Prepared by: Fernando Quijano and Yvonn Quijano And Modified by Gabriel Martinez 6 C H A P T E R The Labor Market

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard What’s the point of this chapter?  The Aggregate Supply curve is a relation between production and the price level.  Production happens because firms hire workers (among other things).  The real cost of hiring workers is the real wage.  Higher price levels reduce the real wage.  Lower real wages cause firms to hire more workers and increase production.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard What’s the point of this chapter? Cont.  Two complications: –Workers want purchasing power in return for their work.  Since they sign contracts to work in the future, they care about the future price level.  Price level expectations may move more slowly than the actual price level. –Workers’ effort (which is difficult to monitor) and their bargaining power depends on the unemployment rate.  And on unemployment benefits, etc.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard A Tour of the Labor Market A Tour of the Labor Market 6-1  The noninstitutional civilian population are the number of people potentially available for civilian employment.  The civilian labor force is the sum of those either working or looking for work.  Those who are neither working nor looking for work are out of the labor force.  The participation rate is the ratio of the labor force to the noninstitutional civilian population.  The unemployment rate is the ratio of the unemployed to the labor force.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard A Tour of the Labor Market Population, Labor Force, Employment, and Unemployment in the United States (in millions), 2000

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Large Flows of Workers  An unemployment rate may reflect two very different realities: –A a labor market with many separations and many hires, –A labor market, with few separations, few hires, and a stagnant unemployment pool.  What is worse? To lose your job and get a new one 12 times a year? Or to be unemployed for 6 months?

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Large Flows of Workers (1) (1)The flows of workers in and out of employment are large. (2) (2)The flows in and out of unemployment are large in relation to the number of unemployed. (3) (3)There are also large flows in and out of the labor force, much of them directly to and from employment. Average Monthly Flows Between Employment, Unemployment, and Nonparticipation in the United States,

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Large Flows of Workers From the CPS data we conclude that: 1.The flows of workers in and out of employment are large. Separations consist of:  Quits, or workers leaving their jobs for a better alternative, and  Layoffs, which come from changes in employment levels across firms.  The Current Population Survey (CPS) produces employment data, including the movements of workers.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Large Flows of Workers From the CPS data we conclude that: 2.The flows in and out of unemployment are large in relation to the number of unemployed.  The average duration of unemployment is about three months.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Large Flows of Workers From the CPS data we conclude that: 3.There are large flows in and out of the labor force, much of them directly to and from employment.  Discouraged workers are classified as “out of the labor force,” but they may take a job if they find it.  The nonemployment rate is the ratio of population minus employment to population.  Because it includes the discouraged, it might be a better measure of unemployment.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Movements in Unemployment  Fluctuations in the aggregate unemployment rate affect: –The welfare of individual workers –Wages 6-2  Higher unemployment affects workers:  Through a decrease in hires—more difficult to find jobs.  Through higher layoffs—higher risk of losing their jobs.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Movements in Unemployment Since 1948, the average yearly U.S. unemployment rate has fluctuated between 3 and 10%. Movements in the U.S. Unemployment Rate,

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Movements in Unemployment When unemployment is high, the proportion of unemployed finding jobs is low. The Unemployment Rate and the Proportion of Unemployed Finding Jobs, Note, the scale on the right is an inverse scale.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Movements in Unemployment The Unemployment Rate and the Monthly Separation Rate from Employment, When unemployment is high, a higher proportion of workers lose their jobs.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wage Determination  Collective bargaining is bargaining between firms and unions. –The result depends on each side’s bargaining power, which in turn depends on each side’s opportunity cost of not making the deal. For example:  The skills of the worker compared to the skills required for the job;  The current and expected unemployment rates;  Going wages, social norms and laws regarding hiring and firing.  Etc. 6-3

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wage Determination  Common forces at work in the determination of wages: –Wages are typically higher than the reservation wage, that is, the wage that make them indifferent between working or becoming unemployed.  “I won’t work unless you pay me more than $7 an hour.” –Labor-market conditions.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Bargaining  How much bargaining power a worker has depends on: 1.How costly it would be for the firm to replace him—the nature of the job. 2.How hard it would be for him to find another job—labor market conditions. It’s important to realize that, generally speaking, low-income workers have less bargaining power than potential employers.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Efficiency Wages  Should we pay you as low a wage as you’ll take?  If we do, we might lose you and we’ll have to train someone else. –When unemployment is high, a higher proportion of workers lose their jobs.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Efficiency Wages  Efficiency wage theories are theories that link the productivity or the efficiency of workers to the wage they are paid. –These theories also suggest that wages depend on both the nature of the job and on labor- market conditions. –Efficiency wages are typically higher than market-clearing wages: unemployment will result.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wages, Prices, and Unemployment  The aggregate nominal wage, W, depends on three factors: 1.The expected price level, P e 2.The unemployment rate, u 3.A catchall variable, z, that catches all other variables that may affect the outcome of wage setting.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wages, Prices, and Unemployment 1.Both workers and firms care about real wages (W/P), not nominal wages (W). Suppose your job is to write a computer program. To do so, you spend 25,000 calories of energy – i.e., you’ve given real effort to the firm. You’ll want to be paid back in stuff, in real purchasing power, so that you can at least buy 25,000 calories worth of food.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wages, Prices, and Unemployment Workers Workers also care about what wages they’ll earn in the future, so their expectation of the price level, P e, is key. Suppose you know that 25,000 calories of energy cost $25 today. But you are getting paid in 15 days. In two weeks, 25,000 calories will cost $28. Which price level is relevant here?

