The Labor Market

1
The Labor Market
2
Whats the point of this chapter?

• The Aggregate Supply curve is a relation between
  production and the price level.
• Production happens because firms hire workers
  (among other things).
• The real cost of hiring workers is the real wage.
• Higher price levels reduce the real wage.
• Lower real wages cause firms to hire more workers
  and increase production.

3
Whats the point of this chapter? Cont.

• Two complications
• Workers want purchasing power in return for their
  work.
• Since they sign contracts to work in the future,
  they care about the future price level.
• Price level expectations may move more slowly
  than the actual price level.
• Workers effort (which is difficult to monitor)
  and their bargaining power depends on the
  unemployment rate.
• And on unemployment benefits, etc.

4
A Tour of the Labor Market
6-1

• The noninstitutional civilian population are the
  number of people potentially available for
  civilian employment.
• The civilian labor force is the sum of those
  either working or looking for work.
• Those who are neither working nor looking for
  work are out of the labor force.
• The participation rate is the ratio of the labor
  force to the noninstitutional civilian
  population.
• The unemployment rate is the ratio of the
  unemployed to the labor force.

5
A Tour of the Labor Market

• Population, Labor Force, Employment, and
  Unemployment in the United States (in millions),
  2000

6
The Large Flows of Workers

• An unemployment rate may reflect two very
  different realities
• A a labor market with many separations and many
  hires,
• A labor market, with few separations, few hires,
  and a stagnant unemployment pool.
• What is worse? To lose your job and get a new one
  12 times a year? Or to be unemployed for 6
  months?

7
The Large Flows of Workers
Average Monthly Flows Between Employment,
Unemployment, and Nonparticipation in the United
States, 1994-1999

1. The flows of workers in and out of employment are
   large.
2. The flows in and out of unemployment are large in
   relation to the number of unemployed.
3. There are also large flows in and out of the
   labor force, much of them directly to and from
   employment.

8
The Large Flows of Workers

• From the CPS data we conclude that

• The flows of workers in and out of employment are
  large.
• Separations consist of
• Quits, or workers leaving their jobs for a better
  alternative, and
• Layoffs, which come from changes in employment
  levels across firms.

• The Current Population Survey (CPS) produces
  employment data, including the movements of
  workers.

9
The Large Flows of Workers

• From the CPS data we conclude that

• The flows in and out of unemployment are large in
  relation to the number of unemployed.
• The average duration of unemployment is about
  three months.

10
The Large Flows of Workers

• From the CPS data we conclude that

• There are large flows in and out of the labor
  force, much of them directly to and from
  employment.
• Discouraged workers are classified as out of the
  labor force, but they may take a job if they
  find it.
• The nonemployment rate is the ratio of population
  minus employment to population.
• Because it includes the discouraged, it might be
  a better measure of unemployment.

11
Movements inUnemployment
6-2

• Fluctuations in the aggregate unemployment rate
  affect
• The welfare of individual workers
• Wages

• Higher unemployment affects workers
• Through a decrease in hiresmore difficult to
  find jobs.
• Through higher layoffshigher risk of losing
  their jobs.

12
Movements in Unemployment
Movements in the U.S.Unemployment Rate, 1948-2000

• Since 1948, the average yearly U.S. unemployment
  rate has fluctuated between 3 and 10.

13
Movements in Unemployment
The Unemployment Rate and the Proportionof
Unemployed Finding Jobs, 1968-1999

• When unemployment is high, the proportion of
  unemployed finding jobs is low.

Note, the scale on the right is an inverse scale.
14
Movements in Unemployment
The Unemployment Rate and the Monthly Separation
Rate from Employment, 1968-1999

• When unemployment is high, a higher proportion of
  workers lose their jobs.

15
Wage Determination
6-3

• Collective bargaining is bargaining between firms
  and unions.
• The result depends on each sides bargaining
  power, which in turn depends on each sides
  opportunity cost of not making the deal. For
  example
• The skills of the worker compared to the skills
  required for the job
• The current and expected unemployment rates
• Going wages, social norms and laws regarding
  hiring and firing.
• Etc.

