Employment and prices in a simple macroeconomy.

• Author: Goeree, Jacob K.
• Position: Teaching Economics with Classroom Experiments: A Symposium

1. Introduction

   The standard macroeconomic models used in undergraduate courses (Keynesian cross, "ISLM") are presented at a high level of aggregation that is a common source of complaint. However, attempts to build in microfoundations, for example, overlapping generations or infinite-lived representative agents, require a level of mathematical analysis that is beyond the abilities and interests of most economics majors. The upshot of this is that intermediate macroeconomics courses are often unpopular with both students and faculty in comparison to more institutionally based courses such as those in finance or money and banking. This paper presents a simple classroom experiment in which the students themselves are the optimizing agents and the outcomes can be related to standard macroeconomic issues of full employment, price determination, and so on.

   The exercise is appropriate for classes or discussion sections that range in size from 6 to 40 students and can be completed, with discussion, in about an hour. This is a relatively complex classroom experiment and would be difficult to run in a large lecture class. The discussion sections often tied to such classes would provide a good setting, and the variety of outcomes across discussion sections might be useful in a subsequent lecture. Depending on the level of discussion, the exercise can be used in conjunction with introductory and intermediate macroeconomics courses, with more emphasis on dynamics and the role of money in intermediate classes. In an introductory class, this exercise can be used while the students are reading a chapter on employment and the labor market and can also serve as a review of supply and demand, the circular flow, and basic macroeconomic concepts such as money, the real wage, and so on. The procedures are described in more detail in section 2, and some suggestions for structuring the class discussion are provided in section 3. Section 4 contains a guide to some of the related research in experimental economics.

2. Procedures

   The basic idea is to set up a closed economy with production, exchange, and fiat money. Students are given the role of either a worker or a firm. There are exactly twice as many workers as firms to facilitate the calculation of optimal allocations, as explained below. Workers are endowed in each period with leisure, which they can consume or sell to firms, who use the labor to produce goods, which in turn are either consumed by that firm or sold to workers. Firms need to acquire labor before producing output, so the labor market opens before the goods market. The money that workers receive as wages is then used to purchase goods, as depicted in a standard circular flow chart.

   This classroom experiment is obviously somewhat more complex than most, given the need to keep track of money, goods, and trades in two markets. In particular, you will probably not have time in a single class to run enough periods to obtain stable wages and prices (leaving time for discussion), at least not in a typical 50-minute discussion section. The exercise does go faster and more smoothly if you have done it previously. Another time-saving hint is to limit the numbers of firms and workers, say, to three firms and six workers. (If necessary, you can allow groups of two or three students to constitute each firm or worker.) Before you try this the first time, we recommend that you practice by reading the instructions out loud and explaining the procedures to a teaching assistant.

   The economy is quite simple, but record keeping can become complicated; therefore, we use playing cards to keep track of money and goods. The red cards (Hearts or Diamonds) are units of currency, and the black cards (Clubs or Spades) represent units of real goods and services. In particular, each firm starts off the first period with 26 red cards that can be used to purchase labor from workers (so you need one deck of cards per firm). Workers are endowed with three black cards in each period, which they can either consume or sell in exchange for fiat money. The markets operate in sequence: firms post wages, workers sell labor and/or retain leisure, firms produce output, firms post prices, workers purchase output, and final consumption determines "earnings" for the period before a new labor/leisure-time endowment is given to workers for the next period.

   After workers sell some or all of their black cards, there is a phase in which workers consume their remaining time as leisure and firms engage in production. First, consider the production and its effect on the demand for labor. The marginal product of each of the first two units of labor input is 6, the marginal product of the third and fourth units of labor is 3, and the marginal product of additional units of labor input is 1. This production is implemented: the first black card (labor unit) purchased by a firm becomes six black card output units (we add five to the original); the second black card purchased also becomes six black cards. If a third black card is purchased, we add two black cards and similarly for the fourth black card purchased.(1) Nothing is added to the fifth and higher numbers of black cards, so the marginal product of these input units is 1 (one unit of input yields one unit of output). This marginal product schedule for a firm is shown as the dark line in Figure 1.(2) In a static setting, a firm will demand a unit of labor if its marginal product exceeds the real wage, so the marginal product schedule represents the firm's demand for labor, with real wage on the vertical axis. (This analysis would be modified slightly if you decided to introduce a dynamic element associated with the probability of stopping the experiment, as described below.)

   Next consider the supply of labor. Note that selling a unit of labor implies consuming two units of leisure and so on. There is a diminishing marginal value of leisure, which is implemented as follows. If a worker sells two black cards (labor) and keeps only one (leisure), the one card kept is tripled; that is, we add two black cards to the one kept. If the worker keeps two black cards (leisure), the first card is tripled, but the second card is only doubled. Finally, the third black card kept is left unchanged. Therefore, the marginal value of leisure is 3 for the first unit, 2 for the second unit, and 1 for the third unit. The supply of labor is obtained by taking these units in reverse order: The first black card sold by the worker has an opportunity cost of 1 (black card), the second an opportunity cost of 2, and the third an opportunity cost of 3. Because there are two workers per firm, we have plotted the supply function of two workers combined in Figure 1. At a real wage of 1.5, for example, each worker would be willing to sell only one unit because the second unit has a leisure value of 2. Note that the supply function overlaps the firm's labor demand function at a quantity of four labor units, which is the...