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6) Suppose that all jobs pay a lower wage. In the one-sided search model, determine what
happens to the reservation wage and the unemployment rate, and explain.
Answer: If all jobs pay a lower wage, this shifts down the welfare function of the employed,
which increases the reservation wage. The fact that all wages are lower implies that the function
H(w) shifts down. There are therefore two effects on the flow of workers from unemployment to
employment UpH(w*). Since H(w) is lower for each w, and w* is higher, both effects serve to
reduce the flow of workers from unemployment to employment. As a result, long-term
unemployment must increase.
LO: 6.5: Use the one-sided search model to determine the effects of changes in the labor market
on the reservation wage and the unemployment rate.
Difficulty: difficult
Classification: application
AACSB: analytical thinking
7) In the two-sided search model, explain what decisions firms make, and how they make them.
Answer: Would-be firms make a decision as to whether they should post a vacancy in an
attempt to hire a worker — to be an active firm — or to remain idle. Posting a vacancy costs the
firm k in recruiting costs. If the firm successfully matches with a worker, it receives the output
from production, z, minus the wage it pays to the worker w. But, the chances of matching with a
worker are given by em(1/j, 1), where e is matching efficiency, m is the matching function, and j
is labor market tightness. In equilibrium, the expected payoff for an firm from posting a vacancy
will be zero, so em(1/j,1)(z-w) - k = 0.
LO: 6.6: Construct an equilibrium in the two-sided search model.
Difficulty: moderate
Classification: application
AACSB: analytical thinking
8) In the two sided search model, explain what happens in equilibrium if the unemployment
insurance benefit goes down.
Answer: There are two initial effects, on each side of the labor market. On the supply side,
consumers find it less attractive to search for work, as the payoff is lower should their search
prove to be unsuccessful. On the demand side of the labor market, the payoff to firms from
searching for workers goes up, as the firms can now pay a lower wage — the lower UI benefits
imply that the worker's outside option is lower. This implies that more firms enter the labor
market searching for workers, so labor market tightness goes up. Therefore the unemployment
rate will decline and the vacancy rate will go up. The effect on the size of the labor force is
ambiguous, since workers are discouraged from searching because of lower UI benefits, but the
labor market is tighter, so the chances of finding a job are higher.
LO: 6.7: Use the two-sided search model to explain how shocks to the labor market change
labor force participation, unemployment, vacancies, aggregate output, and labor market
tightness.
Difficulty: easy
Classification: application
AACSB: analytical thinking