1. The Labour Market Lecture 23 – academic year 2014/15 Introduction to Economics Fabio Landini

2. Questions of the day How does the labour market function? Why are some workers unemployed? What does the unemployment rate depend on?

3. Quick review of the model of demand and supply (Part I - Microeconomics) Construction of the model WS-PS Determination of the equilibrium Analysis of the determinants of unemployment What do we do today

4. Premise Labour market -> Analysis of medium period In this class we examine the functioning of the labour market and the determinants of unemployment In the next class we will come back to the passage from short period to medium period using part of the results obtained today

5. Demand and supply of labour It is the simplest model to study the labour market Firms “demand” labour -> the labour demand (D L ) point out how many workers the firms want to hire at the market wage (W) It follows that the higher the wage the lower the number of workers that the firms are willing to hire D L is a decreasing function of the wage

6. Workers “supply” labour -> the supply of labour (S L ) tells us how many workers are willing to work at the market wage (W) It follows that the higher the wage the larger the number of workers that are willing to work S L is an increasing function of wage Demand and supply of labour

7. In equilibrium -> D L = S L -> Point E in the graph N E is the number of workers that are employed W E is the equilibrium wage W N° workers SLSL DLDL E NENE WEWE Demand and supply of labour

8. In equilibrium: Along D L -> firms hire the number of workers that they wish Along S L -> workers that wish to work are hired -> there is no unemployment N° workers SLSL DLDL E NENE W

9. In real economies, however, there is unemployment To explain the existence of unempl. -> WS-PS model Demand and supply of labour

10. Construction of the WS-PS model In the WS-PS model : Firms fix the prices of the goods that are produced Firms and workers negotiate on wages Let’s examine them separately: Determination of wages Determination of prices

11. The determination of wages Wage negotiation is explained by different theories Summary of the main theories -> “wage setting” equation (WS) W = P E F(u,z) - + where W is the wage, P E is the expected prices, u is unemployment, and z is institutional variables of the labour market Construction of the WS-PS model

12. Let’s examine the different components of this equation W = P E F(u,z) a) W depends on P Workers are not interested in the amount of money they receive but in the quantity of goods that they can buy with their wage -> Workers are interested in the wage “in proportion” to the level of prices Construction of the WS-PS model

13. b) In the equation we have P E rather than P Wages are negotiated ahead of time and remain fixed for a certain period of time so that the level of prices is not known with certainty -> Wages depends on “expected” prices -> P E (Important to distinguish between short and medium period) c)F(u,z) -> W depends negatively on u u -> Greater competition among workers -> Workers’ bargaining power -> W Construction of the WS-PS model

14. d)F(u,z) -> W depends also on institutional variables z (positive for convention) The latter include: The level of unemployment subsidies Subsidies -> Compensations requested to work Minimum wage Minimum W -> Workers’ wage requests Construction of the WS-PS model

15. Let’s go back to the WS equation -> W = P E F(u,z) For the moment, let’s assume that price “expectations” are correct -> P E = P In this case: WS -> W = P F(u,z) By rearranging we obtain W/P represent the wage relative to the level of prices, i.e. the “real wage” Construction of the WS-PS model

16. Let’s draw the equation in a (W/P, u) diagram F is decreasing in u -> the curve WS is decreasing WS u W/P Construction of the WS-PS model

17. The determination of prices Firms’ behaviour -> production Two main simplifications: Only one input -> labour (N) The total product (Y) is equal to the amount of labour that is employed -> Y = N This implies that the cost to produce one unit of Y is equal to the cost to employ one worker, which is equal to the wage W Construction of the WS-PS model

18. Let’s assume that firms fixe the price on the basis of the unitary cost of input following the rule: Price= Unitary cost X (1+  ) where 0<  is  the so-called mark-up. Important:  is a % of “refill” on costs For instance, if  10% the price is equal to the costs increased by 10% Construction of the WS-PS model

19. In our case the unitary cost is W so that: P = W(1+  ) P = W(1+  ) -> “Price setting” equation Important: the dimension of mark up depends on the degree of competition among firms In particular: competition among firms ->   implies  and P = W Construction of the WS-PS model

20. Let’s go back to equation PS -> P = W(1+  ) After some algebraic passages we obtain -> Construction of the WS-PS model

21. We draw the PS in a (W/P, u) diagram In the PS the real wage W/P does not depend on u -> the curve PS is an horizontal line W/P u PS Construction of the WS-PS model

22. We defined the two curves that describe the determination of wages (WS) and prices (PS) Let’s now consider the two curves together in the same graph The equilibrium in the labour market

23. We draw the two curves In E we are both on the WS and on the PS -> E is the equilibrium In E there is unemployment -> u = u n u n is the “natural” rate of unemployment WS u W/P PS unun E

24. In the WS-PS model the system presents some positive degree of unemployment in equilibrium This happens in because of two components of the model (that are absent in the standard supply and demand model): Competition among firms is not perfect in the goods market Presence of a wage negotiation mechanism The determinants of unemployment

25. The equilibrium level of unemployment u n depends on the same factors In particular u n is influenced by: The degree of competition among firms The institutional characteristics of the labour market To understand these relationships let’s look at the effect on u n of : competition among firms Changes in the labour market legislation ( unemployment subsidies) The determinants of unemployment

26. Let’s start from E and in competition competition -> mark up  -> -> PS shifts downward Effects: E -> E’ and u n WS u W/P PS unun E PS’ E’E’ un’un’

27. Let’s start from E and subsidies subsidies -> z -> F(u,z) -> WS shifts upward Effects: E -> E’ and u n WS u W/P PS unun E WS’ un’un’ E’E’

28. The above results show that: Competition among firms -> u n Changes in the labour market legislation affects u n (e.g. Unemployment subsidies -> u n ) The rate of unemployment u n depends on some structural factors (how market functions) -> for this reason is called “natural rate of unemployment” The determinants of unemployment