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Chapter 9 (1) - The labour market: wages, profits and unemployment -…
Chapter 9 (1) - The labour market: wages, profits and unemployment
Unit 1
To determine the price to set, the firm finds the markup over their production cost that balances the gains from a higher price against the losses from lower sales so as to maximize its profits
Real wage is the nominal wage divided by the price level of a standard bundle of consumer goods, so it is determined both by the nominal wages paid by the firms and the prices they each set
In order to motivate employees to work hard and well, firms must set the wage sufficiently high so that the worker receives an employment rent. If the worker is very likely to find alternative work if she is fired, which will be the case if the employment level in the economy is high, she will need a higher wage to work hard.
Here is how the first stage (choosing the wage, price and employment) takes place in each firm:
- The human resources department determines the lowest wage it can pay
- The marketing department sets the price
- The production department then calculates how many employees have to be hired to produce the output determined by the marketing department, based on the firm's production function
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The second stage - considering the outcome of all the firm's decisions added together.
Once all firms in the economy have made their wage and price (markup) decisions, the output per worker in the economy is divided into the real wage that a worker receives, and the real profits that the owner receives. If all firms are charging the same price and setting the same nominal wage, then a higher real wage (W/P) means a lower markup [1-(W/P)] To understand how the real wage and employment are jointly determined in the labour market we need two basic concepts:
- The wage-setting curve
- The price-setting curve
The only input to production is labour, so that the only cost is the wage, and the profits are determined by just three things: the nominal wage (the actual amount received in a particular currency), the price at which the firm sells its goods, and the average output produced by a worker in an hour
Unit 3
With an unemployment rate of 12%, the reservation wage is shown by point F. The employer's profit-maximizing choice is point A with the low wage (WL)
In the lower panel, we plot point A. The dashed line from unemployment of 12% indicates that the wage is set at WL. We now assume a fixed size for the labour force and the horizontal axis gives the number of workers employed, N
A higher unemployment rate reduces the reservation wage, because a worker faces a longer expected period of unemployment if he or she loses a job. This weakens the employees' bargaining power and shifts the best response curve to the left
As employment increases to the right, the unemployment rate falls
The top-panel of this figure shows the employee's best response curve at the two unemployment rates of 12% and 5%
Both the reservation wage and the wage set by the employer are higher, as shown by point B. This gives the second point on the wage-setting curve in the lower panel
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- The wage-setting curve is an upward sloping line.
- Like the best-effort response function of the employee on which it is based, the wage-setting curve is a mathematical version of an "if-the" statement: If the employment rate is x then the NASH EQUILIBRIUM wage will be w.
- This means that at the employment rate x, the wage w is the result of both employers and employees doing the best they can in setting wages and responding to the wage with a given amount of effort, respectively
Figure 6 is a wage-setting curve estimated from data for the US. Note the horizontal axis shows the unemployment rate explicitly, falling from left to right
- The labour force is the vertical line furthest to the right, it has a value less than 1, depending on the participation rate.
- Inactive workers are to the right of the labour force line
- The employment rate is the vertical line to the left of the labour force, indicating the share of the population who are actually working
- The unemployment rate is the proportion of those in the labour force who are not employed, that is those workers in between the employment rate line and the labour force line
By using data on unemployment rates and wages in local areas, economists can estimate and plot the wage-setting curve for an economy
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Unit 4
The marketing department asks: which combinations of p and q are feasible? These combinations are shown by the demand curve, which will depend on the amounts that other firms are producing, the prices they are setting, the wages they are paying, and other influences on the total level of demand for goods in the economy. Pick a point on the demand curve, so the marketing departments look at figure 7 to determine how profitable each price-quantity combination would be
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Using the value of W chosen by HR, the marketing department constructs the isoprofit curves shown.
