2003-7-13 1
Chapter 8,The Labor Market
8-1,A Tour of the Labor Market
8-2,Movements in Unemployment
8-3,Wage Determination
8-4,Price Determination
8-5,The Natural Rate of Unemployment
8-6,Where We Go From Here
2003-7-13 2
8-1,A Tour of the Labor Market
The Large Flows of Workers
Differences across workers
2003-7-13 3
Figure 8-1,Average Monthly Flows
Between Employment,Unemployment,
and Nonparticipation in the United
States,1968-1986
1.3 1.5
1.6 1.6
1.0
0.8
Employment
93.8 million
Unemployment
6.5million
Out of labor
force 57.3
million
2003-7-13 4
Figure 8-1 has three striking
features
1.The size of the flows into and out of
employment
2.The size of the flows into and out of
unemployment in relation to the total number
of unemployed.
3.The size of the flows into and out of the
labor force.
2003-7-13 5
Table 8-1,Population,Labor force,
Employment,and Unemployment
in the United States(in
million),1998
Total population 270.2
Civilian noninstitutional population 205.2
Civilian labor force 137.6
Employed 131.4
Unemployed 6.2
2003-7-13 6
Table 8-2,Monthly Separation
Rates for Different Group,
1968-1986
Monthly Separation rate (%)
Category (Quits and Layoffs)
Male,Ages 16-19 15.9
35-44 1.6
Female,Ages 16-19 16.1
35-44 5.0
2003-7-13 7
Unemployment rate in the U.S,1955-2002
Movements in the U.S.Unemployment Rate,1955-2002
0.0
2.0
4.0
6.0
8.0
10.0
12.0
1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000
Year
Unemployment rate
(percent)
2003-7-13 8
8-2,Movements in
Unemployment
First,there is evidence of a small upward trend in the
unemployment rate,The average unemployment rate
was 4.5% in the 1950s,4.7% in the 1960s,6.2% in the
1970s,7.3% in the 1980s,In the 1990s however,
average unemployment has been only 5.75%.
Second,the trend increase is dominated by large
fluctuations in the unemployment rate,
2003-7-13 9
8-3,Wage Determination
Bargaining
Efficiency Wages
Wages and Unemployment
? The Expected Price Level
? The Unemployment Rate
? The other Factors
2003-7-13 10
The Way of Wage determination
Wages are set in many ways,Sometimes they are
set by collective bargaining,that is,bargaining
between firms and unions,In the United States
however,collective bargaining plays a limited
role,especially outside manufacturing,Today,
less than 25% of workers are covered by
collective bargaining agreements,For the
rest,wages are set either by employers,or by
individual bargaining between the employee.
2003-7-13 11
The character of Wage
determination
1.Workers are typically paid a wage that exceeds
their reservation wage,the wage that would make
them indifferent to working or becoming
unemployed,In other words,most workers are
paid a high enough wage that they prefer to be
employed rather than unemployed.
2.Wage typically depend on labor-market
condition:The lower the unemployment rate,the
higher the wages,
2003-7-13 12
Bargaining
How much bargaining power a worker has
depends on two factors:
? The first is how easy it would be for the firm to
replace him,were he to leave the firm.
? The second is how easy it would be for him to
find another job,were he to leave the firm
The harder it is for the firm to replace him,
or the easier it is for him to find another
job,the stronger he will be in bargaining.
2003-7-13 13
Efficiency Wages (1)
Most firms want their workers to feel good
about their jobs,Feeling good promotes
good works,which leads to higher
productivity,Paying a high wage is one
instrument the firm can use to achieve these
goals,Economists call the theories that link
the productivity or the efficiency of workers to
the wage they are paid efficiency wage
theories.
2003-7-13 14
Efficiency Wages (2)
Efficiency wage theories suggest that wages
depend both on the nature of the job and on
labor-market condition:
? Firms—such as high-tech firms—that see
employees’ morale and commitment as essential to
the quality of their work will pay more than firms in
sectors where workers’ activity is more routine.
? Labor-market condition will affect the wage,Lower
unemployment rate makes it more attractive for
employed workers to quit.
