Macroeconomic Foundations: Unemployment and Wages Explained

University of New England Week 2 Macroeconomic Foundations: Part II

ECON102
Week 2
Tutorial Problem Setune
University of
New England

Question 1: Barista Wages and Turnover

Jane is the general manager at a new cafe and wants to hire a
few baristas. The going rate for baristas in the area is $26.50
per hour. Jane has heard that many local coffee shops have
high turnovers, with baristas ghosting them-simply not
showing up for their shift and never coming back.

Jane starts to put together an advertisement to hire baristas for
$26.50 per hour but changes her mind and lists the wage she
will pay at $29 per hour. Why would Jane pay $26.50 per
hour? What's the rationale for paying $29 (or any wage higher
than $26.50)?

Question 1: Wage Rationale

Paying the prevailing wage of $26.50 per hour:
Jane will have to compete with other employers for
workers.
Self-selection: Jane may only attract lazy workers.
Paying the efficiency wage of $29 per hour:
Jane's workers feel more appreciated, inspiring greater
commitment to their work, which would also increase
worker productivity and reduce worker turnover.

.
Remember:
P
W = MPLune
University of
New England

Question 2: Economic Downturn and Unemployment

An economic downturn leads to hundreds of thousands of
people losing their jobs. In some industries, workers who
remain employed, or "insiders," continue to develop their skills,
enabling them to push wages above the level at which
less-skilled "outsiders" could be employed. What do you expect
to happen to the equilibrium unemployment rate due to
hysteresis? Explain your reasoning.

Question 2: Types of Unemployment and Hysteresis

Types of unemployment:

1. Frictional unemployment: The time it takes for employers
   to search for workers and for workers to search for jobs.
2. Structural unemployment: Wages don't fall to bring labour
   demand and supply into equilibrium
3. Cyclical unemployment: A temporary downturn in the
   economy.

Equilibrium unemployment rate: The sum of frictional and
structural unemployment
Hysteresis: When a period of high unemployment leads to
a higher equilibrium unemployment rate.
Some workers who become unemployed in a cyclical
downturn remain unemployed even after the economy
recovers.
"Outsiders" lost their old jobs because the skills needed to
perform them have changed.une
University of
New England

Question 3: University Student Cost of Living

Suppose the typical university student spends money primarily
on the products in the following table.

Product
Quantity
2020 price
2021 price
Soft drink
365
$2.25
$2.30
Pizzas
200
$10.00
$11.00
Chicken wings
165
$7.00
$7.50
Rent
1
$10,000
$10,800
Textbooks
4
$150
$165

a
What is the cost of the basket in 2020?
b
What is the cost of the basket in 2021?
c
What is the 2021 inflation rate for a university student?
d
Has the cost of living for university students risen or fallen?

Question 3: Cost of Living Calculation

Product
Quantity
2020
price
2021
price
Cost in 2020
Cost in 2021
Soft Drink
365
$2.25
$2.30
$821.25
$839.50
Pizzas
200
$10.00
$11.00
$2,000.00
$2,200.00
Chicken wings
165
$7.00
$7.50
$1,155.00
$1,237.50
Rent
1
$10,000
$10,800
$10,000.00
$10,800.00
Textbooks
4
$150
$165
$600.00
$660.00
Cost of Basket
(a) $14,576.25
(b) $15,737.00

c
TT2021
=
$15,737.00-$14,576.25
$14,576.25
× 100 = 7.96%

c
The cost of living for university students has risen.une
University of
New England

Question 4: Inflation Measures

Which measure or measures of inflation should be used in the
following scenarios and why?

a
You're a buyer at an oil refinery that is facing rising input
costs. Your manager asks you to determine if your
competitors are also experiencing rising input prices.

b A teacher's union wants to include annual cost-of-living
adjustments in their next contract.une
University of
New England

Question 4: Inflation Measure Scenarios

a
Producer Price Index: Tracks the cost of inputs into
production process and can help you estimate what's likely
happening to your competitor's costs.

b
Consumer Price Index (headline CPI): Tracks average price
consumers pay over time for representative basket, most
widely accepted measure of cost-of-living, union can ask
for indexation of teacher's salary

Other price level indicators:
Core CPI: It excludes volatile items like food and energy.
GDP deflator: It tracks the price of all goods and services
produced domestically.une
University of
New England

Question 5: Real Earnings Comparison

In 2003, Julia Roberts was paid a then-record shattering
US$25 million for her role in the film Mona Lisa Smile. In
2013, Sandra Bullock earned US$70 million for the film
Gravity. Given that the CPI in the U.S. was 184.0 in 2003, and
233.0 in 2013. Assuming the current CPI is 251.1, determine
which of the two had higher real earnings.une
University of
New England

Question 5: Inflation Adjustment Formula

Use the inflation adjustment formula to adjust for
changing prices:
Current CPI
Current dollars = Another time's dollars
X
CPI in another time
Mona Lisa Smile in current dollars:
US$25m X
251.1
184.0
= US$34m
Gravity in current dollars:
US$70m X
251.1
233.0
= US$75m
Sandra Bullock had higher real earnings.une
University of
New England

Question 6: Income Changes and Money Illusion

Behavioural economists have discovered that people view a 2%
decrease in their income without inflation as unfair, but a 3%
increase in their income in the presence of 5% inflation as fair.
What are the nominal and real rates of change in their
incomes? What tendency is leading people to feel like the pay
decrease is unfair?une
University of
New England

Question 6: Real Rate of Change and Money Illusion

Salary decrease without inflation:
.
Real rate of change = - 2%
Salary increase with inflation:
.
Real rate of change = 3%-5% = - 2%
Although the net decrease in income is the same, people
view the pay decrease without inflation as unfair.
This tendency is known as money illusion, when people
focus on nominal variables instead of inflation-adjusted
variables.
This is an example of how money illusion creates nominal
wage rigidity, which is a reluctance to cut nominal wages.une
University of
New England

Question 7: Costs of Inflation

Identify which cost of inflation-menu costs or shoe-leather
costs-is illustrated in each of the following scenarios.

1. During the German hyperinflation of 1922-1923, some
   workers reportedly were paid two to three times per day.
   They would then rush out to spend their earnings before
   they became nearly worthless.
2. A hyperinflation in Zimbabwe was so severe that,
   according to one observer of supermarket employees, they
   were "running around that store with label makers,
   changing the prices three, four times a day."une
   University of
   New England

Question 7: Inflation Cost Scenarios

a
Shoe-leather costs: The costs incurred trying to avoid
holding cash.

b
Menu costs: The marginal cost of adjustment prices.