Questions & explanations
1. If a country increases the average years of schooling from 6 to 12, what does the Lucas model predict about its growth rate?
The model predicts that the growth rate will increase permanently. Because human capital accumulation drives growth, higher education leads to faster human capital growth. However, the effect depends on the fraction of time spent on learning. If the increase is a one-time rise in the stock, growth may temporarily accelerate but then return to a higher steady state? Actually, in the Lucas model, growth rate is determined by the rate of human capital accumulation. A higher level of human capital does not itself raise growth unless the rate of accumulation increases. So if the country now invests more in education (spending more time learning), growth rises. If it just has a higher stock but same learning time, growth stays same. So answer needs care: The model emphasizes the growth rate of human capital, not the level. So a permanent increase in the fraction of time spent on education raises the growth rate forever.
2. What is the insider-outsider theory?
The insider-outsider theory explains how labour market is segmented between insiders (current employees) and outsiders (unemployed or new entrants). Insiders have bargaining power from their job tenure, firm-specific skills, and the costs of replacing them. They use this power to push for higher wages and job security. Outsiders, whether unemployed or new workers, have little influence on wage setting and often face lower wages or less stable jobs. The theory suggests that insiders can block wage cuts even when outsiders are willing to work for less, causing involuntary unemployment. Furthermore, insider power can lead to hysteresis: temporarily high unemployment becomes permanent because insiders bargain for their own interests, keeping wages high and preventing outsiders from gaining jobs. Institutions like strong unions and employment protection laws amplify insider power.
3. Give an example of a shock that the DMP model can analyze during a recession.
A common shock is a sudden drop in aggregate productivity. In a recession, average productivity falls, making many matches less valuable. Firms respond by cutting back on vacancy posting because expected profits decrease. This reduces tightness, lowering the job-finding rate. At the same time, some existing jobs become unprofitable as productivity declines below thresholds, increasing job destruction. The model predicts that unemployment will rise significantly. Additionally, because the matching process takes time, the increase in unemployment persists even after productivity recovers. The DMP model captures the slow recovery typical in recessions due to depleted job vacancies. It also shows that policies like hiring subsidies can speed up recovery by reducing the cost of posting vacancies. This framework is extensively used in business cycle research.
4. Compare the DMP model's predictions for the effects of an increase in unemployment benefits on vacancies and unemployment.
An increase in unemployment benefits raises the outside option of workers, making them more selective and demanding higher wages in bargaining. Higher wages reduce the profit from a match, so firms post fewer vacancies. This drop in vacancies reduces labour market tightness, which in turn lowers the job-finding rate for workers. With fewer jobs created and more workers unemployed, unemployment rises. Additionally, higher benefits may reduce workers' search effort, further lowering the job-finding rate. The Beveridge curve shifts outward: for a given level of vacancies, unemployment becomes higher. In the model, the effect on job destruction is ambiguous: higher wages might make firms more likely to destroy marginal jobs, increasing separations. Overall, the model clearly shows that more generous benefits increase the steady-state unemployment rate.
5. Explain why the Pissarides model cannot be used to analyze long-run steady-state unemployment without accounting for the Beveridge curve.
The Beveridge curve shows the negative relationship between unemployment and vacancies over time. The Pissarides model produces a steady-state Beveridge curve because, in equilibrium, job creation and job destruction flows are balanced. Without the Beveridge curve, the model would only give a single equilibrium point rather than the whole relationship. The curve helps identify shifts in labour market efficiency, like when matching becomes worse. For example, a rightward shift of the Beveridge curve indicates structural unemployment. The Pissarides model incorporates the matching function and labour market tightness to trace out this curve. So, analyzing long-run unemployment requires understanding the Beveridge curve, which the model endogenously generates. Ignoring it would miss the dynamics of how job vacancies and unemployment co-move.
6. Why might the efficiency wage model lead to persistent discrimination in hiring?
If certain groups of workers are believed to have higher average shirking tendencies (even if that belief is wrong), firms may use group membership as a signal. For example, if employers think young workers shirk more, they may offer them lower efficiency wages or avoid hiring them altogether. This can lead to higher unemployment for that group. Because the model relies on wages above market level, firms have a pool of applicants; they can choose whom to hire based on stereotypes. Such statistical discrimination can persist because breaking the stereotype is individually costly for any single firm. The efficiency wage framework thus provides a mechanism for how discrimination operates even without prejudice, just based on imperfect information about effort. However, actual discrimination may also involve biases beyond statistical reasons.
