Suppose the government introduces a subsidy on firms sales e

Suppose the government introduces a subsidy on firms’ sales (e.g. for every $1 of output sold, firms receive an additional 5 cents from the government). Keeping everything else constant, what do you expect to happen according to the frictionless labor market model?

A drop in wages and an increase in employment.

An increase in wages and a drop in employment.

A drop in both wages and employment.

An increase in both wages and employment.

Solution

This subsidy will lower the effective cost of production, which will encourage firms to increase production and supply more output. Higher output will increase the demand for labor, so employment will increase, and higher labor demand will raise wages.

Correct option (d).