Wage Determination

Lets turn to wage determination, and to the relation between wages

and unemployment. Wages are set in many different ways.
Collective bargaining
Bargaining between a union (a group of unions) and a firm (a group
of firms)
Two common forces at work in wage determination in all countries
Workers are usually paid a wage that exceeds their reservation
wage.
Reservation wage
The wage that would make workers indifferent between working
and being unemployed

Wage Determination
Two common forces at work in wage determination in all countries
Wages typically depend on conditions in labor market. The lower
the unemployment rate, the higher the wages.
Economists Have Focused on Two Broad Lines of Explanation to
Think of These Facts
Even in the absence of collective bargaining, workers have some
bargaining power.
The degree of a workers bargaining power depends on two factors:
(i) The nature of a job how costly it would be for a firm to replace
a worker, were he/she to leave the firm;

Wage Determination
Economists Have Focused on Two Broad Lines of Explanation to
Think of These Facts
the higher the skills needed to do a job, the more likely there is to be
bargaining. Wages offered for entry-level jobs are on a take-it-or leave-it basis.
(ii) conditions in labor market when the unemployment is low, it is
more difficult for firms to find acceptable replacement workers.
Efficiency wage theory
Paying a wage above the reservation wage makes it more attractive
for workers to stay. It decreases turnover and increases productivity.

Wages, Prices, and Unemployment

6.8 : = ,
,+

The aggregate nominal wage depends on three factors:

The expected price level
The unemployment rate
All other variables that may affect wage setting
(i) The expected price level
Q: Why does the price level affect nominal wages?
A: Because both firms and workers care about real wages = how
many goods can be purchased with wages =

Wages, Prices, and Unemployment

Q: Why do wages depend on the expected price level , rather
than the actual price level ?
A: Because wages are set in nominal terms, and when they are set,
the relevant price level is not yet known.
(ii) The unemployment rate
Higher unemployment weakens workers bargaining power, forcing
them to accept lower wages. Also, higher unemployment allows firms
to pay lower wages and still keep workers willing to work.

Wages, Prices, and Unemployment

(iii) The other factors
Unemployment insurance, an increase in minimum wage, and
an increase in employment protection lead to an increase in wage.
Unemployment insurance: the payment of unemployment benefits
to workers who lose their jobs - allows unemployed workers to hold
out for higher wages.
An increase in the minimum wage leads to an increase in
the average wage, .
An increase in employment protection is likely to increase
the bargaining power of workers covered by this protection.

Price Determination

The prices set by firms depend on the costs they face. These cost, in turn,
depend on the nature of the production function and on the prices of
the inputs used in production.
Simplest Cobb-Douglas Production Function
Firms produce goods using labor () as the only factor of production:
= =

= : per (called labor prodiuctivity)

= 1 One worker produces one unit of output.

Thus, 6.9 : = =
= : The cost of producing one more unit of output, called
the marginal cost, is the cost of employing one more worker at wage W.

Price Determination
Profit = Revenue Cost
= (), where = .
(i) Price Determination in Competitive Markets

Profit

= = 0

=
=

=0

Price Determination
(ii) Price Determination in imperfectly competitive market
(such as monopoly and monopolistic competition):
Profit =

Profit

+
1 +
1 +

1
=

=0

Price Determination
=

1
1+

1+

1=
1=

1
1+
1+
1+

1 =
= 1 +

= 1 +

1
1+

Price Determination
. : = +
Meaning: Now that goods markets are not competitive and firms
have market power, m is positive, and the price will exceed the cost
W by a factor equal to 1 + .

The excess of the price over the marginal cost
The ratio of the price to the (marginal) cost which can be used as
a measure of market power across firms, industries, or economies

The Natural Rate of Unemployment

Consider the implications of wage and price determination for

unemployment. Under the assumption of = ,wage setting and
price setting determine the equilibrium (also called natural) rate of
unemployment.
Wage-Setting Relation
Relation between the real wage and the rate of unemployment
Given the assumption of = , = , .
6.11 :

= , , wage-setting (WS) relation

,+

Wage-Setting Relation
6.11 :

= , , wage-setting (WS) relation

,+

The higher the unemployment rate, the lower the real wage chosen
by wage setter: The higher the unemployment rate, the weaker
the workers bargaining position, and the lower the real wage will be.
Wage setters
Unions and firms if wages are set by collective bargaining or
Individual workers and firms if wages are set on a case-by-case
basis or
Firms if wages are set on a take-it-or-leave basis

Figure 6.5: Wages, Prices, and the Natural Rate of Unemployment

Downward-sloping wage-setting (PS) curve: The higher

the unemployment rate, the lower the real wage.

