ECO1011S

THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT

The Firm’s Hiring Decision

and
Profit-Maximizing Choice of Price, Quantity and Employment
Assumptions:
 Labour is the only input
 Wage is the only cost
 Majority labour skills are identical
 Each unit of output is produced by one person
 Marginal & average costs are equal (MC = AC)
 Amount produced (Q) depends on ability to sell, which depends on price charged

Equilibrium Conditions:
 Profit-maximizing rule
 Total revenue (TR) > total cost (TC)
 Revenue and cost per unit production, MR = MC
 MR > MC, Q should be expanded
 MR < MC, Q should be reduced
 MR = MC, profits are maximized

Chain of Decisions:
 Nominal wage = f(other firms’ prices & 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)

Profit-Maximizing Price:
 Optimal price lies where demand curve is tangent to isoprofit curve
 Firm hires necessary number of employees to produce output quantity demanded at
that price
 Reference: Figure 1

Real Wage:
 Nominal wage divided by price level of consumer goods bundle purchased
 Real wage = W/P
 Each firm decides its: price, wage, number of employees
 Addition of those (mentioned above) gives economies total employment & real wage
 The Wage-Setting Curve: Employment and Real Wages
The Wage-Setting Curve:
 Equivalent to real wage necessary at each level of economy-wide employment to
provide incentive to workers
 Higher unemployment reduces reservation wage
 If unemployment = X, equilibrium wage = Y
 Reference: Figure 2

Deriving the Wage-Setting Curve:

 Lowering unemployment rate shifts workers best response curve right
 Reservation wage (lowest possible wage) increases
 Increase in wage
 Results in upward-sloping wage-setting curve
 Reference: Figure 3/4

The Price-Setting Curve: Wages and Profits in the Whole Economy

The Price-Setting Curve:
 Depends on competition & labour productivity
 Competition determines the markup
 Labour productivity determines real wage for given markup
 Reference: Figure 5/6

Deriving the Price-Setting Curve:

 Price-setting curve = real wage paid when profit maximizing price is chosen
 Average product of labour (λ, price per unit output) is split into real profit per worker
(Π/P) & real wage (W/P)
 Output/worker - real profit = real wage
 Price-setting curve not really a curve: single number when firms set their prices to
maximize profits
 Reference: Figure 7/8

Wages, Profits and Unemployment in the Whole Economy

Labour Market Equilibrium:
 Wage-setting & price setting curves are two sides of the economy
 Nash-equilibrium of the labour market is where the wage & price-setting curves
intersect
 Reference: Figure 9

Involuntary Unemployment:
 Unemployment = excess supply in the labour market
 Always unemployment in labour market equilibrium
 No unemployment  zero cost of job loss  no effort
 Some unemployment is necessary to motivate workers
  These are the involuntary unemployed
 Natural rate of unemployment = structural + frictional unemployment

Labour Market Equilibrium and the Distribution of Income

The Lorenz Curve:
 Difference: wealth is a stock of assets whilst income is the flow of earnings from the
wealth of stock
 Reference: Figure 10

The Income Lorenz Curve:

 Cumulative percentage of income is graphed against cumulative percentage of
households
 Line of equality shows a perfectly equal distribution of income
 Compare Lorenz curve to line of equality
 Closer the Lorenz curve is to the line of equality, the more equal is the distribution of
income
 Reference: Figure 10

Distribution of Wealth:
 Lorenz curve for wealth is much further from the line of equality
 Distribution of wealth is much more unequal than distribution of income
 Reference: Figure 10

Division of Output:
 Labour market determines division of the economy’s output between employed
workers, the unemployed and firm owners
 Gini coefficient will rise with: unemployment rate increase/real wage decrease/markup
increase/productivity increase
 Reference: Figure 11/12

Labour Supply, Labour Demand and Bargaining Power

Wage Bargaining:
 Labour union: an organization consisting predominantly of employees
 Labour unions mainly negotiate rates of pay & employment conditions for its members
 With trade unions, wage is not set by employer but rather negotiated between union &
firm
 Bargained wage can be above the wage setting curve

Labour Unions: Bargained Wages and the Union Voice Effect

Bargained Wage and Union Effect:
 Bargained wage setting curve: union-employer bargaining process will produce for
every employment level
  Wage-setting curve depends on the relative bargaining power of the union and the
employer
 Employees with a voice induce them to provide more effort for the same wage
 Reference: Figure 13/14

Labour Market Policies to Address Unemployment and Inequality

Labour Market Policies:
Shifts in the Price-Setting Curve:
 Education & training: increase labour productivity
 Wage subsidy: decrease production costs & prices

Shifts in the Wage-Setting Curve:

 Lower unemployment benefit: decrease reservation wage

Shifts in Labour Supply Curve:

 Immigration policies: increase labour supply
 Childcare provision: increase female labour participation

Measuring the Economy: Employment and Unemployment

The unemployed:
 Not in paid for employment or self-employment
 Are available for work
 Actively seeking work in the four weeks

Why is Unemployment a Problem:

Lost Incomes and Production:
 Job loss brings a loss of income & lost production
 Unemployment benefits create a safety net but do not fully replace lost earnings

Lost Human Capital:

 Prolonged unemployment permanently damages a person’s job prospects by
destroying human capital
 The cost of unemployment is spread unequally making it a highly charged political
problem & economic problem

Type of Unemployment:
Frictional Unemployment:
 Unemployment that arises from normal labour turnover
 Unending flow of people in & out of the labour force
 Unending process of job creation & destruction
Structural Unemployment:
 Unemployment that arises when changes in technology or international competition
change the skills needed to perform jobs or change the locations of jobs

Cyclical Unemployment:
 Higher than normal unemployment at a business cycle trough and lower at peak

Labour Market Statistics:

 Two countries with the same unemployment rate can differ in their employment rates
if one has a high participation rate and the other a low
 The structure of the labour market differs widely across countries
 Participation rate = (labour force)/(population of working age)
 Unemployment rate = (unemployed)/(labour force)
 Employment rate = (employed)/(population of working age)
 Broad unemployment = (unemployed + discouraged)/(labour force + discouraged)