high value of money means a low price level and vice versa.c.

At the equilibrium, the quantity of money demanded is equal to the quantity of money supplied.C. The Effects of a Monetary Injection 1. Assume that the economy is currently in equilibrium and the Fed suddenly increases the supply of money.2. The supply of money shifts to the right.3. The equilibrium value of money falls and the price level rises.4.

When an increase in the money supply makes dollars more plentiful, the result is an increase in the price level that makes each dollar less valuable.5. Definition of quantity theory of money : a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate,D.

  1. A Brief Look at the Adjustment Process 1.
  2. The immediate effect of an increase in the money supply is to create an excess supply of money.2.
  3. People try to get rid of this excess supply in a variety of ways.a.
  4. They may buy goods and services with the excess funds.b.
  5. They may use these excess funds to make loans to others by buying bonds or depositing the money in a bank account.

These loans will then be used to buy goods and services.c. In either case, the increase in the money supply leads to an increase in the demand for goods and services.d. Because the supply of goods and services has not changed, the result of an increase in the demand for goods and services will be higher prices.F.

  • Velocity and the Quantity Equation 1.
  • Definition of velocity of money :.3.
  • If P is the price level (the GDP deflator), Y is real GDP, and M is the quantity of money 5.
  • Definition of quantity equation : the equation M × V = P × Y, which relates the quantity of money, the velocity of money, and the dollar value of the economy’s output of goods and services,a.

The quantity equation shows that an increase in the quantity of money must be reflected in one of the other three variables.b. Specifically, the price level must rise, output must rise, or velocity must fall.c. Figured in the text shows nominal GDP, the quantity of money (as measured by M2) and the velocity of money for the United States since 1960.

It appears that velocity is fairly stable, while GDP and the money supply have grown dramatically.6. We can now explain how an increase in the quantity of money affects the price level using the quantity equation.a. The velocity of money is relatively stable over time.b. When the central bank changes the quantity of money ( M ), it will proportionately change the nominal value of output ( P × Y ).c.

The economy’s output of goods and services ( Y ) is determined primarily by available resources and technology.d. This must mean that P increases proportionately with the change in M,e. Thus, when the central bank increases the money supply rapidly, the result is a high level of inflation.

  1. Do prices adjust as in the quantity equations or are they sticky? The previous unemployment chapter indicates they are sticky and here are some more thoughts.
  2. They are old and have old-fasion names, but I ask you can they be updated? Shoeleather Costs 1.
  3. Because inflation erodes the value of money that you carry in your pocket, you can avoid this drop in value by holding less money.2.

However, holding less money generally means more trips to the bank.3. Definition of shoeleather costs : the resources wasted when inflation encourages people to reduce their money holdings,4. This cost can be considerable in countries experiencing hyperinflation.C.

  1. Menu Costs 1.
  2. Definition of menu costs : the costs of changing prices,2.
  3. During periods of inflation, firms must change their prices more often.D.
  4. Relative-Price Variability and the Misallocation of Resources 1.
  5. Because prices of most goods change only once in a while (instead of constantly), inflation causes relative prices to vary more than they would otherwise.2.

When inflation distorts relative prices, consumer decisions are distorted and markets are less able to allocate resources to their best use.F. Confusion and Inconvenience 1. Money is the yardstick that we use to measure economic transactions.2. When inflation occurs, the value of money falls.

This alters the yardstick that we use to measure important variables like incomes and profit.I. The Consumer Price Index A. Definition of consumer price index (CPI) :.B. How the Consumer Price Index Is Calculated 1. Fix the basket.a. The Bureau of Labor Statistics uses surveys to determine a representative bundle of goods and services purchased by a typical consumer.2.

Find the prices.a. Prices for each of the goods and services in the basket must be determined for each time period.b. Example:

Year Price of Hot Dogs Price of Hamburgers
2008 $1 $2
2009 $2 $3
2010 $3 $4

3. Compute the basket’s cost.a. By keeping the basket the same, only prices are being allowed to change. This allows us to isolate the effects of price changes over time.

  1. b. Example:
  2. Cost in 2008 = ($1 × 4) + ($2 × 2) = $8.
  3. Cost in 2009 = ($2 × 4) + ($3 × 2) = $14.
  4. Cost in 2010 = ($3 × 4) + ($4 × 2) = $20.

4. Choose a base year and compute the index.a. The base year is the benchmark against which other years are compared.

  • b. The formula for calculating the price index is:
  • c. Example (using 2008 as the base year):
  • CPI for 2008 = ($8)/($8) × 100 = 100.

CPI for 2009 = ($14)/($8) × 100 = 175. CPI for 2010 = ($20)/($8) × 100 = 250.5. Compute the inflation rate.a. Definition of inflation rate : the percentage change in the price index from the preceding period,b. The formula used to calculate the inflation rate is:

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  • c. Example:
  • Inflation Rate for 2009 = (175 – 100)/100 × 100% = 75%.
  • Inflation Rate for 2010 = (250 – 175)/175 × 100% = 43%.
  • D. FYI: What Is in the CPI’s Basket? The largest category is housing, which makes up 43% of a typical consumer’s budget.t improvements into account when computing the CPI.F. Problems in Measuring the Cost of Living 1. Substitution Bias a. When the price of one good changes, consumers often respond by substituting another good in its place.b.

    The CPI does not allow for this substitution; it is calculated using a fixed basket of goods and services.c. This implies that the CPI overstates the increase in the cost of living over time.2. Introduction of New Goods a. When a new good is introduced, consumers have a wider variety of goods and services to choose from.b.

    This makes every dollar more valuable, which lowers the cost of maintaining the same level of economic well-being.c. Because the market basket is not revised often enough, these new goods are left out of the bundle of goods and services included in the basket.3.

    Unmeasured Quality Change a. If the quality of a good falls from one year to the next, the value of a dollar falls; if quality rises, the value of the dollar rises.b. Attempts are made to correct prices for changes in quality, but it is often difficult to do so because quality is hard to measure.4. The size of these problems is also difficult to measure.5.

    Most studies indicate that the CPI overstates the rate of inflation by approximately one percentage point per year.6. The issue is important because many government transfer programs (such as Social Security) are tied to increases in the CPI. : Untitled 1

    When a minimum wage law forces the wage to remain above the level that balances supply and demand it quizlet?

    When a minimum-wage law forces the wage to remain above the level that balances supply and demand, it raises the quantity of labor supplied and reduces the quantity of labor demanded compared to the equilibrium level.

    When actual wages remain above the equilibrium level it creates?

    A minimum wage above equilibrium results in unemployment by creating a surplus in some labor markets.

    Why is minimum wage above equilibrium quizlet?

    A minimum wage set above the equilibrium wage rate creates a surplus of labor – the quantity of labor supplied exceeds the quantity of labor demanded. The minimum wage reduces employment so that it is less than the efficient amount.

    What happens when minimum wage is below equilibrium?

    Minimum Wage – To parallel the price ceilings and floors that are sometimes set in the goods and services market, the government regulates the labor market by setting a minimum wage that firms must pay their workers. This has the same effect as a price floor.