Price-Setting Relation
Recall 6.10 : = 1 + 6.12 :

= +

Now invert 6.12 to get the implied real wage:

6.13 :

,
+

price-setting (PS) relation

Meaning: Price-setting decisions determine the real wage paid by

firms. An increase in the markup leads firms to increase their prices,
given the wage they have to pay; equivalently, it leads to a decrease
in the real wage: , given

The real wage implied by price setting (PS) is

independent of .

1
,
1+

which is

Equilibrium Real Wage and Unemployment

Equilibrium condition in the labor market: =
The real wage chosen in the wage setting should be equal to
the real wage implied by price setting.
6.14 : , =

The equilibrium unemployment rate is such that real wage

chosen in wage setting (WS) is equal to the real wage implied by price
Setting (PS).

Equilibrium Unemployment Rate

Natural rate of unemployment or full-employment rate of

unemployment
The rate of unemployment when output and employment are at

the full-employment level

The unemployment rate that prevails if =
The rate of unemployment toward which the economy gravitates in
the long run, given all the labor-market imperfections that prevent
workers from instantly finding jobs
Frictional unemployment + Structural unemployment

Equilibrium Unemployment Rate

The labor market is considered to be: overheating when < and

cooling off when > .
That's definitely not the case for January 2012, with a natural rate of
unemployment of 7.87% and an official rate of unemployment of
8.26%.
Because of the combination of frictional and structural
unemployment, an economys unemployment rate is never zero.
Cyclical unemployment =

Cyclical Unemployment
Cyclical unemployment =
(i) When > , < and < .
Positive cyclical unemployment.
(ii) When < , > and > .
Negative cyclical unemployment.
(iii) When = , = , = .
Cyclical unemployment is zero. In other words, the economy is at full
employment. The term full employment does not mean that every
worker has a job.

Figure 6.6: Unemployment rate and Natural Rate of

Unemployment in the United States

Positions of WS and PS, and thus Equilibrium Unemployment

Rate

Increase in unemployment benefits

from WS to
Since an increase in benefits makes the prospect of unemployment
less painful, it increases the wage set by wage setters at a given
unemployment rate.
The economy moves along the PS line from to
The natural rate of unemployment increases from to

Figure 6.7: Unemployment Benefits and the Natural Rate of

Unemployment

Unemployment Benefits and Natural Rate of Unemployment

At a given unemployment rate, higher unemployment benefits lead
to a higher real wage.
A higher unemployment is needed to bring the real wage back to
what firms are willing to pay.

Positions of WS and PS, and thus Equilibrium Unemployment

Rate
A less stringent enforcement of existing antitrust regulation
It allows firms to collude more easily and increase their market
power
An increase in m
leads to an increase in P

given W

from PS to
The economy moves along the WS line from to
The natural rate of unemployment increases from to

Figure 6.8: Markups and the Natural Rate of Unemployment

Markups and Natural Rate of Unemployment

By letting firms increase their prices (P) given wage (W),
less stringent enforcement of antitrust legislation leads to a decrease
in real wage.
Higher unemployment is required to make workers accept this lower
real wage, leading to an increase in the natural rate of
unemployment.

From Unemployment to Employment

Natural level of employment is associated with
the natural rate of unemployment .
Natural level of employment or full employment
The level of employment that prevails when unemployment is
equal to its natural rate ( = )
( = )

Let denote the labor force, the number of workers employed

(employment), and the number of workers unemployed
(unemployment). = + .

From Unemployment to Employment

= + .

= 1

=1

= 1
= if =

For example, = 150 and = 5% 0.05

= 150 1 0.05 = 142.5 .

From Employment to Output

The natural level of output is associated with the natural level of
employment.
Natural level of output or full-employment level of output
The level of production when employment is equal to the natural
level of employment
Given the simplest production function = ,
= ( ) = 1 .
Using 6.14 : , =

1
1+

and = 1

=1

From Employment to Output

6.15 : 1

1
1+

The real wage chosen in wage setting is equal to the real wage
implied by price setting

Job Separation, Job Finding, and

We will develop a model of labor-force dynamics that shows what

determines the natural rate of unemployment.
We assume that the labor force L is fixed and focus on
the transition of workers in the labor force between employment E
and unemployment U.
If the unemployment rate is neither rising nor falling that is, if
the labor market is in a steady state 6.16 : = ,
the steady-state condition.
In a boom, > ; In a recession, <

Job Separation, Job Finding, and

Derivation of Steady-State (Medium-run) Unemployment Rate:

= + +1 =
In steady state, +1 = 0
0 =
0 = since =
0 = +

=
(the
+

=
(+)

number of the unemployed in steady state)

. : =

Steady-State Unemployment Rate

Intuition of . : This equation holds in the steady state

(the medium run or the long run) to determine the natural rate of
unemployment: the rate that prevails when the economy is neither in
a boom nor a recession.
The steady-state unemployment rate depends on the rate of job
separation and the rate of job finding .
The higher the rate of job separation, the higher the unemployment
rate. Mathematically, take the derivative of (6.17) w.r.t. ;

+
+

>

Steady-State Unemployment Rate

The higher the rate of job finding, the lower the unemployment rate.
Mathematically,

(+)
+

< .

