The Labor Market

Prepared by:Prepared by:

Fernando Quijano and Yvonn Fernando Quijano and Yvonn QuijanoQuijano

And Modified by Gabriel MartinezAnd Modified by Gabriel Martinez

66C H A P T E RC H A P T E R

The Labor MarketThe Labor Market

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier Blanchard

What’s the point of this chapter?What’s the point of this chapter?

The Aggregate Supply curve is a relation The Aggregate Supply curve is a relation between between productionproduction and the and the price levelprice level..

Production happens because firms hire Production happens because firms hire workers (among other things).workers (among other things).

The real cost of hiring workers is the real The real cost of hiring workers is the real wage.wage.

Higher price levels reduce the real wage.Higher price levels reduce the real wage. Lower real wages cause firms to hire more Lower real wages cause firms to hire more

workers and increase production.workers and increase production.


What’s the point of this chapter? What’s the point of this chapter? Cont.Cont.

Two complications:Two complications:– Workers want purchasing power in return for Workers want purchasing power in return for

their work.their work. Since they sign contracts to work in the future, they Since they sign contracts to work in the future, they

care about the care about the futurefuture price level. price level. Price level expectations may move more slowly than Price level expectations may move more slowly than

the actual price level.the actual price level.– Workers’ effort (which is difficult to monitor) and Workers’ effort (which is difficult to monitor) and

their bargaining power depends on the their bargaining power depends on the unemployment rate.unemployment rate. And on unemployment benefits, etc.And on unemployment benefits, etc.


A Tour of the Labor A Tour of the Labor MarketMarket6-1

The The noninstitutional civilian populationnoninstitutional civilian population are the are the number of people potentially available for civilian number of people potentially available for civilian employment.employment.

The The civilian labor forcecivilian labor force is the sum of those either is the sum of those either working or looking for work.working or looking for work.

Those who are neither working nor looking for Those who are neither working nor looking for work are work are out of the labor forceout of the labor force..

The The participation rateparticipation rate is the ratio of the labor is the ratio of the labor force to the noninstitutional civilian population.force to the noninstitutional civilian population.

The The unemployment rateunemployment rate is the ratio of the is the ratio of the unemployed to the labor force.unemployed to the labor force.


A Tour of the Labor MarketA Tour of the Labor Market

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


The Large Flows of WorkersThe Large Flows of Workers

An unemployment rate may reflect two very An unemployment rate may reflect two very different realities:different realities:– A a labor market with many A a labor market with many separationsseparations and and

many many hireshires,,– A labor market, with few separations, few hires, A labor market, with few separations, few hires,

and a stagnant unemployment pool.and a stagnant unemployment pool. What is worse? To lose your job and get a new one 12 What is worse? To lose your job and get a new one 12

times a year? Or to be unemployed for 6 months?times a year? Or to be unemployed for 6 months?



(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.

Average Monthly Flows Average Monthly Flows Between Employment, Between Employment, Unemployment, and Unemployment, and Nonparticipation in the United Nonparticipation in the United States, 1994-1999States, 1994-1999



From the CPS data we conclude that:From the CPS data we conclude that:1.1. The flows of workers in and out of The flows of workers in and out of

employment are large.employment are large.Separations consist of:Separations consist of: QuitsQuits, or workers leaving their jobs for a better , or workers leaving their jobs for a better

alternative, andalternative, and LayoffsLayoffs, which come from changes in , which come from changes in

employment levels across firms.employment levels across firms.

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



From the CPS data we conclude that:From the CPS data we conclude that:2.2. The flows in and out of unemployment are The flows in and out of unemployment are

large in relation to the number of large in relation to the number of unemployed.unemployed. The The average duration of unemploymentaverage duration of unemployment is is

about three months.about three months.



From the CPS data we conclude that:From the CPS data we conclude that:3.3. There are large flows in and out of the labor There are large flows in and out of the labor

force, much of them directly to and from force, much of them directly to and from employment.employment. Discouraged workersDiscouraged workers are classified as “out of are classified as “out of

the labor force,” but they may take a job if they the labor force,” but they may take a job if they find it.find it.

The The nonemployment ratenonemployment rate is the ratio of is the ratio of population minus employment to population.population minus employment to population. Because it includes the discouraged, it might Because it includes the discouraged, it might

be a better measure of unemployment.be a better measure of unemployment.