7. What is the Diamond-Mortensen-Pissarides (DMP) model?
The DMP model is a framework that explains equilibrium unemployment as a result of search frictions. It was developed by Peter Diamond, Dale Mortensen, and Christopher Pissarides, who won the Nobel Prize for this work. In the model, workers and firms take time to find each other because of imperfect information and mismatch. A matching function describes how many job matches form given the number of unemployed workers and vacancies. Wages are determined through bargaining between a worker and a firm after they meet. The model endogenously determines job creation (by firms posting vacancies) and job destruction (by firms laying off workers when productivity is low). It predicts a steady-state unemployment rate that balances flows into and out of unemployment. The DMP model is widely used to study labour market policies and business cycles.
8. Explain the role of wage determination through Nash bargaining in the DMP model.
In the DMP model, after a worker and firm meet, they bargain over the wage. Nash bargaining splits the total surplus from the match: the worker gets a share β and the firm gets (1-β). The surplus for the worker is the value of having a job minus the value of being unemployed; for the firm, it is the profit from the job minus the value of a vacant job. The wage that results depends on the worker's bargaining power β, the unemployment benefit, and labour market tightness. A higher β gives workers a larger share, raising wages. Higher unemployment benefits also raise the worker's outside option, increasing the wage. High tightness (many vacancies relative to unemployed) improves the worker's bargaining position too, as they have better alternatives. The bargained wage, in turn, affects the firm's hiring decision and equilibrium unemployment.
9. Explain how job flows relate to worker flows in the Davis-Haltiwanger framework.
Job flows measure changes in the number of jobs at establishments, while worker flows measure hires and separations. The two are linked but not identical because workers can move between jobs without changing the number of positions. For example, a plant might hire 10 workers and fire 10 others, resulting in zero job creation but 20 worker flows (separations and accessions). The Davis-Haltiwanger data shows that there is significant churning: worker flows are much larger than job flows. During recessions, job destruction rises, leading to many separations, and subsequently, many workers become unemployed. The framework helps decompose unemployment fluctuations into contributions from job destruction and from hiring (including reallocation). It reveals that a large part of unemployment is due to workers losing jobs in shrinking plants.
10. What are job creation and job destruction in the Davis-Haltiwanger framework?
Job creation is the total number of new jobs added at establishments that are expanding or being born. Job destruction is the total number of jobs lost at establishments that are shrinking or dying. The Davis-Haltiwanger approach measures these gross flows at the micro level using establishment-level data. They count job creation as the sum of employment gains in units that increase employment, and job destruction as the sum of employment losses in units that decrease. These measures are usually expressed as rates relative to average employment. The framework reveals that job creation and destruction are large and persistent, even in normal times. It also shows that job destruction is more volatile over the business cycle than job creation. These facts are crucial for understanding unemployment dynamics and labour reallocation.
11. How does the DMP model account for job destruction?
Job destruction occurs when a match is hit by a negative productivity shock that makes the match unprofitable. Each job has a match-specific productivity level that varies randomly over time. If productivity falls below a reservation threshold, the firm and worker agree to separate because the surplus becomes negative. The reservation productivity is determined endogenously: it occurs where the total surplus from continuing the job equals zero. If productivity is above this threshold, the job continues; below, it is destroyed. Firms also may destroy jobs if the worker quits, but the model focuses on layoffs due to shocks. The rate at which these shocks arrive and the distribution of productivity changes determine the job destruction flow. This flow, combined with job creation flow, gives the steady-state unemployment rate.
12. Compare the implications of the insider-outsider theory for temporary versus permanent workers.
In this theory, insiders hold permanent, protected jobs with higher wages and better conditions. Outsiders often end up in temporary or part-time positions with lower pay and little security. The presence of insiders makes firms reluctant to hire outsiders on permanent contracts because it would later give them insider power. Consequently, firms rely more on temporary workers who have no power to bargain, keeping labour costs down for that segment. This dual labour market means that even when the economy improves, outsiders may not transition into insider jobs quickly because insiders block reforms. Temporary workers remain stuck as outsiders, and their jobs are more sensitive to business cycles. Thus, insider-outsider divisions can create a cycle where outsiders face unstable employment and limited career progression.