4- labor markets and the ad-as model

7/23/2019 4- Labor Markets and the AD-As Model

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Chapter 6 of Macroeconomics,

Olivier Blanchard and David R. Johnson

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How the labour market conditions that involve unemployment

rates and different policies can affect the wage bargainingpowers of employees/workers and firms.

The wage setting and price setting.

Why natural unemployment occurs where the wage setting

and price setting equate.

How different policies or events can affect the natural

unemployment rate.

How we can use the wage setting and price setting to derive

(graphically) the labour supply and labour demand respectively

How we can derive the Short run Aggregate Supply curve fromthe algebras.

Short Run, Medium Run and Long Run


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The noninstitutional civilian population (NIP) are the

number of people potentially available for civilian employment.

The civilian labor force (LF) 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. (= LF/NIP)

The unemployment rate (u) is the ratio of the unemployed to

the labor force.

Seperations refer to movements from being employed to

being unemployed or being out of labour force.

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Popu lation, Labo r Force,

Employment, and

Unemploym ent in the

United States (in

m il l ions ), 2010

Figure 6 - 1

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The Large Flows of Workers

An unemployment rate may reflect two very differentrealities.

It may reflect an active labor market, with many

separations and many hires, or it may reflect asclerotic labor market, with few separations, few

hires, and a stagnant unemployment pool.

The Current Population Survey (CPS) producesemployment data, including the movements of

workers.

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The Large Flows of Workers

(1) The flows of workers in and

out of employment are large.

(2) The flows in and out of

unemployment are large

relative to the number of

unemployed. (3) There are also

large flows in and out of the

labor force, much of it directly

to and from employment.

Average Monthly Flow s

between Employment,

Unemploym ent, and

Nonpart ic ipat ion in the

Unit ed States, 1994 to

2011 (mill ion s)

Figure 6 - 2

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Since 1948, the average

yearly U.S. unemployment

rate has fluctuated between

3% and 10%.

Movements in the U.S.

Unemployment Rate

Sin ce 1948-2010

Figure 6 - 3

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How fluctuations in the aggregate unemployment rate

affect individual workers is important because the

answer determines two effects:

The effect of movements in the aggregateunemployment rate on the welfare of individual

workers

The effect of the aggregate unemployment rate on

wages

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During recessions, there are labor marketadjustments. There are implications for both

employed and unemployed workers:

If the adjustment takes place through fewer hires,the chance that an unemployed worker will find a

job diminishes. Equivalently, they can expect to

remain unemployed for a longer time.

If the adjustment takes place instead through

higher layoffs, then employed workers are at a

greater risk of losing their jobs.

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When unemployment is

high, the proportion ofunemployed finding jobs is

low. Note that the scale on

the right is an inverse scale.

The Unemploym ent Rate

and the Propo rt ion of

Unemployed Finding

Jobs, 19942010

Figure 6 - 4

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When unemployment is high, a

higher proportion of workers lose

their jobs.

The Unemploym ent Rate

and the MonthlySeparat ion Rate from

Emplo yment, 19942010

Figure 6 - 5

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Collective bargaining is bargaining between firms

and unions.Common forces at work in the determination of

wages include:

Workers are typically paid a wage that exceedstheir reservation wage, the wage that would

make them indifferent between working or being

unemployed.

Wages typically depend on labor market

conditions. The lower the unemployment rate,

the higher the wages.

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How much bargaining power a worker has depends ontwo factors.

How costly it would be for the firm to replace him

the nature of the job.

How hard it would be for him to find another job

labor market conditions.

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Economists call the theories that link theproductivityor

the efficiencyof workers to the wage they are paid

efficiency wage theories.

These theories also suggest that wages depend on both

the nature of the job and on labor-market conditions:

Firms that see employee morale and commitment as

essential to the quality of their work, will pay more than

firms in sectors where workers activities are moreroutine.

Labor market conditions will affect the wage.

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Wage

determination

High

unemployment

FIRM

Anything/Policiesin favour of

workers

Z

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Both workers and firms care about real wages (W/P), not

nominal wages (W).

Workers do not care about how many dollars they receive

but about how many goods they can buy with those dollars.

They care about W/P.

Firms do not care about the nominal wages they pay but

about the nominal wages, W, they pay relative to the price ofthe goods they sell, P. They also care about W/P.

How real wage is related to employm ent out look

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As we see in the slide 17, there are two factors that

affect the real wage (W/P) that the workers request

for:

Unemployment rate: If we think of wages as beingdetermined by bargaining, then higher unemployment

weakens workers bargaining power, forcing them to

accept lower wages. Higher unemployment allows firms to

pay lower wages and still keep workers willing to work.

All factors or policies that give higher bargaining power to

the workers (eg. unemployment benefits).

How real wage is related to employment out look

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To capture the effects of the two factors on the real wage,we can assume the following relationship.

( , )

= , (1)

This equation tells us of the workers behaviour (i.e. their

real wage request in response to the labour market

conditions that involve unemployment rate, u and the

catchall variable, z).

