Download Chapter 6. The Labor Market

CHAPTER 6. THE LABOR MARKET
I.
MOTIVATING QUESTION
How Is the Unemployment Rate Determined in the Medium Run?
In the medium run, the unemployment rate tends to return to the so-called natural rate, determined by
equilibrium in the labor market when the expected price level equals the actual price level. Conditional
on price level expectations, equilibrium in the labor market occurs when the real wage implied by wagesetting behavior (influenced by the relative bargaining power of workers and firms) equals the real wage
implied by price-setting behavior (influenced by the degree of competition in the goods market).
II.
WHY THE ANSWER MATTERS
The analytical framework in the text is built around equilibrium in three markets: goods, financial, and
labor. Following the approach of Chapters 3 and 4, this chapter begins the discussion of the labor market
by considering it in isolation. The assumption that isolates the labor market from the other markets is
that the expected price level equals the actual price level. In these circumstances, the framework
presented in the book produces an equilibrium rate of unemployment and an equilibrium real wage,
independent of the goods and financial markets. Unlike the other markets, however, the labor market
considered in isolation is relevant not to the short run but to the medium run, a time frame over which it
is reasonable to assume that price expectations are, on average, correct. The task of Chapter 7, which
discusses aggregate demand and aggregate supply, is to unite all three markets in general equilibrium, in
both the short and medium run, and to consider the transition from the short run to the medium run.
III. KEY TOOLS, CONCEPTS, AND ASSUMPTIONS
1.
Tools and Concepts
i.
The chapter reviews the definition of key labor market terms introduced in Chapter 2 and
introduces several new ones, including the nonemployment rate, discouraged workers, separations,
layoffs, and quits.
ii.
The chapter makes use of a production function.
iii.
The chapter introduces wage-setting and price-setting relations.
iv. The chapter defines analytically the natural rate of unemployment and the natural level of
output.
v.
The chapter introduces the concept of an expected price level, the first expectation seen in the
book.
2.
Assumptions
i.
The chapter assumes that labor is the only factor of production.
assumption until Chapter 10, which introduces growth.
The text maintains this
ii.
The chapter assumes a constant returns to scale production function. This implies that, given fixed
technology, the real wage is constant.
27
IV. SUMMARY OF THE MATERIAL
1.
A Tour of the Labor Market
The chapter begins by describing the U.S. labor market. The most important point is the discussion of
flows in the labor market between the three states of labor market activity: employed, unemployed, and
out of the labor force. The chapter notes that flows from the group not in the labor market into
employment suggest that some individuals classified as not in the labor force may, in fact, be discouraged
workers, i.e., people who have given up looking for work, but who would take work if it was offered.
2.
Movements in Unemployment
The chapter develops four facts about the U.S. unemployment rate. First, after World War II, there was
an upward trend in the unemployment rate until the mid-1980s; since then, the unemployment rate has
declined. Second, year-to-year fluctuations in the unemployment rate are associated with recessions and
expansions. Third, when the unemployment rate is high, the proportion of unemployed workers finding
jobs is low. Finally, when the unemployment rate is high, the proportion of employed workers losing
their jobs is high.1
3.
Wage Determination
The text offers considers wage determination from two perspectives: bargaining and efficiency wages.
Wage bargaining between employers and employees takes many different forms. In some occupations,
wages are determined by collective bargaining between unions and firms. In the United States, less than
15% of workers are covered by collective bargaining agreements. Highly or uniquely skilled workers
(e.g., athletes, entertainers) engage in individual bargaining with their employers. For jobs that require
little skill, employers may make take-it-or-leave-it wage offers.
Efficiency wage theories are motivated by the idea that labor productivity is related to the wage. Paying
a high wage may improve employee morale. A high wage may reduce turnover, which can be
advantageous to the firm as the costs of advertising, screening, hiring and traning new workers are
expensive. From this perspective, firms have an incentive to offer a wage above the reservation wage.
(The reservation wage is the wage at which a worker is indifferent between working or becoming
unemployed.)
The text summarizes the complex wage determination process by focusing on two factors. First, wage
outcomes depend on labor market conditions, which can be proxied by the unemployment rate (u). When
the unemployment rate is high, it is relatively easier for firms to replace workers and harder for workers
to find new jobs, so worker bargaining power is relatively low. In addition, workers will be highly
motivated to work and will be unlikely to quit, so firms have less incentive to pay a wage above the
reservation wage. Second, given the unemployment rate, there are institutional and structural factors
(summarized by the variable z) that affect the bargaining power of workers relative to employers. These
factors include, among other things, the generosity of unemployment insurance and the level of the
minimum wage.
The text provides evidence about job separations, which include quits as well layoffs. However, a note argues that
quits are lower when the unemployment rate is high – as we would expect from theory – so that layoffs actually
increase by more than separations when the unemployment rate is high.
1
28
These points suggest an aggregate wage determination equation of the following form:
W=PeF(u, z).
- +
(6.1)
The nominal wage depends on the price level, because both workers and firms care about the real wage.
However, wages are changed infrequently, so the price level that matters is the one that prevails over the
duration of the contract. Since this future price level is unknown, wage determination depends on the
expected price level.
4.
Price Determination
Assume that labor is the only factor of production and that firms operate under constant returns to scale.
Then, the production function takes the form
Y=N.
(6.2)
Since the text assumes that technology is fixed in the medium run, equation 6.2 sets the marginal
productivity of labor to one.