Movements inMovements inUnemploymentUnemployment

Fluctuations in the aggregate unemployment Fluctuations in the aggregate unemployment rate affect:rate affect:– The welfare of individual workersThe welfare of individual workers– WagesWages

6-2

Higher unemployment affects workers:Higher unemployment affects workers: Through a decrease in hires—more difficult to find Through a decrease in hires—more difficult to find

jobs.jobs. Through higher layoffs—higher risk of losing their Through higher layoffs—higher risk of losing their

jobs.jobs.


Movements in UnemploymentMovements in Unemployment

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

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



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

The Unemployment The Unemployment Rate and the Rate and the ProportionProportionof Unemployed of Unemployed Finding Jobs, 1968-Finding Jobs, 1968-19991999

Note, the scale on the right is an inverse scale.



The Unemployment The Unemployment Rate and the Rate and the Monthly Separation Monthly Separation Rate from Rate from Employment, 1968-Employment, 1968-19991999

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


Wage DeterminationWage Determination Collective bargainingCollective bargaining is bargaining between is bargaining between

firms and unions.firms and unions.– The result depends on each side’s bargaining power, The result depends on each side’s bargaining power,

which in turn depends on each side’s opportunity cost which in turn depends on each side’s opportunity cost of not making the deal. For example:of not making the deal. For example: The skills of the worker compared to the skills required for The skills of the worker compared to the skills required for

the job;the job; The current and expected unemployment rates;The current and expected unemployment rates; Going wages, social norms and laws regarding hiring and Going wages, social norms and laws regarding hiring and

firing.firing. Etc.Etc.

6-3


Wage DeterminationWage Determination Common forces at work in the Common forces at work in the

determination of wages:determination of wages:– Wages are typically higher than the Wages are typically higher than the

reservation wagereservation wage,, that is, the wage that make that is, the wage that make them indifferent between working or becoming them indifferent between working or becoming unemployed.unemployed. ““I won’t work unless you pay me more than $7 an I won’t work unless you pay me more than $7 an

hour.”hour.”– Labor-market conditions.Labor-market conditions.


BargainingBargaining

How much How much bargaining powerbargaining power a worker a worker has depends on:has depends on:1.1. How costly it would be for the firm to replace How costly it would be for the firm to replace

him—the nature of the job.him—the nature of the job.2.2. How hard it would be for him to find another How hard it would be for him to find another

job—labor market conditions.job—labor market conditions.

It’s important to realize that, generally speaking, It’s important to realize that, generally speaking, low-income workers have less bargaining low-income workers have less bargaining power than potential employers.power than potential employers.


Efficiency WagesEfficiency Wages

Should we pay you as low a wage as you’ll Should we pay you as low a wage as you’ll take?take?

If we do, we might lose you and we’ll have If we do, we might lose you and we’ll have to train someone else.to train someone else.– When unemployment is high, a higher When unemployment is high, a higher

proportion of workers lose their jobs.proportion of workers lose their jobs.


Efficiency WagesEfficiency Wages Efficiency wage theoriesEfficiency wage theories are theories that are theories that

link the productivity or the efficiency of link the productivity or the efficiency of workers to the wage they are paid.workers to the wage they are paid.– These theories also suggest that wages depend These theories also suggest that wages depend

on both the nature of the job and on labor-on both the nature of the job and on labor-market conditions.market conditions.

– Efficiency wages are typically higher than Efficiency wages are typically higher than market-clearing wages: unemployment will market-clearing wages: unemployment will result.result.


Wages, Prices, and Wages, Prices, and UnemploymentUnemployment

The aggregate nominal wage, The aggregate nominal wage, WW, , depends on three factors:depends on three factors:1.1. The expected price level, The expected price level, PPee

2.2. The unemployment rate,The unemployment rate, u u3.3. A catchall variable, z, that catches all A catchall variable, z, that catches all

other variables that may affect the other variables that may affect the outcome of wage setting.outcome of wage setting.

W P F u ze ( , )( , )



1.1. Both workers and firms care about real wages Both workers and firms care about real wages ((WW//PP), not nominal wages (), not nominal wages (WW).).