    If the equilibrium wage is higher than the minimum wage (price floor), then the minimum wage has no discernable effect on the market, since the equilibrium point will be above the minimum wage. If the equilibrium wage is below the minimum wage, however, then there will be a surplus of labor: at the artificially high minimum wage, aggregate demand for labor is lower than aggregate supply, meaning that there will be unemployment (surpluses of labor).

    In this situation, not every worker who is willing to work for the minimum wage will be able to find a firm who wants to hire them. Figure %: Labor Market with a Minimum Wage So is a minimum wage worth it? There are strong arguments for either side. On one hand, if the minimum wage were removed, there might be lower unemployment, but workers might not make enough money to support themselves and their families.

    On the other hand, with the minimum wage in place, the employed are able to make more money, but many more workers are forced into unemployment and forced to take welfare, while making no contribution towards national productivity. Whom does the minimum wage hurt the most? Firms will always want skilled workers who can make large contributions to productivity.

    When the minimum wage is installed, however, it is the least productive workers who are cut from payrolls first. The skilled workers will keep their jobs, perhaps even with higher pay; but the unskilled workers, because their MRP is lower than the new minimum wage, will be unemployed.

    What would happen when minimum wage is set above the equilibrium level by the government?

    Answer and Explanation: When the government sets the minimum wage above the equilibrium wage, it creates unemployment in the market. Besides, the higher minimum wage will create a disparity between the labor demanded and labor supplied.

    What will happen if a newly imposed minimum wage is set above the equilibrium wage in a Labour market?

    If the minimum wage is set above the equilibrium wage rate, what happens? the quantity of labour supplied by workers exceeds the quantity demanded by employers & there is a surplus of labour.

    What is the effect of paying workers above the equilibrium wage?

    And when the wage is above the equilibrium level, the quantity of labor supplied exceeds the quantity of labor demanded, and you’ve got unemployment.

    What happens to equilibrium if wages increase?

    In model A, higher labor compensation causes a leftward shift in the supply curve, a decrease in the equilibrium quantity, and an increase in the equilibrium price.

    What would cause equilibrium wage to increase?

    Key Takeaways –

    • Wages in a competitive market are determined by demand and supply.
    • An increase in demand or a reduction in supply will increase the equilibrium wage. A reduction in demand or an increase in supply will reduce the equilibrium wage.
    • The government may respond to low wages for some workers by imposing the minimum wage, by attempting to increase the demand for those workers, or by subsidizing the wages of workers whose incomes fall below a certain level.

    Is minimum wage below or above equilibrium?

    The Market Price and Quantity In addition to the shortage, there are other consequences of the government’s price ceiling. Because of the increased quantity demanded landlords have less incentive and because of the lower rent they have less rental income to maintain the rental properties. In the graph above, the market is at equilibrium at a price of $11 and a quantity of 9. If the price were set at $7, a shortage of 7 products results. At $7 the quantity demanded is 13 (from $7 go straight over to the demand curve) and the quantity supplied is 6 (from $7 go straight over to the supply curve).

    • Similarly, if the price were set at $14, a surplus of 5 units (11 minus 6) results.
    • For a video explanation of the equilibrium price and quantity, please watch: Below are some supply and demand applications, in which we study what happens when the government, instead of the free market, determines the price.

    The Case of Rent Control Rent control is an example of a price set below the equilibrium point. This is called a price ceiling, In the graph below, the equilibrium (market) price of a rental unit is $1,800 per month. The city government wants the rental units priced at no more than $1,000 per month, so that more tenants can afford to live in the inner city. In addition to the shortage, there are other consequences of the government’s price ceiling. Because of the increased quantity demanded landlords have less incentive to provide an excellent product, and because of the lower rent they have less rental income to maintain the rental properties.

    • This usually leads to a deterioration of the rental units.
    • Due to the shortage of rental units in the inner city, the demand for properties not subject to rent controls increases.
    • This increases the price of non-rent-controlled properties.
    • Rent control also makes discrimination more likely.
    • Hopefully, landlords don’t discriminate when they accept tenants.

    However, when landlords have a waiting list of people applying for the lower-rent units, landlords who want to discriminate can more easily do so. At market prices, this is less likely to be the case. As rents are higher, there are far fewer waiting lists, and landlords are more likely to accept tenants based on their ability to pay, rather than on their race, ethnic origin, and lifestyle. Despite these disadvantages, rent controls are still in existence in various big cities around the industrialized world.

    Politicians often focus on the short-term social benefits of helping the poor, but are not always aware of the long-term economic disadvantages. Furthermore, they receive pressure from tenants, who ask for lower rent and more-affordable housing. Politicians are tempted to oblige tenants’ wishes, because there are far more tenants who vote than landlords.

    The Case of the Minimum Wage The minimum wage is an example of a price set above the equilibrium point. This is called a price floor, In the graph below, the equilibrium price of labor (the market wage) is $6.00 per hour. The government determines that it wants firms to hire workers at a minimum of $7.50, so that workers can earn more money per hour and better afford their daily expenditures. Minimum wage is a hotly debated topic. The graph above predicts that an increase in the minimum wage causes unemployment. Some studies, however, claim that an increase in the minimum wage has no significant effect on unemployment. Both studies can be correct, depending on the market conditions.

    Below is an example of a case study in which the minimum wage increases, but there is no effect on employment or unemployment. The Case when the Market Wage is above the Minimum Wage Let’s say that the equilibrium (market) wage in the New York metropolitan area for a certain type of worker is $10.00 per hour (see graph below).

    If the state government of New York raises the minimum wage from $7.50 to $8.50 (hypothetical example), the minimum wage will still be below the market wage. Therefore, there is no effect of an increase in the minimum wage on employment. The Case when the Market Wage is below the Minimum Wage If in another state the equilibrium (market) wage is $4.50 per hour, and the state government increases the minimum wage to $6.50 per hour, then businesses are required to pay many workers more per hour compared to what they were paying at the market wage.

    This will increase the incomes of workers who are able to keep their jobs. And it will lead to unemployment of workers (especially full-time workers), because the higher wage decreases the quantity demanded of labor and increases the quantity supplied. Critically Analyzing Minimum Wage Studies As you can see, the effect of an increase in the minimum wage differs, depending on whether the market wage is above or below the minimum wage.

    Another reason for discrepancies in studies on the minimum wage is that employment definitions vary. Economists Card and Krueger concluded in their study on the minimum wage that after the minimum wage increased in New Jersey, employment actually rose.

    The measure of employment they used was “the number of jobs held by people.” However, another measure of employment, which they did not use, is “the number of hours worked by people.” Using the latter definition, employment decreased. To illustrate this difference, consider the following example. Let’s say that as a result of an increase in the minimum wage, the number of full-time jobs decreases by 400, and the number of part-time jobs increases by 500.

    This can be expected as businesses, faced with a higher wage, decide to replace full-time workers with part-time workers in order to save money on benefits and reduce the total hours worked. Assuming that full-time workers work a 40-hour week, and part-time workers work a 20-hour week, the total number of hours worked declines by 16,000 (400 workers times 40) hours, and increases by 10,000 (500 times 20) hours.

    On balance, the number of hours worked decreases by 6,000. However, the total number of jobs increases by 100. As you can see, measuring employment by the total number of jobs (this is how our nation’s unemployment rate is calculated and this is the definition Card and Krueger used – see Unit 1, section 7 on critical thinking) can be deceiving and can lead to bad government policy.

