The Labor Market: The Medium Run
A Medium Run Response to an Increase in Demand
 Higher production requires an increase in
employment
 Higher employment reduces unemployment
 Lower unemployment puts pressure on
wages
 Higher wages increase production costs and
therefore prices
Econ 302
The Labor Market
Slide #1
The Labor Market: The Medium Run
A Medium Run Response to an Increase in Demand
 Higher prices lead workers to ask for higher
wages….
 Prices and wages (the labor market) adjust
over the medium run and influence output
Econ 302
The Labor Market
Slide #2
The Labor Market: The Medium Run
Interpreting the Labor Force Data
Employment
93.8 million
1.0
Unemployment
6.5 million
Out of labor
force
57.3 million
0.8
Econ 302
The Labor Market
Slide #3
A Tour of the Labor Market
The Large Flow of Workers
Observations: 1. (Continued)
1. The size of the flows into and out of employment
•Half of the flows from employment are quits
•Half of the flows from employment are layoffs
Econ 302
The Labor Market
Slide #4
A Tour of the Labor Market
The Large Flow of Workers
Observations:
2. The size of the flows into and out of unemployment
in relation to the total number of unemployed
•Average monthly flow out of unemployment is
2.4 million
•1.6 million to employment
•0.8 million to out of the labor force
•Duration of unemployment is 3 months
Econ 302
The Labor Market
Slide #5
A Tour of the Labor Market
The Large Flow of Workers
Observations:
3. The size of the flows into and out of the labor
force
•Each month:
•350,000 new people enter
•200,000 retire
•The aggregate flow indicates that many people
move back and forth from participants to
non-participants
Econ 302
The Labor Market
Slide #6
A Tour of the Labor Market
Differences Across Workers
Monthly Separation Rates for Different Groups, 1968-1986
Monthly Separation Rate (%)
(Quits and Layoffs)
Category
Econ 302
Male:
Ages 16-19
35-44
15.9
1.6
Female:
Ages 16-19
35-44
16.1
5.0
The Labor Market
Slide #7
A Tour of the Labor Market
Movements in Unemployment
To Summarize:
High Unemployment:
• Increases the probability of workers losing
their jobs
•Reduces the probability of the unemployed
finding a job
• Increases the duration of unemployment
Econ 302
The Labor Market
Slide #8
A Tour of the Labor Market
Wage Determination
Two Observations:
1. Workers’ wages exceed their
reservation wage
2. Wages depend on labor-market
conditions
Econ 302
The Labor Market
Slide #9
A Tour of the Labor Market
Wage Determination
Bargaining power depends on:
1. How easily can a worker be replaced.
2. How easily a worker can find another
job.
Econ 302
The Labor Market
Slide #10
A Tour of the Labor Market
Wage Determination
Efficiency Wages:
Wages above the reservation wage that
increase productivity and reduce the
turnover rate.
Econ 302
The Labor Market
Slide #11
A Tour of the Labor Market
Wages and Unemployment
Wage determination:
W  P F (u, z )
e
(,)
W = Wage
Pe = Expected price level
u = The unemployment rate
z = Other variables that affect the wage setting
Econ 302
The Labor Market
Slide #12
A Tour of the Labor Market
Wages and Unemployment:
The expected price level, Pe & wages
W  P e F (u, z )
(,)
•Workers base their wage request on the
purchasing power of their wages or real wage W/P
•Employers base the wage they pay on the price of
the product they sell or the real wage W/P
•Therefore, if Price (P) increases, wages (W)
increase
Econ 302
The Labor Market
Slide #13
A Tour of the Labor Market
Wages and Unemployment:
The unemployment rate,
W  P e F (u, z )
u and wages
(,)
• Higher unemployment reduces bargaining power
and wages
• Higher unemployment reduces the efficiency
wage
Econ 302
The Labor Market
Slide #14
A Tour of the Labor Market
Wages and Unemployment:
The other factors (z )and wages
W  P e F (u, z )
(,)
• Unemployment insurance: higher benefits leads
to higher wages
• Structural Economic Change: wages increase
when jobs created exceed jobs destroyed
Econ 302
The Labor Market
Slide #15
A Tour of the Labor Market
Price Determination and the Production Function
Assume labor is the only input, then
Output (Y) = AN
N = Employment
A = Labor Productivity
Assume A=1
Y=N
If Y=N: then marginal cost = Wage (W)
Econ 302
The Labor Market
Slide #16
A Tour of the Labor Market
Price Determination and the Production Function
