Download Chapter 6: The Medium Run

CHAPTER
6
The Labor Market
Prepared by:
Fernando Quijano and Yvonn Quijano
And Modified by Gabriel Martinez
What’s the point of this chapter?
 The Aggregate Supply curve is a relation
between production and the price level.
 Production happens because firms hire
workers (among other things).
 The real cost of hiring workers is the real
wage.
 Higher price levels reduce the real wage.
 Lower real wages cause firms to hire more
workers and increase production.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
What’s the point of this chapter?
Cont.
 Two complications:
– Workers want purchasing power in return for
their work.
 Since they sign contracts to work in the future, they
care about the future price level.
 Price level expectations may move more slowly than
the actual price level.
– Workers’ effort (which is difficult to monitor) and
their bargaining power depends on the
unemployment rate.
 And on unemployment benefits, etc.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
6-1
A Tour of the Labor
Market
 The noninstitutional civilian population are the
number of people potentially available for civilian
employment.
 The civilian labor force is the sum of those either
working or looking for work.
 Those who are neither working nor looking for
work are out of the labor force.
 The participation rate is the ratio of the labor
force to the noninstitutional civilian population.
 The unemployment rate is the ratio of the
unemployed to the labor force.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
A Tour of the Labor Market
Population, Labor
Force,
Employment, and
Unemployment in
the United States
(in millions), 2000
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Large Flows of Workers
 An unemployment rate may reflect two very
different realities:
– A a labor market with many separations and
many hires,
– A labor market, with few separations, few hires,
and a stagnant unemployment pool.
 What is worse? To lose your job and get a new one
12 times a year? Or to be unemployed for 6
months?
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Large Flows of Workers
Average Monthly Flows
Between Employment,
Unemployment, and
Nonparticipation in the United
States, 1994-1999
(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.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Large Flows of Workers
From the CPS data we conclude that:
1. The flows of workers in and out of
employment are large.
Separations consist of:


Quits, or workers leaving their jobs for a better
alternative, and
Layoffs, which come from changes in
employment levels across firms.
 The Current Population Survey (CPS) produces employment
data, including the movements of workers.
© 2003 Prentice Hall Business Publishing
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Olivier Blanchard
The Large Flows of Workers
From the CPS data we conclude that:
2. The flows in and out of unemployment are
large in relation to the number of
unemployed.

The average duration of unemployment is
about three months.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Large Flows of Workers
From the CPS data we conclude that:
3. There are large flows in and out of the labor
force, much of them directly to and from
employment.


