Unit 2 Unemployment, wages, and inequality: Supply-side policies and institutions

2.8 Imported materials and the WS–PS model

The Russia–Ukraine war, which began in February 2022, disrupted the supply of gas and oil from Russia to European economies. The disruption was so severe that it increased the world price of oil and gas. Since households spend a substantial part of their budget on gas for heating, oil for transport and, indirectly, on both sources of energy when purchasing other goods and services, a rise in oil and gas prices reduces the real consumption wage. It has a larger effect for lower income households for whom heating, transport, and food make up a larger share of their budget. For example, in 2020 in the UK, the share of a household’s spending on gas and electricity was 7.3% for the lowest (poorest) decile and only 2.4% for the highest decile.

We can modify the WS–PS model to include the costs of imported materials in the same way as we did to allow for taxes. To keep it simple, we will do this for the original model that ignores taxes. Remember from Section 1.7 that the firm sets its price as a markup on the marginal cost of output. In the original model, wages were the only input cost, but if we also allow for imported materials, the marginal cost will be higher. It is only imported materials that are new to the model since all the firms in the home economy are already included (and are assumed to be identical).

Suppose that when we allow for imported input materials, the marginal cost is higher by a factor (\(1+ \tau\)) than in the model where labour is the only input. (The Greek letter \(\tau\) is pronounced ‘tau’, rhyming with cow.) Then the price will also be higher by the same factor, and the price-setting real wage, derived just as before, is:

\[\frac{W}{P} = \frac{(1 - \sigma)\lambda}{(1 + \tau) }\]

Then we can model the effect of a rise in energy prices as an increase in \(\tau\), and you can determine from the equation that this will reduce the price-setting real wage. The PS curve shifts down, because firms pass on the higher costs in the price of their products. Real output per worker is shared between foreign suppliers of input materials, workers, and firms.

Once again, as long as the conditions for competition in their markets for goods and services are unchanged, firms continue to get the markup, \(\sigma\), and an increase in the price of imported materials leaves the profit share unaffected. With the same amount of output per worker going to owners and more going to foreigners supplying inputs, there is less for the real wage. An increase in energy prices, for example, means that real wages fall as shown by the downward shift of the PS curve, and structural unemployment rises.