Macroeconomics III Prof. Juan Gabriel Rodríguez Chapter 1 The Labor Market

Task Thus far, we have assumed constant prices and wages… But firms respond to increases in demand by increasing production… In turn, higher production leads to lower unemployment… Lower unemployment increase wages so production costs also increase… Higher production costs lead to higher prices… …and therefore to higher wages, and so on. The Medium Run: Exploration of how price and wage adjustments affect output

Definition of Terms The noninstitutional civilian population are the number of people potentially available for civilian employment. (not in the military, prisons and mental hospitals) The civilian labor force 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. The unemployment rate is the ratio of the unemployed to the labor force.

The Labor Market in Spain

Participation Rate by Sex (15-64) in Spain

6

Employment Rate (15-64) 7

Unemployment Rate (1993-2010) 12

Unemployment Rate by Sex (1993-2010) 13

Unemployment Rate for individuals under 25 (1993-2010) 14

Duality (“insiders and outsiders”):  27.9%

Hourly Productivity (UE15=100), 1997-2009 16

Salaries versus Productivity in Spain and the United Kingdom (1996-2005)

Salaries and Productivity 18

Unitary Labor Cost (2004-2010) 19

Unitary Labor Costs: Total and manufactures 20

Differential Features Index Spain OCDE Difficulty to employ 78 25.7 Rigidity of hours 60 42.2 Difficulty to layoff 30 26.3 Rigidity of employment 58 31.4 Costs of layoff (weeks of salary) 56 25.8

Differential Features

Spanish Labor Market Fails The new productive model requires: A more innovative scientific and tecnological system. Higher level of human capital: sharp reduction of drops from the education system. But…

Spanish Labor Market Fails 1st. Our labor regulation provokes firms to adapt their production to the business cycle by changing the number of workers (“labor rotation”) instead of changing the labor structure of the firm. 2nd. Collective bargaining is too centralized. 3rd. Unemployment subsidies in some cases disincentive the search for a job. 4th. Active policies for unemployed workers present large deficiencies.

Spanish Labor Market Fails 1st Spanish Labor Market Fail Large generation of low-quality jobs in booms which are destroyed during economic crisis (Intensive cyclical job creation and destruction). Thus, a) The unemployment rate has increased 12 points in 2 years. b) It has mainly concentrated in temporary contracts. Reason: A dual labor market. Some workers (insiders) have undefined contracts and their jobs are highly secure (45 days of severance pay per worked year, now 33 days). Others (outsiders) have temporary contracts and their jobs are highly unsecure (8 days of severance pay per worked year).

Spanish Labor Market Fails One solution for the dual labor market: Temporary contracts must disappear and there should be an unique undefined contract (there are so many different contracts). Severance payments should increase with antiquity. Consequences 1. A unique labor market 2. Improvement for young people, women and immigrants. 3. Increase of partial jobs.

Spanish Labor Market Fails 2nd Spanish Labor Market Fail Agreements at the firm level should be superior to agreements at higher levels. Consequences 1. Higher adaptation of labor conditions in the firm to business cycle. 2. Improvements in productivity.

Spanish Labor Market Fails 3rd Spanish Labor Market Fail Subsidies (pasive policy) should be larger at the beginning but lower at the end (less smooth) to incentive the search for a job. Moreover: Gratifications to those firms that lay off less workers. Punishments to those firms that lay off more workers.

Spanish Labor Market Fails 4th Spanish Labor Market Fail - Active policies for employment should focus on low-skilled workers (they suffer more from long-run unemployment). Example: Spain 0.5% of GDP while Denmark 1.5% of GDP. - Evaluation of active policies to improve their design (programs, agencies and public servants). - Not only public but also private agencies.

Wage Determination Workers are typically paid a wage that exceeds their reservation wage, the wage that would make them indifferent between working or being unemployed. Wages typically depend on labor market conditions and the nature of the job…

Wage Determination Bargaining How much bargaining power a worker has depends on: 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.

Wage Determination The theories that link the productivity or the efficiency of workers to the wage they are paid are called 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 more routine. Labor market conditions will affect the wage: when unemployment is low, a firm must increase wages to avoid quits. Therefore, the lower the unemployment rate, the higher the wages.

