Economics 401 – Answers to Problems from Chapter 11

 

Review Questions
 1.   The efficiency wage is the real wage that maximizes effort or efficiency per dollar of real wages. It assumes that workers will exert more effort, the higher the real wage. The real wage will remain rigid even if there is an excess supply of labor, because firms won’t reduce the wage they pay; doing so would reduce their profits, since workers wouldn’t work as hard.
 2.   Full-employment output is the amount of output produced by firms with employment determined by the labor demand curve at the point where the marginal product of labor equals the efficiency wage.
       A productivity shock does not lead to a change in the efficiency wage, since it does not affect work effort. But it does affect the marginal product of labor, so employment changes. A beneficial productivity shock, for example, leads to an increase in employment. Both the employment increase and the increase in productivity lead to an increase in full-employment output.
       Labor supply changes have no effect on the efficiency wage or employment; they simply affect the amount of unemployment. So they have no impact on full-employment output.
 3.   Price stickiness is the tendency of prices to adjust only slowly to changes in the economy. Keynesians believe it is important to allow for price stickiness to explain why monetary policy is not neutral.
 4.   Menu costs are the costs of changing prices. Menu costs may lead to price stickiness in monopolistically competitive markets but not in perfectly competitive markets, because a monopolistically competitive firm’s demand is not as sensitive to the price as is a perfectly competitive firm’s demand. Monopolistically competitive firms may meet the demand at a fixed price when demand increases, because price exceeds marginal cost, so that profits still rise, and because the cost of changing prices may exceed the additional profit earned from doing so. A perfect competitor would lose all of its customers if its price were a little above the price charged by its competitors. But a monopolistically competitive firm would lose only some of its customers in this case.
 5.   In the Keynesian model, money is not neutral in the short run, but it is neutral in the long run. In the short run, an increase in the money supply increases output and the real interest rate, while the price level and real (efficiency) wage are unchanged. In the long run, however, only the price level is changed, with no change in output, the real interest rate, or the real wage. In the basic classical model, money is neutral in both the short run and the long run, so only the price level is affected by a change in the money supply, just as in the long-run Keynesian model. The extended classical model with misperceptions is similar to the Keynesian model. In the short run, an increase in the money supply increases output and the real interest rate, just as in the Keynesian model. However, unlike the Keynesian model, the price level rises, as does the real wage. The long run of the extended classical model is identical to the classical model or the long run of the Keynesian model—only the price level is affected.
 6.   In the Keynesian model in the short run, output and the real interest rate increase due to an increase in government purchases. In the long run, the real interest rate is higher, but output returns to its full-employment level. Since the real interest rate is higher in the long run, investment is lower and consumption is lower.
7.    In response to a recession, policymakers can (1) make no change in macroeconomic policy,
(2) increase the money supply, or (3) increase government purchases.
       If they make no change in macroeconomic policy, then during the recession output is below its full-employment level. Over time, the price level will decline to restore equilibrium. In the long run, the price level will be lower and employment will return to the full-employment level.
       If policymakers increase the money supply, the economy returns to full employment without a change in the price level. The composition of output is the same as when the economy returns to full employment without monetary or fiscal policy.
       If policymakers increase government purchases, again the economy returns to full-employment equilibrium without a change in the price level. However, the higher real interest rate caused by the expansionary fiscal policy reduces consumption and investment, and the higher taxes to pay for the government spending also reduce consumption relative to either the situation in which monetary policy is used, or in which there is no policy response at all.
       There are practical difficulties with increasing the money supply or increasing government purchases to return the economy to full employment. It is difficult to tell how far the economy is below full employment to know the right amount of fiscal or monetary stimulus to apply. We do not know exactly how much output will increase in response to a monetary or fiscal expansion. And since these policies take time to implement and more time to affect the economy, we really need to know where the economy will be six months or a year from now, not just where it is today, but such knowledge is very imprecise.
8.    Employment is procyclical because a contractionary aggregate demand shock reduces both output and employment. Money is procyclical because price stickiness means that an increase in the money supply increases output as the aggregate demand curve moves along the flat, short-run, aggregate supply curve. Inflation is procyclical, because in a recession the price level declines over time to restore general equilibrium. Investment is procyclical for two reasons. First, shifts in the expected future marginal product of capital are important causes of cycles, shifting the IS and AD curves, thus affecting output in the same direction. Also, a shift in the LM curve leads to a change in the real interest rate, moving investment in the same direction as the change in output.
9.    The Keynesian theory assumes that demand shocks cause most cyclical fluctuations. This means that during expansions when employment rises, average labor productivity declines, so it is countercyclical. But the business cycle fact is that average labor productivity is mildly procyclical. However, if labor hoarding occurs, so that a given measured amount of employment produces less output during recessions and more output during expansions, then measured average labor productivity would be procyclical.
10.   In Keynesian analysis, a supply shock may reduce output in two ways: (1) a reduction in output, because the supply shock reduces the marginal product of labor, shifting the FE line to the left; and (2) a further reduction in output if the supply shock is something like an oil price shock that is large enough to cause many firms to raise prices, shifting the LM curve up and to the left so much that it intersects the IS curve to the left of the FE line. Supply shocks create problems for stabilization policy because: (1) policy can do nothing to affect the location of the FE line; and (2) using expansionary policy risks worsening the already-high rate of inflation.


