1 The Labor Market: Wages … Prices … Wages Higher production requires an increase in employment Higher employment reduces unemployment Lower unemployment puts pressure on wages Higher wages increase production costs and prices Higher prices lead workers to ask for higher wages…. Prices and wages (the labor market) adjust over the medium run and influence output Medium Run Response to an Increase in Demand

2 The Labor Market: The Medium Run A Tour of the Labor Market U.S. Population million Minus: Pop. under 16,-69.8 million Armed forces and Incarcerated Civilian Noninstitutional Pop million Civilian Labor Force146.5 million Employed137.7 million Unemployed 8.8 million Out of the Labor Force 74.7 million

3 The Labor Market: The Medium Run A Tour of the Labor Market The participation rate= The unemployment rate =

4 The Labor Market: The Medium Run Employment 127 million Job Change 3.5 million Unemployment 7.0 million Out of labor force 66.7 million Labor Force Data, 1994 – 1999 (monthly flows)

5 A Tour of the Labor Market Differences Across Workers Monthly Separation Rates for Different Groups, Category Male: Ages Female: Ages Monthly Separation Rate (%) (Quits and Layoffs)

6 Movements in Unemployment

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9 High Unemployment: Increases the probability of workers losing their jobs Reduces the probability of the unemployed finding a job Increases the duration of unemployment

10 Wage Determination 1.Workers’ wages exceed their reservation wage 2.Wages depend on labor-market conditions: How easily can a worker be replaced? How easily a worker can find another job? Efficiency Wages : Wages above the reservation wage that increase productivity and reduce the turnover rate.

11 Wages and Unemployment Wage determination: W = Wage P e = Expected price level u = The unemployment rate z = Other variables that affect the wage setting

12 The expected price level, P e & wages Wage Setting Behavior: Workers base their wage request on the purchasing power of their wages or real wage W/P Employers base the wage they pay on the price of the product they sell or the real wage W/P Therefore, if Price (P) increases, wages (W) increase The unemployment rate, and wages Higher unemployment reduces bargaining power of labor and wages Higher unemployment reduces the efficiency wage The other factors and wages Unemployment insurance: higher benefits  higher wages Structural Economic Change: wages increase when jobs created exceed jobs destroyed

13 Price Determination and the Production Function Assume labor is the only input, then Output (Y) = AN N = Employment A = Labor Productivity Assume A=1 Y = N If Y=N: then marginal cost = Wage (W) In non-competitive markets: P=(1+µ)W µ= Markup of price over cost If markup (µ) increases Price (P) increases, given wages (W) Real wage falls

14 The wage-setting relation P e = P in medium run, so W =P F(u,z) The higher the unemployment rate (u), the lower the real wage

15 The wage-setting relation: WS Unemployment Rate, u Real Wage, W/P Wage-setting relation (W/P varies inversely with u) The Price-setting relation: Unemployment Rate, u Real Wage, W/P PS Price-setting relation (W/P is independent of u)

16 Unemployment Rate, u Real Wage, W/P u n – The natural rate of unemployment Natural Rate of Unemployment …Structural Rate … Equilibrium Rate … NAIRU Equilibrium Real Wages, Employment and Unemployment Labor Market Equilibrium WS PS Wage-setting, F(u, Z) = Price-setting, A

17 WS´ = F(u, Z´) The Natural Rate of Unemployment / Structural Rate of Unemployment = The unemployment rate at which wage-setters accept the real wage they must accept, given markup μ. The Natural Rate of Unemployment / Structural Rate of Unemployment = The unemployment rate at which wage-setters accept the real wage they must accept, given markup μ. Is the natural rate of unemployment “natural”? Scenario: Increase unemployment benefits (z increases) Is the natural rate of unemployment “natural”? Scenario: Increase unemployment benefits (z increases) Unemployment Rate, u Real Wage, W/P WS = F(u, Z) PS unun A B un´un´ The increase in Z increases u n

18 The Natural Rate of Unemployment Scenario: More stringent antitrust legislation (µ decreases) Real Wage, W/P WS = F(u, Z) PS unun un´un´ The decrease in µ reduces u n PS´ Unemployment Rate, u

19 From Unemployment to Output U = unemployment N = employment L = labor force u = unemployment rate Rearranging for N: N=L(1-u) The Natural Level of Employment N=L(1-u) u n = natural rate of unemployment N n = natural level of employment N n = L(1-u n )

20 From Unemployment to Output Equilibrium Unemployment Rate: Natural level of output:

21 Equilibrium Real Wages, Employment, and Unemployment At Y n the associated and the real wage chosen in wage setting equals the real wage implied by price setting.

22 Short-Run Price level may not equal the expected price Unemployment may not equal natural unemployment level Output may not equal natural output Price level may not equal the expected price Unemployment may not equal natural unemployment level Output may not equal natural output Medium- Term Price level tends to equal expected prices Unemployment tends to the natural rate Output moves toward the natural rate Price level tends to equal expected prices Unemployment tends to the natural rate Output moves toward the natural rate The Appropriate Time Frame