Labor Markets FIN 30220: Macroeconomic Analysis

Of the 317 million people that make up the US population, approximately 246 million are considered by the Bureau of Labor Statistics to be “eligible” to work. US Population 320 Million Non-Eligible Population 71 Million Eligible Civilian Population 249 Million Under 16 On Active Military Duty Inmates in Penal or Mental Institutions

The US labor market is a very dynamic market. The 249 million Americans currently counted as part of the US eligible population are in a constant state of motion between three possible states Not In Labor Force 92 Million Employed 148 Million Unemployed 9 Million Unemployment Rate (UR) 9M 157M = 5.7%= Participation Rate (PR) 157M 249M = 63%= Employment Rate (ER) 148M 249M = 59%= ER UR =1 - PR Source: Household Survey

“Natural Rate” Cyclical Unemployment The Natural Rate, or NAIRU (Non Accelerating Inflation Rate of Unemployment) refers to what’s “normal” in the labor market. If unemployment is at the “natural rate”, then the inflation rate should be stable.

Note that the “Natural Rate” of unemployment is not zero! A healthy labor market should have some turnover as workers look for better jobs. 0% 5% 1.5% Structural Unemployment: Workers whose skills are no longer needed due to industry evolution. These people generally require retraining Frictional Unemployment: Workers in the process of finding a job

A better measure of the labor market is simply the total number of people working Recession Total Change From Previous Month

What’s a “good” employment number ? US Population 300 Million Our population growth rate averages around 1% per year 250,000 per month Labor Market 100,000 per month Every month, people retire, go back to school, etc. To maintain a constant unemployment rate, we need to create approximately 150,000 jobs per month!!

The employment figures generally coincide with the unemployment rate, but not always Unemployment Rate Change in Employment

JanuaryFebruaryJulyMarchAprilMayJune Consider two economies. Both have a labor force equal to 100. In economy A, 10 people lose their jobs every month (but find a job the following month). In Economy B, 10 people get laid off every 3 months, but take three months to find work. 10 At any point in time, both economies have identical unemployment rates of 10% Duration measures the average length of an unemployment spell. Economy A has a duration of 1 month. Economy B has a duration of 3 months. A B

Suppose that we have the following data. JanuaryFebruaryMarchAprilMayJune 24 Weeks3 Million 12 Weeks 8 Weeks2.5 Million 3.5 Million Labor Force = 200M 12 Weeks 8 Weeks Unemployment Rate = 17.5 Million 9M 200M = 4.5% 3.5 Million 2.5 Million 7.5 Million 7 Million 3 Million + Average Duration = 3M 17.5M 7M 17.5M 7.5M 17.5M = 12.3 weeks

Length of unemployment spells in the US

Mean = 39 weeks Median = 22 weeks However, average and median duration has been rising!

Production Functions measure the relationship between inputs and output Labor Capital (Fixed in Short Run) Output Productivity (Exogenous) Typically the production function used is Cobb-Douglas Labor’s Share of Income Capital’s Share of Income

As labor increases (given a fixed capital stock), labor productivity declines!! The Marginal Product of Labor (MPL) measures the change in production associated with a small change in employment MPL=2 MPL=10 Production in the short run – capital is fixed

We also assume that the marginal product of labor is positively related to increases in either productivity and capital Production in the short run – capital is fixed MPL=14 MPL=2 MPL=10 MPL=4 or

We assume that firms are perfectly competitive. They choose labor hours to maximize profits Total Output Price of Output Labor Costs Capital Costs (Fixed in Short Run) Wage Rate Price of Capital

The best choice for labor can be found by taking looking at changes in both revenues and costs at the margin. A little rearranging gives us the following condition Real Wage Qualitatively, this tells us we would expect to see a strong positive correlation between productivity and wages

Labor HoursOutputMPL Example: For the production function given above, at a real wage of 8, 4 hours of labor are hired

Labor demand records the hiring decision (# of hours) chosen by the firm at every real wage Labor HoursOutputMPL Hours of Labor Real Wage

Altering the real wage (holding production values fixed) allows us to trace out the labor demand curve Labor HoursOutputMPL Hours of Labor Real Wage

Altering the production values (holding the real wage fixed) allows us to shift the labor demand curve Labor HoursOutputMPL Hours of Labor Real Wage

Households have utility functions that describe the relationship between choices and happiness Labor Hours Time Endowment Utility Consumption We only have a couple requirements for utility functions Utility is increasing in consumption (i.e. we like to buy things!) Utility is decreasing in labor (we don’t like to work) Utility exhibits diminishing marginal utility (the more we have of anything, the less it is worth to us at the margin)

A B C More is always better! Indifference curves show various combinations of consumption and leisure that provide the same level of utility

The marginal rate of substitution (MRS) measures the amount of consumption you are willing to give up in order to acquire a little more leisure How much consumption do you require to give up one hour of leisure (i.e. work an extra hour)?