Numerical Problems
1.    The following table shows the real wage (w), the effort level (E), and the effort per unit of real wages (E/w).


 w

E

             E/w

  8

  7

0.875

10

10

1.00

12

15

1.25

14

17

1.21

16

19

1.19

18

20

1.11

        The firm will pay a wage of 12, since that wage provides the maximum effort per unit of the real wage (E/w = 1.25). The firm will employ 88 workers, since that is the number of workers for which
w = MPN. As long as the supply of labor exceeds the demand for labor, labor supply has no effect on the firm’s decision.
2.     (a)  The IS curve is found from the equation Y = Cd + Id + G = 130 + 0.5(Y – 100) – 500r + 100 –
500r + 100, or 0.5Y = 280 – 1000r, or Y = 560 – 2000r.
The LM curve comes from the equation M/P = L, which in this case is 1320/P = 0.5Y – 1000r, or Y = (2640/P) + 2000r.
        (b)  At full employment, Y = 500. Using this in the IS curve gives 500 = 560 – 2000r, which has the solution r = 0.03. Plugging the values for Y and r in the LM curve gives 500 = (2640/P) + (2000 ´ 0.03), or 440 = 2640/P, which has the solution P = 6. Then consumption is C = 130 + 0.5(Y – 100) – 500r = 130 + 0.5(500 – 100) – (500 ´ 0.03) = 315. Investment is I = 100 – (500 ´ 0.03) = 85.
        (c)  If desired investment increases to 200 – 500r, the IS curve shifts from IS1 to IS2 in Figure 11.11. This can be seen in the equation Y = Cd + Id + G = 130 + 0.5(Y – 100) – 500r + 200 – 500r + 100, or 0.5Y = 380 – 1000r, or Y = 760 – 2000r. In the short run, the price level remains fixed at 6, so the LM curve remains at LM1. With the price level equal to 6, the LM curve has the equation Y = (2640/P) + 2000r = 440 + 2000r. The IS and LM curves intersect where 760 – 2000r = 440 +
              2000r, or 320 = 4000r, which has the solution r = 0.08. At r = 0.08, output is given from the
IS curve as Y = 760 – 2000r = 760 – (2000 ´ 0.08) = 600. Then consumption is C = 130 + 0.5
(Y – 100) – 500r = 130 + 0.5(600 – 100) – (500 ´ 0.08) = 340. Investment is I = 200 – 500r =
200 – (500 ´ 0.08) = 160.

Figure 11.11
            In the long run, the price level rises to shift the LM curve from LM1 to LM2 to restore equilibrium. The IS curve is given by the equation Y = 760 – 2000r. At full employment, Y = 500, so the IS curve is 500 = 760 – 2000r, or 2000r = 260, which has the solution r = 0.13. The LM curve is given by the equation Y = (2640/P) + 2000r, or 500 = (2640/P) + (2000 ´ 0.13), or 240 = 2640/P, which has the solution P = 11. Then consumption is C = 130 + 0.5(500 – 100) – (500 ´ 0.13) = 265. Investment is
I = 200 – 500r = 200 – (500 ´ 0.13) = 135.
3.     The IS curve is Y = Cd + Id + G = [600 + 0.8(Y – 1000) – 500r] + [400 – 500r]+ 1000, so 0.2Y =
1200 – 1000r. This is plotted in Figure 11.12.

