Labor Market Summarization

The Labor Market

  • Firms respond to increased demand by increasing production, leading to higher employment and lower unemployment.

  • Lower unemployment leads to higher wages, which increases production costs and prices.

  • Higher prices lead workers to ask for higher wages, leading to further price increases.

  • The labor market is central to understanding price and wage adjustments.

Wage Determination

  • Wages are set through collective bargaining or by employers/individual employees.

  • Workers are typically paid above their reservation wage.

  • Wages depend on labor-market conditions: lower unemployment leads to higher wages.

  • Workers' bargaining power depends on the cost for the firm to replace them and how easy it is for them to find another job.

  • Firms may want to pay efficiency wages to increase productivity and decrease turnover.

  • Efficiency wage theories link worker productivity to wages.

Wages, Prices, and Unemployment

  • The aggregate nominal wage W depends on:

    • Expected price level P^e

    • Unemployment rate u

    • Other factors z

  • Workers and firms care about real wages (W/P), not nominal wages.

  • Wages depend on the expected price level because wages are set in nominal terms before the actual price level is known.

  • Higher unemployment weakens workers' bargaining power, leading to lower wages.

  • The variable z includes factors like unemployment insurance and employment protection.

Price Determination

  • Prices set by firms depend on costs, production function, and input prices.

  • Assuming labor as the only production factor, the production function is Y = AN, where Y is output, N is employment, and A is labor productivity.

  • Simplifying with A = 1, the production function becomes Y = N.

  • Marginal cost of production equals W.

  • Firms set prices according to P = (1 + m)W, where m is the markup over cost.

The Natural Rate of Unemployment

  • Assuming nominal wages depend on the actual price level (P), wage and price setting determine the natural rate of unemployment.

  • Wage-Setting Relation: \\frac{W}{P} = F(u, z)

  • Price-Setting Relation: \\frac{W}{P} = \frac{1}{1 + m}

  • Equilibrium requires the real wage chosen in wage setting to equal the real wage implied by price setting.

  • Equilibrium condition: F(u_n, z) = \frac{1}{1 + m}

  • The natural rate of unemployment (u_n) is the equilibrium unemployment rate.

  • An increase in unemployment benefits (higher z) shifts the wage-setting relation up, increasing u_n.

  • Less stringent antitrust legislation (higher m) shifts the price-setting relation down, increasing u_n.

  • The natural level of employment is Nn = L(1 - un).

  • The natural level of output is Yn = Nn = L(1 - u_n).

  • Equilibrium level of output: F(1 - \frac{Y_n}{L}, z) = \frac{1}{1 + m}

Where We Go from Here

  • The natural rate of unemployment is derived under the assumptions of labor market equilibrium and P = P^e.

  • In the short run, P may not equal P^e, so unemployment may not equal the natural rate.

  • In the medium run, unemployment tends to return to the natural rate.

  • Short-run output is determined by monetary and fiscal policy.

  • Medium-run output is determined by factors in F(u_n, z) = \frac{1}{1 + m}.