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Chapter 7
The Labor Market,
Wages, and
Unemployment
By Charles I. Jones
7.2 The U.S. Labor Market
• In the U.S. labor market
– Wages account for two-thirds of per capita
GDP.
– Average wages have grown at 2 percent
per year for the last century.
Media Slides Created By
Dave Brown
Penn State University
7.1 Introduction
• In this chapter, we learn:
– How a basic supply-and-demand model helps
us understand the labor market.
– How labor market distortions like taxes and
firing costs affect employment in the long run.
• The employment-population ratio
– The fraction of the civilian population over the
age of 16 that is working
• This ratio:
– Has been increasing over time in large part
due to the entry of women into the workforce.
– Decreases in times of a recession.
7.1 Introduction
• In this chapter, we learn:
– How to compute present discounted values
– How to value your human capital.
– Why the return to a college education has
risen enormously over the last half-century.
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The Dynamics of the Labor Market
• Job creation and job destruction in the
United States
– Occur each month
– Are part of normal changes in the economy
• The unemployment rate
– The fraction of the labor force that is
unemployed
• A person is unemployed if the following
conditions hold:
– She does not have a job that pays a wage or
salary.
– She actively looked for a job during the four
weeks before measuring the unemployment
rate.
– She is available to work.
Unemployment
• For most people, periods of
unemployment are relatively short.
• People who are unemployed for long
periods account for most of the total
weeks of lost work.
• Many countries have developed social
safety nets.
7.3 Supply and Demand
• The labor demand curve slopes
downward because of diminishing
marginal product of labor (MPL).
• The labor supply curve slopes upward
because the price of leisure is higher
when wages are higher.
• The intersection of labor supply and
demand determines the level of
employment and the wage rate.
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A Change in Labor Demand
• Suppose the government creates
regulations making it harder to fire
workers.
– Firms will demand fewer workers.
– Labor demand shifts left, causing wages and
employment to fall.
– The unemployment rate rises initially and
recovers as discouraged workers drop out of
the labor force.
A Change in Labor Supply
• If the government collects a tax on a
worker’s wage:
– The labor supply curve shifts left.
– A worker receives less money and supplies
less labor—this applies to any wage.
– In order to be in equilibrium, firms must
raise wages.
Wage Rigidity
• Wage rigidity
– Wages fail to adjust after a shock to labor
demand or supply.
• What happens if wages do not fall in the
above demand shock example?
– The labor market will not clear and this
results in a larger fall in employment.
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Different Kinds of Unemployment
• The natural rate of unemployment
– Rate that would prevail if the economy
were in neither a boom nor a bust
• Cyclical unemployment
– The difference between the actual rate and
the natural rate
– Associated with short-run fluctuations in
output
Case Study: Supply and Demand
Shocks in the U.S. Labor Market
• Increase in the employment-population ratio
– Due in large part to increases in the number of
women working
• Supply shocks
– Changes in social norms
– Changes in technology for managing fertility
• The natural rate of unemployment includes
two components:
– Frictional unemployment
• workers being between jobs in the dynamic
economy
– Structural unemployment
• labor market failing to match up workers
and firms in the market
• Demand shocks
– Reduced discrimination against women
We distinguish between three types of unemployment
• Historically:
– Rising unemployment in the 1960s and 1970s
– Decline in unemployment in the 1980s
– Possibly explained by the baby boom
All Unemployment
1. Cyclical Unemployment
Caused by booms or
recessions like the
Great Depression
2. Frictional unemployment
Unemployment during the
normal course of hirings and
leavings, layoffs, or firings
Natural unemployment
The level that would prevail if
there were no “wiggles” —
booms or recessions
3. Structural unemployment
Unemployment resulting from the
structure of the labor market —
regulation, taxes, or government
subsidies — or other constraints
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• Actual unemployment is the sum of
frictional, structural, and cyclical
unemployment.
• Solving the model:
– Set the change in unemployment to zero
– Solve the equation for U
7.4 Bathtub Model of
Unemployment
• Bathtub model:
– Two endogenous variables: employment E
and unemployment U
– Model states how employment and
unemployment evolve over time
– Analogy: water entering and draining a
bath tub at the same rate
• The unemployment rate is defined as
the fraction of the labor force that is
unemployed. Therefore:
• Two equations:
employment
change in
unemployment
unemployment
job separation
rate
size of
labor force
job finding
rate
• Insights of the model:
– Only way to alter the natural rate of
unemployment is:
• change the job finding rate.