Discouraged workers are classified as “out of
the labor force,” but they may take a job if they
find it.
The nonemployment rate is the ratio of
population minus employment to population.
 Because it includes the discouraged, it might
be a better measure of unemployment.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
6-2
Movements in
Unemployment
 Fluctuations in the aggregate unemployment
rate affect:
– The welfare of individual workers
– Wages
 Higher unemployment affects workers:
 Through a decrease in hires—more difficult to find
jobs.
 Through higher layoffs—higher risk of losing their
jobs.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Movements in Unemployment
Movements in the
U.S.
Unemployment
Rate, 1948-2000
Since 1948, the
average yearly
U.S.
unemployment
rate has
fluctuated
between 3 and
10%.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Movements in Unemployment
The Unemployment
Rate and the
Proportion
of Unemployed
Finding Jobs, 19681999
When
unemployment
is high, the
proportion of
unemployed
finding jobs is
low.
Note, the scale on the right is an inverse scale.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Movements in Unemployment
The Unemployment
Rate and the
Monthly Separation
Rate from
Employment, 19681999
When
unemployment is
high, a higher
proportion of
workers lose their
jobs.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
6-3
Wage Determination
 Collective bargaining is bargaining between
firms and unions.
– The result depends on each side’s bargaining power,
which in turn depends on each side’s opportunity cost
of not making the deal. For example:
 The skills of the worker compared to the skills required for
the job;
 The current and expected unemployment rates;
 Going wages, social norms and laws regarding hiring and
firing.
 Etc.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Wage Determination
 Common forces at work in the
determination of wages:
– Wages are typically higher than the
reservation wage, that is, the wage that make
them indifferent between working or becoming
unemployed.
 “I won’t work unless you pay me more than $7 an
hour.”
– Labor-market conditions.
© 2003 Prentice Hall Business Publishing
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Olivier Blanchard
Bargaining
 How much bargaining power a worker
has depends on:
1. How costly it would be for the firm to replace
him—the nature of the job.
2. How hard it would be for him to find another
job—labor market conditions.
It’s important to realize that, generally speaking,
low-income workers have less bargaining
power than potential employers.
© 2003 Prentice Hall Business Publishing
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Olivier Blanchard
Efficiency Wages
 Should we pay you as low a wage as you’ll
take?
 If we do, we might lose you and we’ll have
to train someone else.
– When unemployment is high, a higher
proportion of workers lose their jobs.
© 2003 Prentice Hall Business Publishing
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Olivier Blanchard
Efficiency Wages
 Efficiency wage theories are theories that
link the productivity or the efficiency of
workers to the wage they are paid.
– These theories also suggest that wages depend
on both the nature of the job and on labormarket conditions.
– Efficiency wages are typically higher than
market-clearing wages: unemployment will
result.
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Olivier Blanchard
Wages, Prices, and
Unemployment
W  P e F (u, z)
(  , )
 The aggregate nominal wage, W,
depends on three factors:
1. The expected price level, Pe
2. The unemployment rate, u
3. A catchall variable, z, that catches all
other variables that may affect the
outcome of wage setting.
© 2003 Prentice Hall Business Publishing
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Olivier Blanchard
Wages, Prices, and
Unemployment
1. Both workers and firms care about real wages
(W/P), not nominal wages (W).
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.
© 2003 Prentice Hall Business Publishing
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Olivier Blanchard
Wages, Prices, and
Unemployment
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?
© 2003 Prentice Hall Business Publishing
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Olivier Blanchard
Wages, Prices, and
Unemployment
2. Higher unemployment weakens workers’
bargaining power, forcing them to accept
lower 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?
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Wages, Prices, and
Unemployment
W  P e F (u, z )

If we divide this equation by P, we obtain
W Pe

F (u, z )
P
P


This allows us to draw a relation between the
real wage W/P and unemployment u.
This relation has to be downward sloping
because higher unemployment makes
workers weaker on the negotiating table.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Wages and Unemployment
W
P
Higher
unemployment
reduces the
bargaining power
of workers and
encourages them
to accept lower
real wages.
u
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Wages, Prices, and
Unemployment
3. Among other factors that affect wages is
unemployment insurance—the payment of
unemployment benefits to workers who lose
their jobs. Higher unemployment insurance
allows workers to hold out for higher wages.
Minimum wages and employment protection
are other factors.
Suppose the government pays you $150,000 a year
in unemployment insurance. Do you care if
you lose your job?
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Wages, Unemployment, and
Unemployment Benefits
W
P
Higher unemployment
benefits reduces the
opportunity cost of
unemployment,
encouraging workers to ask
for higher wages at the
given unemployment rate.
u
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Wages, Prices, and
Unemployment
W Pe

