T
hink about what happens when firms respond to an increase in demand by increasing production:
• Higher production leads to higher employment.
• Higher employment leads to lower unemployment.
• Lower unemployment leads to higher wages.
• Higher wages increase production costs, leading firms to increase prices.
• Higher prices lead workers to ask for higher wages.
• And so on.
So far, we have simply ignored this sequence of events. By assuming a constant price level, in effect we assumed that firms were willing to supply any amount of output at a given price level. As long as our focus was on the short run, this assumption was acceptable. But, as our attention turns towards the medium run, we must now abandon this assumption and explore how prices and wages adjust over time and how this, in turn, affects the response of output.This will be our task in this and the next three chapters.
At the centre of the sequence of events sketched above is the labour market, the market in which wages are determined. This chapter focuses on the labour market.
• Section 6.1 provides an overview of the labour market.
• Section 6.2 focuses on unemployment, how it moves over time, and how its movements affect individual workers.
• Sections 6.3 and 6.4 look at wage and price determination.
• Section 6.5 looks at equilibrium in the labour market. It characterises the natural rate of unemployment, the rate of unemployment to which the economy tends to return in the medium run.
• Section 6.6 considers how taxes can lead to distortions that affect the natural rate of unemployment.
• Section 6.7 gives the map of where we go next.
6.1 A TOUR OF THE LABOUR MARKET
The total Australian population in lulv 2008 was 21.39 million (Table 6.1 . Excluding those who were either under working age (under 15), in the armed forces or behind bars, the number of people potentially available for civilian employment, the civilian population (non-institutional), was 17.16 million in July 2008.
The civilian labour force—the чип ot those either working or looking lor work—was only 11.20 million, however. The other 5.96 million people were not in the labour force neither working in the marketplace nor looking lor work. So, the participation rate, defined as the ratio ol the labour lorcc to the non-institutional civilian population, was 65.3 per cent = 100 x II .20/17.16 . The partici¬pation rate has steadily increased over time, reflecting mostly the increasing participation rale ol women. In the 1960s, about one woman (actually 1.2!) out ol three was in the labour lorce,- now the number is getting towards two (actually 1.7: > out of three. In contrast, the participation rate of men has fallen in that period Irom about 83 per cent to 72 per cent. Economists predict that the overall participation rate will decline to about 60 percent in the next twenty years due to population ageing. This could become a serious problem because it threatens to diminish the average standard ol living.
< Sclerosis, a medical term, means hardening, e.g. of the arteries. By analogy, it is used in economics to describe markets (such as the labour market) that function poorly and have few transactions.
Of those in the labour lorce in luly 2008 10.72 million were employed and 0.48 million were unemployed—looking for work. So, the unemployment rate, defined as the ratio ot the unemployed to the labour force, was 0.48/11.20 4.3 per cent. As discussed in Chapter I. the average unemployment rate Irom I960 to 2007 was 5.3 per cent, and so the 2008 unemployment rate was unusually low.
The large flows of workers
To think lurther about unemployment, and what it implies for individual workers, consider the following analogy.
Take an airport full of passengers. It may be hill because many planes arc coming and going, and many passengers are quickly moving in and out ol the airport. Or it may be lull because bad weather is delaying (lights and passengers are stuck. wailing lor lhe weather to improve. The number ol passengers in the airport will be high in both cases, but their plight will be quite different.
In the same way, an unemployment rate may reflect two very different realities. It may reflect an active labour market, with many separations and many hires, and so with many workers entering and exiting unemployment,- or it may reflect a sclerotic labour market, with lew separations, few hires and a stagnant unemployment pool.
finding out which reality hides behind the aggregate unemployment rate requires data on movements ol workers. Such flow data are available in Ausiralia Irom a monthly survey called thc Labour Force Survey (LFS). Average monthly Mows, calculated from the LFS lor Australia Irom July 2007 to lime 2008, are reported in Figure 6.1. These figures show the stocks ol people employed, unemployed and out ol the labour force for the previous month and then the flows Irom these stocks to those of the current month. The stock numbers in Table (>.1 are actually larger than those in Figure 6.1,. for example, the actual number ol employed was 10.72 million while employment Irom the LFS was 8.58 million. There are three reasons for this discrepancy:
4 Work in the home, such as keeping house and raising children, is not classified as work in official statistics. The reason is the difficulty o: measuring these activities, not a value judgment as to what is, or is not, considered со be work.
• The LFS data on flows of workers is based on a survey ol matching individuals over two months. This means thai some surveyed in one month might not have been located and therefore matched in the next month.