16
Wage Determination

• Common forces at work in the determination of
  wages
• Wages are typically higher than the reservation
  wage, that is, the wage that make them
  indifferent between working or becoming
  unemployed.
• I wont work unless you pay me more than 7 an
  hour.
• Labor-market conditions.

17
Bargaining

• How much bargaining power a worker has depends
  on
• How costly it would be for the firm to replace
  himthe nature of the job.
• How hard it would be for him to find another
  joblabor market conditions.
• Its important to realize that, generally
  speaking, low-income workers have less bargaining
  power than potential employers.

18
Efficiency Wages

• Should we pay you as low a wage as youll take?
• If we do, we might lose you and well have to
  train someone else.
• When unemployment is high, a higher proportion of
  workers lose their jobs.

19
Efficiency Wages

• Efficiency wage theories are theories that link
  the productivity or the efficiency of workers to
  the wage they are paid.
• These theories also suggest that wages depend on
  both the nature of the job and on labor-market
  conditions.
• Efficiency wages are typically higher than
  market-clearing wages unemployment will result.

20
Wages, Prices, and Unemployment

• The aggregate nominal wage, W, depends on three
  factors
• The expected price level, Pe
• The unemployment rate, u
• A catchall variable, z, that catches all other
  variables that may affect the outcome of wage
  setting.

21
Wages, Prices, and Unemployment

• Both workers and firms care about real wages
  (W/P), not nominal wages (W).
• Suppose your job is to write a computer program.
  To do so, you spend 25,000 calories of energy
  i.e., youve given real effort to the firm.
• Youll want to be paid back in stuff, in real
  purchasing power, so that you can at least buy
  25,000 calories worth of food.

22
Wages, Prices, and Unemployment

• Workers also care about what wages theyll earn
  in the future, so their expectation of the price
  level, Pe, is key.
• Suppose you know that 25,000 calories of energy
  cost 25 today.
• But you are getting paid in 15 days.
• In two weeks, 25,000 calories will cost 28.
  Which price level is relevant here?

23
Wages, Prices, and Unemployment

• Higher unemployment weakens workers bargaining
  power, forcing them to accept lower wages.
• Suppose you are the only available candidate with
  a bachelors degree in aerospace engineering.
  Boeing pays you whatever you want.
• Suppose, now, that there are seven more people
  with bachelors degrees in aerospace engineering.
  They are all unemployed. Will you ask for that
  15 raise?

24
Wages, Prices, and Unemployment

• If we divide this equation by P, we obtain
• This allows us to draw a relation between the
  real wage W/P and unemployment u.
• This relation has to be downward sloping because
  higher unemployment makes workers weaker on the
  negotiating table.

25
Wages and Unemployment
Higher unemployment reduces the bargaining power
of workers and encourages them to accept lower
real wages.
u
26
Wages, Prices, and Unemployment

• Among other factors that affect wages is
  unemployment insurancethe payment of
  unemployment benefits to workers who lose their
  jobs. Higher unemployment insurance allows
  workers to hold out for higher wages. Minimum
  wages and employment protection are other
  factors.
• Suppose the government pays you 150,000 a year
  in unemployment insurance. Do you care if you
  lose your job?

27
Wages, Unemployment, and Unemployment Benefits
Higher unemployment benefits reduces the
opportunity cost of unemployment, encouraging
workers to ask for higher wages at the given
unemployment rate.
u
28
Wages, Prices, and Unemployment

• Its obvious that a change in price expectations
  will change the real wage that workers demand.
• Suppose you expected prices to be fairly low.
  Then, in your nominal wage negotiations with your
  employer, youll make fairly low nominal wage
  demands.
• But now suppose that prices actually turn out to
  be higher, so Pe/P lt 1. Then W/P will be
  relatively low.
• Pe/P lt 1 may happen if an unexpected shock raises
  prices.

