Labor Market Notes

Unit 9: The Labour Market: Wages, Profits, and Unemployment

Introduction

This unit explores the labor market, focusing on how wages and employment are determined at the economy-wide level. It builds upon concepts from previous units, such as price-setting behavior of firms producing differentiated products (Unit 7) and the principal-agent model which clarifies the conflict of interest between employers and employees regarding worker effort (Unit 6), which explains why contracts alone can't resolve it. The central questions addressed are:

  • How are economy-wide wages and employment determined?
  • How can we improve these outcomes?

The unit models the price-setting and wage-setting behaviors of firms, which determine the economy-wide unemployment rate and the real wage. It explains why unemployment exists even in equilibrium and shows how government policies and labor unions can affect wages and unemployment.

Measuring Unemployment

The unemployed are defined as individuals who:

  • Are not in paid employment or self-employment.
  • Are available for work.
  • Are actively seeking work.

The labor market is composed of the population of working age, which is further divided into the labor force and those out of the labor force (inactive). The labor force consists of the employed and the unemployed.

Labor market statistics can vary significantly across countries. Two countries with the same unemployment rate may have different employment rates if one has a higher participation rate than the other.

Price-Setting and Wage-Setting

Firms set wages high enough to make job loss costly, motivating employees to work hard in the absence of complete contracts. They also set a markup above the cost of production to maximize profits, considering the demand for their products.

The real wage is the nominal wage divided by the price level of consumer goods. The process involves:

  1. Each firm deciding on its price, wage, and number of employees.
  2. Aggregating these decisions across all firms to determine total employment and the real wage in the economy.

Chain of Firm’s Decisions:

  • Nominal wage = f(other firms’ 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)

The wage-setting curve represents the real wage necessary at each level of economy-wide employment to provide workers with incentives to work hard and well. Lowering the unemployment rate shifts a worker’s best response curve to the right, increasing the wage and resulting in an upward-sloping wage-setting curve. Estimated wage curves can be derived from data on unemployment rates and wages in local areas.

Firms choose a profit-maximizing price where the demand curve is tangent to an isoprofit curve. This determines the number of employees needed to produce the quantity demanded at that price.

The firm’s choice of a profit-maximizing price determines the optimal markup above the marginal cost of production, influencing how output is distributed between firm owners and workers. Once firms set prices, this determines the level of output, markup, and the real wage in the economy.

The price-setting curve represents the real wage paid when firms choose their profit-maximizing price. It depends on:

  • Competition, which determines the markup.
  • Labor productivity, which determines the real wage for a given markup.

Labour Market Equilibrium

The labor market equilibrium occurs where the wage-setting and price-setting curves intersect. This represents the Nash equilibrium of the labor market.

At equilibrium:

  • Firms offer the least wage to ensure worker effort.
  • Employment is the highest possible, given the wage.
  • Those with jobs cannot improve their situation by asking for higher pay or working less.
  • Those without jobs would like to work but cannot persuade firms to hire them at a lower wage due to labor discipline concerns.

Involuntary unemployment exists because some unemployment is necessary to motivate workers, as zero unemployment would mean zero cost of job loss, leading to no effort. This is viewed as excess supply in the labor market.

The firm's demand for labor depends on the demand for their goods and services (derived demand for labor). Aggregate demand is the sum of the demand for all goods and services produced in the economy. A fall in aggregate demand causes demand-deficient unemployment.

In cases of deficient demand:

  • Firms could lower wages, leading to lower costs and prices, and increased output and employment.

However, real economies do not adjust so smoothly because:

  • Workers resist nominal wage cuts (lower morale, strikes).
  • Lower wages reduce spending, further decreasing aggregate demand.
  • Falling prices may cause consumers to delay purchases, hoping for better bargains later.

Government intervention through monetary or fiscal policy can increase aggregate demand, encouraging firms to produce more and hire more workers.

An increase in labor supply shifts the wage-setting curve downward. This is due to a greater pool of unemployed and, therefore, a lower cost of effort.

Division of Output and Labour Unions

A labor union is an organization of employees that negotiates rates of pay and conditions of employment for its members.

In unionized settings, wages are negotiated between the union and the firm, potentially above the wage-setting curve. The wage-setting curve reflects the employer’s threat of firing, while the union can threaten to strike.

The bargaining curve indicates the wage resulting from the union-employer bargaining process for every level of employment. Its position above the wage-setting curve depends on the relative bargaining power of the union and the employer. The model sometimes suggests that labor unions increase unemployment rates; however, this effect is not always clear in the data.

Giving employees a voice in decision-making may induce them to provide more effort for the same wage, shifting the bargained wage curve downward. The overall effect of labor unions on employment is ambiguous.

Labour Market Policies

Policies that shift the price-setting curve:

  1. Education & training: increase labor productivity.
  2. Wage subsidy: reduces production costs and prices.

Policies that shift the wage-setting curve:

  1. Lower unemployment benefit: decreases the reservation wage.

Policies that shift the labor supply curve:

  1. Immigration policies: affect labor supply.
  2. Childcare provision: affects female labor participation.

Summary

  1. Firm behavior determines wages and employment. The wage-setting curve reflects wages and unemployment feasible with worker effort, while the price-setting curve determines the real wage corresponding to the profit-maximizing price.

  2. Involuntary unemployment always exists due to incomplete contracts and deficient demand.

  3. Labor unions bargain over wages, affecting employment. Giving workers a voice may improve their effort and productivity.