Figure 11.12
        Since pe= 0, the nominal interest rate (i) equals the real interest rate (r).
        (a)  Can the economy reach full employment? Since full-employment output is Y = 8000, for the economy to be on the IS curve, 0.2Y = 1200 – 1000r, so (0.2 ´ 8000) = 1200 – 1000r, or 1000r = –400, so r = i = –.4. But since the nominal interest rate can’t be negative, this isn’t possible. Thus, the requirement that i be non-negative means that there’s no way to satisfy the goods market equilibrium condition at full employment. Assuming that the result is that i = 0 and that output is determined along the IS curve means that 0.2Y = 1200 – (1000 ´ 0), so Y = 6000. Note that this is the best result possible, no matter what the money supply is, so monetary policy can’t restore full employment.
        (b)  To restore full employment while the nominal interest rate is zero clearly requires a shift in the IS curve. If we return to the original derivation and put G in the equation instead of using the original value of G = 1000, we get:
Y = Cd + Id + G = [600 + 0.8(Y – 1000) – 500r] +[400 – 500r]+ G, so 0.2Y = 200 + G – 1000r. To get Y = 8000 and r = 0, we have 0.2 ´ 8000 = 200 + G – (1000 ´ 0), so G = 1400. Then the IS curve is 0.2Y = 1600 – 1000r. This is plotted in Figure 11.13 as IS2, while the original IS curve is IS1.

Figure 11.13
            Thus, raising G to 1400 can generate full employment, if the money supply is chosen so that the LM curve intersects the IS curve at the right point. Note that taxes are 1000, so the government must run a large budget deficit.
            What must the money supply be? Since P = 2, we need money supply (M/P) = money demand (L), so M/2 = 0.5Y – 200i = (0.5 ´ 8000) – (200 ´ 0) = 4000, so M = 8000.
            This situation is quite similar to the situation in Japan in the 1990s and suggests that to get out of the liquidity trap, Japan will need to use expansionary monetary policy, along with expansionary fiscal policy.


4.     (a)  The IS curve is given by Y = Cd + Id + G = 300 + 0.5(Y – 100) – 300r + 100 – 100r + 100 = 450 + 0.5Y – 400r. This can be rewritten as 0.5Y = 450 – 400r, or Y = 900 – 800r. The LM curve is
M/P = L, or 6300/P = 0.5Y – 200r.
To find the aggregate demand curve, substitute the LM curve into the IS curve to eliminate r.
To do this, multiply both sides of the LM curve by 4 to get 25,200/P = 2Y – 800r, or 800r = 2Y – (25,200/P). Then substitute this in the IS curve: Y = 900 – 800r = 900 – [2Y – (25,200/P)]. This can be rewritten as 3Y = 900 + (25,200/P), or Y = 300 + (8400/P).
        (b)  With P = 15, the AD curve is Y = 300 + (8400/15) = 860. From the IS curve, 860 = 900 – 800r, which has the solution r = 0.05. Consumption is C = 300 + 0.5(860 – 100) – (300 ´ 0.05) = 665. Investment is I = 100 – (100 ´ 0.05) = 95.
        (c)  In the long run, Y = 700. From the IS equation, 700 = 900 – 800r, which has the solution r = 0.25. The LM curve then is 6300/P = (0.5 ´ 700) – (200 ´ 0.25) = 300, which has the solution P = 21. Consumption is C = 300 + 0.5(700 – 100) – (300 ´ 0.25) = 525. Investment is I = 100 – (100 ´ 0.25) = 75.
5.     (a)  Setting w = MPN, w = 10/ This is the labor demand curve.
        (b)  At W = 20, w = W/P = 20/P. Since labor demand is given by w = 10/ then 20/P = 10/ or 2 = P.
        (c)  Y = 20 = 10P, or P = (1/10) Y, as shown in Figure 11.14 by the SRAS curve.

Figure 11.14
        (d)  The IS curve is Y = 120 – 500r. The LM curve is M/P = 0.5Y – 500r, which can be rewritten as 500r = 0.5Y – (M/P). Plugging the LM curve into the IS curve to eliminate r gives Y = 120 –
500r = 120 – [0.5Y – (M/P)]. This can be rewritten as 1.5Y = 120 + (M/P). This is the AD curve.
With M = 300, the AD curve is 1.5Y = 120 + (300/P), or Y = 80 + (200/P). The AD curve is shown in Figure 11.14.