    For a video explanation of how the minimum wage affects employment, please watch:

    When the minimum wage is established above the equilibrium wage then quizlet?

    When minimum wage is above the equilibrium wage, then increases in the minimum wage will cause more unemployment because employers are already forced to pay employees an equilibrium wage above the equilibrium wage.1.

    When a minimum wage is set above the equilibrium wage rate unemployment increases?

    Chapter – 6 GOVERNMENT ACTIONS IN MARKETS A Housing Market with a Rent Ceiling A price ceiling or price cap is a regulation that makes it illegal to charge a price higher than a specified level. When a price ceiling is applied to a housing market it is called a rent ceiling,

    1. If the rent ceiling is set above the equilibrium rent, it has no effect.
    2. The market works as if there were no ceiling.
    3. But a rent ceiling set below the equilibrium rent creates § A housing shortage § Increased search activity § A black market Increased Search Activity The time spent looking for someone with whom to do business is called search activity,

    When a price is regulated and there is a shortage, search activity increases. Search activity is costly and the opportunity cost of housing equals its rent (regulated) plus the opportunity cost of the search activity (unregulated). Because the quantity of housing is less than the quantity in an unregulated market, the opportunity cost of housing exceeds the unregulated rent.

    1. A Black Market A black market is an illegal market that operates alongside a legal market in which a price ceiling or other restriction has been imposed.
    2. A shortage of housing creates a black market in housing.
    3. Illegal arrangements are made between renters and landlords at rents above the rent ceiling— and generally above what the rent would have been in an unregulated market.

    Inefficiency of a Rent Ceiling A rent ceiling set below the equilibrium rent leads to an inefficient underproduction of housing services. The marginal social benefit from housing services exceeds its marginal social cost and a deadweight loss arises. Are Rent Ceilings Fair? According to the fair rules view, a rent ceiling is unfair because it blocks voluntary exchange.

    According to the fair results view, a rent ceiling is unfair because it does not generally benefit the poor. A rent ceiling decreases the quantity of housing and the scarce housing is allocated by § Lottery § First-come, first-served § Discrimination A lottery gives scarce housing to the lucky. A first-come, first served gives scarce housing to those who have the greatest foresight and get their names on the list first.

    Discrimination allocates scarce housing based on the self-interest of the owner. None of these methods leads to a fair outcome. A price floor is a regulation that makes it illegal to trade at a price lower than a specified level. When a price floor is applied to labor markets, it is called a minimum wage,

    If the minimum wage is set below the equilibrium wage rate, it has no effect. The market works as if there were no minimum wage. If the minimum wage is set above the equilibrium wage rate, it has powerful effects. Minimum Wage Brings Unemployment If the minimum wage is set above the equilibrium wage rate, the quantity of labor supplied by workers exceeds the quantity demanded by employers.

    There is a surplus of labor. The quantity of labor hired at the minimum wage is less than the quantity that would be hired in an unregulated labor market. Because the legal wage rate cannot eliminate the surplus, the minimum wage creates unemployment. Is the Minimum Wage Fair? A minimum wage rate in the United States is set by the federal government’s Fair Labor Standards Act.

    • In 2009, the federal minimum wage rate was raised to $7 an hour and has remained at $7 an hour through 2017.
    • Some state governments have set minimum wages above the federal minimum wage rate.
    • Most economists believe that minimum wage laws increase the unemployment rate of low- skilled younger workers.

    Inefficiency of a Minimum Wage A minimum wage leads to an inefficient outcome. The quantity of labor employed is less than the efficient quantity. The supply of labor measures the marginal social cost of labor to workers (leisure forgone). The demand for labor measures the marginal social benefit from labor (value of goods produced).

    Everything you earn and most things you buy are taxed. The supply of this good is perfectly elastic—the supply curve is horizontal. When a tax is imposed on this good, buyers pay the entire tax. Taxes in Practice Taxes usually are levied on goods and services with an inelastic demand or an inelastic supply.

    Alcohol, tobacco, and gasoline have inelastic demand, so the buyers of these items pay most of the tax on them. Labor has a low elasticity of supply, so the seller—the worker—pays most of the income tax and most of the Social Security tax. Taxes and Fairness Economists propose two conflicting principles of fairness to apply to a tax system: § The benefits principle § The ability-to-pay principle The Benefits Principle The benefits principle is the proposition that people should pay taxes equal to the benefits they receive from the services provided by government.

    • This arrangement is fair because it means that those who benefit most pay the most taxes.
    • The Ability-to-Pay Principle The ability-to-pay principle is the proposition that people should pay taxes according to how easily they can bear the burden of the tax.
    • A rich person can more easily bear the burden than a poor person can.

    So the ability-to-pay principle can reinforce the benefits principle to justify high rates of income tax on high incomes. Intervention in markets for farm products takes two main forms: § Production quotas § Subsidies A production quota is an upper limit to the quantity of a good that may be produced during a specified period.

    A subsidy is a payment made by the government to a producer. Markets for Illegal Goods The U. government prohibits trade of some goods, such as illegal drugs. Yet, markets exist for illegal goods and services. How does the market for an illegal good work? To see how the market for an illegal good works, we begin by looking at a free market and see the changes that occur when the good is made illegal.

    Legalizing and Taxing Drugs An illegal good can be legalized and taxed. A high enough tax rate would decrease consumption to the level that occurs when trade is illegal. Arguments that extend beyond economics surround this choice.

    Why is minimum price above equilibrium?

    Minimum Prices – When A Minimum-Wage Law Forces The Wage To Remain Above The Equilibrium Level, The Result Is A minimum price is when the government don’t allow prices to go below a certain level. If minimum prices are set above the equilibrium it will cause an increase in prices. For example, the EU has used minimum prices for agriculture. It is argued farmers incomes are too low.

    • Disadvantages of CAP
    • Minimum price for alcohol – prevent the problem of binge drinking

    Related to minimum prices is the concept of a minimum wage

    What would happen to the economy if the minimum wage was raised?

    FAQS – EFFECTS ON EMPLOYMENT How would increasing the minimum wage affect employment? Raising the minimum wage would increase the cost of employing low-wage workers. As a result, some employers would employ fewer workers than they would have under a lower minimum wage.

    However, for certain workers or in some circumstances, employment could increase. Changes in employment would be seen in the number of jobless, not just unemployed, workers. Jobless workers include those who have dropped out of the labor force (for example, because they believe no jobs are available for them) as well as those who are searching for work.

    How did CBO estimate effects on employment? In CBO’s analysis, the size of the effects depends on the number of workers affected by the increase in the minimum wage, the changes in wages induced by the higher minimum, and the responsiveness of employment to those changes in wages.

    Effects would generally be greater if the minimum-wage change affected more workers, if it led to larger mandated increases for directly affected workers, if firms had more time to respond (for example, because the change was phased in over a longer period), and if the minimum wage was indexed to inflation or wage growth.

    For details of CBO’s analysis, see Appendix A of CBO’s July 2019 report The Effects on Employment and Family Income of Increasing the Federal Minimum Wage, Although CBO’s economic and budget projections have changed since that analysis was completed, CBO has not adjusted its methods for estimating how employment would respond to a higher minimum wage.