Example (6.2): Suppose that in the long run, 1.5 percent of the
employed lose their jobs each month ( = 0.015), which means that

the average spell of employment lasts =

= . months.

Suppose further that in the long run, 25 percent of the unemployed

find a job each month ( = 0.25), so that the average spell of

unemployment is =

= months.

Steady-State Unemployment Rate

Thus, the steady-state unemployment rate or natural rate of

unemployment is =

.
.+.

= . . .

Public Policy Implications of (6.17)

Any policy aimed at lowering the natural rate of unemployment must

either reduce the rate of job separation or increase the rate of job
finding. Similarly, any policy that affects the rate of job separation or
job finding also changes the natural rate of unemployment.
Lower minimum wage
Better information
Better training of workers
Remove disincentives to work
Reducing in payroll taxes

Public Policy Implications of (. )

Unfortunately, well-intentioned policies to change the job-finding rate

and the job-separation rate can have unintended consequences.
For example, policymakers may try to reduce the job separation by
imposing firing costs on firms; any firm that fires a worker must pay
one years salary as a severance package, and this would indeed
reduce the natural rate of unemployment.
But firms could then become reluctant to hire new workers, reducing
the job-finding rate. The net of these effects could be to increase
the natural rate of unemployment than to decrease it.

Unemployment and Okuns Law

We can use the concept of cyclical unemployment to provide a more
precise link between the state of the labor market and aggregate
output (Y).
Q: What relationship should we expect to find between
unemployment and real GDP (Y)?
A: Increases in the unemployment rate should be associated with
decreases in real GDP (Y); i.e., if output growth is very high,
unemployment will fall.
This negative relationship between unemployment and GDP is called
Okuns law, after Arthur Okun.

The Growth Rate Form of Okuns Law, Assuming is Constant:

6.18

= .

% = 3% 2 %
is actual output or real GDP
is actual unemployment rate
is the average annual growth rate of natural-level of output
is a factor relating changes in unemployment to changes in output
Meaning of =2
1% increase in the unemployment rate, on average, decreases real
GDP growth by 2 percent.

The Growth Rate Form of Okuns Law, Assuming is Constant

= 0
Real GDP grows by about 3%; this normal growth in the production
of goods is due to growth in the labor force, capital accumulation,
and technological progress.
For example, if the unemployment rises from 5 to 7 percent,
then % = 3% 2 % = 3% 2 7% 5% = 1%.
Okuns law says that GDP would fall by 1 percent, indicating that
the economy is in a recession.

Figure 6.9: Okuns Law in the United States: 1951 - 2011

The Gap Version of Okuns Law

6.19

Interpretation: The deviation of output from its natural level is

inversely related to the deviation of unemployment from its natural
level; that is, when > , < .
The gap between an economys full-employment output and its
actual level of output increases by 2 percentage points for each
percentage point the unemployment increases
The percentage gap between potential and actual output equals
2 times the cyclical unemployment

Example (6.3): Okuns Law

= 6%, = $15,000 billion $15 trillion and = 7%.
What is the current level of output?
(Ans.)
Cyclical unemployment = = 7% 6% = 1%
Okuns law predicts that actual output (Y) will be 2%(= 2 1%)
lower than

= 0.98 $15,000 billion = $14,700 billion

Okuns Law
Q: Why doe s a 1% point increase in unemployment lead to twice as
large a drop in output?
A: When cyclical unemployment increases, other factors that
determine output the number of people in the labor force,
the number of hours each worker works, the average labor
productivity also fall, which magnifies the effect of the increase
in unemployment.

Derivation of the Growth Rate Form of Okuns Law

= 2( )

= 2 + 2

1 = 2 + 2

Calculate the change from the previous year to the current year
for each side of the equation:

= 2 1 + 2 ,
assuming that is constant

Derivation of the Growth Rate Form of Okuns Law

= 2

= 2

Rule 2:

X
Z

X
Z

X
Z

In the United States, the average growth rate of

3% = 2
= 3% 2

, ,

is 3%.