Consider an economy that consists of two regions – the East and West. The elasti
ID: 1200800 • Letter: C
Question
Consider an economy that consists of two regions – the East and West. The elasticity of labor demand in each region is –0.5. The economy-wide labor supply is perfectly inelastic. The labor market is initially in an economy wide equilibrium, with 600,000 people employed in the East and 400,000 in the West at the wage of $15 per hour. Suddenly, 20,000 people immigrate from abroad and initially settle in the West. They possess the same skills as the native residents and their labor supply is also perfectly inelastic. a) What is the effect of this immigration on wages in each region in the short run (before migration)? Compute the value of wages in each region as a result of this immigration AND use graphs to show the outcome of this event. b) What is the effect of this immigration on wages in each region in the long run (after native workers are able to migrate), assuming labor demand does not change in either region. Specify the new wage in each region and show the changes using graphs.
Explanation / Answer
ANS:
a.) There will be no effect on the East labor supply in the short run, so the wage rate will not change there. In the West, labor supply will be increased by 5 percent ( as per the question 20,000*100 / 400,000 = 5%), so the wage rate must fall by 5 / (0.5) = 10 percent (as given in question above the elasticity of labor demand is -0.5, so a one percent decrease in wages would have been generated by a 0.5 percent expansion of the labor supply). The new hourly wage in the West, is ($15 * 10 / 100 = $1.5 ) $15 - $1.5 = $13.50 and total employment in the West is 420,000.
b.) In the long run, people must move from the West to the East to equalize the wage rates in the two regions. Since the wages were equal in the two regions before the influx of immigrants, and they also must be equal after things settle down, the proportional decrease in the wage rate should be the same in East and as well as in West. Because the elasticity of labor demand is the same in the two regions, this last observation implies that the percentage increase in employment in the East must be the same as the percentage increase in employment in the West. Thus, as 60 percent of the original workers were employed in the East from total number of workers as given in the question, 60 percent of 20,000 increase in Western employment will eventually migrate to the East. In the long run, therefore, total Eastern employment will be 612,000 while total Western employment will be 408,000. (Note: there is no presumption that only immigrants further migrate to the East.) In each region, therefore, employment increases by 2 percent in the long run, i.e., 12,000 is 2 percent of 600,000 and 8,000 is 2 percent of 400,000. (This can also be seen immediately as 20,000 is 2 percent of the 1 million workers.) Now, given that the elasticity of labor demand is -0.5, the 2 percent increase in overall employment will cause the wage rate to fall by 4 percent (2 / 0.5 = 4). Hence, the long-run equilibrium hourly wage will be $14.40 ( $15 - $15 * 4 / 100 = $15 - 0.6 = $14.40).