Unit 9

THE LABOUR MARKET: WAGES, PROFITS, AND

UNEMPLOYMENT
OUTLINE
A. Introduction
B. Measuring unemployment
C. Price-setting and wage-setting
D. Labour market equilibrium
E. Division of output and labour unions
F. Labour market policies
A. Introduction
 The Context for This Unit
Price-setting firms produce differentiated products. (Unit 7)
The principal-agent model can explain the conflict of interest
between the employer and the employee over worker’s effort,
and why contracts are not enough to resolve this.
(Unit 6)
• How are the economy-wide wages and employment
determined?

• How can we improve on these outcomes?

 This Unit
• Models price-setting and wage-setting behaviour of firms,
which determines economy-wide unemployment rate and
real wage

• Explains why unemployment exists even in equilibrium

• Shows how the government can affect wages and

unemployment by its policies

• Analyses the role of labour unions

B. Measuring unemployment
 The unemployed

The unemployed are the people who:

• are not in paid employment or self-employment

• are available for work

• are actively seeking work

The labour market
 Labour market statistics
Two countries with the
same unemployment rate
can differ in their
employment rates if one has
a high participation rate and
the other has a low one.

The structure of the labour

market differs widely across
countries.
C. Price-setting and
wage-setting
 Price-setting and wage-setting

• Firms and employees: firms set wage sufficiently high to

make job loss costly, in order to motivate employees to
work hard in the absence of complete contracts

• Firms and customers: firms set a markup above the cost of

production, to maximise their profits subject to demand.
 The real wage
The real wage is the nominal wage divided by the price level
of the bundle of consumer goods purchased.

1. each firm decides on its: price, wage, how many people to

hire
2. adding up all of these across all firms gives the total
employment in the economy and the real wage
 The chain of firm’s decisions
Nominal wage = f(other firms’ prices and wages, unemployment rate)

Price = f(own nominal wage, demand for own product)

Output = f(optimal price, demand curve)

Number of employees = f(output, production function)

 The wage-setting curve

The wage-setting curve = the

real wage necessary at each
level of economy-wide
employment to provide
workers with incentives to
work hard and well.

If the employment rate is X, then the equilibrium wage will be Y.

 Deriving the wage-setting curve
• Start with the labour
discipline model (unit 6)
• Lowering the
unemployment rate will shift
worker’s best response curve
to the right (reservation
wage↑) and increase wage
• This results in upward-
sloping wage-setting curve
 An estimated wage curve
• Estimated from US
data
• Uses data on
unemployment rates and
wages in local areas
Profit-maximizing price
Firm’s optimal price lies where
the demand curve is tangent to
an isoprofit curve (unit 7).

The firm then hires a number

of employees necessary to
produce the quantity of output
demanded at that price.
 Distribution of output
The firm’s choice of profit-maximizing price also determines
the firm’s optimal markup above the marginal cost of
production.

For the economy as a whole, this translates into how output is

distributed between the firm-owners and the workers.
 Deriving the price-setting curve
Once firms set their prices, this determines the level of output
and markup in the economy. This then pins down the real
wage.
 The price-setting curve
The price-setting curve = the
real wage paid when firms
choose their profit-maximizing
price.

It depends on:
• competition, which
determines markup
• labour productivity, which
determines real wage for given
markup
D. Labour market
equilibrium
 The labour market equilibrium
The wage-setting and price-
setting curves are two sides of
the economy.

The Nash equilibrium of the

labour market is where the
wage- and price-setting curves
intersect.
 The labour market equilibrium
All parties are doing the best they can, given what everyone else
is doing:

• The firms are offering the least wage to ensure workers’ effort
• Employment is the highest it can be, given the wage
• Those who have jobs cannot improve their situation by asking
for higher pay or working less hard
• Those who do not have jobs would like to work, but cannot
persuade firms to hire them by accepting lower wage (labour
discipline concerns)
 Involuntary unemployment
Unemployment = excess supply in the labour market

There will always be unemployment in labour market equilibrium

• No unemployment → zero cost of job loss → no effort

• Therefore some unemployment is necessary to motivate
workers
• These are the involuntarily unemployed
 Unemployment and aggregate demand
The firm’s demand for labour depends on the demand for their
goods and services (derived demand for labour).