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This firm has only one input - labour - so the wage is the only cost. We assume that one hour of labour produces one unit of output (An average product of labour = a = 1
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The firm's decision comes from the interaction between the firm's three departments. These are the human resources (HR), the marketing department, and the production department (PD)
Maximum profits occur at point B, where the demand curve is tangent to an isoprofit curve
The amount produced depends on the amount that the firm is able to sell, which in turn depends on the price that is charged
Notice from the figure the that once the firm has set a price, it has determined the division of the total revenue between the profits and the wages. This is based on the markup (p-W) / p OR 1 - (W/p). This is greater when the demand curve is less elastic, indicating less intense competition
Unit 2
Participation rate - shows the proportion of the working age population that is in the labour force. It is calculated as follows:
participation rate = (labour force) / (population of working age)
= (employed + unemployed) / (population of working age)
The unemployment rate - shows the proportion of the labour force that is unemployed. It is calculated as follows:
unemployment rate = unemployed / labour force
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Employment rate - shows the proportion of the population of working age that are in paid work or self-employed. It is calculated as follows:
employment rate = employed / population of working age
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The denominator is different for the unemployment and the employment rate. Two countries with the same unemployment rate can differ in their employment rates if one has a high participation rate and the other has a low one
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The unemployed are the people who:
- were without work during a reference period (usually 4 weeks) which means they were not in paid employment or self-employment
- were available for work
- were seeking work, which means they had taken specific steps in that period to seek paid employment or self-employment
This figure provides a picture of the labour markets and shows how the labour market statistics relate to each other
Unit 5
In figure 8, above the price-setting curve, like point A, firms raise prices and cut employment
Below the price-setting curve, at a point like C, firms lower prices and hire more people
The rise in price and the reduction in employment are indicated by the arrow at point A in figure 9, which points down and to the left. It points down because the rise in prices implies a fall in the real wage, that is, the nominal wage divided by the price. It points left because a price increase implies a fall in output and employment
- What will determine the height of the price setting curve?
- Competition which determines mark-up
- Labour productivity which determines real wage for given mark-up
Point B in figures 8 and 9 on the price-setting curve shows the outcome of profit-maximizing price-setting behaviour of firms for the economy as a whole
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The higher the elasticity, the lower the firm's price and mark-up
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Using our assumptions, the firm's marginal and average cost is its unit labour cost (W/n), and we can say that the firm sets its price, p so that:
u = (p - W/n) / p
= 1 - (W/p) / n
For the economy as a whole, when all firms set prices this way, output per worker (labour productivity, or equivalently, the average product of labour, called lambda, a) is split into real profit per worker pie/P and the real wage W/P
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When the firm sets the price as a markup on its wage cost, this means that the price per unit of output is split into the profit per unit and the wage cost per unit
In words, this says:
real wage = output per worker (n) - real profit per worker (nu)
Unit 6
Employment is the highest it can be on the price setting curve, given the wage offered
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The equilibrium of the labour market is where the wage-and price- setting curves intersect. This is a Nash equilibrium because all parties are doing the best they can, given what everyone else is doing. Each firm is setting the nominal wage where the isocost curve is tangent to the best response function and is setting the profit-maximizing price
We now show why there will always be unemployment in labour market equilibrium, this is called equilibrium unemployment
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Unemployment means that there are people seeking work but not finding it. This is also termed excess supply in the labour market, meaning that demand for labour at the given wage is lower than the number of workers willing to work at that wage.
There is no work done and no profits, so nobody is hired: the only outcome possible in the long run if the real wage is below the wage-setting curve is zero employment
We assume that the labour supply curve is vertical, meaning that higher wages do not lead to more people to offer more hours at work
All points in the shaded area below the wage setting curve are labeled "no work done" because in this region the real wage is insufficient to motivate workers to work.
- Why will there always be some involuntary unemployment in labour market equilibrium?
- If there was no unemployment the cost of job loss is zero
- Some unemployment is necessary, it means the employer can motivate workers to provide effort on the job
- Therefore the wage-setting curve is always to the left of the labour supply curve
- It follows that in any equilibrium, where the wage and price-setting curves intersect, there must be unemployed people, this is shown by the gap between the wage-setting curve and the labour supply curve
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Any policy that comes close to entirely eliminating unemployment would put employers in a position that the best they could do would be to pay wages so high they would eliminate the employers' profits and drive the firms out of business