Answer for Question from My Last Ph.D. Micro Midterm
By Bryan Caplan
Despite the lack of a consensus in the comments on the right answer to my micro midterm question, I maintain that there’s just one right answer. The key point – and the reason I emphasized the words virtually and before long – is that as consumption approaches satiation, workers reduce their hours of work to prevent themselves from actually reaching satiation. More technically, as workers approach satiation, their labor supply curves start to “bend backwards.” The result is that rising labor demand stemming from rising productivity raises wages yet reduces employment. From my answer key:
Output: Output continues to rise slightly as labor productivity keeps going up, approaching but
never reaching the satiation level. If
output hit satiation, people would stop working; but otherwise the tendency of
greater productivity to raise output remains.
Employment and wages: Increasing labor productivity raises labor demand, and
as workers approach satiation, their labor supply curve starts to bend
backwards. The result: Wages go up, but
employment declines as satiated high-wage workers switch from labor to leisure.
Real Interest Rates: As the intertemporal GE consumption model at the end
of the Week 2 notes explains, positive time preference (β<1) and growing income (g>0) guarantee a
positive real interest rate. Since the
question says, “Labor productivity continues
to improve,” there is no reason to say that real interest rates rise; all we
can say is that they remain positive.
Note: The question says “virtually satiated,” not “completely satiated”; furthermore,
nothing in the question suggests that consumers would remain satiated if there
were a drastic fall in output. It is
incorrect, then, to claim that output and employment would fall to zero. Even if this were so, though, wages would
still go up, because in GE workers earn their marginal product.
no matter what happens to output, there’s no reason to think that real interest
rates would fall. If labor productivity is rising, workers who
feel almost satiated today should expect to feel even more satiated next year, so interest rates would still be positive!