Unit 4ter: The Labour Market
1. Introduction
Motivation
The market for labor has common traits with competitive markets, but also a few features that make
it unique:
1. It doesn’t “clear” in the strict sense that we have seen for other goods.
2. Heavily regulated.
3. Demand for labor (from firms) is subject to other aspects than the price (cf. the effort model
we have seen in Unit 3)
4. Asymmetric information (cf. the effort model we have seen in Unit 3).
Labor market participants
Labor demand comes from firms that consume labor. Workers offer their hours of labor for a certain
price. Firms will typically try to coordinate two decisions:
A. Price setting on the goods markets, which depends on its labor bill. We will simplify and
assume that firms have only one input in production: labor.
B. Wage offered on the labor market, which depends on how much it can charge for its
product(s).
Total labor demand will be the aggregation of all firms’ demand for labor at different prices.
Unemployment and the labor market
The participation rate measures the percentage of working age population that belongs to the labor
force, while the unemployment rate measures the fraction of active (= available to work) that do not
have a job.
A confusion to avoid
The unemployment rate is defined as:
u = Unemployment rate = Unemployed / Labor force
while the employment rate is defined as:
Employment rate = Employed / Pop of working age = (1 − u) (Labor force / Pop of working age)
Employment rate depends partially on the rate of participation in the labor force. Can you think of a
situation with low unemployment but also low employment?
2. Unemployment and labor market conditions
The wage-setting and price-setting curves
Because the decision of the firm really is two dimensional, there are two layers to the labor market
summarized in two curves:
1. The wage-setting curve: This gives the (real) wage necessary at each level of economy-wide
employment to provide workers with incentives to work hard and well.
2. The price-setting curve: This gives the real wage paid when firms choose their profit-
maximizing price.
Note that because firms set their prices, the relevant metric for potential employees is the real wage,
which is the nominal wage adjusted for prices.
The simplified model
We broaden the perspective from the single firm in Unit 3 to the whole economy, and we now ask
how changes in the unemployment rate affect the wage set by employers.
We assume that participation does not depend on the real wage offered.
We know that high unemployment reduces employment rents, therefore the real wage offered at
high unemployment rates will be lower than those closer to full employment. The wage-setting curve
is therefore upward sloping.
The wage-setting curve
The wage-setting curve is to be understood as a “if-then” negotiation between firms and the labor
force. This means that at the employment rate x, the wage w is the result of both employers and
employees doing the best they can in setting wages and responding to the wage with a given
amount of effort, respectively.
The price-setting curve
Recall that we simplified the model so that the firm’s only cost is determined by the wage. We assume
that the wage is always set in a way that one hour of labor produces one unit of output. We denote
W the nominal wage and w = W/p the real wage.
Given a wage decided upon, the firm can set its price. Quantity sold will be given by the demand
curve that the firm faces. The slopes of the firm’s isoprofit curves will be, like before:
Slope= (p−W) / q and the firm will want to set this slope equal to the slope of the (inverse) demand
it faces.
Price, quantities and wage
Given the assumption, the hours of labor demanded are n∗ = q∗ at a wage W and real wage w∗ =
W/p∗.
A reminder on markups
Recall that the optimum price and quantities, the firm’s markup over marginal cost is given by:
p* / W = e / (e-1) à e = elasticity
Another way to express this markup is as a percentage of price:
(p* - W) / p* = 1 – ((e-1) / e) = 1 / e
This also points out that the real wage offered by the firm is a function of the elasticity of the demand
it faces.
Aggregating at the economy level
At the firm level, price can be broken down into:
pi = πi + Wi = Profit per worker + Per worker nominal cost
At the aggregate level:
∫pidi = ∫πidi + ∫widi ≡ Π + W. Output per worker will be given by:
∫piqidi / ∫qkdk = Π’ + W’ = Avg Profit per worker + Avg Nominal wage.
Expressed in real terms, λ ≡ Π/P + W/P represents the firms’ real revenue per worker at the
economy level.
Average real output per worker decomposition
Point B is the firm’s profit-maximizing price and profit margin. Given economy-wide demand, total
profits are lower at A and C.
Determinants of the price-setting curve
What will determine the height of the price-setting curve?
• Competition: See the discussion on elasticity and markup size. Lower competition leads to
higher prices across the whole economy with lower real wages, pushing down the price-
setting curve.
• Labour productivity: For any given markup, the level of labour productivity—how much a
worker produces in an hour—determines the real wage. The greater the level of labour
productivity (λ), the higher the real wage that is consistent with a given markup.
3. Market equilibrium
Equilibrium unemployment
In the WS-PS model, unemployment is an equilibrium feature.
Who are the unemployed in this model?
In this model, unemployment comes from the level of the price setting curve. The larger the
markup, the higher the unemployment and vice versa.
This essentially says that more competitive markets will foster lower unemployment by forcing firms
to offer higher real wages and accepting lower profits.
In our model, we assumed that the labor supply curve is vertical: higher wages do not lead more
people to offer more hours at work.
But this is not important. We know from Unit 3 that for there to be some form of employment rents,
there must be some unemployment to motivate people to work.
Also remember that at higher wage levels, income effects dominate substitution effects and
people tend to consume more leisure (ie reduce their labor supply).
Effect of business cycles
A recession would shift the demand curve that a given firm faces towards the South West of the
graph. All in all, it means lower price and lower demand of labor.
The WS-PS model allows for temporary unemployment coming from shifts in demand. Output per
worker is fixed, but the equilibrium total output is lower.
The economy can be brought back to previous employment levels by:
• Allowing real wages to drop – very hard and undesirable in practice.
• Stimulating demand through government intervention – more on that in later chapters.
Stimulating demand to lower unemployment
What would happen to the wage-setting curve following an increase in labour supply?
• New jobseekers would enter the pool of unemployed which would increase the expected
duration of a spell of unemployment.
• Firms would then be paying more than necessary to ensure worker motivation on the job,
therefore firms would lower their wages to make the employment rent the same as it was.
Any increase in the labor supply shifts the wage-setting curve downward, lowering the
wage offered by firms. But this is only one side of the story.
The first effect of immigration would be to move from point A to point B. In the long run, the
economy will move to point C with the same real wage and higher employment.
Presence of union
The presence of union might result in a negotiated wage that is higher than the efficiency wage,
which all else being equal would result in higher unemployment.
However, if unions give employees a voice in decision making and thus reduce the reservation
wage (by reducing the disutility of effort), then the overall effect is unclear.
Concluding remarks
The most obvious difference between the labor market and competitive goods markets is that the
market does not clear, even in equilibrium.
Unemployment can be higher than equilibrium unemployment as a result of various aspects:
• A fall in the economy-wide demand for goods and services. • An exogenous increase in the labor
supply.
• The result of inefficient negotiations.