Suppose your job is to write a computer program. To do so, you spend 25,000 calories of energy – i.e., you’ve given real effort to the firm.

You’ll want to be paid back in stuff, in real purchasing power, so that you can at least buy 25,000 calories worth of food.



Workers Workers also care about what wages they’ll 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?



2.2. Higher unemployment weakens workers’ Higher unemployment weakens workers’ bargaining power, forcing them to accept lower bargaining power, forcing them to accept lower wages.wages.

Suppose you are the only available candidate with a bachelor’s degree in aerospace engineering. Boeing pays you whatever you want.

Suppose, now, that there are seven more people with bachelor’s degrees in aerospace engineering. They are all unemployed. Will you ask for that 15% raise?



If we divide this equation by P, we obtainIf we divide this equation by P, we obtain

This allows us to draw a relation between the This allows us to draw a relation between the real wage real wage W/PW/P and unemployment and unemployment uu..

This relation has to be downward sloping This relation has to be downward sloping because higher unemployment makes because higher unemployment makes workers weaker on the negotiating table.workers weaker on the negotiating table.

),( zuFPW e

),( zuFPP

PW e


Wages and UnemploymentWages and Unemployment

u

W

PHigher unemployment reduces the bargaining power of workers and encourages them to accept lower real wages.



3.3. Among other factors that affect wages is Among other factors that affect wages is unemployment insuranceunemployment insurance—the payment of —the payment of unemployment benefits to workers who lose unemployment benefits to workers who lose their jobs. Higher unemployment insurance their jobs. Higher unemployment insurance allows workers to hold out for higher wages. allows workers to hold out for higher wages. Minimum wages and employment protection Minimum wages and employment protection are other factors.are other factors.

Suppose the government pays you $150,000 a year in unemployment insurance. Do you care if you lose your job?


Wages, Unemployment, and Wages, Unemployment, and Unemployment BenefitsUnemployment Benefits

u

W

P

Higher unemployment benefits reduces the opportunity cost of unemployment, encouraging workers to ask for higher wages at the given unemployment rate.



4.4. It’s obvious that a change in price expectations will change It’s obvious that a change in price expectations will change the real wage that workers demand.the real wage that workers demand.

Suppose you expected prices to be fairly low. Then, in your nominal wage negotiations with your employer, you’ll make fairly low nominal wage demands.

But now suppose that prices actually turn out to be higher, so Pe/P < 1. Then W/P will be relatively low.

Pe/P < 1 may happen if an unexpected shock raises prices.

),( zuFPP

PW e


Wages, Unemployment, and Wages, Unemployment, and Unemployment BenefitsUnemployment Benefits

u

W

P

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.


Price DeterminationPrice Determination The The production functionproduction function is the relation between is the relation between

the inputs used in production and the quantity of the inputs used in production and the quantity of output produced.output produced.

Assuming that firms produce goods using only Assuming that firms produce goods using only labor, the production function can be written as:labor, the production function can be written as:

6-4

Y ANYY = output = outputNN = employment = employmentAA = = labor productivity,labor productivity, or output per worker or output per worker

Further, assuming that one worker produces one unit Further, assuming that one worker produces one unit of output—so that of output—so that AA = 1, then, the production function = 1, then, the production function becomes:becomes: Y N


Price DeterminationPrice Determination

If the production function isIf the production function is

then there are no fixed coststhen there are no fixed costsand the only variable cost is the wage rate.and the only variable cost is the wage rate.

Then what is the cost of an additional unit of Then what is the cost of an additional unit of output?output?

WW

Y N



If the cost of an additional unit of output is If the cost of an additional unit of output is W, then W is firms’ marginal cost.W, then W is firms’ marginal cost.– In perfect competition, P = W.In perfect competition, P = W.

If a firm charges more than marginal cost, consumers If a firm charges more than marginal cost, consumers just go to one of a million competitors.just go to one of a million competitors.

– In In imimperfect competition, P > Wperfect competition, P > W Firms can charge more than marginal cost because Firms can charge more than marginal cost because

there are few other firms selling a product that is there are few other firms selling a product that is similar enough.similar enough.