2003-7-13 15
Wages and Unemployment
The following equation captures the main conclusions
of our discussion of wage determination:
W = Pe F(u,z) (8.1)
(-,+)
Where W,the nominal wage depends on three factors:
● The expected price level,Pe,
● The unemployment rate,u.
● A catchall variable,z,that stands for all other
variables that affect the outcome of wage setting.
2003-7-13 16
The expected price level
Workers care not about how many dollars
they receive,but about how many goods
they can buy with their wages,In other words,
they care about their wage in terms of
goods,about W/P.
In the same way,firm care not about the
nominal wages they pay workers,but about
the nominal wages they pay in terms of the
price of the output they sell,So firms also
care about W/P.
2003-7-13 17
The unemployment rate
Also affecting the aggregate wage in equation (8.1) is
the unemployment rate,The minus sign under u
indicates that an increase in the unemployment rate
decreases wages.
Higher unemployment weakens workers’ bargaining
power,forcing them to accept lower wages.If we think
of wages as being determined by efficiency wage
considerations,higher unemployment allows firms to
pay lower wages and still keep workers willing to work.
2003-7-13 18
The other factors
The third variable in equation (8.1),z,is a
catchall variable that stands for all the
factors that affect wages given the expected
price level and the unemployment rate,By
convention,z is defined in such a way that
an increase in z leads to an increase in the
wage—hence the plus sign under z,Our
earlier discussion suggests a long list of
such factors.
2003-7-13 19
8-4,Price Determination (1)
Price depend on costs,Costs depend on the
nature of the production function,If we
assume that firms produce goods using labor
as the only factor of production,then
Y = AN
We can make one further simplification,
Assume A=1,then the production function
becomes
Y = N (8.2)
2003-7-13 20
Price Determination (2)
If there were perfect competition in the goods
market,the price of unit of output would be equal to
marginal cost,P would be equal to W,But many
goods market are not competitive,and firms charge
a price higher than their marginal cost,A simple
way of capturing this fact is to assume that firms set
their price according to
P = (1+ μ)W (8.3)
where μ is the markup of price over cost.
2003-7-13 21
8-5,The Natural Rate of
Unemployment
The Wage-Setting Relation
The Price-Setting relation
Equilibrium Real Wages,Employment,
and Unemployment
From Unemployment to Output
2003-7-13 22
The Wage-Setting Relation
Given the assumption that nominal wages depend on
the actual price level (P) rather than on the expected
price level (Pe),equation (8.1),which characterizes
wage determination,becomes
W = PF(u,z)
Or,dividing both sides by the price level
W/P = F(u,z)
(-,+)
This relation between the real wage and the rate of
unemployment,let’s call it the wage-setting relation,is
draw in Figure
Figure,The Wage-Setting relation,the
Price-Setting relation,and the natural Rate
of Unemployment
Rea l w age,W/P
1/(1 + μ ) A (Pri ce - setti ng r ela tion)
P S
W S
(W age - setti ng r ela tion)
u n Unemployment rate,u
2003-7-13 24
The Price-Setting relation
Turn now to implications of price determination,If
we divide both sides of the price-determination
equation (8.3),by the nominal wage,we get
P/W = 1+μ (8.5)
The ratio of the price level to the wage implied by
the price-setting behavior of firms equals 1 plus the
markup,Now invert both sides of this equation to
get the implied real wage
W/P = 1/(1+μ) (8.6)
2003-7-13 25
A Numerical example
Suppose it takes one hour of work to produce one
unit of output,firms pay a wage of $10 per hour,and
the firms’ markup is 20%,so they sell each unit of
output for $10× 1.2 = $12.The real wage—how
many units of the good workers can buy if they
work for an hour—is 10/12 = 0.83 units of the
good.If firms increase their markup to 30%,the real
wage falls to 10/13= 0.76 units,By choosing their
markup,firms in effect determine the real wage,
This is what is captured in equation (8.6)
2003-7-13 26
