Chapter 10MORE ON UNEMPLOYMENT

Efficiency wage theory is the idea that firms

may permanently hold to a real wage greater
than the equilibrium wage.
KEY POINTS

Efficiency wages are wages that are higher than the market
equilibrium. Firms that pay efficiency wagescould lower their

wages and hire more workers, but choose not to do so.

Some reasons that managers might choose to pay efficiency

wages are to avoid shirking, reduce turnover, and attract
productive employees.

The consequence of the efficiency wage theory is that the

market for labor does may not clear, even in the long run,
and unemployment may be persistenly higher than its natural
rate.

TERMS

shirking
To provide less quality work than is required.

turnover
The number of times a worker is replaced after leaving.
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Efficiency-Wage Theory
The market-clearing wage is the wage at which supply
equals demand; there is no excess supply of labor (unemployment)
and no excess demand for labor (labor shortage). In the
basic economic theory, in the long run the economy will achieve this
market-clearing equilibrium and will experience the natural level of
unemployment. Some economists, however, argue that a real wage
that achieves equilibrium in the labor market may never be reached.
They suggest that firms may intentionally pay a wage greater than
the market equilibrium. Such firms could hire additional workers at
a lower wage, but they choose not to do so. The idea that firms may
hold to a real wage greater than the equilibrium wage is called
efficiency-wage theory.

Why Pay Efficiency Wages?

Why would a firm pay higher wages than the market requires?
Suppose that by paying higher wages, the firm is able to boost
the productivity of its workers. Workers become more contented
and more eager to perform in ways that boost the firms profits.
Workers who receive real wages above the equilibrium level may
also be less likely to leave their jobs. That would reduce job
turnover. A firm that pays its workers wages in excess of the
equilibrium wage expects to gain by retaining its employees and by
inducing those employees to be more productive. Efficiency-wage
theory thus suggests that the labor market may divide into two
segments. Workers with jobs will receive high wages. Workers
without jobs, who would be willing to work at an even lower wage

than the workers with jobs, find themselves closed out of the
market.
Specifically, there are several theories of why managers might pay
efficiency wages:

Avoiding shirking: If it is difficult to measure the quantity or

quality of a worker's effort, there may be an incentive for him or her
to "shirk" (do less work than agreed). The manager thus may pay an
efficiency wage in order to increase the cost of job loss, which gives
a sting to the threat of firing. This threat can be used to prevent

shirking .

Minimizing turnover: As mentioned above, by paying abovemarket wages, the worker's motivation to leave the job and look for
a job elsewhere will be reduced. This strategy makes sense when it
is expensive to train replacement workers.

Selection: If job performance depends on workers' ability and

workers differ from each other in those terms, firms with higher
wages will attract more able job-seekers, and this may make it
profitable to offer wages that exceed the market clearing level.

Consequence of Efficiency Wage

The consequence of the efficiency wage theory is that the market for
labor does may not clear and unemployment may be persistently
higher than its natural rate. Instead of market forces causing the
wage rate to adjust to the point at which supply equals demand, the
wage rate will be higher and supply will exceed demand. This
produces higher wages for those who are employed but higher levels
of unemployment.

Chapter 8
THE ISLM MODEL

Definition of 'ISLM Model'

A macroeconomic model that graphically represents two intersecting curves, called
the IS and LM curves. The investment/saving (IS) curve is a variation of the
income-expenditure model incorporating market interest rates (demand for this
model), while the liquidity preference/money supply equilibrium (LM) curve
represents the amount of money available for investing (supply for this model).

Investopedia explains 'ISLM Model'

The model attempts to explain the investing decisions
made by investors given the amount of money they have
available and the interest rate they will receive.
Equilibrium occurs when the amount of money invested
equals the amount of money available for investing.

General Equilibrium, the IS-LM Model, and International

Influences
The IS Curve:
Aggregate expenditure depends on real income
and the real interest rate, as well as other
autonomous influences (including the price level)
The combination of real interest rates and real
income levels that result in equilibrium in the
goods market is called the IS curve
The LM Curve
The demand for real money balances depends on
real income and the real interest rate
The real money supply depends on the nominal
money supply and the price level

 The combination of real interest rates and real

income levels that result in equilibrium in the
money market is called the LM curve
IS-LM Equilibrium
Equilibrium income and the real interest rate is
determined by simultaneous equilibrium in the
goods market and the money market
Change in autonomous forces and the price level
will lead to a shift in the IS or LM curve leading to a
change in equilibrium income
Fiscal Policy and the IS Curve
Higher expenditure or lower taxes shift the IS
curve and AD curve to the right
The impact of the shift depends in part on the
slope of the LM curve
Monetary policy and the LM Curve
More money shifts the LM curve and the AD curve
to the right
The impact of the shift depends in part on the
slope of the IS curve
IS curve[edit]
For the investmentsaving curve, the independent variable is the interest rate and the
dependent variable is the level of income. (Note that economics graphs like this one
typically place the independent variable (interest rate, in this example) on the vertical
axis rather than the horizontal axis.)
he IS curve can be said to represent the equilibria where total private investment equals
total saving, where the latter equals consumer saving plus government saving (the
budget surplus) plus foreign saving (the trade surplus).
Chapter 7
Demand & supply of labour
1)determinants of demand & supply of labour?
Labour Supply

The labour supply refers to the total number of hours that labour
is willing and able to supplyat a given wage rate.