How real wage is related to employment out look

Therefore, if the people know u, z andprice level P, they

would request for nominal wage equal to W (as shown in

(1) )

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RealWage,W

/P

WS

Unemployment Rate, u

Real wage & unemploym ent

=

This red graph is drawn to

show that the real wagerequested by the workers is

negatively related to the

unemployment rate.

Intuition: as theunemployment rate goes up,

the bargaining power of the

workers falls; so they are

willing to accept lower real

wage.

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Suppose that the economy is at where u = . Suppose alsothat the corresponding real wage that the workers request is

equal to .

However, the workers cannot possibly know the price level of

the whole economy (reasonable assumption?).

So, they have to form expectation of price level, Pe . Then

hypothetically, they could form this thinking process: With

this unemployment rate, and this catchall variable z, and our

expectation that the price would be Pe, we want to have a

nominal income, W, so that our expected real wage is W/Pe

(which is equal to = )

Previous g raph explained

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That is, at a given state of the economy whereunemployment rate is equal to u, catchall variable is equal

to z and if the expected p rice level is equal to Pe , the

workers would request for (or accept) W as nominal wage.

Note: a catchall variable, z, that stands for all othervariables that may affect, in favor of the workers, the

outcome of wage setting, given the expected price level

and the unemployment rate.

Then at a given u and z, we have:

= , = , (2)

( , )

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Y= output

N = employment

A = labor productivity, or output per worker

Further, assuming that one worker produces one unitof outputso thatA = 1, then, the production

function becomes:

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, theproduction function can be written as:

=

=

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Marginal productivity of labour = MPL

One unit of labour

produces A units of

goods

Nominalmarginal cost of labour= W; so the nominal

marginal cost, which is the cost of producing one unit of

goods is:

= = 1

= / =

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One unit of labour costs $W; one unit of labour can

produce A units of goodsCost of producing one unit of

goods = W/A


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Suppose that the firm has some market power suchthat it can set the price above the marginal cost:

Where m is the markup of price over the nominal

marginal cost

If all markets were perfectly competitive, m = 0, and

P = W.

= 1 +

= 1 +

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This relation between the real wage and the

rate of unemploymentwage-setting relation.

W

PF u z ( , )

( , )

Recall that we have the equation (1):

This equation illustrates the workers behaviour in

response to the labour market conditions

captured in u an z.

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The price-determination equation is:

If we divide both sides by W, we get:

To state this equation in terms of the wage rate,

we invert both sides:

The price-setting

relation

= 1 +

= 1 +

=

1

1 +

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RealWage,

W/

P

A PS

WS

un Unemployment Rate, u

At equilibrium, where two

curves meet, we have

unemployment rate =

natural unemployment rate

The natural rate of

unemployment is

the unemployment

rate such that the

real wage chosen

in wage setting isequal to the real

wage implied by

price setting.

Wages , Pric es,

and the Natural

Rate of

Unemployment

Figure 6 - 6

Graph 1

1

1 +

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Medium-run equilibrium:

Medium run is when Pe = P. This is because when the

expected price is equal to the actual price, there is no longer

a need to adjust the expectation. (We will explain more in

detail in next lecture)

Pe = P happens when WS meets PS. (why?)

We can also manipulate to get:

So un here is affected by A, z and m.

, =

1 + =

1

1 +

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RealWa

ge,

W/P

A PS

WS


=

1

1 +

=

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The positions of the wage-setting and price-setting curves,

and thus the medium run equilibrium unemployment rate,

depend on both z and m.

At a given unemployment rate, higher unemployment

benefits lead to a higher real wage. A higherunemployment rate is needed to bring the real wage back

to what firms are willing to pay. (Graph 2)

By letting firms increase their prices given the wage, lessstringent enforcement of antitrust legislation leads to a

decrease in the real wage. (Graph 3a-3b)

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RealWage,

W/

P

1

1+m( )

A PS

WS


Example: Unemployment benefits ,

causing WS to shift up higher un.

This is because? : Prospect of

unemployment is less painful (whohas more bargaining power?)

A

un

IF z

WS

B

Graph 2

Unemploym ent Benef i ts

and th e Natural Rate of

Unemployment

Figure 6 - 7

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Higher z higher bargaining power for workers for the

same u, workers demand for higher real wage. So WS shifts

up. If the unemployment rate is still at un, the workers would

demand higher real wage (point B)

But the firms are not willing because it does not correspond

to their price setting

Thus, firms would respond not by not hiring those who insist

on higher nominal wage. These workers are willing to wait for

better job (because it is less costly to wait now)

which causes higher unemployment.

The economy will be at point A where natural rate of

unemployment is higher.

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RealWage,

W/P

A PS

WS


Graph 3a

Markups and the Natural

Rate of Unemp loyment

Figure 6 - 8

Here, the economy is in

medium run equilibrium with

un and we have priceexpectation, Pe to be equal to

the actual price level, P.

