Question

Explain how a countercyclical labor wedge could potentially be driven by:

a) Output price stickiness.

b) Firms purposefully increasing their price markups over marginal cost during recessions.

Answer 1

Output price stickiness is behaviour which assumes firms charge higher markup prices and reduce production in face of negative demand shocks. To achieve this lower production they offer kower real wages and hence bring about countercyclical labor wedge.

Secondly firms purposely raise markup cost during production by lowering production and increasing demand of the product when they have sufficient market power. Thus by lowering production and exploiting market rates during recession they explicitly pay lower real wages and hence bring about countercyclical labor wedge.