It is the number of workers willing and able to work in a particular job or

industry for a given wage.

The labour supply curve for an industry or occupation will be upward

sloping.

This is because, as wages rise, other workers enter this industry attracted
by the incentive of higher rewards. They may have moved from other
occupations or they may not have previously held a job, such as
housewives or the unemployed.

The extent to which a rise in the prevailing wage or salary in an

occupation leads to an expansion in the supply of labour depends on the
elasticity of labour supply.

Key factors affecting labour supply

The supply of labour to a particular occupation is influenced by:
The real wage rate on offer in the industry itself higher wages
should boost the number of people willing and able to work.

Overtime: Opportunities to boost earnings come through overtime,

productivity-related pay schemes, and share option schemes.
Substitute occupations: The real wage rate on offer in competing jobs
is another factor because this affects the wage and earnings differential
that exists between two or more occupations. So for example an increase
in the relative earnings available to trained plumbers and electricians may
cause some people to switch their jobs.
Barriers to entry: Artificial limits through the introduction of minimum
entry requirements or other legal barriers to entry can restrict labour
supply and force average pay levels higher e.g. legal services and
medicine where there are strict entry criteria to the professions.
Improvements in the occupational mobility of labour: For example if
more people are trained with the necessary skills required to work in a
particular occupation.
Non-monetary characteristics of specific jobs include factors such
as the level of risk, the requirement to work anti-social hours, job
security, opportunities for promotion and the chance to live and work
overseas, employer-provided in-work training, subsidised health and
leisure facilities and occupational pension schemes.
Net migration of labour the UK is a member of the EU single market
that enshrines free movement of labour as a guiding principle. A rising
flow of people seeking work in the UK is making labour migration an
important factor in determining the supply of labour available to many
industries be it to relieve shortages of skilled labour in the NHS or
education, or to meet the seasonal demand for workers in agriculture and
the construction industry. The recession has caused inward migration to
slow down and in some cases to reverse.
Elasticity of labour supply

The elasticity of labour supply to an occupation measures the extent to

which labour supply responds to a change in the wage rate in a given time
period.

In lower-skilled occupations, labour supply is elastic because a pool of

labour is employable at a fairly constant market wage rate.

Where jobs require specific skills and training, the labour supply will be
more inelastic because it is hard to expand the workforce in a short period
of time when demand for workers has increased.

Labour

1. The Output Price

An increase in the price of the product raises the value of the marginal product of
labour and therefore increases the demand for labour.
A decrease in the price of the product lowers the value of the marginal product of
labour and therefore decreases the demand for labour.
2. Technological Change
Technological advance raises the marginal product of labour, which in turn raises the
value of the marginal product of labor. Thus, any new technology which raises
marginal product of labour will lead to an increase in the demand for labour.
However, as technology improves, demand for certain types of labour falls while
demand for other types of labour rises. For example, introduction of word processors
reduced the demand for typists and increased the demand for computer literate
office assistants.
Technology may also allow employers to replace labour with machines.
3. The Supply of Other Factors
The quantity available of one factor can affect the marginal product of another.
Therefore, any change in the availability of another factor will likely affect the
demand for labour.

Chapter 12
Section 1: Fiscal Policy
Macroeconomics - Unit 6
Definition of Fiscal Policy
Fiscal policy is a government's attempt to change economic activity by changing
government expenditures, taxation and borrowing, and lending policies. A government
can choose to change spending on highways, defense, education, public works, and
social programs. A government can change tax rates, tax systems, and taxation to
certain groups. If a government spends more than it receives in tax revenue, it borrows
the difference.
Keynesian Economics and Fiscal Policy
The two policies that governments can use to influence the economy are fiscal policy and
monetary policy. Fiscal policy is covered in this unit. Monetary policy is covered in Unit 9.
Keynes supported both policies, but believed that fiscal policy is more effective. According to
Keynes, governments should primarily increase spending when the economy experiences a
recessionary gap. He stated that governments can also lower taxes to stimulate the economy,