=

1

1 +

=

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Re

alWage,

W/P

A PS

WS


Example: less stringent

enforcement of antitrust

legislation, causing PS toshift down

IF m

PS

Graph 3b



Figure 6 - 8

= 1

1 +

=

=

1

1 +

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RealWage,W

/P

A PS

WS


PS

Graph 3c



Figure 6 - 8

=

1

1 +

=

1

1 +

At the moment (in short run), the workers do

not know of price level change. So, they still

maintain the same expectation of price

level. And they still want to provide labour

level where unemployment rate is equal to un

In fact, the price level

has changed. Nominal

wage is still the same 39


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RealWage,

W/P

A PS

WS


A

un

PS

Graph 3d



Figure 6 - 8

=

1

1 +

After some time, the workers realize that the

price has increased. So they update their

expectation of price to match with the new

actual price level. But the unemployment rate

has increased because some workers refuse towork at this real wage level

Pe = P

=

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Now, the price level has gone up because mark-up is

higher In the short run, workers are not aware of the price level

change, they still think the real wage is at point A.

After a while, workers find out that price level has gone

up (this means that now, they know that their realwageis lower).

They then update their price expectation to matchwith the new actual price level set by firms.

With the new expected price level, the real wage issmaller (W/Pe). The response from the workers is thatsome would not choose to work but to wait. So, theunemployment rate goes up.

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Associated with unemployment is employment:

Employment then is:

Natural level of employment Nn is:

=

=

= 1

= (1 )

= (1 )

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RealWage,

W/

P

1

1+m( )

A PS

WS


Graph 4

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RealWage,

W/

P

1

1+m( )

APS

WS

NnEmployment,N

L

N U

Equivalent to

Labour Supply

Equivalent to

Labor demand:

Why is it flat?

Graph 5

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If we have a production function as follows:

where 0 <


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Natural output is associated with natural employmentand thus also with natural unemployment rate:

So, the natural output will satisfy the following:

= = 1 = (1 )

1

, =

1 + 1

, =

1

1 +

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We have the following two relations:

And:

In the short-run, the workers would not know what is the

price level so they form expectation of the price level. Theywould demand the nominal wage, W, according to the price

level that they form in their minds or expectand the

labour market conditions, captured in variables u and z

= (,)

= 1 +

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First Step, we combine two equations:

Second Step:

Definition of

unemployment

rate

Definition of

unemployment

Math

manipulationSpecification

of production

function Y=AN

= 1 + (, )

=

=

= 1

= 1

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So then we have:

We can have:

This is our Short Run Aggregate Supply (simply

call it Aggregate Supply) curve which showsthe relationship between P and Y (P also

depends clearly on Pe and m, A, L and z)

= 1

= 1

= 1 + 1

,

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To draw the AS curve, let us find the special point onthe P-Y plane.

Recall: If P=Pe, then the unemployment rate would be

the natural unemployment rate, un (refer back to slide31). If we have u = un, corresponding output would be

Yn (refer back to slide 49)

Hence, AS will go through a special point, which is(Yn, P

e), on P-Y plane.

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= 1 + 1

,

If Y increases, then 1

, increases. Then, for a

given Pe and m, we should have P to increase.

So the AS curve would be a upward-sloping curve that goes

through the point (Pe

, Yn).

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Graph 6


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PriceLevel,P

A

AS

Y=Yn Output, Y

When Y=Yn

then

P=Pe

Graph 6

= 1 + 1

,

(Yn, Pe)

=

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Thus, we can say The first property isthat, given the expected price level, an

increase in output leads to an increase in

the price level Rationale: (see graph 6)

Y requires higher employment

u, which leads to W (why?),Which in turn leads to P (why?)

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Graph 7


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Price

Level,P

A

AS (for a given Pe)

Y=Yn Output, Y

AS (for Pe > Pe)Graph 7

A

=

=

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Also, given unemployment, an increase in Pe

leads to one-to-one increase in actual price

level Medium-Run Equilibrium

Rationale: (See graph 7)

Wage setters expected Pe, they push firms for higher

W, causing Labor Cost to rise. Therefore, firms would

push up prices to match the higher labour cost, leading to

higher actualPrice level (P).

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SHORT RUN: Year-to-year movements inoutput are primarily driven by

movements in demand

How Consumption and Investment behavemovements in demand (responsive to

current events)

Consumer confidence and other factors thatleads to Y or

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MEDIUM RUN: Economy tends to returns to the level of output

determined by the supply factors (potential

production, Yn): Productions depend on capital

stock, level of technology (captured in variable A)

and the amount of labor which can potentially be

employed, Nn.

At the medium run, expected price level is equalto actual price level. This is intuitive because when

Pe = P, there is no more adjustment in price or

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LONG RUN: When we have technological

progress that increases the variable A. This

will push the Yn higherWe have growth

of potential output.

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Concerns with shocks,

especially demand shocks

with consumptions and

investments

reactionary policies

Economy will settle

down at the potential

or natural state; with Ynand un and P = P

e

Innovations, technological

breakthrough higher

potential, right shift of LRAS,

A

SR MR LR

4- labor markets and the ad-as model

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