The Labour Market
Lecture 23 – academic year 2014/15
Introduction 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?
What do we do today
• 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
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
Demand and supply of labour
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
SL
E
WE
DL
NE
N° workers
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
W
SL
E
DL
NE
N° workers
Demand and supply of labour
In real economies, however, there is unemployment
To explain the existence of unempl. -> WS-PS model
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
Construction of the WS-PS model
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
 F(u, z )
P
W/P represent the wage relative to the level of
prices, i.e. the “real wage”
Construction of the WS-PS model
Let’s draw the equation
W
 F(u, z )
P
in a (W/P, u) diagram
F is decreasing in u -> the curve WS is decreasing
W/P
WS
u
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+m)
where 0<m<1 is m the so-called mark-up.
Important: m is a % of “refill” on costs
For instance, if m 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+m)
P = W(1+m) -> “Price setting” equation
Important: the dimension of mark up depends on the
degree of competition among firms
In particular:
• competition among firms -> m
•In the limit, perfect competition implies m  0 and
P=W
Construction of the WS-PS model
Let’s go back to equation PS -> P = W(1+m)
After some algebraic passages we obtain
P
= 1+ m
W
->
W
1
=
P 1+ m
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
PS
u
The equilibrium in the labour market
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
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
W/P
E
1
1+ m
PS
WS
un
u
The determinants of unemployment
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)
Let’s start from E and
competition ->
downward
Effects: E -> E’ and
in competition
mark up m ->
1
1+ m
-> PS shifts
un
W/P
1
1+ m
E
PS
E’
1
1 + m'
PS’
WS
un
un’
u
Let’s start from E and
subsidies ->
Effects: E -> E’ and
subsidies
z ->
F(u,z) -> WS shifts upward
un
W/P
E
1
1+ m
E’
PS
WS’
WS
un
un’
u
The determinants of unemployment
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”