If you have a lot of leisure relative to consumption, then leisure is much less valuable than consumption - MRS is low! Given the assumption of diminishing marginal utility, MRS varies predictably as consumption/leisure changes MRS = 12 MRS = 2 If you have a lot of consumption relative to leisure, then leisure is much more valuable than consumption - MRS is high!

Households take wages and prices as given. Further, house possess some non-labor income (i.e. asset income). Households maximize utility subject to an income constraint. Note that the choice for labor will determine the level of consumption possible.

Suppose that the hourly wage is $10 and that consumption goods cost $2. Further, you have $20 of non-labor income. Assume you have 1 hour of time available. L = 0: You don’t work at all 10 L = 1: you work as much as you can 10 15

Recall that maximizing anything requires equating costs and benefits at the margin A little rearranging…. How much is an extra unit of consumption worth to you? How much extra consumption will an extra hour of work buy you? (i.e. the real wage) How unhappy does working an extra hour make you??

At the optimum choice for labor, the slope of the indifference curve is equal to the slope of the budget constraint Consumption Hours of Labor Hours of Leisure Real Wage

10 0 Suppose the wage rate rises to $16 (non-labor income is still $20 and the price level is still $2). Does labor supply increase of decrease? 18 Hours of Labor Real Wage Hours of Leisure Substitution Effect: As the real wage increases, the price of leisure has increased relative to consumption – buy more consumption, less leisure. Income Effect: As the real wage increases, your purchasing power goes up. Buy more of both goods (consumption and leisure) Income Effect: Substitution Effect:

10 0 We typically assume that the substitution effect is dominant…a rise in the real wage increases hours of labor supplied. 18 Hours of Labor Real Wage Hours of Leisure

10 0 Suppose that the hourly wage is still $10 and that consumption goods cost $2. However, Non-labor income increases to $ Hours of Labor Real Wage Hours of Leisure

An equilibrium in the labor market is defined as a real wage where labor supply equals labor demand (i.e. the labor market clears) Note: This equilibrium assumes fixed values for productivity (A), capital (K) and non- labor income (NLI)

Note that once employment is known (capital is taken as fixed in the short run), output can be determined 1 Labor Markets 2 Production Function

We need to make assumptions about the evolution of productivity. Let’s suppose that productivity evolves according to an autoregressive process Productivity shock Persistence parameter

Suppose that the economy is hit by a positive productivity shock that is perceived to be temporary Rise in productivity For a given level of employment and capital, production increases

Suppose that the economy is hit by a positive productivity shock that is perceived to be temporary Rise in productivity With a rise in productivity, at the initial real wage, demand for labor rises Non-Labor income is (relatively) unaffected

Suppose that the economy is hit by a positive productivity shock that is perceived to be temporary Rise in productivity Non-Labor income is (relatively) unaffected The rise in labor demand increases employment and real wages

An increase in productivity that is permanent will have a larger effect on non-labor income, and create a decrease in labor supply Rise in productivity Non-Labor income increases The drop in labor supply creates a larger increase in the real wage and a smaller effect on output and employment

Just the facts ma’am. Labor Markets and the business cycle Given the mechanics of the labor market, what relationships would we expect to see between productivity, wages, employment, and output? CorrelationOutput Employment+ or - Wages+ Productivity+

GDP vs. Employment (% Deviation from trend) Correlation =.84

GDP vs. Productivity (% Deviation from trend) Correlation =.66

GDP vs. Real Wages (% Deviation from trend) Correlation =.18

The low correlation between real wages and GDP suggests that labor supply is very elastic Random labor productivity fluctuations cause large employment movements, but very little change in the real wage

Example: Oil Price Shocks in the 1970’s Dollars per Barrel 1973 Arab Oil Embargo (Permanent Shock) 1979 Iranian Revolution (Temporary Shock)

 This temporary drop in labor productivity caused a decrease in labor demand  A temporary shock creates a small income effect and, therefore, no change in labor supply. If the shock were more permanent, a rise in labor supply would push the real wage even lower This dramatic rise in oil prices can be thought of as a negative productivity shock. Remember, we are measuring GDP by value added. When energy costs go up, value added goes down

% Deviation From Trend Real Compensation (1972 – 1982) 1973 Arab Oil Embargo 1979 Iranian Revolution

% Deviation From Trend Employment (1972 – 1982) 1973 Arab Oil Embargo 1979 Iranian Revolution

% Deviation From Trend GDP (1972 – 1982) 1973 Arab Oil Embargo 1979 Iranian Revolution