    1. That is partly because CBO projects that employment will be near the level that it was at in the baseline projections underlying the 2019 report.
    2. If workers lost their jobs because of a minimum-wage increase, how long would they stay jobless? At one extreme, an increase in the minimum wage could put a small group of workers out of work indefinitely so that they never benefited from higher wages.

    At the other extreme, a large group of workers might shuffle regularly in and out of employment, experiencing short spells of joblessness but receiving higher wages during the weeks they were employed. In analyzing the effects of joblessness on poverty, CBO used its estimates of the distribution of durations of unemployment for the 2000–2020 period to assign directly affected workers either no joblessness or a duration of joblessness within the projection year that was randomly chosen from that distribution.

    1. Thus, some workers in CBO’s analysis are out of work for nearly an entire year, whereas others are jobless for shorter—sometimes much shorter—periods.
    2. EFFECTS ON INCOME How would increasing the minimum wage affect family income? By boosting the income of low-wage workers who have jobs, a higher minimum wage would raise their families’ real income (that is, income adjusted to remove the effects of inflation), lifting some of those families out of poverty.

    However, income would fall for some families because other workers would not be employed and because business owners would have to absorb at least some of the higher costs of labor. For those reasons, a minimum-wage increase would cause a net reduction in average family income.

    • How did CBO estimate the effects on family income? CBO projected the distribution of family income in future years and then combined those forecasts with estimates of the effects on wage rates, employment, business income, and prices.
    • Effects on wage rates include increases in the wages of workers who would have earned slightly more than the proposed minimum wage in the absence of the policy.

    Losses in business owners’ income and consumers’ purchasing power would be partly offset by an increase in the productivity of workers who received higher wages. That increase in productivity might occur through various channels, such as a reduction in employee turnover.

    (For details, see The Effects on Employment and Family Income of Increasing the Federal Minimum Wage,) How would increasing the minimum wage affect the number of people in poverty? By boosting the income of low-wage workers with jobs, a higher minimum wage would lift some families’ income above the poverty threshold and thereby reduce the number of people in poverty.

    But low-wage workers who lost employment would see their earnings decrease, and in some cases their family income would fall below the poverty threshold. The first effect would tend to be larger than the second, so the number of people in poverty would generally fall.

    What happens if the price level is above the equilibrium level?

    A surplus exists when the price is above equilibrium, which encourages sellers to lower their prices to eliminate the surplus. A shortage will exist at any price below equilibrium, which leads to the price of the good increasing.

    What happens to the economy when the minimum wage is raised?

    Raising the federal minimum wage will also stimulate consumer spending, help businesses’ bottom lines, and grow the economy. A modest increase would improve worker productivity, and reduce employee turnover and absenteeism. It would also boost the overall economy by generating increased consumer demand.

    What happens when the government imposes minimum wage?

    Key Takeaways –

    • When the government imposes a minimum wage, the real wage is determined by the minimum wage divided by the price level, not by the interaction between labor supply and demand.
    • If there is inflation and a fixed nominal minimum wage, then the level of employment will increase and the real minimum wage will decrease.
    • The minimum wage creates deadweight loss because some trades of labor services do not take place.

    What happens to supply curve when minimum wage increases?

    Baumol, William J., and Alan S. Blinder. Economics: Principles and Policy, 7th ed, Orlando, FL: The Dryden Press, 1997, pp.628-642. THE AGGREGATE SUPPLY CURVE In earlier chapters we noted that aggregate demand is a schedule, not a fixed number. The quantity of real GDP that will be demanded depends on the price level, as summarized in the economy’s aggregate demand curve.

    Analogously, the concept of aggregate supply does not refer to a fixed number, but rather to a schedule (a supply curve). The volume of goods and services that profit-seeking enterprises will provide depends on the prices they obtain for their outputs, on wages and other production costs, on the state of technology, and on other things.

    The relationship between the price level and the quantity of real GDP supplied, holding all other determinants of quantity supplied constant, is called the economy’s aggregate supply curve. A typical aggregate supply curve is drawn in Figure 27-1, It slopes upward, meaning that as prices rise more output is produced, other things held constant.

    1. It is not difficult to understand why.
    2. Producers in the U.S.
    3. Economy are motivated mainly by profit.
    4. The profit made by producing a unit of output is simply the difference between the price at which it is sold and the unit cost of production: Profit per unit = Price – Cost per unit So, the response of output to a rising price level-which is what the slope of the aggregate supply curve shows-depends on the response of costs.

    Many of the prices that firms pay for labor and other inputs are relatively fixed for periods of time-though certainly not forever. Often, workers and firms enter into long-term labor contracts that set money wages up to 3 years in advance. Even where there are no explicit contracts, wage rates typically adjust only once a year.

    During the interim period, money wages are fixed. Similarly, a variety of material inputs are delivered to firms under long-term contracts at prearranged prices. Why is it significant that firms often purchase inputs at prices that stay fixed for considerable periods of time? Because firms decide how much to produce by comparing their selling prices with their costs of production; and production costs depend, among other things, on input prices.

    If the selling prices of the firm’s products rise while its wages and other factor costs are fixed, production becomes more profitable, and firms will presumably increase output. A simple example will illustrate the idea. Suppose a firm uses I hour of labor to manufacture a gadget that sells for $9.

    If workers earn $8 per hour, and the firm has no other production costs, its profit per unit is: Profit per unit = Price – Cost per unit = $9 – $8 = $1 Now what happens if the price of a gadget rises to $10, but wage rates remain constant? The firm’s profit per unit becomes: Profit per unit = Price – Cost per unit = $10 – $8 = $2 With production more profitable, the firm will likely supply more gadgets.

    The same process operates in reverse. If selling prices fall while input costs are relatively fixed, profit margins will be squeezed and production cut back. This behavior is summarized by the upward slope of the aggregate supply curve: Production rises when the price level (henceforth, P) rises, and falls when P falls.

    In other words: The aggregate supply curve slopes upward because firms normally can purchase labor and other inputs at prices which are fixed for some period of time. Thus, higher selling prices for output make production more attractive.1 The phrase “for some period of time” alerts us to an important fact: The aggregate supply curve may not stand still for long.

    If wages or prices of other inputs change, as they surely will during inflationary times, then the aggregate supply curve will shift. SHIFTS OF THE AGGREGATE SUPPLY CURVE We have concluded so far that, for given levels of wages and other input prices, there will be an upward-sloping aggregate supply curve relating the price level to aggregate quantity supplied.

    Now let us consider what happens when these input prices change. THE MONEY WAGE RATE The most obvious determinant of the position of the aggregate supply curve is the money wage rate. Wages are the major element of cost in the economy, accounting for more than 70 percent of all inputs. Since higher wage rates mean higher costs, they spell lower profits at any given prices.

    That is why companies like American Airlines and Caterpillar have staged fierce battles with their unions in recent years in an effort to reduce wages. Returning to our example, consider what would happen to a gadget producer if the money wage rose to $8.75 per hour while the price of a gadget remained $9.

    • Profit per unit would decline from: $9 – $8 = $1 to $9.00 – $8.75 = $0.25 With profits squeezed, the firm would probably cut back on production.
    • This is the way firms in our economy typically react to a rise in wages.
    • Therefore, a wage increase leads to a decrease in aggregate quantity supplied at current prices.

