The Labour Market

Lecture 23 – academic year 2014/15Introduction to Economics

Fabio Landini

Questions of the day

• How does the labour market function?

• Why are some workers unemployed?

• What does the unemployment rate depend on?

• Quick review of the model of demand and supply (Part I - Microeconomics)

• Construction of the model WS-PS

• Determination of the equilibrium

• Analysis of the determinants of unemployment

What do we do today

Premise

Labour market -> Analysis of medium period

In this class we examine the functioning of the labour market and the determinants of unemployment

In the next class we will come back to the passage from short period to medium period using part of the results obtained today

Demand and supply of labour

It is the simplest model to study the labour market

Firms “demand” labour -> the labour demand (DL) point out how many workers the firms want to hire at the market wage (W)

It follows that the higher the wage the lower the number of workers that the firms are willing to hire

DL is a decreasing function of the wage

Workers “supply” labour -> the supply of labour (SL) tells us how many workers are willing to work at the market wage (W)

It follows that the higher the wage the larger the number of workers that are willing to work

SL is an increasing function of wage

Demand and supply of labour

In equilibrium -> DL = SL -> Point E in the graph NE is the number of workers that are employed WE is the equilibrium wage

W

N° workers

SL

DL

E

NE

WE

Demand and supply of labour

In equilibrium:•Along DL -> firms hire the number of workers that they wish•Along SL -> workers that wish to work are hired -> there is no unemployment

N° workers

SL

DL

E

NE

W

In real economies, however, there is unemployment

To explain the existence of unempl. -> WS-PS model

Demand and supply of labour

Construction of the WS-PS model

In the WS-PS model :•Firms fix the prices of the goods that are produced•Firms and workers negotiate on wages

Let’s examine them separately: •Determination of wages•Determination of prices

The determination of wages

Wage negotiation is explained by different theories

Summary of the main theories -> “wage setting” equation (WS)

W = PE F(u,z) - +

where W is the wage, PE is the expected prices, u is unemployment, and z is institutional variables of the labour market

Construction of the WS-PS model

Let’s examine the different components of this equation W = PE F(u,z)

a) W depends on P•Workers are not interested in the amount of money they receive but in the quantity of goods that they can buy with their wage ->•Workers are interested in the wage “in proportion” to the level of prices

Construction of the WS-PS model

b) In the equation we have PE rather than P

• Wages are negotiated ahead of time and remain fixed for a certain period of time so that the level of prices is not known with certainty ->

• Wages depends on “expected” prices -> PE (Important to distinguish between short and medium period)

c)F(u,z) -> W depends negatively on u• u -> Greater competition among workers ->

Workers’ bargaining power -> W

Construction of the WS-PS model

d)F(u,z) -> W depends also on institutional variables z (positive for convention)

The latter include:• The level of unemployment subsidies Subsidies -> Compensations requested to work• Minimum wage Minimum W -> Workers’ wage requests

Construction of the WS-PS model

Let’s go back to the WS equation -> W = PE F(u,z)

For the moment, let’s assume that price “expectations” are correct -> PE = P

In this case: WS -> W = P F(u,z)By rearranging we obtain

W/P represent the wage relative to the level of prices, i.e. the “real wage”

)z,u(FPW

Construction of the WS-PS model

Let’s draw the equation in a (W/P, u) diagram

F is decreasing in u -> the curve WS is decreasing

WS

u

W/P

)z,u(FPW

Construction of the WS-PS model

The determination of prices

Firms’ behaviour -> production

Two main simplifications:• Only one input -> labour (N) • The total product (Y) is equal to the amount of labour

that is employed -> Y = N

This implies that the cost to produce one unit of Y is equal to the cost to employ one worker, which is equal to the wage W

Construction of the WS-PS model

Let’s assume that firms fixe the price on the basis of the unitary cost of input following the rule:

Price= Unitary cost X (1+)

where 0<is the so-called mark-up.

Important: is a % of “refill” on costs

For instance, if 10% the price is equal to the costs increased by 10%

Construction of the WS-PS model

In our case the unitary cost is W so that: P = W(1+)

P = W(1+) -> “Price setting” equation

Important: the dimension of mark up depends on the degree of competition among firms

In particular:• competition among firms -> •implies and P = W

Construction of the WS-PS model

Let’s go back to equation PS -> P = W(1+)

After some algebraic passages we obtain

->

Construction of the WS-PS model

We draw the PS in a (W/P, u) diagram

In the PS the real wage W/P does not depend on u -> the curve PS is an horizontal line

W/P

u

PS

Construction of the WS-PS model

We defined the two curves that describe the determination of wages (WS) and prices (PS)

Let’s now consider the two curves together in the same graph

The equilibrium in the labour market

We draw the two curves In E we are both on the WS and on the PS -> E is the equilibrium

In E there is unemployment -> u = un

un is the “natural” rate of unemployment

WS

u

W/P

PS

un

E

In the WS-PS model the system presents some positive degree of unemployment in equilibrium

This happens in because of two components of the model (that are absent in the standard supply and demand model):•Competition among firms is not perfect in the goods market•Presence of a wage negotiation mechanism

The determinants of unemployment

The equilibrium level of unemployment un depends on the same factors

In particular un is influenced by:•The degree of competition among firms•The institutional characteristics of the labour market

To understand these relationships let’s look at the effect on un of :• competition among firms•Changes in the labour market legislation ( unemployment subsidies)

The determinants of unemployment

Let’s start from E and in competition

competition -> mark up -> -> PS shifts downward

Effects: E -> E’ and un

WS

u

W/P

PS

un

E

PS’E’

un’

Let’s start from E and subsidies

subsidies -> z -> F(u,z) -> WS shifts upward

Effects: E -> E’ and un

WS

u

W/P

PS

un

E

WS’

un’

E’

The above results show that:• Competition among firms -> un

•Changes in the labour market legislation affects un (e.g. Unemployment subsidies -> un)

The rate of unemployment un depends on some structural factors (how market functions) -> for this reason is called “natural rate of unemployment”

The determinants of unemployment