F (u, z )
P
P
4. It’s obvious that a change in price expectations
will change 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.
© 2003 Prentice Hall Business Publishing
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Olivier Blanchard
Wages, Unemployment, and
Unemployment Benefits
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.
u
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
6-4
Price Determination
 The production function is the relation between
the inputs used in production and the quantity of
output produced.
 Assuming that firms produce goods using only
labor, the production function can be written as:
Y = output
Y  AN
N = employment
A = labor productivity, or output per worker
 Further, assuming that one worker produces one unit
of output—so that A = 1, then, the production function
becomes:
Y N
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Price Determination
 If the production function is
Y N
then there are no fixed costs
and the only variable cost is the wage rate.
 Then what is the cost of an additional unit of
output?
W
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Olivier Blanchard
Price Determination
 If the cost of an additional unit of output is
W, then W is firms’ marginal cost.
– In perfect competition, P = W.
 If a firm charges more than marginal cost, consumers
just go to one of a million competitors.
– In imperfect competition, P > W
 Firms can charge more than marginal cost because
there are few other firms selling a product that is
similar enough.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Price Determination
 Firms set their price according to:
P  (1  m)W
 The term m is the markup of the price over
the cost of production.
– 1+m is the difference between the marginal cost
of labor (W) and the price (P).
© 2003 Prentice Hall Business Publishing
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Price Determination
P  (1  m)W
 1+m is the difference between the marginal cost of
labor (W) and the price (P).
 If markets are imperfectly competitive,
m > 0, and P > W.
P
P
MC
MC
D
MR
D=MR
Q
Q
 If all markets were perfectly competitive, m = 0,
and P = W.
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Price Determination
P  (1  m)W
 What determines m?
– The market power of firms in the product market
(firms may sell differentiated products or they
may be oligopolists).
© 2003 Prentice Hall Business Publishing
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Price Determination
P  (1  m)W
 What determines m?
– The market power of firms probably increases when the
economy is doing well.
 It’s easier to sell and to raise prices (at any given wage) when
unemployment is low  the real wage falls.
– The market power of firms probably decreases when the
economy does poorly
 Discounts, price cuts, and “incentives” become larger (at any
given wage) when unemployment is high  the real wage rises.
© 2003 Prentice Hall Business Publishing
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Olivier Blanchard
Price Determination
W
P  (1  m)W
P
W
1

P 1 m
Higher
unemployment
means lower
prices for a given
wage (or higher
real wages).
1
1+m
u
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
6-5
The Natural Rate
of Unemployment
 Wage setting and price setting determine the
equilibrium rate of unemployment.
 Define the medium run as the period of time when
price expectations are fulfilled; or when people
have adjusted their expectations to reality.
 Therefore we assume that Pe = P, so that this
equation W P e
becomes this equation.
P

P
© 2003 Prentice Hall Business Publishing
F (u, z )
W
 F (u , z )
P
Macroeconomics, 3/e
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The Wage-Setting Relation
 Earlier, we stated that the nominal wage rate
was determined as follows:
W Pe

F (u, z )
P
P
 Now, since Pe = P,
W
 F ( u, z )
P
(  , )
© 2003 Prentice Hall Business Publishing
The wage-setting
relation:
Workers and firms set real
wages depending on
unemployment and other things.
Macroeconomics, 3/e
Olivier Blanchard
Wages and Unemployment
W
P
Higher
unemployment
reduces the
bargaining power
of workers and
encourages them
to accept lower
real wages.
u
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Price-Setting Relation
 The price-determination equation is:
P  (1  m)W
 If we divide both sides by W, we get:
P
 1 m
W
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The Price-Setting Relation
P
 1 m
W
 To state this equation in terms of the wage
rate, we invert both sides:
W
1

P 1 m
© 2003 Prentice Hall Business Publishing
The price-setting
relation:
Firms set prices (at given
nominal wages) depending
on their degree of monopoly
power.
Macroeconomics, 3/e
Olivier Blanchard
Price Determination
W
P  (1  m)W
P
W
1

P 1 m
Higher
unemployment
means lower
prices for a given
wage (or higher
real wages).
1
1+m
u
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Wages and Unemployment
PS relation:
Higher
unemployment
means lower
prices for a given
wage (or higher
real wages).
W
P
WS relation: Higher
unemployment
reduces the
bargaining power of
workers and
encourages them to
accept lower real
wages.
u
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Wages and Unemployment
W
P
Greater monopoly power allows
firms to increase the difference
between W and P, at any u,
reducing W / P.
PS relation:
High u lowers
prices and raises
W/P.
WS relation: High u
weakens workers
and lowers real
wages.
u
© 2003 Prentice Hall Business Publishing
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Olivier Blanchard
Price Determination
P  (1  m)W
 For simplicity we’ll assume m > 0.
– Assume m doesn’t depend on unemployment,
but that it does depend on structural
characteristics such as anti-Trust enforcement.
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Price Determination
W
P  (1  m)W
P
W
1