Equilibrium Real Wages,
Employment,and Unemployment
We can also characterize the equilibrium
unemployment rate algebraically; eliminating W/P
between equations (8.4) and (8.6) gives
F(un,z) = 1/ (1+μ) (8.7)
The equilibrium unemployment rate,un,is such that
the real wage chosen in wage setting—the left side of
equation (8.7)—is equal to the real wage implied by
price setting—the right side of equation (8.7)
The equilibrium unemployment rate un is called the
natural rate of unemployment
Figure:Unemployment benefits,Markups,and
the Natural Rate of unemployment
Re al w ag e,W / P
1/ ( 1+ μ ') A " P S '
1 / ( 1 + μ ) A A '
W S '
W S
u "
n
u
n
u '
n
U n e m p l o y m e n t r a t e,u
2003-7-13 28
From Unemployment to Output
Let U denote unemployment,N employment,and L the labor
force,Then u≡ U/L = (L-N)/L = 1- N/L
Rearranging to get,N = L(1-u)
If the natural rate of employment is un,the natural level of
employment Nn is given by Nn = L(1- un),Given the production
function Y=N,the relation takes the simple form
Yn = Nn = L(1- un)
The natural level of output satisfies
F[(1 - Yn /L),z ] = 1/(1+μ) (8.8)
The natural level of output(Yn) is such that,at the associated
rate of unemployment (un =1- Yn /L),the real wage chosen in
wage setting—the left side of equation (8.8) –is equal to the real
wage implied by price setting—the right side of equation (8.8)
2003-7-13 29
8-6,Where We Go From Here (1)
We have just seen how equilibrium in the labor market
determines the natural rate of unemployment,which
then determines the natural level of output,So what
have we been doing in the previous three chapters? If
our primary goal was to understand the determination
of output,why did we spend so much time looking at
the goods and financial markets? What about our
earlier conclusions that the level of output was
determined by factors such as monetary policy,fiscal
policy,consumer confidence,and so on—all factors
that do not enter equation (8.7) and thus do not affect
the natural level of output?
2003-7-13 30
8-6,Where We Go From Here (2)
The key to the answers
We have assumed equilibrium in the labor market,
We have assumed that the price level was equal to
the expected price level
There is no reason for the second assumption to be
true in the short run
Expectations of the price level are unlikely to be
systematically wrong (say,always too high,or
always too low) forever.
Chapter 8,The Labor Market
8-1,A Tour of the Labor Market
8-2,Movements in Unemployment
8-3,Wage Determination
8-4,Price Determination
8-5,The Natural Rate of Unemployment
8-6,Where We Go From Here
2003-7-13 2
8-1,A Tour of the Labor Market
The Large Flows of Workers
Differences across workers
2003-7-13 3
Figure 8-1,Average Monthly Flows
Between Employment,Unemployment,
and Nonparticipation in the United
States,1968-1986
1.3 1.5
1.6 1.6
1.0
0.8
Employment
93.8 million
Unemployment
6.5million
Out of labor
force 57.3
million
2003-7-13 4
Figure 8-1 has three striking
features
1.The size of the flows into and out of
employment
2.The size of the flows into and out of
unemployment in relation to the total number
of unemployed.
3.The size of the flows into and out of the
labor force.
2003-7-13 5
Table 8-1,Population,Labor force,
Employment,and Unemployment
in the United States(in
million),1998
Total population 270.2
Civilian noninstitutional population 205.2
Civilian labor force 137.6
Employed 131.4
Unemployed 6.2
2003-7-13 6
Table 8-2,Monthly Separation
Rates for Different Group,
1968-1986
Monthly Separation rate (%)
Category (Quits and Layoffs)
Male,Ages 16-19 15.9
35-44 1.6
Female,Ages 16-19 16.1
35-44 5.0
2003-7-13 7
Unemployment rate in the U.S,1955-2002
Movements in the U.S.Unemployment Rate,1955-2002
0.0
2.0
4.0
6.0
8.0
10.0
12.0
1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000
Year
Unemployment rate
(percent)
2003-7-13 8
8-2,Movements in
Unemployment
First,there is evidence of a small upward trend in the
unemployment rate,The average unemployment rate
was 4.5% in the 1950s,4.7% in the 1960s,6.2% in the
1970s,7.3% in the 1980s,In the 1990s however,
average unemployment has been only 5.75%.