but he preferred increases in government spending because governments spend all of their
money whereas citizens may save part of their tax benefits. Conversely, governments should
decrease spending and/or raise taxes when the economy experiences an inflationary gap.
Many politicians, influenced by Keynes's encouragement to run deficits to stimulate the
economy, support active fiscal policy. Since Keynesian economics became popular in the
1930s and beyond, government spending has increased significantly. Politicians often cater to
special interest groups, because it translates into more votes and possible campaign
donations. Consequently, government spending often increases even during expansions.
Classical Economics and Fiscal Policy
Classical economists and supporters of classical schools of thought (for example, neo-classical
and Austrian economists), disagree with Keynesian fiscal policy. According to classical
economists, efforts to change the demand side of the economy may benefit an economy in
the short run, but causes harm in the long run. Increases in government spending lead to
increases in the money supply, or increases in a nation's debt, or increases in taxation.
Increases in the money supply equate to inflation. Increases in interest rates lead to
decreases in borrowing and decreases in private spending. And increases in taxation lead to
decreases in private consumption and savings.
Keynes argued that a rapidly growing economy during times of full employment causes
inflation. Classical economists disagree. They believe that increases in the money supply
equate to inflation, and long-term increases in the price level are impossible without increases
in the money supply. Classical economists, and in particular the so-called monetarists, believe
that inflation can be slowed or avoided by decreasing the rate of growth in the money supply.
Classical economists do not believe that active fiscal policy is beneficial to the economy in the
long run.
According to the classical school, proper fiscal policy is when the government creates an
economic environment in which private properties are well-protected, and households and
businesses have maximum incentive to produce and innovate. Government spending should
be limited to defense, a judicial system, fire and police protection, infrastructure, education,
transportation and a small and efficient administrative system. Taxes should be relatively low
and regulations minimal.
Fiscal Policy Lags
In addition to the long-run disadvantages of active fiscal policy mentioned in the previous
paragraph, neo-classical economists and monetarists believe that lags in the economy
hamper the effectiveness of government policy. There are three lags: the information lag,
the policy lag, and the impact lag.
The information lag is the period of time during which the economy changes and economists
find out that it changes. For example, if in March of this year the economy slows down,
economists may not receive accurate data to determine the slowdown until June of this year.
The policy lag is the period of time during which the information is received and politicians
come to a decision to take action. If the information about the slowdown is received in June, it
may be January of the following year before politicians change fiscal policy (increase
government spending and/or decrease taxes).
The impact lag is the period of time during which politicians have taken action and the impact
of the action is actually felt in the economy. If politicians took action in January, the impact
may not be felt until April or May.
The three lags combined means that it may take approximately 13 or 14 months from the
beginning of the slowdown until fiscal policy takes effect. At that time, the economy may have
already begun an expansion on its own, and the policy may be counter-effective. This is
another reason why classical, neo-classical, and monetarist economists support limited
government involvement in the economy.

iscretionary fiscal expenditures are changes in government spending and taxation that
need specific approval from Congress and the President. Examples include increases in

spending on roads, bridges, stadiums, and other public works. Because discretionary
fiscal policy is subject to the lags discussed in the last section, its effectiveness is often
criticized. Automatic stabilizers, on the other hand, do not need government approval
and take effect immediately.
Automatic Stabilizers
Automatic stabilizers are changes in government spending and taxation that
do not need approval by Congress or the President. Automatic stabilizers are expense and
taxation items that are part of existing economic programs.

Examples of automatic stabilizers include

1. Unemployment compensation.
When the economy turns down, the government's expense on unemployment compensation
automatically increases as more people lose their jobs. According to Keynesians, this increase in
government spending prevents the economy from a more severe slowdown compared to what
would occur if no unemployment compensation existed.
2. Subsidies to farmers.
When the economy turns down and farmers struggle, the government's expenses on farmer
subsidies automatically increase. According to Keynesians, this increase in government spending
stimulates the economy.
3. A progressive tax system.
Most industrialized countries' tax systems are set up to tax higher-income individuals and
corporations at higher rates. If the economy slows down, incomes decrease, and people pay less
money in taxes. This decrease in tax (compared to a system without progressive taxes) puts more
money in people's pockets and stimulates private spending.
Active Government Policy and Crowding Out
Keynes strongly supported automatic stabilizers. The advantage of automatic stabilizers is that
they do not suffer from the three lags mentioned in the previous section. Some economists,
however, still question the effectiveness of automatic stabilizers, or any active fiscal policy, for that
matter. Anytime government spending increases, the funds have to come from somewhere.
Government borrowing during recessionary gaps typically increases. Increased borrowing leads to
something economists call crowding out. Crowding out is when government borrowing "crowds
out" (replaces) funds that otherwise could be used by the private sector. The more the government
borrows from the private sector, the fewer funds are available in the private sector for investments,
research and development, etc.
Keynesians suggest that instead of borrowing the money, the government can increase its money
supply and, thus, generate funds for the additional spending. However, classical economists
believe that increasing the money supply equates to inflation. According to the classical school,
either method (borrowing from the public, or increasing the money supply), will have long-run
disadvantages. Classical economists believe that active fiscal and monetary policies do more harm
to the economy in the long run compared to the benefits they produce in the short run.