Firms set their price according to:Firms set their price according to:

The term The term m m is the is the markupmarkup of the price over of the price over the cost of production.the cost of production.– 1+m1+m is the difference between the marginal cost is the difference between the marginal cost

of labor (W) and the price (P).of labor (W) and the price (P).

WmP )1(


1+m1+m is the difference between the marginal cost of is the difference between the marginal cost of labor (W) and the price (P).labor (W) and the price (P).

If markets are If markets are imimperfectly competitive,perfectly competitive,mm > 0, and > 0, and PP > > W.W.

If all markets were perfectly competitive, If all markets were perfectly competitive, mm = 0, = 0, and and PP = = WW..


Q

P

DMR

Q

P

D=MRMCMC

WmP )1(



What determines What determines mm??– The market power of firms in the product market The market power of firms in the product market

(firms may sell differentiated products or they (firms may sell differentiated products or they may be oligopolists).may be oligopolists).

WmP )1(



What determines What determines mm??– The market power of firms probably increases when the The market power of firms probably increases when the

economy is doing well.economy is doing well. It’s easier to sell and to raise prices (at any given wage) when It’s easier to sell and to raise prices (at any given wage) when

unemployment is low unemployment is low the real wage falls. the real wage falls.

– The market power of firms probably decreases when the The market power of firms probably decreases when the economy does poorlyeconomy does poorly Discounts, price cuts, and “incentives” become larger (at any Discounts, price cuts, and “incentives” become larger (at any

given wage) when unemployment is high given wage) when unemployment is high the real wage rises. the real wage rises.

WmP )1(



u

W

P

Higher unemployment means lower prices for a given wage (or higher real wages).

11+m

mPW

11

WmP )1(


The Natural RateThe Natural Rateof Unemploymentof Unemployment

Wage setting and price setting determine the Wage setting and price setting determine the equilibrium rate of unemployment.equilibrium rate of unemployment.

Define the Define the medium runmedium run as the period of time when as the period of time when price expectations are fulfilled; or when people price expectations are fulfilled; or when people have adjusted their expectations to reality.have adjusted their expectations to reality.

Therefore we assume that Therefore we assume that PPee = = PP, so that this , so that this equation becomes this equation.equation becomes this equation.

6-5

),( zuFPP

PW e

),( zuF

PW


The Wage-Setting RelationThe Wage-Setting Relation

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

Now, since Now, since PPee = P = P,,

),( zuFPP

PW e

WP

F u z ( , )( , )

The wage-setting relation:

Workers and firms set real wages depending on

unemployment and other things.



u

W

PHigher unemployment reduces the bargaining power of workers and encourages them to accept lower real wages.


The Price-Setting RelationThe Price-Setting Relation

The price-determination equation is:The price-determination equation is:

If we divide both sides by If we divide both sides by WW, we get:, we get:

WmP )1(

mWP

1


The Price-Setting RelationThe Price-Setting Relation

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

The price-setting relation:

Firms set prices (at given nominal wages) depending

on their degree of monopoly power.mP

W

11

mWP

1



u

W

P

Higher unemployment means lower prices for a given wage (or higher real wages).

11+m

mPW

11

WmP )1(



u

W

P

WS relation: Higher unemployment reduces the bargaining power of workers and encourages them to accept lower real wages.

PS relation: Higher unemployment means lower prices for a given wage (or higher real wages).



u

W

P

WS relation: High u weakens workers and lowers real wages.

PS relation: High u lowers prices and raises W/P.

Greater monopoly power allows firms to increase the difference between W and P, at any u, reducing W / P.



For simplicity we’ll assume For simplicity we’ll assume mm > 0. > 0.– Assume m doesn’t depend on unemployment,

but that it does depend on structural characteristics such as anti-Trust enforcement.

WmP )1(



u

W

PUnemployment doesn’t affect how firms set prices or wages.

11+m

mPW

11

WmP )1(



u

W

PGreater monopoly powerincreases the difference between W and P,reducing W / P.

mPW

11

11+m

11+m’


Wage-Setting and Price-SettingWage-Setting and Price-Setting

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

The Wage-Setting Relation, The Wage-Setting Relation, the Price-Setting Relation, the Price-Setting Relation, and the Natural Rate of and the Natural Rate of UnemploymentUnemployment


Equilibrium Real WagesEquilibrium Real Wagesand Unemploymentand 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.

