Finals Period- Advanced Macroeconomics lecture number 1
Atty. Roentgen Jude Paolo L. Ignacio
THE MEDIUM RUN
Firms respond to an increase in demand by increasing production. The following events will then
occur:
1. Higher production will lead to higher employment
2. Higher employment leads to lower unemployment
3. Lower unemployment leads to higher wages
4. Higher wages increase production costs, leading firms to increase prices
5. Higher prices lead workers to ask for higher wages
6. Higher wages lead to further increases in prices and so on
When we studied our short run models, this event was taken for granted. The effect of our
assumption that demand determines output is that we assumed a constant price level. In effect we
assumed that firms were able and willing to supply any amount of output at a given price level.
Since we are now in the medium run, we will now abandon this assumption. We now begin to
explore how prices and wages adjust overtime and explore how this affects out put
The Labor Market
Non institutional civilian population- those who ARE NOT:
1. Under the working age (15 years of age)
2. In the armed forces
3. Behind bars or
4. Members of religious institutions
Civilian Labor force- the sum of those either working or looking for work
Out of the labor force- those neither working nor looking for work
Participation Rate- ratio of the labor force to the non-institutional civilian population
Unemployment Rate- ratio of the unemployed to the labor force
The unemployment rate is closely associated with recessions and expansions:
 When there is a recession, unemployment rate increases
 When there is an expansion, unemployment rate goes down
How firms decrease employment in response to decrease in demand:
 They can hire fewer workers, or they can lay off the workers they currently employ
 Typically, firms prefer to slow or stop the hiring of new workers first, relying on quits or
retirements to achieve a decrease in employment

But doing only the prior mentioned, may not be enough if the decrease in demand is
large, so in effect firms may then have to lay off workers.
The Following are then the implications for both employed an unemployed workers:
 If the adjustment takes place through fewer hires, the chance that an unemployed worker
will find a job diminishes
o Fewer hires means fewer job openings; higher unemployment means more job
applicants
o Fewer openings and more applicants combine to make it harder for unemployed
to find jobs
 If the adjustment takes place instead through higher layoffs, then employed workers are
at greater risk of losing their jobs
What happens in reality is that, generally firms do both, higher unemployment is associated with
both a lower chance of finding a job if a person is unemployed and a higher chance of losing it if
a person is already employed.
The following are then the effects of high unemployment that makes workers worse off:
1. Employed workers face a higher probability of losing their jobs
2. Unemployed workers face a lower probability of finding a job; equivalently, they can
expect to remain unemployed for a longer time
Wage Determination
This is mostly determined in 2 ways:
1. Collective bargaining- bargaining between firms and unions
2. As set by employers or bargaining between the employer and individual employees
The higher the skills needed to do the job, the more likely there is to be bargaining. An example
of this is that players and CEOs can negotiate a lot more of their wages than those employed as
service crew in McDonalds.
The culture on wage determination differs across countries, collective bargaining plays a huge
role in Japan and most European countries.
There are however common forces at work among countries:
1. Workers are typically paid a wage that exceeds their reservation wage, the wage that
would make them indifferent between working or being unemployed. In other words,
most workers are paid high enough wage that they prefer being employed to being
unemployed
2. Wages typically depend on market conditions. The lower the unemployment rate the
higher the wages.
In relation to these factors, economists have focused on 2 broad lines of explanation
1. In the absence of collective bargaining, workers have some form bargaining power,
which they can and do use to obtain wages above their reservation wages.
2. Firms themselves may for a number of reasons, want to pay wages higher than their
reservation wage.
Bargaining
How much bargaining power a worker has depends on 2 factors:
1. How costly it would be for the firm to replace him, were he to leave the firm
2. How hard would it be for him to find another job were he to leave the firm.
This means that the more costly it is for the firm to replace the worker and the easier it is for
him to find another job, the more bargaining power he will have. This has 2 implications:
1. How much bargaining power a worker has depends on the nature of the job
a. When a worker is easily replaced and the required skills for the job can be taught
easily, typically many applicants can easily apply for the job.
b. In this case if that worker asks for a higher wage, the firm can lay him off and
find replacement at minimum cost.
2. How much bargaining power a worker has also depends on labor market conditions.
a. When the unemployment rate is low, it is more difficult for firms to find
acceptable replacement workers and at the same time, workers can easily find
other jobs.
b. In the above condition, workers have a stronger bargaining position and may be
able to obtain a higher wage.
Efficiency Wages
Regardless of workers’ bargaining power, firms may want to pay more than the reservation
wage. The goal is to incentivize workers to be productive.
Paying a wage above the reservation wage makes it financially attractive for workers to stay. It
decreases turnover and increases productivity.
Efficiency wage theories- theories that link productivity or the effectivity of workers to the wage
they are paid.
These theories suggest that wages depend on both the nature of the job and on labor market
conditions:
 Firms such as high tech firms- that see employee morale and commitment as essential to
the quality of their work will pay more than firms in sectors where workers’ activities are
more routine
 Labor market conditions will affect the wage