    Graphically, the aggregate supply curve shifts to the left (or inward), as shown in Figure 27-2, In this diagram, firms are willing to supply $6,000 billion in goods and services at a price level of 100 when wages are low (point A). But after wages increase these same firms are willing to supply only $5,500 billion at this price level (point B).

    By similar reasoning, the aggregate supply curve will shift to the right (or outward) if wages fall. Thus: A rise in the money wage rate makes the aggregate supply curve shift inward, meaning that the quantity supplied at any price level declines. A fall in the money wage rate makes the aggregate supply curve shift outward, meaning that the quantity supplied at any price level increases.

    PRICES OF OTHER INPUTS In this regard, there is nothing special about wages. An increase in the price of any input that firms buy will shift the aggregate supply curve in the same way; that is: The aggregate supply curve is shifted inward by an increase in the price of any input to the production process, and it is shifted outward by any decrease.

    While there are many inputs other than labor, the one that has attracted the most attention in recent decades is energy. Increases in the price of energy, such as those that took place in the early 1980s and again during the 1990 Gulf war, push the aggregate supply curve inward more or less as shown in Figure 27-2,

    By the same token, a rise in the price of any input we import from abroad would have the effect shown in the figure. TECHNOLOGY AND PRODUCTIVITY Another factor that determines the position of the aggregate supply curve is the state of technology. Suppose, for example, that a technological breakthrough increases the productivity of labor, that is, output per hour of work.

    1. If wages do not change, such an improvement in productivity will decrease business costs, improve profitability, and encourage more production.
    2. Once again, our gadget company will help us understand how this works.
    3. Suppose the price of a gadget stays at $9 and the hourly wage rate stays at $8, but gadget workers become much more productive.

    Specifically, suppose the labor input required to manufacture a gadget falls from 1 hour (which costs $8) to three-quarters of an hour (which costs $6). Then profit per unit rises from $9 – $8 = $1 to $9 – $6 = $3 The lure of higher profits should induce gadget manufacturers to increase production-which is, of course, why manufacturers are constantly striving to raise productivity.

    • In brief, we have concluded that: Improvements in productivity shift the aggregate supply curve outward.
    • Figure 27-2 can therefore be viewed as applying to a decline in productivity.
    • Since the 1970s, slow growth of productivity has been a persistent problem for the U.S.
    • Economy, one that we will examine in depth in Chapter 37.

    AVAILABLE SUPPLIES OF LABOR AND CAPITAL The last determinant of the position of the aggregate supply curve is obvious. The bigger the economy-as measured by its available supplies of labor and capital-the more it is capable of producing. So: As the labor force grows or improves in quality, and as the capital stock is increased by investment, the aggregate supply curve shifts outward to the right, meaning that more output can be produced at any given price level.

    This last aspect of the aggregate supply curve is central to the political debate over alternative supply-side strategies. Although neither party excludes the other factor of production, Republicans tend to concentrate on augmenting the supply of capital while Democrats tend to emphasize improvements in labor quality.

    These, then, are the major “other things” that we hold constant when drawing up an aggregate supply curve: wage rates, prices of other inputs (such as energy), technology, labor force, and capital stock. While a change in the price level moves the economy along a given supply curve, a change in any of the other determinants of aggregate quantity supplied shifts the entire supply schedule.

    EQUILIBRIUM OF AGGREGATE DEMAND AND SUPPLY Chapter 25 taught us that the price level is a crucial determinant of whether equilibrium GDP is below full employment (a “recessionary gap”), precisely at full employment, or above full employment (an “inflationary gap”). We are now in a position to analyze which type of gap, if any, will actually occur in any particular case.

    By combining the analysis of aggregate supply just completed with the analysis of aggregate demand from the last two chapters, we can determine simultaneously the equilibrium level of real GDP (Y) and the equilibrium price level (P). Figure 27-3 displays the mechanics.

    1. Aggregate demand curve DD and aggregate supply curve SS intersect at point E, where real GDP is $6,000 billion and the price level is 100.
    2. As can be seen in the graph, at any higher price level, such as 120, aggregate quantity supplied would exceed aggregate quantity demanded.
    3. There would be a glut on the market as firms found themselves unable to sell all their output.

    As inventories piled up, firms would compete more vigorously for the available customers, thereby forcing prices down. Both the price level and production would fall. At any price level lower than 100, such as 80, quantity demanded would exceed quantity supplied.

    • There would be a shortage of goods on the market.
    • With inventories disappearing and customers knocking on their doors, firms would be encouraged to raise prices.
    • The price level would rise, and so would output.
    • Only when the price level is 100 are the quantities of real GDP demanded and supplied equal.

    Therefore, only the combination of P = 100, Y = $6,000 is an equilibrium. Table 27-1 illustrates the same conclusion in another way, using a tabular analysis similar to that of Chapter 25 (refer back to Table 25-2, page 597). Columns 1 and 2 constitute an aggregate demand schedule corresponding to the aggregate demand curve DD in Figure 27-3,

    Columns 1 and 3 constitute an aggregate sup. ply schedule corresponding exactly to aggregate supply curve SS in the figure. It is clear from the table that equilibrium occurs only at P = 100 and Y = $6,000. At any other price level, aggregate quantities supplied and demanded would be unequal, with consequent upward or downward pressure on prices.

    For example, at a price level of 90, customers demand $6,200 billion worth of goods and services, but firms wish to provide only $5,800 billion. The price level is too low and will be forced upward. Conversely, at a price level of, say, 110, quantity supplied ($6,200 billion) exceeds quantity demanded ($5,800 billion), implying that the price level must fall.

    RECESSIONARY AND INFLATIONARY GAPS REVISITED Let us now reconsider a question we posed, but could not answer, in Chapter 25: Will equilibrium occur at, below, or beyond full employment? We could not give a complete answer to this question in Chapter 25 because we had no way to determine the equilibrium price level, and therefore no way to tell which type of gap, if any, would arise.

    The aggregate supply and demand analysis summarized in Figure 27-3 now gives us what we need. But we fir that our answer is the same as it was in Chapter 25-anything can happen. The reason is that nothing in Figure 27-3 tells us where full employment is; could be above the $6,000 billion equilibrium level or below it.

    • Depending ( the locations of the aggregate demand and aggregate supply curves, then, v can reach equilibrium above full employment (an inflationary gap), at fl employment, or below full employment (a recessionary gap).
    • In the short run with wages and other input costs fixed, that is all there is to it.

    All three possibilities are illustrated in Figure 27-4, The three upper panels a familiar from Chapter 25. As we move from left to right, the expenditure schedule rises from C + Io + G + (X – IM) to C +I1 + G + (X – IM) to C + I2 + G + (X – IM), leading respectively to a recessionary gap, an equilibrium at full employment, and an inflationary gap.

    1. In fact, the upper left-hand diagram looks just like Figure 25-6 (page 601), and the upper right-hand diagram duplicates Figure 25-7 (page 602).
    2. We emphasized in Chapter 25 that any one of the three cases is possible, depending on the price level and the expenditure schedule.
    3. In the three lower panels, the equilibrium price level is determined at poi E by the intersection of the aggregate supply curve (SS) and the aggregate demand curve (DD).