29
Wages, Unemployment, and Unemployment Benefits
If workers expect prices to be fairly low (Pe is
low), they will demand fairly low nominal wages,
W. But if prices P turn out to be higher, the
real wage W/P will be relatively low.
u
30
Price Determination
6-4

• The production function is the relation between
  the inputs used in production and the quantity of
  output produced.
• Assuming that firms produce goods using only
  labor, the production function can be written as

Y outputN employmentA labor productivity,
or output per worker

• Further, assuming that one worker produces one
  unit of outputso that A 1, then, the
  production function becomes

31
Price Determination

• If the production function is
• then there are no fixed costs
• and the only variable cost is the wage rate.
• Then what is the cost of an additional unit of
  output?
• W

32
Price Determination

• If the cost of an additional unit of output is W,
  then W is firms marginal cost.
• In perfect competition, P W.
• If a firm charges more than marginal cost,
  consumers just go to one of a million
  competitors.
• In imperfect competition, P gt W
• Firms can charge more than marginal cost because
  there are few other firms selling a product that
  is similar enough.

33
Price Determination

• Firms set their price according to
• The term m is the markup of the price over the
  cost of production.
• 1m is the difference between the marginal cost
  of labor (W) and the price (P).

34
Price Determination

• 1m is the difference between the marginal cost
  of labor (W) and the price (P).
• If markets are imperfectly competitive,m gt 0,
  and P gt W.
• If all markets were perfectly competitive, m
  0, and P W.

P
P
MC
MC
DMR
D
MR
Q
Q
35
Price Determination

• What determines m?
• The market power of firms in the product market
  (firms may sell differentiated products or they
  may be oligopolists).

36
Price Determination

• What determines m?
• The market power of firms probably increases when
  the economy is doing well.
• Its easier to sell and to raise prices (at any
  given wage) when unemployment is low ? the real
  wage falls.
• The market power of firms probably decreases when
  the economy does poorly
• Discounts, price cuts, and incentives become
  larger (at any given wage) when unemployment is
  high ? the real wage rises.

37
Price Determination
Higher unemployment means lower prices for a
given wage (or higher real wages).
u
38
The Natural Rateof Unemployment
6-5

• Wage setting and price setting determine the
  equilibrium rate of unemployment.
• Define the medium run as the period of time when
  price expectations are fulfilled or when people
  have adjusted their expectations to reality.
• Therefore we assume that Pe P, so that this
  equation becomes this
  equation.

39
The Wage-Setting Relation

• Earlier, we stated that the nominal wage rate was
  determined as follows

• Now, since Pe P,

The wage-setting relation Workers and firms set
real wages depending on unemployment and other
things.
40
Wages and Unemployment
Higher unemployment reduces the bargaining power
of workers and encourages them to accept lower
real wages.
u
41
The Price-Setting Relation

• The price-determination equation is

• If we divide both sides by W, we get

42
The Price-Setting Relation

• To state this equation in terms of the wage rate,
  we invert both sides

The price-setting relation Firms set prices (at
given nominal wages) depending on their degree of
monopoly power.
43
Price Determination
Higher unemployment means lower prices for a
given wage (or higher real wages).
u
44
Wages and Unemployment
PS relation Higher unemployment means lower
prices for a given wage (or higher real wages).
WS relation Higher unemployment reduces the
bargaining power of workers and encourages them
to accept lower real wages.
u
45
Wages and Unemployment
Greater monopoly power allows firms to increase
the difference between W and P, at any u,
reducing W / P.
PS relation High u lowers prices and raises W/P.
WS relation High u weakens workers and lowers
real wages.
u
46
Price Determination

• For simplicity well assume m gt 0.
• Assume m doesnt depend on unemployment, but that
  it does depend on structural characteristics such
  as anti-Trust enforcement.

47
Price Determination
Unemployment doesnt affect how firms set prices
or wages.
u
48
Price Determination
Greater monopoly powerincreases the difference
between W and P,reducing W / P.
u
49
Wage-Setting and Price-Setting
The Wage-Setting Relation, the Price-Setting
Relation, and the Natural Rate of Unemployment

• Real wages are set by workers and firms as a
  decreasing function of the unemployment rate.
• The real wage implied by firms price-setting
  (given nominal wages) is constant, independent of
  the unemployment rate.