Example of Efficiency Wages In 1914,Henry Ford decided his company would pay every qualified employee a minimum of $5 per day for an eight-hour day (before it was around $2 per day for a nine-hour day). While the effects support efficiency wage theories, Ford probably had other objectives as well for raising his wages (publicity, avoiding the unions). Annual Turnover and Layoff Rates (%) at Ford, 1913-1915 1913 1914 1915 Turnover Rate 370 54 16 Layoff Rate 62 7 0.1

Wage Determination The aggregate nominal wage, W, depends on three factors: The expected price level, Pe The unemployment rate, u A catchall variable, z, that stands for all other variables that may affect the outcome of wage setting.

Wage Determination The Expected Price Level Both workers and firms care about real wages (W/P), not nominal wages (W). Workers do not care about how many Euros they receive but about how many goods they can buy with those Euros. Firms do not care about the nominal wages they pay but about the nominal wages, W, they pay relative to the price of the goods they sell, P. But nominal wages are set before the relevant prices so…

Wage Determination The Unemployment Rate Also affecting the aggregate wage is the unemployment rate, u. If we think of wages as being determined 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.

Wage Determination The Other Factors The third variable, z, is a catchall variable that stands for all the factors that affect wages, given the expected price level and the unemployment rate. Unemployment insurance is the payment of unemployment benefits to workers who lose their jobs. But also minimum wage and employment protection.

Price Determination 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, the production function can be written as: Y = output N = employment A = labor productivity, or output per worker (constant returns to labor in production but it increases over time) Further, assuming that one worker produces one unit of output—so that A = 1, then, the production function becomes: This implies that MgC = W!

Price Determination Under a perfect competitive market P=MgC and, therefore, P=W but many goods markets are not competitive so they charge a price higher than their MgC… Firms set their price according to:   More realistically: The term  is the markup of the price over the cost of production. If all markets were perfectly competitive,  = 0, and P = W/A.

The Natural Rate of Unemployment Let’s assume that nominal wages depend on the actual price level, P, rather than on the expected price level, . Wage setting and price setting determine the equilibrium rate of unemployment.

The Natural Rate of Unemployment The Wage-Setting Relation Since Pe equals P, then: This relation between the real wage and the rate of unemployment: wage-setting relation.

The Natural Rate of Unemployment The Price-Setting Relation   The price-determination equation is:   To state this equation in terms of the wage rate, we invert both sides:   The price-setting relation

The Natural Rate of Unemployment Unemployment rate (u) Real Wage (W/P) WS PS The natural rate of unemployment is the unemployment rate such that the real wage chosen in wage setting is equal to the real wage implied by price setting.

The Natural Rate of Unemployment Eliminating W/P from the wage-setting and the price-setting relations, we can obtain the equilibrium unemployment rate, un:   The equilibrium unemployment rate (un) is called the natural or structural rate of unemployment.

The Natural Rate of Unemployment The positions of the wage-setting and price-setting curves, and thus the natural or structural unemployment rate, depend on μ, A and z. At a given unemployment rate, higher unemployment benefits lead to a higher real wage. A higher unemployment rate is needed to bring the real wage back to what firms are willing to pay. By letting firms increase their prices given the wage, less stringent enforcement of antitrust legislation leads to a decrease in the real wage. Higher labor productivity is somehow equivalent to a reduction in wages

The Natural Rate of Unemployment WS’ Unemployment rate (u) Real Wage (W/P) WS PS An increase in unemployment benefits leads to an increase in the natural rate of unemployment.

The Natural Rate of Unemployment Unemployment rate (u) Real Wage (W/P) WS PS An increase in markups decreases the real wage and leads to an increase in the natural rate of unemployment. PS’ What would happen if A changes?

The Natural Rate of Unemployment Given the rate of unemployment and the level of employment (N) we have: Employment in terms of the labor force and the unemployment rate equals: The natural level of employment, Nn, is given by:

The Natural Rate of Unemployment Associated with the natural level of employment is the natural level of output, and since (Y=N):   The natural level of output satisfies the following:   In words, the natural level of output is such that, at the associated rate of unemployment, the real wage chosen in wage setting is equal to the real wage implied by price setting. ,

The Natural Rate of Unemployment If equilibrium in the labor market determines the unemployment rate, and therefore, the level of output, we should not need the goods and financial markets… Because in the short run there is no reason to believe that the price level equals the expected price level, unemployment (output) can be different to the natural rate (level) at the short run. In the short run the factors that determine changes in output are monetary and fiscal policies, consumer confidence and so on. In the medium run the factors are those related to the labor market.