Question

Using the one-sided search model, show the effects of an increase in the total factor productivity on the reservation wage and on the long-run unemployment rate.

Answer 1

In the one sided search model, the reservation wages of the employer depends upon the value placed on being employed (Ve(w*)) and the value of being unemployed (Vu (w*)). The condition for determining the reservation wage is given by:

Ve (w*) greater than or equal to Vu ( w*)

As the total factor productivity increases, the value of staying employed at current wages decreases, leading to a downward shift in the Ve curve leading to higher reservation wages. Due to the increase in reservation wages, the rate if unemployment becomes higher in the long run. These changes are shown the figures below.