Second,the trend increase is dominated by large
fluctuations in the unemployment rate,
2003-7-13 9
8-3,Wage Determination
Bargaining
Efficiency Wages
Wages and Unemployment
? The Expected Price Level
? The Unemployment Rate
? The other Factors
2003-7-13 10
The Way of Wage determination
Wages are set in many ways,Sometimes they are
set by collective bargaining,that is,bargaining
between firms and unions,In the United States
however,collective bargaining plays a limited
role,especially outside manufacturing,Today,
less than 25% of workers are covered by
collective bargaining agreements,For the
rest,wages are set either by employers,or by
individual bargaining between the employee.
2003-7-13 11
The character of Wage
determination
1.Workers are typically paid a wage that exceeds
their reservation wage,the wage that would make
them indifferent to working or becoming
unemployed,In other words,most workers are
paid a high enough wage that they prefer to be
employed rather than unemployed.
2.Wage typically depend on labor-market
condition:The lower the unemployment rate,the
higher the wages,
2003-7-13 12
Bargaining
How much bargaining power a worker has
depends on two factors:
? The first is how easy it would be for the firm to
replace him,were he to leave the firm.
? The second is how easy it would be for him to
find another job,were he to leave the firm
The harder it is for the firm to replace him,
or the easier it is for him to find another
job,the stronger he will be in bargaining.
2003-7-13 13
Efficiency Wages (1)
Most firms want their workers to feel good
about their jobs,Feeling good promotes
good works,which leads to higher
productivity,Paying a high wage is one
instrument the firm can use to achieve these
goals,Economists call the theories that link
the productivity or the efficiency of workers to
the wage they are paid efficiency wage
theories.
2003-7-13 14
Efficiency Wages (2)
Efficiency wage theories suggest that wages
depend both on the nature of the job and on
labor-market condition:
? Firms—such as high-tech firms—that see
employees’ morale and commitment as essential to
the quality of their work will pay more than firms in
sectors where workers’ activity is more routine.
? Labor-market condition will affect the wage,Lower
unemployment rate makes it more attractive for
employed workers to quit.
2003-7-13 15
Wages and Unemployment
The following equation captures the main conclusions
of our discussion of wage determination:
W = Pe F(u,z) (8.1)
(-,+)
Where W,the nominal wage depends on three factors:
● The expected price level,Pe,
● The unemployment rate,u.
● A catchall variable,z,that stands for all other
variables that affect the outcome of wage setting.
2003-7-13 16
The expected price level
Workers care not about how many dollars
they receive,but about how many goods
they can buy with their wages,In other words,
they care about their wage in terms of
goods,about W/P.
In the same way,firm care not about the
nominal wages they pay workers,but about
the nominal wages they pay in terms of the
price of the output they sell,So firms also
care about W/P.
2003-7-13 17
The unemployment rate
Also affecting the aggregate wage in equation (8.1) is
the unemployment rate,The minus sign under u
indicates that an increase in the unemployment rate
decreases wages.
Higher unemployment weakens workers’ bargaining
power,forcing them to accept lower wages.If we think
of wages as being determined by efficiency wage
considerations,higher unemployment allows firms to
pay lower wages and still keep workers willing to work.
2003-7-13 18
The other factors
The third variable in equation (8.1),z,is a
catchall variable that stands for all the
factors that affect wages given the expected
price level and the unemployment rate,By
convention,z is defined in such a way that
an increase in z leads to an increase in the
wage—hence the plus sign under z,Our
earlier discussion suggests a long list of
such factors.
2003-7-13 19
8-4,Price Determination (1)
Price depend on costs,Costs depend on the
nature of the production function,If we
assume that firms produce goods using labor
as the only factor of production,then
Y = AN
We can make one further simplification,
Assume A=1,then the production function
becomes
Y = N (8.2)
2003-7-13 20
Price Determination (2)
If there were perfect competition in the goods
market,the price of unit of output would be equal to
marginal cost,P would be equal to W,But many
goods market are not competitive,and firms charge
a price higher than their marginal cost,A simple
way of capturing this fact is to assume that firms set
their price according to
P = (1+ μ)W (8.3)
where μ is the markup of price over cost.