When perfect competition exists in the product market
Price (P) = Marginal Cost
Given: Marginal cost = W
Then: P=W
In non-competitive markets
P=(1+µ)W
µ= Markup of price over cost
Econ 302
The Labor Market
Slide #17
A Tour of the Labor Market
The Natural Rate of Unemployment
The wage-setting relation
Assume: Pe = P
W=PF(u,z) and dividing by P
W
 F (u , z )
P
( ,  )
The higher the unemployment rate (u), the lower
the rate wage W
P
Econ 302
The Labor Market
Slide #18
A Tour of the Labor Market
The Natural Rate of Unemployment
W
 F (u , z )
P
( ,  )
Real Wage, W/P
The wage-setting relation:
Wage-setting relation
(W/P varies inversely with u)
WS
Unemployment Rate, u
Econ 302
The Labor Market
Slide #19
A Tour of the Labor Market
The Natural Rate of Unemployment
The Price-setting relation:
W
1

Recall:
P 1 μ
Observe: • If markup (µ) increases
• Price (P) increases, given wages (W)
• Real wage falls
• Price setting a function of markup (µ)
Econ 302
The Labor Market
Slide #20
A Tour of the Labor Market
The Natural Rate of Unemployment
The Price-setting relation:
W
1

P 1 
Real Wage, W/P
Price-setting relation
(W/P is independent of u)
1
1 
PS
Unemployment Rate, u
Econ 302
The Labor Market
Slide #21
A Tour of the Labor Market
The Natural Rate of Unemployment
Equilibrium Real Wages, Employment and Unemployment
Labor Market Equilibrium
Real Wage, W/P
Wage-setting, F(u, Z) =
Price-setting, 1 1
1
1 
A
PS
WS
un – The natural rate of unemployment
Unemployment Rate, u
Econ 302
The Labor Market
Slide #22
A Tour of the Labor Market
The Natural Rate of Unemployment
Real Wage, W/P
Is the natural rate of unemployment “natural”?
Scenario: Increase unemployment benefits (z increases)
1
1 
A
B
PS
WS´ = F(u, Z´)
WS = F(u, Z)
un
u n´
Unemployment Rate, u
The increase in Z increases un
Econ 302
The Labor Market
Slide #23
A Tour of the Labor Market
The Natural Rate of Unemployment
Real Wage, W/P
Scenario: More stringent antitrust legislation (µ decreases)
1
1  ´
PS´
1
1 
PS
WS = F(u, Z)
un
u n´
Unemployment Rate, u
The decrease in u reduces un
Econ 302
The Labor Market
Slide #24
A Tour of the Labor Market
The Natural Rate of Unemployment
From Unemployment to Output
The Natural Level of Employment
U = unemployment
N = employment
L = labor force
u = unemployment rate
U LN
N
u 
 1
L
L
L
Rearranging for N: N=L(1-u)
Econ 302
The Labor Market
Slide #25
A Tour of the Labor Market
The Natural Rate of Unemployment
From Unemployment to Output
The Natural Level of Employment
N=L(1-u)
un = natural rate of unemployment
Nn = natural level of employment
Nn = L(1-un)
Econ 302
The Labor Market
Slide #26
A Tour of the Labor Market
From Unemployment to Output
The Natural Level of Output
Assuming the
Production
Function:
Econ 302
Y=N
Yn = Nn = L(1-un)
The Labor Market
Slide #27
A Tour of the Labor Market
From Unemployment to Output
Equilibrium Unemployment Rate:
Natural level of output:
1
F (un , z ) 
1 
(Yn )  L(1  un )
Yn
1
F (1  , z ) 
L
1 
Econ 302
The Labor Market
Slide #28
A Tour of the Labor Market
Equilibrium Real Wages, Employment, and Unemployment
At Yn the associated
1
un 
Yn / L
and the real wage chosen in wage setting
equals the real wage implied by price setting.
Econ 302
The Labor Market
Slide #29
A Tour of the Labor Market
A Summary
Assume: The expected price = actual price level
Then:
• Wage setting implies the real wage is inversely
related to unemployment
•The price setting real wage is constant
•Labor market equilibrium occurs when W/P
wage setting = W/P price setting
•Labor market equilibrium determines the
unemployment rate – the natural rate of
unemployment
Econ 302
The Labor Market
Slide #30
A Tour of the Labor Market
Where We Go From Here
Recall: • Labor market equilibrium determines the
natural level of unemployment which
determines the natural level of output
Observe: • Monetary policy, fiscal policy, consumer
confidence does not impact the natural level
of unemployment and output
Econ 302
The Labor Market
Slide #31
A Tour of the Labor Market
Where We Go From Here
The Appropriate Time Frame
Short-Run • Price level may not equal the expected price
• Unemployment may equal natural
unemployment level
• Output may equal natural output
MediumTerm
• Price level tends to equal expected prices
•Unemployment tends to the natural rate
•Output moves toward the natural rate
Econ 302
The Labor Market
Slide #32