The Labor Market: Wages … Prices … Wages
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
prices
Higher prices lead workers to ask for higher
wages….
Prices and wages (the labor market) adjust
over the medium run and influence output
1
The Labor Market: The Medium Run
A Tour of the Labor Market
U.S. Population 2003
Minus: Pop. under 16,
Armed forces and
Incarcerated
291.0 million
-69.8 million
Civilian Noninstitutional Pop.
Civilian Labor Force
Employed
Unemployed
Out of the Labor Force
221.2 million
146.5 million
137.7 million
8.8 million
74.7 million
2
The Labor Market: The Medium Run
A Tour of the Labor Market
The participation rate=
Labor Force
146.6

 66.3% (2003)
Noninstitutional Population 221.2
The unemployment rate =
Unemployed
8.8

 6.0% (2003)
Labor Force 146.5
3
The Labor Market: The Medium Run
Labor Force Data, 1994 – 1999 (monthly flows)
Employment
127 million
Job Change
3.5 million
1.1
Unemployment
7.0 million
Out of labor
force
66.7 million
1.3
4
A Tour of the Labor Market
Differences Across Workers
Monthly Separation Rates for Different Groups, 1968-1986
Category
Monthly Separation Rate (%)
(Quits and Layoffs)
Male:
Ages 16-19
35-44
15.9
1.6
Female:
Ages 16-19
35-44
16.1
5.0
5
Movements in Unemployment
6
7
8
Movements in Unemployment
High Unemployment:
•Increases the probability of workers losing their
jobs
•Reduces the probability of the unemployed finding
a job
•Increases the duration of unemployment
9
Wage Determination
1.
Workers’ wages exceed their
reservation wage
2.
Wages depend on labor-market
conditions:
•How easily can a worker be replaced?
•How easily a worker can find another job?
•Efficiency Wages: Wages above the
reservation wage that increase productivity
and reduce the turnover rate.
10
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
11
Wage Setting Behavior:
The expected price level, Pe & wages
W  P F (u, z )
e
(,)
•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
The unemployment rate,
u and wages
• Higher unemployment reduces bargaining power of labor
and wages
• Higher unemployment reduces the efficiency wage
The other factors (z )and wages
• Unemployment insurance: higher benefits  higher wages
• Structural Economic Change: wages increase when jobs
12
created exceed jobs destroyed
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)
In non-competitive markets:
P=(1+µ)W
µ= Markup of price over cost
If markup (µ) increases
W
1

P 1 
• Price (P) increases, given wages (W)
• Real wage falls
13
The wage-setting relation
Pe = P in medium run, so
W =P F(u,z)
W
 F (u , z )
P
( ,  )
The higher the unemployment rate (u), the lower
the real wage W
P
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The wage-setting relation:
The Price-setting relation:
Price-setting relation
(W/P is independent of u)
Wage-setting relation
(W/P varies inversely with u)
WS
Real Wage, W/P
Real Wage, W/P
W
 F (u , z )
P
( ,  )
W
1

P 1 
1
1 
PS
Unemployment Rate, u
Unemployment Rate, u
15
Natural Rate of Unemployment …Structural Rate … Equilibrium Rate … NAIRU
Equilibrium Real Wages, Employment and Unemployment
Labor Market Equilibrium
Wage-setting, F(u, Z) =
Price-setting, 1
Real Wage, W/P
1 
1
1 
A
PS
WS
un – The natural rate of unemployment
Unemployment Rate, u
16
The Natural Rate of Unemployment / Structural Rate of Unemployment
= The unemployment rate at which wage-setters accept the real
wage they must accept, given markup μ.
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
17
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 µ reduces un
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From Unemployment to Output
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)
The Natural Level of Employment
N=L(1-u)
un = natural rate of unemployment
Nn = natural level of employment
Nn = L(1-un)
19
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 
20
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.
21
The Appropriate Time Frame
Short-Run • Price level may not equal the expected
price
• Unemployment may not equal natural
unemployment level
• Output may not equal natural output
MediumTerm
• Price level tends to equal expected
prices
•Unemployment tends to the natural rate
•Output moves toward the natural rate
22