Labour Market Notes

The Labour Market (Medium Run)

Topics Covered

• The Labour Force
• Wage Determination, Bargaining, and Efficiency Wages
• Wages, Price, and Unemployment
• Price Determination
• Wage Setting Relation and Price Setting Relation
• Equilibrium Condition in the Labour Market
• Change in Equilibrium
• Natural Level of Unemployment, Natural Level of Employment, and Natural Level of Output

The Labour Force

• Labour Force: All people within the economy who are willing and able to work.
• Participation Rate: The ratio of the labour force to the population in working age.
• Unemployment Rate: The ratio of the unemployed to the labour force.

Wage Determination

• Wages are sometimes set through collective bargaining between firms and unions and sometimes by employers or bargaining between the employer and individual employees.
• Workers are typically paid a wage that exceeds their reservation wage.
• Wages typically depend on labour market conditions; the lower the unemployment rate, the higher the wages.

Bargaining Power

• A worker's bargaining power depends on:
  • How costly it would be for the firm to replace them.
  • How hard it would be for them to find another job.
• The more costly it is for the firm to replace the worker, and the easier it is for the worker to find another job, the more bargaining power the worker will have.

Efficiency Wages

• Firms may pay more than the reservation wage to ensure worker productivity, decrease turnover, and increase commitment.
• Efficiency wage theories suggest wages depend on the nature of the job and labour market conditions.
• Lower unemployment leads to higher wages; higher unemployment leads to lower wages.

Wages, Prices, and Unemployment

• The aggregate nominal wage, $W$, depends on:
  • Expected price level, $P^e$: An increase leads to a proportional increase in $W$.
  • Unemployment rate, $u$: An increase in $u$ leads to a decrease in $W$.
  • A catchall variable, $z$: Represents other factors affecting wage setting; an increase in $z$ leads to an increase in $W$.

The Expected Price Level

• Workers and firms care about real wages, $\frac{W}{P}$, not nominal wages.
• Wages depend on the expected price level, $P^e$, rather than the actual price level, $P$.

The Unemployment Rate

• An increase in the unemployment rate decreases wages.
• Higher unemployment weakens workers’ bargaining power.
• Higher unemployment allows firms to pay lower wages.

Other Factors Influencing Wages

• Unemployment insurance: Higher benefits increase wages.
• Employment protection: Higher protection increases wages.
• Minimum wage: Can cause wage rigidity and increase average wages.

Price Determination

• Prices set by firms depend on costs, influenced by the production function and input prices.
• Production function: $Y = AN$, where $Y$ is output, $N$ is employment, and $A$ is labour productivity.
• Assuming $A = 1$, the cost of producing one more unit of output is the cost of employing one more worker at wage $W$.
• Marginal cost of production = $W$.
• Firms set prices according to: $P = (1 + μ)W$, where $μ$ is the mark-up of the price over the cost.

Price Determination (cont.)

• If goods markets were perfectly competitive, $μ = 0$, and $P = W$.
• Higher degree of competition results in lower mark-up.

Wage Setting Relation

• Wage setting relation: $\frac{W}{P} = F(u, z)$
• A higher unemployment rate implies a lower real wage.

Price Setting Relation

• $\frac{P}{W} = 1 + μ$
• $\frac{W}{P} = \frac{1}{1 + μ}$
• An increase in the mark-up leads to a decrease in the real wage.

Equilibrium Condition

• Equilibrium in the labour market requires that the real wage chosen in wage setting be equal to the real wage implied by price setting.
• The equilibrium unemployment rate, $u_n$, is such that the real wage chosen in wage setting is equal to the real wage implied by price setting.
• The positions of the wage-setting and price-setting curves, and thus the equilibrium unemployment rate, depend on both $z$ and $μ$.

Change in Equilibrium

• An increase in unemployment benefits shifts the wage-setting relation up, increasing the natural rate of unemployment.
• Less stringent enforcement of competition law shifts the price-setting relation down, increasing the natural rate of unemployment.

From Unemployment to Employment

• $U + N = L$ (Unemployment + Employment = Labour Force)
• $N = L - U = L(1 - u)$
• $N<em>n = L(1 - u</em>n)$ (Natural level of employment)

From Employment to Output

• The natural level of output, $Y_n$, is the level of production when employment is equal to the natural level of employment.
• Given $Y = N$, then $Y<em>n = N</em>n$.
• $u<em>n = 1 - \frac{Y</em>n}{L}$
• The natural level of output, $Y_n$, is such that, at the associated rate of unemployment, the real wage chosen in wage setting is equal to the real wage implied by price setting.

To Summarise

• The real wage chosen in wage setting decreases with the unemployment rate.
• The real wage implied by price setting is constant.
• Equilibrium requires the real wage in wage setting equals the real wage in price setting.
• This determines the natural rate of unemployment.
• Associated with the natural rate of unemployment are a natural level of employment and a natural level of output.