Aggregate demand = sum of the demand for all of the goods and
services produced in the economy.

The increase in unemployment caused by the fall in aggregate

demand is called demand-deficient unemployment.
 Demand-deficient unemployment
Low aggregate demand moves the economy from labour
market equilibrium (X) to point B.
B is not a Nash
equilibrium:
• Firms could lower
wages
• Lower costs → lower
prices
• Increase output and
employment
 Automatic adjustment
Point B is not a Nash equilibrium:

• Firms could lower wages without lowering workers’ effort

• Lower wages allow them to cut their prices

• Lower prices stimulate demand → output rises

• Firms hire more workers to produce more

… unemployment falls back to X
 Automatic adjustment in practice
Real economies do not function so smoothly:

• Workers resist cuts to their nominal wage (lower morale,

strikes)
• Lower wages means people spend less → aggregate
demand falls further
• Falling prices across the economy may lead consumers to
postpone their purchases in hope to get even better bargain
later
 Government intervention
The government
could increase its
own spending to
expand aggregate
demand.
• monetary policy
• fiscal policy

At B, firms would find it optimal to produce more (and hire more

workers) instead of reducing wages.
 Labour supply
The supply of labour is
another important
determinant of labour market
equilibrium.

An increase in labour supply

shifts the wage-setting curve
downward:
• greater pool of unemployed
• higher employment rents
• lower cost of effort
E. Division of output and
labour unions
 Division of output
The labour market determines the division of the economy’s output
between employed workers, the unemployed, and firm-owners.

Gini coefficient will rise with:

• unemployment rate ↑
• real wage ↓
• markup ↑
• productivity ↑
 Labour unions
Labour union = an organization consisting predominantly of
employees. Its main activities include the negotiation of rates
of pay and conditions of employment for its members.
 Wage bargaining
Where workers are organized into trade unions, the wage is
not set by the employer but instead is negotiated between
union and firm.

The bargained wage can be above the wage-setting curve

• the wage-setting curve is about the employer’s threat of
firing a worker
• the union can threaten to “dismiss” the employer by going
on strike
 Bargained wage setting curve
Bargained wage setting
curve indicates the wage that
the union-employer bargaining
process will produce for every
level of employment.

Its position above the wage-

setting curve depends on the
relative bargaining power of
the union and the employer.
 Labour unions and unemployment
In equilibrium, wage is
unchanged, but employment
and firm’s profits are lower.

The model tells us that labour

unions will increase
unemployment rates.

However, this is not clear in the

data.
 The union voice effect
Providing employees with a
voice in how decisions are
made may induce them to
provide more effort for the
same wage.

• The bargained wage curve

shifts downward.
• The overall effect of labour
unions on employment is
ambiguous.
F. Labour market policies
 Labour market policies
Shifts in the price-setting curve:
1. Education & training: labour productivity ↑
2. Wage subsidy: Production costs and prices ↓

Shifts in the wage-setting curve:

1. Lower unemployment benefit: reservation wage ↓

Shifts in labour supply curve:

1. immigration policies: labour supply ↑
2. childcare provision: female labour participation ↑
 Summary
1. Behaviour of firms sets wages and employment in an economy
• The wage-setting curve tracks the combinations of wages
and unemployment feasible with workers’ effort
• The price-setting curve determines the real wage
corresponding to profit-maximising price
2. There will always be involuntary unemployment
• Incomplete contracts
• Deficient demand
3. Labour unions bargain over wages with firms, which affects
employment
• Voice to workers may improve their effort and productivity
 In the next unit
• A closer look at financial markets: the banking system

• How individuals choose borrowing, saving, and

consumption

• Banks: Firms that create money in the process of

supplying credit