• change the job separation rate.
– Policies along these lines can have
unintended consequences.
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7.5 Labor Markets around the
World
• Some facts about international labor
markets since 1980:
– Unemployment in Europe
• Substantially above America’s rate
– Unemployment in Japan
• Historically below the United States.
• European unemployment has increased
dramatically because of:
– Adverse shocks and high oil prices.
– Inefficient labor market institutions in the form of
higher unemployment and welfare benefits.
• 1990s hours worked in Europe much lower
than 1970s levels.
• GDP per capita is lower in Europe. Why?
– People work less hours.
• If working less is voluntary:
– Europeans enjoy leisure more and welfare is
likely improved.
• If working less is a result of distortions in
the labor market:
– This outcome is likely not welfare enhancing.
Case Study: Efficiency of Wages and
Henry Ford’s Five-Dollar-a-Day Plan
• Ford instituted a five-dollar-a-day
minimum wage.
• The theory of efficiency wages:
– Recognizes that paying a wage greater
than the wage needed to retain a worker
may actually increase a firm’s profits.
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• Equation for present discounted value
• Paying higher wages
– Allows workers to eat healthier and become
more productive.
– Increases level of effort
– Decreases shirking
– Will attract more able workers to a firm.
7.6 How Much Is Your Human
Capital Worth?
• The present discounted value of
your lifetime income is likely greater
than $1 million.
• To calculate the value of a stream of equal
payments over a given number of years:
– Arrange the sum of each period’s present
discounted values into a geometric series.
– Use the formula for a sum of a geometric
series to calculate the present discounted
value of the stream of payments.
• If a is some number between 0 and 1, then
calculating a geometric series is:
Present Discounted Value
• Present discounted value
– The value of money you would need to put
in the bank today to equal a given future
value.
– Tells how much a future payment or a
future flow of payments is worth today.
• For example, the series for a $100 initial
payment for twenty years is:
• Or:
• From previous page: If a = 1/(1 + R), then:
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• Letting the interest rate R = .10
• What is the pdv on $100 over 20 years?
– $936.
Your Human Capital
• Example: Assume
– The average income is $63,000
– No wage growth
– An interest rate of 3 percent
– A lifetime work span of 45 years
• The pdv of this stream of payments is
1.59 million dollars.
• As wages have grown, so has the supply of
college graduates—an increase in supply should
cause wages to fall. Why hasn’t this
happened?
• The demand for college-educated workers has
increased by an amount large enough to offset
supply.
7.7 The Rising Return to
Education
• The premium to having a college degree:
– Has been rising rapidly over the last forty
years.
– Far outweighs the forgone wages and tuition
costs of going to college.
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• Explanations for a large shift in demand
for highly educated workers include:
– Skill-biased technical change: new
technologies are more effective at improving
productivity of college-educated workers.
– Globalization: increased opening of trade.
Case Study: Income Inequality
• Rising college premium is one cause of
rising income inequality
• Early 1900s
– Most inequality associated with capital
income
• Recently
– Most inequality associated with salaries
and business income
Summary
• The labor market is arguably the most
important market in an economy.
• The tools of supply and demand allow us
to understand the changes in the labor
market that have occurred in the United
States since 1950:
– Increase in the employment-population ratio
– Rising return to education
• Labor markets are often characterized by:
– Large quantities of job creation and job
destruction.
– This results in much smaller overall changes
in employment.
• In the United States:
– Most unemployed workers find new jobs
relatively quickly.
– Most unemployment is accounted for by
people out of work for long periods of time.
• Certain factors appear to play important
roles in explaining the relatively high
unemployment rates and low hours
worked in Europe.
• Examples of factors:
– Oil shocks and productivity slowdown of the
1970s
– Inefficient labor market institutions
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• Because the labor market is so important,
problems like unemployment merit serious
responses by society.
This concludes the Lecture
Slide Set for Chapter 7
Macroeconomics
Third Edition
• Designing the right safety net requires
balancing the needs for social insurance
against the disincentives associated with
the insurance.
by
Charles I. Jones
W. W. Norton & Company
Independent Publishers Since 1923
• Present discounted values help us
compare financial payments received at
different times.
• We value payments today more than
payments tomorrow.
• The rising return to a college education is
one of the key facts of the labor market.
• This college wage premium has risen from
about 50 percent in 1963 to about 90
percent by 2005.
– Wage differentials between college graduates
and high school graduates has increased.
• Possible explanations:
– skill-biased technical change
– globalization
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