The Labour Market Academic year 2015/16 Introduction to Economics Augusto Ninni

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

What do we do today 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

Just some definitions Labour force = employed + unemployed people Employed = Within people that are at least 15 years old: 1. People that have worked (even for a single hour) during the reference week even if self employed, or employed in a family business; 2.People that are employed but temporarily cannot work (illness, maternity leave, training, etc.); Unemployed = Within people that are at least years old: 1.Not employed people : has not worked a single hour during the reference period; 2.Is available for work within 15 days 3.Is actively searching for employment. Inactive: people, not employed neither unemployed people Participation rate = Labour force / Population (referred to the age) Employment rate = Employed / Population (referred to the age) Unemployment rate = Unemployment / Labour force

Demand and supply of labour It is the simplest model to study the labour market Remember: the opposite of the common language → Enterprises “demand” labour Households and workers “supply” labour

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

Demand and supply of labour 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 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

In equilibrium at E: 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

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

Construction of the WS-PS model In the WS-PS (wage setting – price setting) 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

The Wage Setting Equation Determination of wages Individual negotiations Branch agreements (Trade union negotiations) National legislations Two main factors play a role: The reservation wage The wage at which one is indifferent between working or remaining unemployed Market conditions These determine the bargaining power of the employee.

The bargaining power of a worker is a function of two factors: The ease with which the firm can replace him This is linked to the skills of the worker and/or the job characteristics The ease with which he can find another job This is linked to the level of unemployment

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

Construction of the WS-PS model 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 Let’s assume that firms fixe the price on the basis of the unitary cost of input following the rule: Price= Unitary cost X + m where 0< m  is the mark-up. Important: m  is the % surcharge on costs For instance, if m  10% the price is equal to the costs increased by 10%

Construction of the WS-PS model In our case the unitary cost is W so that: P = W (1+ m ) P = W(1+ m ) -> “Price setting” equation Important: the dimension of mark up depends on the degree of competition among firms m  = 0 in case of perfect competition, it increases in cases of monopolistic competition and oligopoly

Construction of the WS-PS model Let’s go back to equation PS -> P = W(1+ m ) P/W = 1 + m W/P = 1 / (1+m)

Construction of the WS-PS model 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

The equilibrium in the labour market 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

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

The determinants of unemployment 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 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)

Let’s start from E and ↓ in competition competition -> ↑ mark up m -> ↓ 1 /(1+m) -> PS shifts downward Effects: E -> E’ and ↑ u n WS u W/P PS unun E PS’ E’E’ un’un’

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’

The determinants of unemployment 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”