A

1) The equation W/P = f (u, z) is a wage-setting (WS) equation. An equilibrium in the labor market is attained when the WS relation is equal to the price-setting (PS) equation. The WS is the employees’ bargaining place while the PS is the company’s position. The wages (W) are affected by price (P), unemployment rate (u), and external variables (z). There is a positive correlation between P (price level) and W (workers’ wages) and a negative correlation between the unemployment rate (u) and wages that workers demand.

The unemployment rate is the rate where the real wage selected in WS is equal to real wage in PS relation. The WS relation reduces when the unemployment rate increases while the PS relation is not affected by the unemployment rate. An increase in the price level implies that workers will demand higher wages. There is a negative correlation between the wage demanded and the unemployment rate. In the labor market, an equilibrium is reached when WS = PS i.e. the price level charged for goods sold is in equilibrium with labor costs, W, taking into account some constant, x. The constant x is determined by the influence of companies in the labor market. The intersection between WS and PS relation is the actual unemployment rate, Un.

2) From the graph, it is clear that a rise in unemployment benefits results in a corresponding increase in the unemployment rate. The amount of unemployment benefits is included among the variables, z, in the WS relation W = P.F (u, z). A rise in the unemployment benefits will lead to a corresponding increase in z. This will cause a shift in the function on the W/P graph. The reason for this is that with a rise in unemployment benefits in all job cadres, employers have to increase the wages to attract workers into the job market. In this case, the labor force has a higher bargaining power than firms. This will cause the WS relation to shift to the right increasing the unemployment rate. Thus, higher benefits would result in the high unemployment rate in a country.