    But the same three possibilities emerge. In the lower left-hand panel, aggregate demand is too low to provide jobs f the entire labor force, so there is a recessionary gap equal to distance EB, $1,000 billion. This corresponds precisely to the situation depicted on the income expenditure diagram immediately above it.

    In the lower right-hand panel, aggregate demand is so high that the economy reaches an equilibrium well beyond full employment. There is an inflationary gap equal to BE, or $1,000 billion, just as in the diagram immediately above it. In the lower middle panel, the aggregate demand curve D1D1 is at just the right level to produce an equilibrium at full employment.

    There is neither inflationary nor a recessionary gap, as in the diagram just above it. It may seem, therefore, that we have done nothing but restate our previous conclusions. But, in fact, we have done much more. Because now that we ha’ studied the determination of the equilibrium price level, we are able to examine how the economy adjusts to either a recessionary gap or an inflationary gap.

    Specifically, since wages are fixed in the short run, any one of the three cases depicted in Figure 27-4 can occur. But, in the long run, wages will adjust to lab market conditions. It is to that adjustment that we now turn. ADJUSTING TO A RECESSlONARY GAP: DEFLATION OR UNEMPLOYMENT? Suppose the economy starts with a recessionary gap-that is, an equilibrium below full employment-as in the lower left-hand panel of Figure 27-4,

    This might be caused, for example, by inadequate consumer spending or by anemic investment spending. What happens next? With equilibrium GDP below potential, jobs will be hard to find. The ran of the unemployed will exceed the number expected to be jobless because moving, changing occupations, and so on.

    • In the terminology of Chapter 23, there will be a considerable amount of cyclical unemployment.
    • Businesses, on the other hand, will have little trouble finding workers.
    • And their current employees will be eager to hang on to their jobs.
    • In such an environment, it will be very difficult for workers to win wage increases.

    Indeed, in extreme situations, wages may even fall-thus shifting the aggregate supply curve outward. (Remember, an aggregate supply curve is drawn for a given money wage.) But as the aggregate supply curve shifts outward-eventually moving from SoSo to S1S1 in Figure 27-5 -prices decline and the recessionary gap shrinks.

    • This is the process by which deflation erodes the recessionary gap, eventually leading the economy to an equilibrium at full employment (point F in Figure 27-5 ).
    • But there is an important catch.
    • In our modern economy, this adjustment process proceeds slowly-painfully slowly.
    • Our brief review of the historical record in Chapter 22 showed that the history of the United States includes several examples of deflation before World War II but none since.

    Not even the severe recession of 1981-1982, during which unemployment climbed above 10 percent, was able to force average prices and wages down-though it certainly slowed their rates of increase. Similarly, the recession of the early 1990s reduced inflation, but certainly did not bring deflation.

    1. Exactly why wages and prices rarely fall in our modern economy has been a subject of intense and continuing controversy among economists for years.
    2. Some economists emphasize institutional factors like minimum wage laws, union contracts, and a variety of government regulations that place legal floors under particular wages and prices.

    Because most of these institutions are of relatively recent vintage, this theory successfully explains why wages and prices fall less frequently now than they did before World War II. However, only a small minority of the U.S. economy is subject to legal restraints on wage and price cutting.

    So it seems doubtful that legal restrictions can provide a complete explanation. Other observers suggest that workers have a profound psychological resistance to accepting a wage reduction. This theory certainly has the ring of truth. Think how you would react if your boss announced he was cutting your hourly wage rate.

    You might quit, or you might devote less care to your job. If the boss suspects you will react this way, he may be reluctant to cut your wage. Nowadays, genuine wage reductions are rare enough to be newsworthy. United Airlines was one of the few firms that managed to cut wages; workers accepted an average 15 percent pay cut shortly after a 1994 employee buyout of the company.

    Many other companies have tried, but failed, to win similar concessions from their workers. While no one doubts that wage cuts can be bad for morale, the psychological theory has one major drawback. It fails to explain why the psychological resistance to wage cuts apparently started only after World War II.

    Until a satisfactory answer to this question is provided, many economists will remain skeptical. A third explanation is based on a fact we emphasized in Chapter 22-that business cycles were less severe in the postwar period than they were in the prewar period.

    • Because workers and firms came to believe that recessions would not turn into depressions, the argument goes, they may have decided to wait out the bad times rather than accept wage or price reductions that they would later regret.
    • Yet another theory is,based on the old adage, “you get what you pay for.” The idea is that workers differ in productivity, but that productivities of individual employees are hard to identify.

    Firms therefore worry that a general wage reduction will result in the loss of their best employees-since these workers have the best opportunities elsewhere in the economy. Rather than take this chance, the argument goes, firms prefer to maintain high wages even in recessions.

    1. There are other theories as well, none of which commands a clear majority of professional opinion.
    2. But, regardless of the cause, we may as well accept the fact that, in our modern economy, prices and wages generally fall only sluggishly when demand is weak.
    3. The implications of this rigidity are quite serious, for a recessionary gap cannot cure itself without some deflation.

    And if wages and prices will not fall, recessionary gaps like EB in Figure 27-5 will linger for a long time. That is: When aggregate demand is low, the economy may get stuck with a recessionary gap for a long time. If wages and prices fall very slowly, the economy will endure a prolonged period of production below potential GDP.

    1. DOES THE ECONOMY HAVE A SELF-CORRECTING MECHANISM? Now a situation like this would, presumably, not last forever.
    2. As the recession lengthened, and perhaps deepened, more and more workers would be unable to find jobs at the prevailing high wages.
    3. Eventually, their need to be employed would overwhelm their resistance to wage cuts.

    Firms, too, would become increasingly willing to cut prices as the period of weak demand persisted and managers became convinced that the slump was not merely a temporary aberration. Prices and wages did, in fact, fall during the Great Depression of the 1930s.

    • And some fell again in the weak markets of the early 1990s.
    • However, nowadays political leaders of both parties believe it is folly to wait for falling wages and prices to eliminate a recessionary gap.
    • They agree that some government action is both necessary and appropriate under recessionary conditions.

    But there is still vocal-and highly partisan-debate over how much and what kind of intervention is warranted. One reason for the disagreement is that the self-correcting mechanism does operate-if only weakly-to cure recessionary gaps. AN EXAMPLE FROM RECENT HISTORY: DISINFLATION IN THE 1990s Recent history provides an excellent example.

    Recovery from the 1990-1991 recession was weak and long delayed, but it did eventually come. The unemployment rate peaked at 7.7 percent in June 1992 and then began a slow descent which brought it all the way down to 5.4 percent by December 1994. Meanwhile the inflation rate was falling from 6.1 percent in 1990 to 3.1 percent in 1991 and down to 2.7 percent in both 1993 and 1994.

    Qualitatively, this is just the sort of behavior the theoretical model of the self-correcting mechanism predicts. But it sure took a long time! Hence, the practical policy question is: How long can we afford to wait? ADJUSTING TO AN INFLATIONARY GAP: INFLATION Let us now consider what happens when the economy starts above full employment, that is, with an inflationary gap like that shown in Figure 27-6,

    1. As we shall see now, the tight labor market produces an inflation that eventually eliminates the gap, though perhaps in a slow and painful way.
    2. Let us see how.
    3. When equilibrium GDP is above potential, jobs are plentiful and labor is in great demand.
    4. Firms are likely to be having trouble recruiting new workers, or even holding onto their old ones as other firms try to lure them away with higher wages.

