(c) Workers continue to be employed at their old job for 5, 10, or 20% lower wages until an entrepreneur makes (b) happen.
So, if the demand for mortgages collapses, all it takes to get back to 2006 levels is for mortgage underwriters to take a 20 percent pay cut?
In a world with no discontinuities, we would not get crazy subprime lending and sudden sharp drops in demand. The no-discontinuity world is what classical economists are trained to work with. Too bad it is not the real world.
[Update: Another way to put this is that if you are a mortgage company in 2008 and an underwriter you just laid off begs you for his job back and says he’ll take any wage you are willing to offer, your response is to hand him a dish and say, “20 cents an hour. Start washing.”]