50
Equilibrium Real Wagesand Unemployment
The Wage-Setting Relation, the Price-Setting
Relation, and the Natural Rate of Unemployment

• The natural rate of unemployment is the
  unemployment rate such that the real wage chosen
  in wage setting is equal to the real wage implied
  by price setting.

51
Equilibrium Real Wagesand Unemployment

• We can solve the Wage-Setting / Price-Setting
  model for the equilibrium unemployment rate, or
  natural rate of unemployment, un.
• Eliminating W/P from the wage-setting and the
  price-setting relations

n
52
Equilibrium Real Wagesand Unemployment

• The equilibrium unemployment rate, or natural
  rate of unemployment, un

un depends on the shape ofthe function Fon
unemployment benefitson the degree of market
power of firms
53
Equilibrium Real Wagesand Unemployment
Unemployment Benefits and the Natural Rate of
Unemployment

• An increase in unemployment benefits leads to an
  increase in the natural rate of unemployment.

54
Equilibrium Real Wagesand Unemployment
Markups and the Natural Rate of Unemployment

• An increase in markups decreases the real wage,
  and leads to an increase in the natural rate of
  unemployment.

Monopolists produce less than perfect
competitors then fewer people are hired.
55
Actual Unemployment versus Natural Unemployment

• Can the actual rate of unemployment be
  different from the natural rate of
  unemployment?
• This is a medium term model.
• In the short-term, many kinds of inflexibilities
  will prevent the economy from adjusting.
• Unemployment changes more slowly than most other
  macroeconomic variables.

56
Movements in Unemployment
Movements in the U.S.Unemployment Rate, 1948-2000

• Labor hoarding causes unemployment to rises
  slowly after the recession begins, and to stay
  high even after the recession ends.

57
Actual Unemployment versus Natural Unemployment

• When will u be different from un?
• When expected prices are higher than actual
  prices Pe gt P.
• If people expect high prices, theyll demand high
  wages
• At every level of unemployment, workers will
  demand a high W/P.
• This means that workers will require W/P gt
  1/(1m).
• Because firms will only pay W/P 1/(1m), they
  wont hire as many workers.

58
Actual Unemployment versus Natural Unemployment

• If Pegt P, workers will require high nominal
  wages, so workers require W/P gt 1/(1m)
• Unemployment will rise because firms dont hire.
• As workers bargaining power weakens, they lower
  their nominal wage requests, untilW/P 1/(1m).
• The actual rate of unemployment will be higher
  than the natural rate of unemployment, ugtun.

59
Actual Unemployment versus Natural Unemployment
Expected Prices and the Actual Rate of
Unemployment

• If expected prices are higher than actual prices
  Pegt P, nominal wage demands will be too high,
  leading to a rise in unemployment.
• Then ugtun.

60
The Structural Rate of Unemployment

• Because the equilibrium rate of unemployment
  reflects the structure of the economy, a better
  name for the natural rate of unemployment is the
  structural rate of unemployment.
• I.e., it depends on institutions and behavior
• Unemployment benefits
• Peoples reactions to being unemployed
• Industrial organization
• Other factors.

61
What next?

• This is all very nice, but whats the connection
  with Aggregate Supply?
• Wage-setting and price-setting determine the
  economys actual level of unemployment and the
  natural level of unemployment.
• The level of unemployment implies the level of
  employment.
• The level of employment implies output.

62
From Unemployment to Employment

• The natural rate of unemployment ? a natural
  level of employment.

The unemployment rate

• Employment in terms of the labor force and the
  unemployment rate equals

The level of employment

• The natural level of employment, Nn, is given by

The natural level of employment
63
From Employment to Output

• A natural level of employment ? a natural level
  of output, (and since YN, then,)

Employment ? output

• The natural level of output satisfies the
  following

The structure of the economy ? Yn