    Such a situation arose in 1995 when the unemployment rate dropped to 5.4 percent. Businesses had to start paying higher wages because many kinds of workers were in short supply. (See the box on the next page.) Rising wages add to business costs, thus shifting the aggregate supply curve inward.

    1. As the aggregate supply curve shifts in from SoSo to S1S1 in Figure 27-6 the size of the inflationary gap declines.
    2. In other words, inflation eventually erodes the inflationary gap and brings the economy to an equilibrium at full employment (point F).
    3. There is a straightforward way of looking at the economics that underlies this process.

    Inflation arises because buyers are demanding more output than the economy is capable of producing at normal operating rates. To paraphrase an old cliche, there is too much demand chasing too little supply. Such an environment encourages price hikes. But rising prices eat away at the purchasing power of consumers’ wealth, forcing them to cut back on consumption, as explained in Chapter 24.

    • In addition, exports fall and imports rise, as we learned in Chapter 25.
    • Eventually, aggregate quantity demanded is scaled back to the economy’s capacity to produce; and, at this point, the self-correcting process stops.
    • That, in essence, is the unhappy process by which the economy cures itself of the excessive aggregate demand.

    In brief: If aggregate demand is exceptionally high, the economy may reach a short-run equilibrium above full employment (an inflationary gap). When this occurs, the tight situation in the labor market soon forces wages to rise. Since rising wages increase business costs, prices increase; there is inflation.

    1. As higher prices cut into consumer purchasing power and net exports, the inflationary gap begins to close.
    2. As the inflationary gap is closing, output falls and prices continue to rise; so the economy experiences stagflation until the gap is eliminated.
    3. At this point, a long-run equilibrium is established with a higher price level and with GDP equal to potential GDP.

    Two caveats about this process should be mentioned. One we have already emphasized: The self-correcting mechanism takes time because wages and prices do not adjust quickly. An inflationary gap sows the seeds of its own destruction, but these seeds germinate slowly.

    1. So, once again, policymakers may want to speed up the process.
    2. The other caveat is that the process works only in the absence of additional forces propelling the aggregate demand curve outward.
    3. But in the last chapter, we encountered several forces that might shift the aggregate demand curve outward.
    4. As you can see by manipulating the aggregate demand-aggregate supply diagram, if aggregate demand is shifting out at the same time that aggregate supply is shifting in, there will certainly be inflation, but the inflationary gap may not shrink.

    (Try this as an exercise, to make sure you understand how to use the apparatus.) So not all inflations come to a natural end. DEMAND INFLATION AND STAGFLATION Simple as it is, this adjustment model teaches us a number of important lessons about inflation in the real world.

    First, Figure 27-6 reminds us that the real culprit in this particular inflation is excessive aggregate demand-relative to potential GDE The aggregate demand curve is initially so high that it intersects the aggregate supply curve well beyond full employment. The resulting intense demand for goods and labor pushes prices and wages higher.

    While aggregate demand in excess of potential GDP is not the only possible cause of inflation, it certainly is the cause in our example. However, business managers and journalists may blame inflation on rising wages. In a superficial sense, of course, they are right, because higher wages do indeed lead firms to raise their prices.

    • But in a deeper sense they are wrong.
    • Both rising wages and rising prices are symptoms of an underlying malady: too much aggregate demand.
    • Blaming labor for inflation in such a case is a bit like blaming high doctor bills for making you ill.
    • Second, we see that output falls while prices rise as the economy adjusts from point E to point F in Figure 27-6,

    This is our first (but not our last!) explanation of the phenomenon of stagflation. Specifically: A period of stagflation is part of the normal aftermath of a period of excessive aggregate demand. It is easy to understand why stagflation occurs in this case.

    • When aggregate demand is excessive, the economy will temporarily produce beyond its normal capacity.
    • Labor markets tighten and wages rise.
    • Machinery and raw materials may also become scarce and so start rising in price.
    • Faced by higher costs, the natural reaction of business firms is to produce less and to charge a higher price.

    That is stagflation. TWO RECENT EXAMPLES The stagflation that follows a period of excessive aggregate demand is, you will note, a rather benign form of the dreaded disease. After all, while output is falling, it nonetheless remains above potential GDP, and unemployment is low.

    • The U.S. economy has experienced two such episodes in the last decade.
    • The more notable one came between 1988 and 1990.
    • The long economic expansion of the 1980s brought the unemployment rate down to 5.5 percent by mid-1988 and (briefly) to a 15-year low of 5.0 percent by March 1989.
    • Almost all economists believe that 5.0 percent is below the full-employment unemployment rate, that is, that the U.S.

    economy had an inflationary gap in 1989. As the theory suggests, inflation began to accelerate-from 4.4 percent in 1988 to 4.6 percent in 1989 and 6.1 percent in 1990. In the meantime, the economy was stagnating. Real GDP growth fell from 3.5 percent during 1988 to 2.4 percent in 1989 and -0.2 percent in 1990.

    Inflation was eating away at the inflationary gap, which was virtually gone by mid-1990, when the recession started. Yet inflation remained high through the early months of the recession. The U.S. economy was in the stagflation phase. A milder version of this same phenomenon occurred in the first half of 1995.

    After the unemployment rate fell to 5.4 percent in late 1994, slightly below the full-employment level, the U.S. economy slowed abruptly in the first half of 1995. But inflation during the first half of 1995 ran at a 3.2 percent annual rate, slightly above the 1994 rate of 2.7 percent.

    1. In both of these episodes, then, the U.S.
    2. Economy behaved more or less as our simple model suggests.
    3. Our overall conclusion about the economy’s ability to right itself seems to run something like this: The economy does indeed have a self-correcting mechanism that tends to eliminate either unemployment or inflation.

    However, this mechanism works slowly and unevenly. In addition, its beneficial effects on either inflation or unemployment are sometimes swamped by strong forces (such as rapid increases or decreases in aggregate demand) pushing in the opposite direction.

    1. Thus, the self-correcting mechanism cannot always be relied upon.
    2. STAGFLATION FROM SUPPLY SHIFTS We have just discussed the type of stagflation that follows in the aftermath of an inflationary boom.
    3. However, that is not what happened in the 1970s and early 1980s when unemployment and inflation soared at the same time.

    What caused this more virulent type of stagflation? Several things, but the principal villain was the rising price of energy. In 1973, the Organization of Petroleum Exporting Countries (OPEC) quadrupled the price of crude oil. American consumers soon found the prices of gasoline and home heating fuels increasing sharply, and American businesses found th_onne important cost of doing business-energy prices-rose drastically.

    wB struck again in 1979 to 1980, this time doubling the price of oil. Then the same thing happened a third time, albeit on a smaller scale, when Iraq invaded Kuwait in 1990. Higher energy prices, we observed earlier, shift the economy’s aggregate supply curve inward in the manner shown in Figure 27-2 (page 631).