2003-7-13 21
8-5,The Natural Rate of
Unemployment
The Wage-Setting Relation
The Price-Setting relation
Equilibrium Real Wages,Employment,
and Unemployment
From Unemployment to Output
2003-7-13 22
The Wage-Setting Relation
Given the assumption that nominal wages depend on
the actual price level (P) rather than on the expected
price level (Pe),equation (8.1),which characterizes
wage determination,becomes
W = PF(u,z)
Or,dividing both sides by the price level
W/P = F(u,z)
(-,+)
This relation between the real wage and the rate of
unemployment,let’s call it the wage-setting relation,is
draw in Figure
Figure,The Wage-Setting relation,the
Price-Setting relation,and the natural Rate
of Unemployment
Rea l w age,W/P
1/(1 + μ ) A (Pri ce - setti ng r ela tion)
P S
W S
(W age - setti ng r ela tion)
u n Unemployment rate,u
2003-7-13 24
The Price-Setting relation
Turn now to implications of price determination,If
we divide both sides of the price-determination
equation (8.3),by the nominal wage,we get
P/W = 1+μ (8.5)
The ratio of the price level to the wage implied by
the price-setting behavior of firms equals 1 plus the
markup,Now invert both sides of this equation to
get the implied real wage
W/P = 1/(1+μ) (8.6)
2003-7-13 25
A Numerical example
Suppose it takes one hour of work to produce one
unit of output,firms pay a wage of $10 per hour,and
the firms’ markup is 20%,so they sell each unit of
output for $10× 1.2 = $12.The real wage—how
many units of the good workers can buy if they
work for an hour—is 10/12 = 0.83 units of the
good.If firms increase their markup to 30%,the real
wage falls to 10/13= 0.76 units,By choosing their
markup,firms in effect determine the real wage,
This is what is captured in equation (8.6)
2003-7-13 26
Equilibrium Real Wages,
Employment,and Unemployment
We can also characterize the equilibrium
unemployment rate algebraically; eliminating W/P
between equations (8.4) and (8.6) gives
F(un,z) = 1/ (1+μ) (8.7)
The equilibrium unemployment rate,un,is such that
the real wage chosen in wage setting—the left side of
equation (8.7)—is equal to the real wage implied by
price setting—the right side of equation (8.7)
The equilibrium unemployment rate un is called the
natural rate of unemployment
Figure:Unemployment benefits,Markups,and
the Natural Rate of unemployment
Re al w ag e,W / P
1/ ( 1+ μ ') A " P S '
1 / ( 1 + μ ) A A '
W S '
W S
u "
n
u
n
u '
n
U n e m p l o y m e n t r a t e,u
2003-7-13 28
From Unemployment to Output
Let U denote unemployment,N employment,and L the labor
force,Then u≡ U/L = (L-N)/L = 1- N/L
Rearranging to get,N = L(1-u)
If the natural rate of employment is un,the natural level of
employment Nn is given by Nn = L(1- un),Given the production
function Y=N,the relation takes the simple form
Yn = Nn = L(1- un)
The natural level of output satisfies
F[(1 - Yn /L),z ] = 1/(1+μ) (8.8)
The natural level of output(Yn) is such that,at the associated
rate of unemployment (un =1- Yn /L),the real wage chosen in
wage setting—the left side of equation (8.8) –is equal to the real
wage implied by price setting—the right side of equation (8.8)
2003-7-13 29
8-6,Where We Go From Here (1)
We have just seen how equilibrium in the labor market
determines the natural rate of unemployment,which
then determines the natural level of output,So what
have we been doing in the previous three chapters? If
our primary goal was to understand the determination
of output,why did we spend so much time looking at
the goods and financial markets? What about our
earlier conclusions that the level of output was
determined by factors such as monetary policy,fiscal
policy,consumer confidence,and so on—all factors
that do not enter equation (8.7) and thus do not affect
the natural level of output?
2003-7-13 30
8-6,Where We Go From Here (2)
The key to the answers
We have assumed equilibrium in the labor market,
We have assumed that the price level was equal to
the expected price level
There is no reason for the second assumption to be
true in the short run
Expectations of the price level are unlikely to be
systematically wrong (say,always too high,or
always too low) forever.