        (e)  To find the intersection of the SRAS curve (Y = 10P) and the AD curve [Y = 80 + (200/P)], find the price level such that 10P = 80 + (200/P). This can be rewritten as 10P2 – 80P – 200 = 0, or as P2 – 8P – 20 = 0. This can be factored as (P – 10)(P + 2) = 0. The nonnegative root is P = 10. At P = 10, from the SRAS curve, Y = 10 P = 10 ´ 10 = 100. On the IS curve, 100 = 120 – 500r, or
r = 0.04. Since P = 2 or 10 = 2 then  = 5, or N = 25. The real wage is w = 20/P =
20/10 = 2.
        (f)  When the money supply falls to 135, the AD curve becomes 1.5Y = 120 + (135/P), or Y = 80 + (90/P). The AD curve intersects the SRAS curve where 10P = 80 + (90/P). This can be rewritten as 10P2 – 80P – 90 = 0, or P2 – 8P – 9 = 0. This can be factored as (P – 9)(P + 1) = 0, which has the nonnegative solution P = 9. From the SRAS curve, Y = 10P = 10 ´ 9 = 90. From the IS curve 90 = 120 – 500r, which has the solution r = 0.06. Since P = 2 N = (P/2)2 = 4.52 = 20.25. The real wage is w = W/P = 20/9 = 2 2/9.
6.     (a)  Y = Cd + Id + G = [325 + 0.5(1000 – 150) – 500r] + [200 – 500r] + 150, so 1000r = 100,
so r = 0.10.
M/P = L, so 6000/P = 0.5Y – 1000r = (0.5 ´ 1000) – (1000 ´ 0.10) = 400, so P = 15.
C = 325 + 0.5(Y – T) – 500r = 325 + 0.5(1000 – 150) – (500 ´ .10) = 700.
I = 200 – 500r = 200 – (500 ´ .10) = 150.
        (b)  aIS = (c0 + i0 + GcYt0)/(cr + ir) = [325 + 200 + 150 – (0.5 ´ 150)]/(500 + 500) = 0.6.
bIS = [1 – (1 – t)cY]/(cr + ir) = [1 – (1 – 0) 0.5]/(500 + 500) = .0005.
aLM = / – pe= 0/1000 – 0 = 0.
bLM = / = 0.5/1000 = .0005.
 = 1000.
        (c)  Since P = 15 at full employment, then Y = 1000 and r = 0.10.
        (d)  aIS = (c0 + i0 + GcYt0)/(cr + ir) = [325 + 200 + 250 – (0.5 ´ 150)]/(500 + 500) = 0.7.
M/P = 6000/15 = 400.
Y = [aISaLM + (1/)(M/P)]/[bIS + bLM] = [0.7 – 0 + (400/1000)]/(.0005 + .0005) =
1.1/.001 = 1100.
        (e)  DY/DG = 1/[(cr + ir)(bIS + bLM)] = 1/[(500 + 500)(.0005 + .0005)] = 1.
              The result is the same as in part (d). In part (d), DY = 100 when DG =100, so DY/DG = 1.


Analytical Problems
1.     In Figures 11.15 and 11.16, point A is the starting point, point B shows the short-run equilibrium after the change, and point C shows the long-run equilibrium after the change.
  
