Venture Capital

Yvonne Ego Esiri

Individual Homework 1

I pledge my honor that I did not violate the Booth Honor Code during this assignment

Question 1: Summary Solution Notes

For the purpose of this question, we assume that K is predetermined as lower future capital stock and number of labor hours is the only variable factor of production.

An expected decline in future capital stock that has the effect of lowering future wages will have the following effects:

Changes is expected future wages will cause a shift in labor supply curve inwards whereby households will be willing to put in more labor hours today (at the expense of leisure today), than in the future, in order to receive higher wages today than in future when expected future wages are expected to be lower. In addition, the decline in future capital stock implies that firms are unwilling to hire more labor hours, therefore, demand curve shifts inwards. Labor supply curve does not shift if the following conditions hold true:

- Labor supply is insensitive to changes in wealth

- Future wages are held constant.

The excess supply of labor hours relative to demand results in a decline in real wages. As real wages decline, quantity of labor demanded by firms increases while quantity of labor hours supplied by households decrease. Therefore, there is likely to be an inward shift of the labor supply curve and an outward shift of the labor demand curve. Real wage declines until excess supply of labor declines. Consequently, equilibrium real wage declines and equilibrium quantity of labor hours (N) declines.

A look at factors that determine an individuals supply of labour and the market supply of labour.

• Higher wages usually will encourage a worker to supply more labour because work is more attractive compared to leisure.
• Therefore the supply curve for labor tends to be upwardly sloping.
• However, a worker isn’t just interested in earning money; they are also interested in leisure. Therefore, there is a choice between working more (higher wage) and working less (more leisure).

Two factors that influence a workers supply of labor

1. Substitution effect of a rise in wages

With higher wages, workers will give greater value to working than leisure. With work more profitable, there is a higher opportunity cost of not working. The substitution effect causes more hours to be worked as wages rise.

2. Income effect of a rise in wages

This occurs when an increase in wages causes workers to work fewer hours. This is because workers can get a higher income by working fewer hours. Therefore they may work less.

Therefore, after wage rise, workers may work less because they can get their target income with fewer hours spent working.

Value of output is likely to decline due to decrease in labor hours (recall Solow equation where output is a function of TFP, capital and labor). Therefore, if labor hours in future declines, output also declines.

The equilibrium quantity of output declines as a decline in future capital stock reduces quantity of output that can be realized for all quantity of labor hours.

A decline in labor hours result in a downward movement along the production curve to reveal lower output as number of labor hours decreases (negative slope), marginal product of labor is negative and results in decrease in number of hours of labor that firms are willing to hire at each real wage.

Solution procedures

1A. Does the production curve shift? Yes. Lower future capital stock reduces the amount of output that can be produced with any given quantity of labor. Consequently, decreases in future capital stock shift the production function lower, decreasing the future MPN and the demand for labor.

1B. Does the labor demand curve shift? Yes. Lower future capital stock reduces marginal productivity of labor associated with each quantity of labor. This decreases the hours of labor firms are willing to hire at each real wage. This labor demand curve shifts inwards when marginal productivity of labor decreases. Firms want fewer workers and a shorter workweek when the real wage is high.