    MINIMUM WAGES

    If the aggregate supply curve shifts inward, as it surely did in 1973 to 1974, 1979 to 1980, and 1990, production will decline. And in order to reduce demand to the available supply, prices will have to rise. The result is the worst of both worlds: falling production and rising prices.

    This conclusion is shown graphically in Figure 27-7, which superimposes an aggregate demand curve, DD, on the two aggregate supply curves of Figure 27-2, The economy’s equilibrium shifts upward to the left, from point E to point A. Thus, output falls while prices rise. In brief: Stagflation is the typical result of adverse supply shifts.

    The numbers used in Figure 27-7 are roughly indicative of what happened in the United States after the big “energy shock” of late 1973. Between 1973 (represented by supply curve SoSo and point E) and 1975 (represented by supply curve S1S1 and point A), real GDP fell by about 1 percent, while the price level rose a stunning 19 percent.

    Thus, inflation soared and the economy weakened. The general lesson to be learned from the U.S. experience with supply shocks is both clear and important: The typical results of an adverse supply shock are a fall in output and an acceleration in inflation. This is one reason why the world economy was plagued by stagflation in the mid-1970s and early 1980s.

    And it can happen again if another series of supply-reducing events takes place. Of course, supply shifts can work in the other direction as well. When the world oil market weakened in 1986, oil prices plummeted. And the price of oil tumbled again just after the Persian Gulf war.

    1. Both of these favorable supply shocks stimulated U.S.
    2. Economic growth and curbed inflation.
    3. In fact the Consumer Price Index actually fell for a few months in 1986! The aggregate supply curve was shifting outward.
    4. Favorable supply shocks tend to push output up and reduce inflation. 1.
    5. There are both differences and similarities between the aggregate supply curve and the microeconomic supply curves studied in Chapter 4.

    Both are based on the idea that quantity supplied depends on how output prices move relative to input prices. But the aggregate supply curve pertains to the behavior of the overall price level, whereas a microeconomic supply curve pertains to the price of some particular commodity.

    Is minimum wage above or below equilibrium?

    The Market Price and Quantity In addition to the shortage, there are other consequences of the government’s price ceiling. Because of the increased quantity demanded landlords have less incentive and because of the lower rent they have less rental income to maintain the rental properties. In the graph above, the market is at equilibrium at a price of $11 and a quantity of 9. If the price were set at $7, a shortage of 7 products results. At $7 the quantity demanded is 13 (from $7 go straight over to the demand curve) and the quantity supplied is 6 (from $7 go straight over to the supply curve).

    1. Similarly, if the price were set at $14, a surplus of 5 units (11 minus 6) results.
    2. For a video explanation of the equilibrium price and quantity, please watch: Below are some supply and demand applications, in which we study what happens when the government, instead of the free market, determines the price.

    The Case of Rent Control Rent control is an example of a price set below the equilibrium point. This is called a price ceiling, In the graph below, the equilibrium (market) price of a rental unit is $1,800 per month. The city government wants the rental units priced at no more than $1,000 per month, so that more tenants can afford to live in the inner city. In addition to the shortage, there are other consequences of the government’s price ceiling. Because of the increased quantity demanded landlords have less incentive to provide an excellent product, and because of the lower rent they have less rental income to maintain the rental properties.

    This usually leads to a deterioration of the rental units. Due to the shortage of rental units in the inner city, the demand for properties not subject to rent controls increases. This increases the price of non-rent-controlled properties. Rent control also makes discrimination more likely. Hopefully, landlords don’t discriminate when they accept tenants.

    However, when landlords have a waiting list of people applying for the lower-rent units, landlords who want to discriminate can more easily do so. At market prices, this is less likely to be the case. As rents are higher, there are far fewer waiting lists, and landlords are more likely to accept tenants based on their ability to pay, rather than on their race, ethnic origin, and lifestyle. Despite these disadvantages, rent controls are still in existence in various big cities around the industrialized world.

    Politicians often focus on the short-term social benefits of helping the poor, but are not always aware of the long-term economic disadvantages. Furthermore, they receive pressure from tenants, who ask for lower rent and more-affordable housing. Politicians are tempted to oblige tenants’ wishes, because there are far more tenants who vote than landlords.

    The Case of the Minimum Wage The minimum wage is an example of a price set above the equilibrium point. This is called a price floor, In the graph below, the equilibrium price of labor (the market wage) is $6.00 per hour. The government determines that it wants firms to hire workers at a minimum of $7.50, so that workers can earn more money per hour and better afford their daily expenditures. Minimum wage is a hotly debated topic. The graph above predicts that an increase in the minimum wage causes unemployment. Some studies, however, claim that an increase in the minimum wage has no significant effect on unemployment. Both studies can be correct, depending on the market conditions.

    Below is an example of a case study in which the minimum wage increases, but there is no effect on employment or unemployment. The Case when the Market Wage is above the Minimum Wage Let’s say that the equilibrium (market) wage in the New York metropolitan area for a certain type of worker is $10.00 per hour (see graph below).

    If the state government of New York raises the minimum wage from $7.50 to $8.50 (hypothetical example), the minimum wage will still be below the market wage. Therefore, there is no effect of an increase in the minimum wage on employment. The Case when the Market Wage is below the Minimum Wage If in another state the equilibrium (market) wage is $4.50 per hour, and the state government increases the minimum wage to $6.50 per hour, then businesses are required to pay many workers more per hour compared to what they were paying at the market wage.

    This will increase the incomes of workers who are able to keep their jobs. And it will lead to unemployment of workers (especially full-time workers), because the higher wage decreases the quantity demanded of labor and increases the quantity supplied. Critically Analyzing Minimum Wage Studies As you can see, the effect of an increase in the minimum wage differs, depending on whether the market wage is above or below the minimum wage.

    Another reason for discrepancies in studies on the minimum wage is that employment definitions vary. Economists Card and Krueger concluded in their study on the minimum wage that after the minimum wage increased in New Jersey, employment actually rose.

    The measure of employment they used was “the number of jobs held by people.” However, another measure of employment, which they did not use, is “the number of hours worked by people.” Using the latter definition, employment decreased. To illustrate this difference, consider the following example. Let’s say that as a result of an increase in the minimum wage, the number of full-time jobs decreases by 400, and the number of part-time jobs increases by 500.

    This can be expected as businesses, faced with a higher wage, decide to replace full-time workers with part-time workers in order to save money on benefits and reduce the total hours worked. Assuming that full-time workers work a 40-hour week, and part-time workers work a 20-hour week, the total number of hours worked declines by 16,000 (400 workers times 40) hours, and increases by 10,000 (500 times 20) hours.

    • On balance, the number of hours worked decreases by 6,000.
    • However, the total number of jobs increases by 100.
    • As you can see, measuring employment by the total number of jobs (this is how our nation’s unemployment rate is calculated and this is the definition Card and Krueger used – see Unit 1, section 7 on critical thinking) can be deceiving and can lead to bad government policy.

    For a video explanation of how the minimum wage affects employment, please watch:

    What happens to the economy when the minimum wage is raised?

    Raising the federal minimum wage will also stimulate consumer spending, help businesses’ bottom lines, and grow the economy. A modest increase would improve worker productivity, and reduce employee turnover and absenteeism. It would also boost the overall economy by generating increased consumer demand.