Economy

Unit 9: The labour market: Wages, pro ts, and unemployment

A. Labor Force Statistics

A.1 Wages and Work in Macroeconomics

Price-setting rms produce di erentiated products.

The principal-agent model can explain the con ict of interest between the employer and the employee over worker's e ort, and why contracts are not
enough to resolve this.

A.2 Unemployment in the Macroeconomy

Models price-setting and wage-setting behavior of rms, which determines economy-wide unemployment rate and real wage.

Explains why unemployment exists even in equilibrium.

Shows how the government can a ect wages and unemployment by its policies.

Analysis the role of labor unions.

A.3 The labor market: De nitions

A.4 Labor market statistics

Two countries with the same unemployment rate can di er in their employment rates if one has a high participation rate and the other has a low one.

The structure of the labor market di ers widely across countries.

A.5 U.S Labor Market Statistics

Total Non-Institutionalized Population

• Over 16, not in jail/prison or the military.

• All those available for work.

Labor Force

• Employed + Unemployed.

• All those who want to work.

Employed

• Those working for pay.

Unemployed

• Those who are not working, want to work, and have looked for work in the last 4 weeks.

A.6 U.S Labor Force Data

A.7 U.S Participation Rate and Unemployment Rate

B. Wage Setting and Price Setting

B.1 Wage-setting and Price-setting

Wage Setting:

• Firms and employees: rms set wage su ciently high to make job loss costly, in order to motivate employees to work hard in the absence of
complete contracts.

Price Setting:

• Firms and costumers: rms set a markup above the cost of production, to maximize their pro ts subject to demand.

B.2 The chain of rm's decisions

Nominal wage = f (other rms' prices and wages, unemployment rate)

Price = f (own nominal wage, demand for own product)

Output = f (optimal price, demand curve)

Number of employees = f (output, production function)

B.3 The Wage-setting Curve

The wage-setting curve = the real wage necessary at each level of economy-wide employment to provide workers with incentives to work hard and
well.

B.4 Deriving the Wage-setting Curve

Start with the labor discipline model (Unit 6).

• Lowering the unemployment rate will shift worker's best response curve to the right (reservation wage ↓) and increase wage.

• This results in upward-sloping wage-setting curve.

B.5 An Estimated Wage Curve

• Estimated from US data.

• Used data on unemployment rates and wages in local areas.

B.6 Pro t-maximizing Price

Firm's optimal price lies where the demand curve is tangent to an isopro t curve (Unit 7).

The rm then hires a number of employees necessary to produce the quantity of output demand at that price.

B.7 Distribution of Output

The rm's choice of pro t-maximizing price also determines the rm's optimal markup above the marginal cost of production.

For the economy as a whole, this translates into how output is distributed between the rm-owners and the workers.

B.8 Deriving the Price-setting Curve

Once rms set their prices, this determines the level of output and markup in the economy. This then pins down the real wage.

B.9 The Price-setting curve

The price-setting curve = the real wage paid when rms choose their pro t-maximizing price.

It depends on:

• competition, which determines markup.

• labor productivity, which determines real wage for given markup.

B.10 The Labor Market Equilibrium

The wage-setting and price-setting curves are two sides of the economy.

The Nash equilibrium of labor market is where the wage- setting curve and price-setting curve intersect.

C. Unemployment and Aggregate Demand

C.1 Involuntary unemployment

Unemployment = excess supply in the labor market.

There will always be unemployment in labor market equilibrium.

• No unemployment → zero cost of job loss → no e ort.

• Therefore some unemployment is necessary to motivate workers.

• These are the involuntarily unemployed.

C.2 Unemployment and aggregate demand

The rm's demand for labor depends on the demand for their goods and services (derived demand for labor).

Aggregate demand = sum of the demand for all of the goods and services produced in the economy.

The increase in unemployment caused by the fall in aggregate demand is called demand-de cient unemployment.

C.3 Demand-de cient Unemployment

Low aggregate demand moves the economy from labor market equilibrium (X) to point B.

B is not a Nash equilibrium:

• Firms could lowers wages.

• Lower costs → lower prices.

• Increase output and employment

C.4 Automatic Adjustment

Point B is not a Nash equilibrium:

• Firms could lower wages without lowering workers' e ort.

• Lower wages allow them to cut their prices.

• Lower prices stimulate demand → output rises.

• Firms hire more workers to produce more

- ...unemployment falls back to X

C.5 Automatic Adjustment in Practice

Real economies do not function so smoothly:

• Workers resist cuts to their nominal wage (lower morale, strikes).

• Lower wages means people spend less → aggregate demand falls further.

• Falling prices across the economy may lead consumers to postpone their purchases in hope to get even better bargain later.

C.6 Government Intervention

The government could increase its own spending to expand aggregate demand.

• monetary policy.
• scal policy.

At B, rms would nd it optimal to produce more (and hire more workers) instead of reducing wages.

C.7 Labor Supply

The supply of labor is another important determinant of labor market equilibrium.

An increase in labor supply shifts the wage-setting curve downward:

• Greater pool of unemployed.

• Higher employment rents.

• Lower cost of e ort.

C.8 Division of Output

The labor market determines the division of the economy0s output between employed workers, the unemployed, and rm-owners.

Gini coe cient will rise with:

• Unemployment rate ↑

• Real wage ↑

• Markup ↑

• Productivity ↑

D. Unions and Wages

D.1 Labor Unions

Labor union = an organization consisting predominantly of employees. Its main activities include the negotiation of rates of pay and conditions of
employment for its members.

D.2 Wage Bargaining

Where workers are organized into trade unions, the wage is not set by the employer but instead in negotiated between union and rm.

The bargain wage can be above the wage-setting curve.

• The wage-setting curve is about the employer's threat of ring a worker.

• The union can threaten to "dismiss" the employer by going on strike.

D.3 Bargaining Curve

Bargaining curve indicates the wage that the union-employer bargaining process will produce for every level of employment.

Its position above the wage-setting curve depends on the relative bargaining power of the union and the employer.

D.4 Labor Unions and Unemployment

In equilibrium, wage is unchanged, but employment and rm's pro ts are lower.

The model tells us that labor unions will increase unemployment rates.

However, this is not clear in the data.

D.5 The Union Voice E ect

Providing employees with a voice in how decisions are made may induce them to provide more e ort for the same wage.

• The bargained wage curve shifts downward.

• The overall e ect of labor unions on employment is ambiguous.

D.6 Labor Market Policies

Shifts in the price-setting curve:

1. Education & training: Labor productivity ↑

2. Wage subsidy: Production costs and prices ↓

Shifts in the wage-setting curve:

1. Lower unemployment bene t: Reservation wage ↓

Shifts in labor supply curve:

1. Immigration policies: Labor supply ↑

2. Childcare provision: Female labor participation ↑