Figure 11.15                                                        Figure 11.16


        (a)  In Figure 11.15, the increase in tax incentives increases investment, shifting the IS curve up and to the right from IS1 to IS2 in Figure 11.15(a), and shifting the AD curve from AD1 to AD2 in Figure 11.15(b). The short-run equilibrium is at point B. Output increases, the real interest rate increases, employment increases, and the price level is unchanged.
To restore long-run equilibrium, the price level rises, shifting the LM curve from LM1 to LM2 in Figure 11.15(a) and the short-run aggregate supply curve from SRAS1 to SRAS2 in
Figure 11.15(b). The long-run equilibrium is at point C. Compared to the starting point, output is the same, the real interest rate is higher, employment is the same, and the price level is higher.
            (b)  In Figure 11.16, the increase in tax incentives increases saving—shifting the IS curve from IS1 to IS2 in Figure 11.16(a), and shifting the AD curve from AD1 to AD2 in Figure 11.16(b). The short-run equilibrium is at point B. Output decreases, the real interest rate decreases, employment decreases, and the price level is unchanged.
              To restore long-run equilibrium, the price level declines, shifting the LM curve from LM1 to LM2 in Figure 11.16(a) and the short-run aggregate supply curve from SRAS1 to SRAS2 in
Figure 11.16(b). The long-run equilibrium is at point C. Compared to the starting point, output is the same, the real interest rate is lower, employment is the same, and the price level is lower.
        (c)  A wave of investor pessimism reduces investment. This shifts the IS curve down and to the left and the AD curve down and to the left, having the same result as in problem part (b).
        (d)  An increase in consumer confidence increases consumption spending, shifting the IS curve up and to the right and the AD curve up and to the right, with the same result as in problem part (a).
2.     In Figures 11.17–11.20, point A is the starting point, point B shows the short-run equilibrium after the change, and point C shows the long-run equilibrium after the change.
        (a)  In Figure 11.17, when banks pay a higher interest rate on checking accounts, the demand for money rises, shifting the LM curve up and to the left from LM1 to LM2 in Figure 11.17(a). As a result, the AD curve shifts down and to the left from AD1 to AD2 in Figure 11.17(b). The new short-run equilibrium occurs at point B, where output is lower, the real interest rate is higher, employment is lower, and the price level is unchanged.
In the long run, the price level decreases to shift the LM curve from LM2 to LM3, which is the same as LM1, to restore equilibrium at point C. As a result, the short-run aggregate supply curve shifts down from SRAS1 to SRAS2. At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the same, employment is the same, and the price level is lower.

Figure 11.17
        (b)  In Figure 11.18, the introduction of credit cards reduces the demand for money—shifting the
LM curve down and to the right from LM1 to LM2 in Figure 11.18(a). As a result, the AD curve shifts from AD1 to AD2 in Figure 11.18(b). The new short-run equilibrium occurs at point B, where output is higher, the real interest rate is lower, employment is higher, and the price level is unchanged.


In the long run, the price level increases to shift the LM curve from LM2 to LM3, which is the same as LM1, to restore equilibrium at point C. As a result, the short-run aggregate supply curve shifts up from SRAS1 to SRAS2. At the new equilibrium, compared to the starting point, output is the same, the real interest rate is the same, employment is the same, and the price level is higher.

Figure 11.18
        (c)  In Figure 11.19, the reduction in agricultural output shifts the FE curve to the left from FE1 to FE2, and shifts the LRAS line from LRAS1 to LRAS2. The rise in agricultural prices increases the price level, so the short-run aggregate supply curve shifts up from SRAS1 to SRAS2. Also, the rise in the price level shifts the LM curve up and to the left from LM1 to LM2. The short-run equilibrium is at


              point B, assuming that the LM curve shifts so much that it intersects the IS curve to the left of the FE line. At point B, compared to the starting point, output is lower, the real interest rate is higher, employment is lower, and the price level is higher.

Figure 11.19
If the water shortage persists, a new long-run equilibrium occurs at point C. To get to this equilibrium, the price level must decline, shifting the LM curve from LM2 to LM3, and the short-run aggregate supply curve from SRAS2 to SRAS3. Relative to point B, the new equilibrium has a higher output level, a lower real interest rate, higher employment, and a lower price level. (Relative to the initial equilibrium at point A, output and employment are lower, and the real interest rate and the price level are higher.)
When the water shortage is over, then the economy goes back to point A in the long run, with no permanent effects.
        (d)  In Figure 11.20, the beneficial supply shock makes more production possible at full employment, so the FE line shifts to the right in Figure 11.20(a) from FE1 to FE2, and the LRAS line shifts from LRAS1 to LRAS2 in Figure 11.20(b). There is no immediate change in the price level, so the LM curve remains at LM1 and the short-run aggregate supply curve remains at SRAS1. The shift of the FE curve does not affect aggregate demand in the short run: output, the real interest rate, and the price level are all unchanged in the short run. The shift in the production function shifts the effective labor demand curve and reduces employment in the short run.

