Negotiations are taking place for the next labor agreement between Thorndike Sports Equipment and its manufacturing employees. The company and the union have agreed to consider linking hourly wages to the predicted Consumer Price Index (CPI) for each of the four years of the new contract. The latest proposal would specify an hourly wage that is 10% of the estimated CPI (e.g., if the estimated CPI for a given year were 230.5, the hourly wage for that contract year would be $23.05).
1. A simple linear estimation equation (ŷ = b0 + b1x) fitted to the 1961–2007 CPI data.
2. A quadratic estimation equation (ŷ = b0 + b1x + b2x2) fitted to the 1961–2007 CPI data. Several additional questions regarding the estimation equations and the contract negotiations:
3. Which equation would each negotiating party tend to prefer as the basis of the hourly wages to be paid during the contract years?
4. Using the mean absolute deviation (MAD) criterion, which equation is the better fit to the CPI time series data?
5. Assuming (a) the hourly wages are linked to the equation identified in the preceding question, (b) the estimated CPI for 2014 actually occurs, and (c) the average Thorndike worker made $12.40 per hour in 1987, will his or her real earnings increase or decrease from 1987 to 2014? Explain.