Questions: Labor Market Equilibrium

Question 1

In a perfectly competitive labor market with flexible wages, involuntary unemployment...

• A. Is the normal equilibrium outcome
• B. Cannot exist because wages adjust to clear the market — anyone willing to work at the equilibrium wage finds employment
• C. Exists because firms always have more applicants than positions
• D. Is caused by workers' unrealistic wage expectations

Answer: (B)

In the competitive model, the wage adjusts until quantity supplied equals quantity demanded. At the equilibrium wage, everyone who wants to work at that wage is employed. Those not working have chosen not to participate at the prevailing wage (voluntary non-participation). Involuntary unemployment — workers willing to work at the going wage who cannot find jobs — requires some departure from the competitive model: wage floors (minimum wages), efficiency wages, search frictions, or other rigidities that prevent wages from adjusting to clear the market.

Question 2

Wage rigidity refers to the observation that wages do not always adjust quickly to restore labor market equilibrium after demand or supply shocks.

• T. True
• F. False

Answer: True

Wage rigidity — both downward and upward — is well-documented empirically. Downward nominal wage rigidity (firms' reluctance to cut nominal wages) is particularly strong: Bewley's survey research found that managers avoid wage cuts due to feared effects on morale and effort. Wage rigidity means that negative demand shocks reduce employment rather than wages, and positive demand shocks produce labor shortages rather than immediate wage increases. This rigidity is a key reason why labor markets do not behave like the frictionless competitive model predicts.

Question 3

How do search frictions modify the competitive model of labor market equilibrium?

Model answer: In the competitive model, workers and firms find each other instantly and costlessly. Search frictions introduce the reality that matching workers to jobs takes time, effort, and resources — both workers and firms must search, and not all matches are immediate or optimal. This produces equilibrium unemployment even when the number of vacancies equals the number of job seekers (frictional unemployment), generates a Beveridge curve (negative relationship between unemployment and vacancies), and creates bilateral monopoly in each match (once matched, both parties have an interest in maintaining the relationship, creating surplus to be divided through bargaining).

Search and matching models (Mortensen, Pissarides — 2010 Nobel Prize) formalize these frictions. The matching function M(U, V) determines how many matches form given U unemployed workers and V vacancies. The resulting equilibrium features simultaneous unemployment and vacancies, wage bargaining within matches, and job creation/destruction dynamics. These models explain why unemployment does not drop to zero even in tight labor markets and why policy interventions like unemployment insurance affect equilibrium through their effects on search intensity.