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wages, Prices, and Unemployment 2.Higher unemployment weakens workers’ bargaining power, forcing them to accept lower wages. Suppose you are the only available candidate with a bachelor’s degree in aerospace engineering. Boeing pays you whatever you want. Suppose, now, that there are seven more people with bachelor’s degrees in aerospace engineering. They are all unemployed. Will you ask for that 15% raise?

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wages, Prices, and Unemployment  If we divide this equation by P, we obtain  This allows us to draw a relation between the real wage W/P and unemployment u.  This relation has to be downward sloping because higher unemployment makes workers weaker on the negotiating table.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wages and Unemployment u WPWP Higher unemployment reduces the bargaining power of workers and encourages them to accept lower real wages.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wages, Prices, and Unemployment 3.Among other factors that affect wages is unemployment insurance—the payment of unemployment benefits to workers who lose their jobs. Higher unemployment insurance allows workers to hold out for higher wages. Minimum wages and employment protection are other factors. Suppose the government pays you $150,000 a year in unemployment insurance. Do you care if you lose your job?

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wages, Unemployment, and Unemployment Benefits u WPWP Higher unemployment benefits reduces the opportunity cost of unemployment, encouraging workers to ask for higher wages at the given unemployment rate.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wages, Prices, and Unemployment 4.It’s obvious that a change in price expectations will change the real wage that workers demand. Suppose you expected prices to be fairly low. Then, in your nominal wage negotiations with your employer, you’ll make fairly low nominal wage demands. But now suppose that prices actually turn out to be higher, so P e /P < 1. Then W/P will be relatively low. P e /P < 1 may happen if an unexpected shock raises prices.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wages, Unemployment, and Unemployment Benefits u WPWP If workers expect prices to be fairly low (P e is low), they will demand fairly low nominal wages, W. But if prices P turn out to be higher, the real wage W/P will be relatively low.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Price Determination  The production function is the relation between the inputs used in production and the quantity of output produced.  Assuming that firms produce goods using only labor, the production function can be written as: 6-4 Y = output N = employment A = labor productivity, or output per worker  Further, assuming that one worker produces one unit of output—so that A = 1, then, the production function becomes:

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Price Determination  If the production function is then there are no fixed costs and the only variable cost is the wage rate.  Then what is the cost of an additional unit of output? W

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Price Determination  If the cost of an additional unit of output is W, then W is firms’ marginal cost. –In perfect competition, P = W.  If a firm charges more than marginal cost, consumers just go to one of a million competitors. –In imperfect competition, P > W  Firms can charge more than marginal cost because there are few other firms selling a product that is similar enough.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Price Determination  Firms set their price according to:  The term m is the markup of the price over the cost of production. –1+m is the difference between the marginal cost of labor (W) and the price (P).

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard  1+m is the difference between the marginal cost of labor (W) and the price (P).  If markets are imperfectly competitive, m > 0, and P > W.  If all markets were perfectly competitive, m = 0, and P = W. Price Determination Q P D MR Q P D=MR MC

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Price Determination  What determines m? –The market power of firms in the product market (firms may sell differentiated products or they may be oligopolists).

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Price Determination  What determines m? –The market power of firms probably increases when the economy is doing well.  It’s easier to sell and to raise prices (at any given wage) when unemployment is low  the real wage falls. –The market power of firms probably decreases when the economy does poorly  Discounts, price cuts, and “incentives” become larger (at any given wage) when unemployment is high  the real wage rises.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Price Determination u WPWP Higher unemployment means lower prices for a given wage (or higher real wages). 1 1+m

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Natural Rate of Unemployment  Wage setting and price setting determine the equilibrium rate of unemployment.  Define the medium run as the period of time when price expectations are fulfilled; or when people have adjusted their expectations to reality.  Therefore we assume that P e = P, so that this equation becomes this equation. 6-5

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Wage-Setting Relation  Earlier, we stated that the nominal wage rate was determined as follows:  Now, since P e = P, The wage-setting relation: Workers and firms set real wages depending on unemployment and other things.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wages and Unemployment u WPWP Higher unemployment reduces the bargaining power of workers and encourages them to accept lower real wages.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Price-Setting Relation  The price-determination equation is:  If we divide both sides by W, we get:

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Price-Setting Relation  To state this equation in terms of the wage rate, we invert both sides: The price-setting relation: Firms set prices (at given nominal wages) depending on their degree of monopoly power.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Price Determination u WPWP Higher unemployment means lower prices for a given wage (or higher real wages). 1 1+m

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wages and Unemployment u WPWP WS relation: Higher unemployment reduces the bargaining power of workers and encourages them to accept lower real wages. PS relation: Higher unemployment means lower prices for a given wage (or higher real wages).