P 1 m
Unemployment
doesn’t affect
how firms set
prices or wages.
1
1+m
u
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Price Determination
W
P
W
1

P 1 m
Greater monopoly power
increases the difference
between W and P,
reducing W / P.
1
1+m
1
1+m’
u
© 2003 Prentice Hall Business Publishing
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Olivier Blanchard
Wage-Setting and Price-Setting
The Wage-Setting Relation,
the Price-Setting Relation,
and the Natural Rate of
Unemployment
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.
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Equilibrium Real Wages
and Unemployment
The Wage-Setting Relation, the
Price-Setting Relation, and the
Natural Rate of 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.
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Equilibrium Real Wages
and Unemployment
 We can solve the Wage-Setting / Price-Setting
model for the equilibrium unemployment rate, or
natural rate of unemployment, un.
 Eliminating W/P from the wage-setting and the
price-setting relations:
1
F (unn , z ) 
1 m
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Equilibrium Real Wages
and Unemployment
The equilibrium
unemployment rate, or
natural rate of
unemployment, un
1
F (un , z ) 
1 m
un depends on: the shape of
the function F;
on unemployment benefits;
on the degree of market power of firms…
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Equilibrium Real Wages
and Unemployment
Unemployment Benefits
and the Natural Rate of
Unemployment
An increase in
unemployment
benefits leads to an
increase in the natural
rate of
unemployment.
© 2003 Prentice Hall Business Publishing
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Equilibrium Real Wages
and Unemployment
Markups and the Natural
Rate of Unemployment
An increase in
markups decreases
the real wage, and
leads to an increase
in the natural rate of
unemployment.
Monopolists produce less
than perfect competitors: then
fewer people are hired.
© 2003 Prentice Hall Business Publishing
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Actual Unemployment versus
Natural 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.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Movements in Unemployment
Movements in the
U.S.
Unemployment
Rate, 1948-2000
Labor hoarding
causes
unemployment to
rises slowly after
the recession
begins, and to
stay high even
after the
recession ends.
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Actual Unemployment versus
Natural Unemployment
 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.
© 2003 Prentice Hall Business Publishing
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Actual Unemployment versus
Natural Unemployment
 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, until
W/P = 1/(1+m).
– The actual rate of unemployment will be higher
than the natural rate of unemployment, u>un.
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Actual Unemployment versus
Natural Unemployment
Expected Prices and the
Actual Rate of
Unemployment
 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.
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The Structural Rate of
Unemployment
 Because the equilibrium rate of unemployment
reflects the structure of the economy, a better
name for the natural rate of unemployment is the
structural rate of unemployment.
– I.e., it depends on institutions and behavior:
 Unemployment benefits;
 People’s reactions to being unemployed;
 Industrial organization;
 Other factors.
© 2003 Prentice Hall Business Publishing
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What next?
 This is all very nice, but what’s the
connection with Aggregate Supply?
– Wage-setting and price-setting determine the
economy’s actual level of unemployment and
the natural level of unemployment.
– The level of unemployment implies the level of
employment.
– The level of employment implies output.
© 2003 Prentice Hall Business Publishing
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Olivier Blanchard
From Unemployment to
Employment
 The natural rate of unemployment  a natural
level of employment.
U L N
N
u

 1
L
L
L
The
unemploymen
t rate
 Employment in terms of the labor force and the
unemployment rate equals:
The level of
N  L(1  u)
employment
 The natural level of employment, Nn, is given by:
N n  L(1  un )
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The natural
level of
employment
Olivier Blanchard
From Employment to Output
 A natural level of employment  a natural level of
output, (and since Y=N, then,)
Yn  N n  L(1  un )
Employment
 output
 The natural level of output satisfies the following:
Y
1  n  un
L
1
 Yn 
F 1  , z  
L  1 m

The structure
of the
economy  Yn
 In words, the natural level of output is such that,
at the associated rate of unemployment, un  1 
Yn
,
L
the real wage chosen in wage setting is equal to
the real wage implied by price setting.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard