Page 45 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes Hence, while socialists advocate the replacement of markets with central planning and
redistribution, the geo-classical school recognizes that markets are not truly free if restricted
and taxed, and it is these interventions that cause unemployment and poverty. Prosperity
can be attained by removing these barriers, not erecting others.

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Self Assessment

Fill in the blanks:

1. ................................ wages are adjusted for inflation.
2. ................................ rate of interest is the rate which the lender receives from the borrower
in money.

3. ................................ is the value of final goods and services planned to be produced in an
economy during a period.
4. The main point of the ................................ is that 'supply creates its own demand'.

5. Classical model is also called the ................................ model.

3.2 Equilibrium in Markets

3.2.1 Labour Market Equilibrium

Adjustment in 'real' wages ensures full employment. The equilibrium is when demand for
labour equals supply of labour.

(a) Demand for Labour (D ): The aggregate D depends upon real w, prices firms receive for
L L
goods and services, and prices firms have to pay for non-labour inputs. With prices of
goods and non-labour inputs held constant, D becomes the function of real w:
L
D = f (real w) = f (w/p)
L
!
Caution There is inverse relation between real w and D . There are two reasons: (i) As
L
wages fall relative to the cost of machines, it pays the firm to substitute workers for
machines; and (ii) as wages fall, VMP becomes greater than w. (VMP equals MPP ×P). A
L L L
firm employs labour upto the point where VMP = real w. A firm goes on employing
L
additional labour so long as VMP is greater than real w. As more labour is employed
L
MPP falls, and so VMP falls. The firm employs labour upto when VMP is once again
L L L
equal to real w.
(b) Supply of Labour (S ): When w changes, it produces two effects: SE and IE.
L
SE: w rises, opportunity cost of labour rises. Therefore, D for leisure falls which means S
L
rises.
IE: w rises, demand for leisure rises. S falls.
L
The two effects work in the opposite directions. Let us assume that the two effects offset
each other, so that S remains unchanged. (We can also conceive of backward sloping
L
supply curve.)

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