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wages and Unemployment u WPWP WS relation: High u weakens workers and lowers real wages. PS relation: High u lowers prices and raises W/P. Greater monopoly power allows firms to increase the difference between W and P, at any u, reducing W / P.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Price Determination  For simplicity we’ll assume m > 0. – –Assume m doesn’t depend on unemployment, but that it does depend on structural characteristics such as anti-Trust enforcement.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Price Determination u WPWP Unemployment doesn’t affect how firms set prices or wages. 1 1+m

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Price Determination u WPWP Greater monopoly power increases the difference between W and P, reducing W / P. 1 1+m 1 1+m’

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Wage-Setting and Price-Setting   Real wages are set by workers and firms as a decreasing function of the unemployment rate.   The real wage implied by firm’s price-setting (given nominal wages) is constant, independent of the unemployment rate. The Wage-Setting Relation, the Price-Setting Relation, and the Natural Rate of Unemployment

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Equilibrium Real Wages and Unemployment The natural rate of unemployment is the unemployment rate such that the real wage chosen in wage setting is equal to the real wage implied by price setting. The Wage-Setting Relation, the Price-Setting Relation, and the Natural Rate of Unemployment

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Equilibrium Real Wages and Unemployment  We can solve the Wage-Setting / Price-Setting model for the equilibrium unemployment rate, or natural rate of unemployment, u n.  Eliminating W/P from the wage-setting and the price-setting relations: n

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Equilibrium Real Wages and Unemployment The equilibrium unemployment rate, or natural rate of unemployment, u n u n depends on: the shape of the function F; on unemployment benefits; on the degree of market power of firms…

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Equilibrium Real Wages and Unemployment An increase in unemployment benefits leads to an increase in the natural rate of unemployment. Unemployment Benefits and the Natural Rate of Unemployment

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Equilibrium Real Wages and Unemployment An increase in markups decreases the real wage, and leads to an increase in the natural rate of unemployment. Markups and the Natural Rate of Unemployment Monopolists produce less than perfect competitors: then fewer people are hired.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Actual Unemployment versus Natural Unemployment   Can the “actual” rate of unemployment be different from the “natural” rate of unemployment? – –This is a medium term model. – –In the short-term, many kinds of inflexibilities will prevent the economy from adjusting. – –Unemployment changes more slowly than most other macroeconomic variables.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Movements in Unemployment Labor hoarding causes unemployment to rises slowly after the recession begins, and to stay high even after the recession ends. Movements in the U.S. Unemployment Rate,

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Actual Unemployment versus Natural Unemployment   When will u be different from u n ? – –When expected prices are higher than actual prices P e > P.   If people expect high prices, they’ll demand high wages – –At every level of unemployment, workers will demand a high W/P. – –This means that workers will require W/P > 1/(1+m). – –Because firms will only pay W/P = 1/(1+m), they won’t hire as many workers.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Actual Unemployment versus Natural Unemployment   If P e > P, workers will require high nominal wages, so workers require W/P > 1/(1+m) – –Unemployment will rise because firms don’t hire. – –As workers’ bargaining power weakens, they lower their nominal wage requests, until W/P = 1/(1+m). – –The actual rate of unemployment will be higher than the natural rate of unemployment, u>u n.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard Actual Unemployment versus Natural Unemployment   If expected prices are higher than actual prices P e > P, nominal wage demands will be too high, leading to a rise in unemployment.   Then u>u n. Expected Prices and the Actual Rate of Unemployment

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard The Structural Rate of Unemployment  Because the equilibrium rate of unemployment reflects the structure of the economy, a better name for the natural rate of unemployment is the structural rate of unemployment. –I.e., it depends on institutions and behavior:  Unemployment benefits;  People’s reactions to being unemployed;  Industrial organization;  Other factors.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard What next?  This is all very nice, but what’s the connection with Aggregate Supply? –Wage-setting and price-setting determine the economy’s actual level of unemployment and the natural level of unemployment. –The level of unemployment implies the level of employment. –The level of employment implies output.

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard From Unemployment to Employment  The natural rate of unemployment  a natural level of employment.  Employment in terms of the labor force and the unemployment rate equals:  The natural level of employment, N n, is given by: The unemploymen t rate The level of employment The natural level of employment

© 2003 Prentice Hall Business PublishingMacroeconomics, 3/e Olivier Blanchard From Employment to Output  A natural level of employment  a natural level of output, (and since Y=N, then,)  The natural level of output satisfies the following:  In words, the natural level of output is such that, at the associated rate of unemployment, the real wage chosen in wage setting is equal to the real wage implied by price setting., Employment  output The structure of the economy  Y n