The Wage-Setting Relation, the The Wage-Setting Relation, the Price-Setting Relation, and the Price-Setting Relation, and the Natural Rate of UnemploymentNatural Rate of Unemployment


mzuF n

11),(


We can solve the Wage-Setting / Price-Setting We can solve the Wage-Setting / Price-Setting model for the equilibrium unemployment rate, or model for the equilibrium unemployment rate, or natural rate of unemployment, natural rate of unemployment, uunn..

Eliminating Eliminating W/PW/P from the wage-setting and the from the wage-setting and the price-setting relations:price-setting relations:

n



The equilibrium The equilibrium unemployment rate, or unemployment rate, or natural rate of natural rate of unemployment, unemployment, uunn

un depends on: the shape ofthe function F;on unemployment benefits;on the degree of market power of firms…

mzuF n

11),(



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

Unemployment Benefits Unemployment Benefits and the Natural Rate of and the Natural Rate of UnemploymentUnemployment



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

Markups and the Natural Markups and the Natural Rate of UnemploymentRate of Unemployment

Monopolists produce less than perfect competitors: then fewer people are hired.


Actual Unemployment versus Actual Unemployment versus Natural UnemploymentNatural 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.



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

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



When will u be different from un?– When expected prices are higher than actual

prices Pe > P. If people expect high prices, they’ll demand high

wages– At every level of unemployment, workers will

demand a high W/P.– This means that workers will require

W/P > 1/(1+m).– Because firms will only pay W/P = 1/(1+m), they

won’t hire as many workers.



If Pe> P, workers will require high nominal wages, so workers require W/P > 1/(1+m)– Unemployment will rise because firms don’t

hire.– As workers’ bargaining power weakens, they

lower their nominal wage requests, untilW/P = 1/(1+m).

– The actual rate of unemployment will be higher than the natural rate of unemployment, u>un.



If expected prices are higher than actual prices Pe> P, nominal wage demands will be too high, leading to a rise in unemployment.

Then u>un.

Expected Prices and the Expected Prices and the Actual Rate of Actual Rate of UnemploymentUnemployment


The Structural Rate of The Structural Rate of UnemploymentUnemployment

Because the equilibrium rate of unemployment Because the equilibrium rate of unemployment reflects the structure of the economy, a better reflects the structure of the economy, a better name for the natural rate of unemployment is the name for the natural rate of unemployment is the structural rate of unemploymentstructural rate of unemployment..– I.e., it depends on institutions and behavior:I.e., it depends on institutions and behavior:

Unemployment benefits;Unemployment benefits; People’s reactions to being unemployed;People’s reactions to being unemployed; Industrial organization;Industrial organization; Other factors.Other factors.


What next?What next?

This is all very nice, but what’s the This is all very nice, but what’s the connection with Aggregate Supply?connection with Aggregate Supply?– Wage-setting and price-setting determine the Wage-setting and price-setting determine the

economy’s economy’s actual actual level of unemployment and level of unemployment and the the naturalnatural level of unemployment. level of unemployment.

– The level of unemployment implies the level of The level of unemployment implies the level of employment.employment.

– The level of employment implies output.The level of employment implies output.


From Unemployment to From Unemployment to EmploymentEmployment

The natural rate of unemployment The natural rate of unemployment a a natural level natural level of employmentof employment..

uUL

L NL

NL

1

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

N L u ( )1

The natural level of employment, The natural level of employment, NNnn, is given by:, is given by:N L un n ( )1

The unemploymen

t rate

The level of employment

The natural level of

employment


From Employment to OutputFrom Employment to Output

A natural level of employment A natural level of employment a a natural level of natural level of output, output, (and since (and since Y=NY=N, then,), then,)

Y N L un n n ( )1

The natural level of output satisfies the following:The natural level of output satisfies the following:

uYLnn 1

In words, the natural level of output is such that, In words, the natural level of output is such that,

at the associated rate of unemployment,at the associated rate of unemployment,

the real wage chosen in wage setting is equal to the real wage chosen in wage setting is equal to the real wage implied by price setting.the real wage implied by price setting.

,,

Employment output

The structure of the

economy Yn

nn uLY

1m

zLYF n

11,1

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The Labor Market

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