WEEK IV Labor Market

W EEK IV Population: 0 ++ Working age: Labor force Out of labor force EmployedUnemployed Full time Part time

W EEK IV Definition in labor market: Labor force participation = Labor force/Working age * 100 Unemployment rate = Unemployment/Labor force * 100 Wage determination: Theoretical framework 1.Wage is paid exceeds reservation wage: the wage that make people indifferent between working or not working. Wages above the reservation wage lead people to prefer working than unemployed. Why wages is paid exceeds reservation wage? 1.Bargaining power that depends on how costly to replace labor and how hard the labor to find another jobs 2.Efficiency wages that higher wage encourage labor to be more productive and less turnover. Efficiency wage theory is linking the productivity or efficiency of labor to the wage. 2.Wages depend on labor market condition. The lower unemployment rate the higher the wages.

W EEK IV Where Pe : expected price level u: unemployment z: variables that may affect the outcome of wage setting Price level will affect real wages and both labor and firms concern on real wage (=W/P) rather than nominal wages (W). Labor concerns how the wages can buy goods and service while firm cares about the wages paid relative to price of goods and service sold. Thus to keep real wage constant, while price level is expected increasing, labor will demand higher nominal wages. Unemployment rate has minus sign thus an increase in unemployment rate decreases wages, vice-versa. z includes unemployment insurance, minimum wage, employment protection

W EEK IV Price determination Price is dependent on costs and the costs affected by the nature of the production function: relationship between inputs and output. Assume the only input used by firms is labor. Y = AN Where Y: output N: employment A: productivity (= output per labor) that is constant If A = 1 (1 labor produces 1 unit output), so the production function: Y = N Interpretation: The cost of producing one more unit of output is the cost of employing one more labor, at wage W. Therefore the marginal cost of production = W. in a perfect competitive market: P = MC thus P = W.

W EEK IV However since there is no competitive market in reality and firms have market power, thus firms charge P > MC. P = (1 + m)W Where m is the markup of the price over the cost Natural rate of Unemployment Assume Pe = P thus wage and price setting determine the equilibrium (natural) rate of unemployment. 1.Wage setting (WS): W = P F(u,z) The equation is divided by P to obtain the real wages function: W/P = F(u, z)

W EEK IV 2.Price setting (PS): P = (1 + m)W The equation is divided by W: P/W = 1 + m The equation is inverted to obtain the real wages W/P = 1/(1 + m) Interpretation: The higher markup set by firms, the lower labor’s real wages, vice versa. 3.Equilibrium condition in labor market: WS = PS F(u, z) = 1/(1 + m)

W EEK IV Natural rate of unemployment is unemployment rate such that the real wage chosen in wage setting is equal to the real wage implied by price setting. Thus PS intersect WS at A and the equilibrium unemployment: u n.

W EEK IV U n is dependent on z and m (1) Effect of an increase in unemployment benefits (z)

W EEK IV (2) Effect of a less stringent enforcement of antitrust legislation (m). The changes of z and m is a matter of structure of the economy not a nature thus u: structural rate of unemployment

W EEK IV Natural rate of Employment u = U/L = (L – N)/L = 1 – N/L Where u: unemployment rate U: unemployment L: labor force N: employment N = L(1 – u) The natural level of employment: N n = L(1 – u n )

W EEK IV Natural rate of Production Y = N Y n = N n = L(1 – u n ) Equilibrium condition in labor market: F(u, z) = 1/(1 + m) Where Y n = L(1 – u n ) or u n = 1 – (Y n /L) F[1 – (Y n /L), z] = 1/(1 + m) Interpretation: The natural rate of output (Y n ) associates with natural rate of unemployment (u n )/natural rate of employment (N n ).

W EEK IV QUIZ III i LM2 LM1 LM3 A i1 IS2 IS3 IS1 Y1 Y 1.Referring to the graph above, it is assumed that the original equilibrium condition is at point A that reflects the intersection between IS1 curve and LM1 curve. Therefore if the Government of Indonesia conducts an expansionary fiscal and monetary policies at the same time; in which the policy mix does not change interest rate. This means that: IS curve will shift (1) …….... and LM curve shifts (2) …..….. The effect of the policy mix on: Y will (3) ……., i will (4) ……, C will (5) …… NS will (6) ….. and Md will (7) ……..