Figure 11.20
If the supply shock persists, prices will decline, so the LM curve will shift from LM1 to LM2 and the SRAS curve will shift from SRAS1 to SRAS2. As shown in the diagrams, the economy reaches a new equilibrium at point C, with a higher output level, a lower real interest rate, and a lower price level.
              When the supply shock disappears, the economy returns to its equilibrium at point A.
3.     A lag in the impact of policy of six months, which is about the time it takes firms to adjust prices, could cause policy to be destabilizing. That is, monetary policy may be pushing the economy away from equilibrium.
        To see this, suppose the economy is in a recession at point A in Figure 11.21. The short-run aggregate supply curve SRAS1 intersects the aggregate demand curve AD1 at point A, to the left of the long-run aggregate supply curve LRAS. Suppose the Fed engages in expansionary monetary policy to try to shift the aggregate demand curve from AD1 to AD2 in six months, to push the economy to point B. But the recession leads firms to reduce their prices, dropping the SRAS curve from SRAS1 to SRAS2. In the absence of monetary policy action, the economy would get back to full employment because of the fall in the price level to point C. But the Fed action leads to a new equilibrium at point D. So the Fed causes the economy to overshoot the equilibrium point. The result may be to exaggerate the business cycle, pushing output too high in expansions. Then if the Fed responds to an expansion by using contractionary monetary policy, it may overshoot on the other side, causing a new recession.

Figure 11.21
        If the Fed could forecast recessions well, it could stabilize the economy by using monetary policy appropriately before a recession begins. Or if the Fed’s policy takes effect before firms adjust prices, then it can also help stabilize output by shifting the AD curve before the SRAS curve shifts.
4.     An increase in government purchases shifts the IS curve up and to the right and the AD curve up and to the right to return the economy to full employment, instead of waiting for the price level to fall to get there. The advantage of doing so, according to Keynesians, is that full employment is restored quickly, whereas if the price level must adjust, it may take a long time for full employment to be restored. In the short run, the fiscal expansion does not affect the real wage, since it is an efficiency wage. However, it increases employment and it increases current and future taxes to pay for the higher government spending. The effect on consumption is ambiguous, with the rise in output raising consumption, while the rise in taxes reduces consumption. In the long run, at full employment, the lasting effects of the fiscal expansion are to decrease consumption, because of the higher real interest rate and the higher taxes, with more of the economy’s output devoted to government purchases and less to the private sector.
        Whether a program of fiscal stimulus in response to a recession is worthwhile depends on the benefits of the government purchases and on how long it takes the economy to return to a full-employment equilibrium by a change in the price level. The more beneficial are government purchases, the more likely such a program is to increase economic welfare. The longer the free market takes to restore equilibrium, the more likely such a program is to increase economic welfare.
5.     (a)  In response to expansionary monetary policy, aggregate demand increases, increasing output and labor demand. This causes the labor demand curve to shift from ND1 to ND2 in the primary labor market, shown in Figure 11.22. The result is an increase in employment and output with no change in the real wage in the primary labor market. Since more workers are now in the primary labor market, the labor supply in the secondary labor market decreases from NS1 to NS2. This causes an increase
in the real wage, a decrease in employment, and a decrease in output in the secondary labor market.

Figure 11.22
        (b)  Increased immigration has no effect in the primary labor market, since labor supply changes in general have no effect. In the secondary labor market, the immigration shifts the labor supply curve to the right from NS1 to NS2, causing a reduction in the real wage, increased employment, and increased output. However, to some extent these effects may be mitigated by the fact that increased immigration leads to increased aggregate demand, increasing labor demand in both
the primary and secondary markets (Figure 11.23).

Figure 11.23
        (c)  If there is a shift in the effort curve, the efficiency wage rises in the primary labor market. Since effort exerted at the higher wage is the same as before the change, the shift in the effort curve has no impact on the marginal product of labor, so there is no shift in the labor demand curve. So the effect of the higher real (efficiency) wage is to reduce employment and thus output in the primary labor market. This means that labor supply in the secondary labor market increases, shifting the labor supply curve from NS1 to NS2. The real wage falls, employment rises, and output rises in the secondary labor market, as Figure 11.24 shows.

Figure 11.24
        (d)  The productivity improvement shifts the labor demand curve to the right, so at the fixed real (efficiency) wage, firms demand more labor. Employment increases, so output increases in the primary labor market. The increase in employment in the primary labor market reduces the labor supply in the secondary labor market, shifting the labor supply curve from NS1 to NS2. This increases the real wage, and reduces employment and output in the secondary labor market. See Figure 11.25.

Figure 11.25
        (e)  The productivity improvement in the secondary labor market has no effect on the primary labor market. In the secondary labor market, increased productivity increases the marginal product of labor so that labor demand increases from ND1 to ND2. The result is a higher real wage, higher employment, and increased output (Figure 11.26).

Figure 11.26