Now assume that the goods market is imperfectly competitive, so firms have some market power. This
implies that firms will set price according to
P=(1+)W.
(6.3)
W, the wage, is the marginal cost of output and  is a markup reflecting the degree of market power
possessed by firms. In a perfectly competitive environment,  =0.
5.
The Natural Rate of Unemployment
If price expectations are correct (i.e., P=Pe), equations (6.1) and (6.3) yield two different expressions for
the real wage:
W/P=F(u,z)
(6.1')
W/P=1/(1+).
(6.3')
The text refers to the first of these equations as the wage-setting relation (WS) and to the second as the
price-setting relation (PS). Conditional on P=Pe, labor market equilibrium requires that the real wage
implied by WS equal the real wage implied by PS, or
F(u,z)=1/(1+).
(6.4)
The value of u that satisfies equation (6.4) is called the natural rate of unemployment. The graphical
solution is given in Figure 6.1. Note that WS slopes down, since an increase in the unemployment rate
tends to reduce the relative power of workers in wage bargaining. The PS curve is flat as a result of the
assumption of constant returns to scale in the production function. If the production function exhibited
decreasing returns to scale, the price-setting relation would be upward sloping.
The natural rate of unemployment is the rate of unemployment that makes WS and PS consistent when
P=Pe. It is a medium-run concept, for two reasons. First, prices can adjust over the medium run.
Second, in the absence of economic disturbances, it is unreasonable to assume that workers and firms
29
will continually hold incorrect price expectations. Eventually, workers and firms will learn from past
experience in forming price expectations. In the short run, there is no presumption that P=Pe, so the
actual unemployment rate need not equal the natural rate of unemployment.
Figure 6.1: The Natural Rate of Unemployment
Moreover, the adjective natural is misleading. The natural rate of unemployment depends on labor
market institutions and market structure. For example, an increase in competition in the goods market (a
decrease in ) would shift the PS line up and reduce the natural rate of unemployment. An increase in
the z index—say, because of an increase in unemployment benefits—would shift the WS curve up and
increase the natural rate of unemployment.
Note that employment N is given by N=(1-u)L, where L is the labor force. Assuming that L is fixed, the
natural rate of unemployment (un) defines a natural level of employment Nn=(1-un)L, which implies a
natural level of output Yn= Nn. The natural level of output is the level of output that would prevail if
price expectations were correct. Like the natural rate of unemployment, the natural level of output is a
medium-run concept. In the short run, the actual price level can differ from the expected price level, the
actual unemployment rate can differ from the natural rate, and the actual level of output can differ from
the natural level of output.
6.
Where We Go from Here
This chapter discusses the determination of the unemployment rate and output in the medium run, when
it is reasonable to assume that the price level equals the expected price level. In the short run, when the
expected price level need not equal the actual price level, the demand factors discussed in the previous
chapters affect the unemployment rate. The next three chapters incorporate the labor market into the
model developed in the previous chapters and analyze the determination of output, the unemployment
rate, and the interest rate in the short and medium run.
V. PEDAGOGY
30
1.
Points of Clarification
The introduction of the expected price level, even in the simple fashion of the text, is a big jump for
students. The text quickly removes the expected price level from discussion by equating it with the
actual price level. As a result, students begin to think of the wage-setting and price-setting diagram as
the method to determine unemployment at any time. Instructors should stress that the natural rate is a
medium-run concept and that there is no presumption that the price level equals the expected price level,
or that the unemployment rate equals the natural rate, in the short run.
VI. EXTENSIONS
1.
The Concept of the Medium Run
It may be worthwhile to reexamine the concept of the medium run in this chapter.
Typically,
disturbances are analyzed in the text as follows. Assume the economy begins in a medium-run
equilibrium. Now consider an economic disturbance. The new medium-run equilibrium describes a
point to which the economy will tend to return in the absence of further disturbances. The new short-run
equilibrium describes the immediate effect of the disturbance. This chapter describes the effects of
disturbances on the unemployment rate and output in the medium run. Chapter 7 describes the short-run
effects of economic disturbances and the transition from the short-run to the medium-run equilibrium. In
the process, Chapter 7 describes the adjustment of prices over the medium run. In the real world, the
economy is always experiencing some short-run shock and responding to previous shocks, so it is rarely
in medium-run equilibrium. The medium-run concept is an analytical tool.
2. Additional Examples
Additional examples are presented in boxes in later chapters on the labor market. Some of these
examples could be introduced here. In Chapter 8, which examines the Phillips curve, boxes
examine the Japanese unemployment rate and changes in the U.S. natural rate over time.
Although these examples fit naturally into a discussion of the history of the Phillips curve,
instructors could use these examples in this chapter to reinforce the idea the natural rate of
unemployment actually depends on structural factors that can change. In Chapter 13, a box
discusses European unemployment. Instructors could also introduce this example in this
chapter, but with care, since the discussion of European unemployment is related to
technological change, the topic of Chapter 13.
VII. OBSERVATIONS
The real wage is unaffected by the business cycle in the model of this chapter. Given the labor only,
constant returns to scale production function, the real wage is always determined by the price-setting
relation, regardless of whether P=Pe. Thus, the real wage is always determined by the degree of
competition in product markets and the marginal product of labor (set equal to one in this chapter).
Assuming that market structure changes relatively slowly, the implication of this model is that the real
wage changes only when labor productivity changes.
31