The WS-PS model of the
labour market
The Macro approach to the
Labour market
The WS-PS model of the Labour market


IS-LM model examines 2 markets : the
goods market and the money market
This allows us to determine 2 variables:



The equilibrium Output
The equilibrium rate of interest
But we’ve assumed that prices stay fixed!!


This might be OK in the short run
But is otherwise unrealistic
The WS-PS model of the Labour market

Problem: We want to determine prices
(inflation) as well as output and interest
rates


How do we do that?
We have to add another market (i.e. Another
equilibrium equation)


It turns out that the required market is the
labour market
This is because it is the market for the main
factor of production
The WS-PS model of the Labour market
Definitions
The Wage-Setting equation
The Price-Setting equation
The structural rate of unemployment
Definitions

Employed population (ILO definition)
1.
People that are at least 15 years of age;
2.
People that have worked (even for a single hour)
during the reference period even if self employed,
or employed in a family business;
3.
People that are employed but on temporary leave of
absence (illness, maternity leave, training, etc.);
4.
Members of the armed forces, apprentices, paid
interns, are part of the active population.
Definitions
Economically Active population in France (ILO
definition, 2004)
Employed
population
Not
25 146.5; 41%
Economically
active
population
33 799,2
55%
Unemployed
2 854,0
4%
Definitions

Unemployed (ILO definition)

According to the 1982 definition, a person is
unemployed if he/she is a member of the
working age population (15 years or more) and
fulfils the following conditions:
1.
Is not employed : has not worked a single hour
during the reference period;
2.
Is available for work within 15 days ;
3.
Is actively searching for employment.
Definitions
Total French Population
(60 Million)
Working Age Population (39)
Economically Inactive Population
(21)
Labour force (Economically
active population) (27)
Economically Inactive Population
(12)
Employed population
(25)
Unemployed (2)
Definitions
Total French Population
(60 Million)
Working Age Population (39)
Economically Inactive Population
(21)
Labour force (Economically
active population) (27)
Economically Inactive Population
(12)
Employed population
(25)
Unemployed (2)
Labour Force
Participation rate 
WorkingAge Population
Definitions
Total French Population
(60 Million)
Working Age Population (39)
Economically Inactive Population
(21)
Labour force (Economically
active population) (27)
Economically Inactive Population
(12)
Employed population
(25)
Unemployed (2)
Labour Force - Employed Population
Unemployme nt rate 
Labour Force
Definitions
Employed
24,6
Unemployed
3,2
19 140
44 070
Inactive
12,0
Average monthly flows (France, 2005)
Economic recovery
12
Recession
First Oil Shock
14
Second Oil Shock
Definitions
10
8
6
4
2
0
1970
1975
1980
1985
1990
1995
2000
The unemployment rate in France
2005
The WS-PS model of the Labour market
Definitions
The Wage-Setting equation
The Price-Setting equation
The structural rate of unemployment
The WS Equation

Wages can be determined in several ways




Individual negotiations
Branch agreements (Trade union negotiations)
National legislations
Two main factors play a role:

The reservation wage
 The wage at which one is indifferent between
working or remaining unemployed

Market conditions
 These determine the bargaining power of the
employee.
The WS Equation

The bargaining power (BP) of a worker is
a function of two factors:

The ease with which the firm can replace
him
 Higher likelyhood of replacement ⇒ ↓ BP
 This is linked to the skills of the worker
and/or the job characteristics

The ease with which he can find another
job
 Higher likelyhood of finding job ⇒ ↑ BP
 This is linked to the level of unemployment
The WS Equation
 
W  P e  F u, z


 
The nominal wage W is a function :

Of the expected level of prices Pe
 Negotiations occur at discrete intervals (every X years)
 They are based on the expected purchasing power
for the duration of the interval

Of the rate of unemployment u
 High unemployment reduces the BP of workers

Market factors z
 Institutional factors (unemployment benefits)
 Structural changes in the economy (skill biased TC)
The WS Equation
Real wages are a negative function of the rate of
unemployment
Real Wage
W
P
 
W
 F u, z
e
 
P
WS
Unemployment
rate u
The WS Equation
Real wages are a positive function of market conditions
Real Wage
W
P
 
W
 F u, z
e
 
P
WS’(z’>z)
WS(z)
Unemployment
rate u
The WS-PS model of the Labour market
Definitions
The Wage-Setting equation
The Price-Setting equation
The structural rate of unemployment
The PS Equation
P  1    W

The actual level of prices is determined by the
wage rate

W represents the marginal cost of production
 In the SR, output is a function of labour: Y=N
 Assumption : constant returns to scale

(1 + μ) : markup on the goods markets
 μ=0 : perfectly competitive market
 μ>0 : Imperfectly competitive market
 In choosing μ, the firms influence the level of the real
wage
The PS Equation
o Rearranging the PS equation allows us to express
the real wage as a function of the markup rate...
P  1     W
P
 1 
W
W
1

P 1 
o This way we can draw the PS equation in the same
space as the WS equation
The PS Equation
Real Wage
W
P
The real wage induced by the PS equation is
independent of the rate of unemployment
1
1 
PS
Unemployment
rate u
The WS-PS model of the Labour market
Definitions
The Wage-Setting equation
The Price-Setting equation
The structural rate of unemployment
The structural rate of unemployment
The structural rate of unemployment un equalises WS and PS
F un , z  
1
1 
o The structural rate of unemployment:
 Is independent of short-term fluctuations
 As a result it is often called “natural” but this is incorrect
o un is a function of the structural parameters on the labour
market z
 Unemployment benefits, production technology, etc.
o un is a function of the structural parameters on the goods
market μ
 Barriers to entry, level of competition, etc.
The structural rate of unemployment
The labour market equilibrium implies that the wages determined
through the bargaining process are consistent with the price setting
behaviour of firms
W
Real Wage
P
1
1 
A
PS
WS
un
Unemployment
rate u
The structural rate of unemployment
W
Real Wage
P
1
1 
1. An increase in unemployment
benefits shifts WS to the right (better
labour market conditions)...
A
A’
PS
WS’
WS
2. ...Which increases the structural
rate of unemployment
un
u’n
Unemployment
rate u
The structural rate of unemployment
1. An increase in the level of competition
reduces the markup...
W
Real Wage
P
1
1 '
1
1 
A’
PS’
A
PS
WS
u’n
un
2. ... Which reduces the structural level of
unemployment
Unemployment
rate u