econ

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Lecture 5: Ch.6 The Labor Market
6.0 Transition from the Short-Run to the Medium-Run
• The price level P is “fixed” in the IS-LM model, which is thus called a short-run
macroeconomic model. We now move toward the medium run, at which inflation and
unemployment are determined.
6.1 A Tour of the Labor Market
• (Adult) Population = Labor force + Out of the labor force
• Labor force = # of employed + # of unemployed
• Unemployment rate (u) =
# ୭୤ ୙୬ୣ୫୮୪୭୷ୣୢ
# ୭୤ ୐ୟୠ୭୰ ୊୭୰ୡୣ
× 100

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• Unemployment rate (u) is not the best estimate of the number of people available for work
because it excludes discouraged workers that are classified as “out of the labor force”.
• Alternative labor market statistics:
Participation rate =
୐ୟୠ୭୰ ୊୭୰ୡୣ
୔୭୮୳୪ୟ୲୧୭୬
× 100
Non-employment rate =
୔୭୮୳୪ୟ୲୧୭୬ି୉୫୮୪୭୷୫ୣ୬୲
୔୭୮୳୪ୟ୲୧୭୬
× 100

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• Population, Labor Force, Employment, and Unemployment in the U.S. in 2010

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6.2 Movements in Unemployment
• The fluctuations in the unemployment rate affect i) workers’ welfare and ii) wages.
• Higher unemployment is associated with both a lower chance of finding a job if a person is
unemployed and a higher chance of losing it if a person is already employed.
• Movements in the U.S. Unemployment Rate between 1948 and 2010

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• Unemployment Rate and the Proportion of Unemployed Finding Jobs, 1994-2010
(Note: The scale on the right is an inverse scale.)

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• Unemployment Rate and Monthly Separation Rate from Employment, 1994-2010
(Note: Separations = Quits + Layoffs)

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6.3 Wage Determination
• Common forces at work in the determination of wages include:
1) Reservation wage: making workers indifferent b/w working or being unemployed
2) Labor market conditions: The lower the unemployment rate (u), the higher the wages.
• Economists have focused on two broad lines of explanation:
i) bargaining power and ii) efficiency wages.
6.3.1 Bargaining
• How much bargaining power a worker has depends on two factors:
1) How costly it would be for the firm to replace him (the nature of the job), and
2) How hard it would be for him to find another job (labor market conditions).
• When the unemployment rate is low, it is more difficult for firms to find acceptable
replacement workers. At the same time, it is easier for workers to find other jobs.

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6.3.2 Efficiency Wages
• According to the theory of efficiency wages, firms want to pay more than the reservation
wage regardless of workers’ bargaining power. Why?
1) Paying high wages gives workers more incentive to stay, reducing turnover.
2) Offering higher wages attracts better job applicants, increasing quality of firm workforce.
3) Workers with high wages have more incentive to work, not shirk, increasing productivity.
6.3.3 Wages, Prices, and Unemployment
• Consider the following equation for the nominal wage:
ܹ = ܲ௘
‫ܨ‬ሺ‫,ݑ‬ ‫ݖ‬ሻ,
(−,+)
where W is the nominal wage, Pe
is the expected price level, u is the unemployment rate
and z is a catchall variable that includes all other variables that may affect the nominal wage.

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• Why does the expected price level Pe
matter (not the actual price level P)?
• Why does the unemployment rate u matter?
• What are the other factors z? One example is unemployment insurance. If there is no
unemployment insurance, then you would be willing to accept very low wages to avoid
being unemployed. Other examples of z include the minimum wage.
6.4 Price Determination
The prices set by firms depend on the costs they face. These costs depend, in turn, on the
nature of the production function.
• Assuming that firms produce goods using labor only, the production can be written as:
Y = AN,
where Y is output, A is labor productivity and N is employment level. Let’s normalize A = 1.
This means that one worker produces one unit of output. Then the production function

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becomes:
Y = N
• What will be the price level P if the firms are in a perfectly competitive market? Firms set
their price according to the zero-profit condition, P = W, where W is wage.
• What will be the price level P if the firms are not in a competitive market? Firms set their
price according to
P = (1 + m)W,
where m is the markup of the price over the cost.
• In general, m > 0 due to market imperfection and firms’ market power.

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6.5 The Natural Rate of Unemployment
• Let’s now look at the implications of wage and price determination for unemployment. For
now, assume that expected price level is the same as the actual price level (Pe
=P ) to
simplify the matter. Then, we have
ܹ
ܲ
= ‫ܨ‬ሺ‫,ݑ‬ ‫ݖ‬ሻ ∶ ‫ܖܗܑܜ܉ܔ܍ܚ ܁܅‬
• This is a condition for a real wage setting; people care about real wages (W/P) because they
do not care about how many dollars they receive but about how many goods they can buy
with those dollars.
• Wage-setting (WS) relation tells us that the real wage
ௐ
௉
decreases with unemployment
rate u and increases with other factors z.

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• From the price-determination equation P = (1 + m)W, we can derive
ܹ
ܲ
=
1
ሺ1 + ݉ሻ
∶ ‫ܖܗܑܜ܉ܔ܍ܚ ܁۾‬
• Price-setting (PS) relation determines the real wage paid by firms.
• Equilibrium in the labor market is achieved
when the real wage chosen in wage setting
is equal to the real wage implied by price
setting.

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• The equilibrium condition can be written as
‫ܨ‬ሺ‫ݑ‬௡, ‫ݖ‬ሻ =
1
1 + ݉
where un is the unemployment rate at which the labor market is in equilibrium.
• We call un the natural rate of unemployment.
• un depends on both z and m. See the next page for examples.

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Example 1
1) What is the effect of an increase in unemployment benefits on the real wage and on the
natural rate of unemployment?
2) Consider a less stringent enforcement of antitrust legislation that causes markets to become
less competitive. What will happen to the real wage and to the natural rate of
unemployment?

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• 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.
• Labor market equilibrium in terms of the natural level of output
Let U denote unemployment, N denote employment, and L the labor force, then
‫ݑ‬ ≡
ܷ
‫ܮ‬
=
‫ܮ‬ − ܰ
‫ܮ‬
= 1 −
ܰ
‫ܮ‬
From this result, we can define the natural level of employment as
ܰ௡ = ‫ܮ‬ሺ1 − ‫ݑ‬௡ሻ
Likewise, since Y = N (from our earlier assumption), we have the natural level of output
ܻ௡ = ܰ௡ = ‫ܮ‬ሺ1 − ‫ݑ‬௡ሻ
Finally, we can write the labor market equilibrium condition in terms of the natural level of
output:
‫ܨ‬ሺ‫ݑ‬௡, ‫ݖ‬ሻ =
1
1 + ݉
→ ‫ܨ‬ ൬1 −
ܻ௡
‫ܮ‬
, ‫ݖ‬൰ =
1
1 + ݉

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Practice Problem
1. Use the WS and PS relations to examine the effects of the following events on the natural
rate of unemployment and on the real wage. Be sure to explain the effects of the event on
the WS and PS relations.
a. reduction in unemployment insurance
b. more stringent antitrust legislation
c. increase in the minimum wage