Page 7 SECTION C: Answer ONE of the two questions 4. Unemployment and Labour (a) Indicate whether the following statement is true, false, or uncertain and explain your answer using words, graphs and equations as appropriate. (i) Paying efficiency wages is one way firms help to reduce the problem of adverse selection they face when trying to hire the best workers. (ii) Assume that a country experiences a reduction in productivity that lowers the marginal product of labor for any given level of labor. In this case, labor supply will decrease. (iii) According to the natural-rate hypothesis, the levels of output and unemployment depend on aggregate demand in the short run, but not in the long run. (15 marks total) (b) Consider a classical economy (i) Briefly explain how we determine labor demand in the classical model. When determining an individual's labor supply decision, briefly explain why the income and substitution effects are important. (ii) Suppose we have a standard Cobb-Douglas production function where capital's share of output is 1/2 and the Solow residual is 2. Suppose that labor supply is given by LS = (12.5)w and that K = 100. Derive labor demand. What is the equilibrium quantity of labor in this economy. Illustrate equilibrium graphically. Question 4 continued on next pagePage 8 Now consider a Keynesian Economy (ii) Briefly explain in words, and graphical illustrations, how we can use the idea of sticky wages to derive the short- run aggregate supply curve. (iv) Briefly explain (using equations and words) how we can derive the aggregate supply curve from the Phillips curve and Okun's Law. (35 marks total)