Table 6.1 Population, labour force, employment and unemployment in Australia. July 2008
Total population: 21.39 million
Civilian population: 17.16 million
Civilian labour force: 1 1.20 million Out of the labour force: 5.96 million
Participation rate: 65.3%
Employed: 10.72 million Unemployed: 0.48 million
Unemployment rate: 4.3%
SOURCE: Australian Bureau of Statistics, cat. no. 6202.
( I) The flows of workers in and out of employment are large.
(2) Thc flows in and out of unemployment are large in relation to the number of unemployed.
(3) There are also large flows in and out of the labour force, much of them directly to and from employment SOURCE: Australian Bureau o' Statistics, cat. no. 6291.
The Australian Bureau of Statistics (ABS) conducts a monthly survey of the Australian labour markets. This is the main source of statistics on the labour force, employment, participation and earnings in Australia. It began in 1978. and is a subset of the broader Monthly Population Survey that includes many other surveys.
Each LFS is based on a sample of about 42,000 people across Australia (reduced from 55,000 in July 2008 due to government budget cuts). It covers about 0.24 per cent of the Australian population.The households are chosen so that the sample is representative of the Australian population. Each household stays in the sample for eight months and then leaves the sample permanently. Interviews are done either in person or by phone during the two weeks beginning on the Monday between the 6th and 12th of each month, with questions relating to the week prior to the interview.
The ABS uses the data to calculate and publish numbers on employment, unemployment and participation by age, sex. education and industry.These LFS estimates are published monthly in Labour Force, Australia (ABS. cat.nos 6202.0 and 6291). A series of time-series spreadsheets are released at the same time. Economists use these data, which are available in large computer spreadsheet files, in two ways.
The first is to get snapshots of how things are at various points in time, to answer questions such as: What is the distribution of wages for workers with only primary education, and how does it compare with the same distribution ten or twenty years ago?
The second, of which Figure 6.1 is an example, is by exploiting the fact that the survey follows people through time. By looking at those who are in the sample in two adjacent months, economists can find out, for example, how many of those who were unemployed last month are employed this month.This number gives them an estimate of the probability of finding a job for those who were unemployed last month.
0.083
Out of the labour force 4.48 million .
гнг мьгаим RUN chapte" 6
Figure 6.1 Average monthly flows (millions) between employment, unemployment and non- participation in Australia. August 2007 to July 2008
For more on the LFS, with descriptions of the underlying concepts of Australia's labour market statistics, and the sources and methods used in compiling the estimates, go to the ABS website (www.abs.gov.au) and search for the document 102.0.55.001.
F.vcry month, one-eighth ot the sample is discarded and a new set added. 1 heretore, individuals in the survey arc kept in the sample for only eight months. In their lirsi month ol being surveyed, the new set cannot have a match over two months.
The data in Table 6.1 are lor one month, July 2008, while in Figure 6.1 they are the monthly averages over the twelve months to Inly 2008.
Despite these discrepancies, the proportional information in figure 6.1 remains relevant. 'For more the ins and outs of the LFS, see the locus box The Australian labour Force Survey LFS . Figure 6.1 has three striking features:
The Mows of workers in and out ot employment are very large.
On average in the year 2007-08, there were 381,000 separations i 0.083 i 0.066 + 0.232 million each month in Australia which is 4.4 percent ol an employment pool ot 8.58 million>: this ligure includes the 83.ООО separations as people moved from job to job without getting unemployed 1 the circle arrow at the topi. An average ol 66,000 moved Irom employment to unemployment 1 the arrow Irom 'Employment' to Unemployment and a huge 232,000 moved from being employed to being out ol the labour lorce (the arrow from 'Employment' to Out ol the labour force').
Why are there so many separations each month? The majority ol separations are usually voluntary quits (68 per cent in 2006, ABS, cat. no. 6209). workers leaving their jobs lor a better alternative. Thc remaining are layoffs, or job losers. Sixty per cent of these job losers worked for less than a year, and hall ol them were in temporary or seasonal jobs. The slowly changing aggregate employment numbers hide a reality ol continual job destruction and job creation across lirms. At any time, some lirms are sullering decreases in demand and decreasing their employment,- other firms are enjoying increases in demand and increasing employment. Though there are many separations every month more than 70 per cent ot Australians remain in the same jobs they had a year ago.
Thc Mows in and out ol unemployment are large in relation to the number ol unemployed.
The average flow out of unemployment each month in 2007-08 was 187,000: 95,000 got a job, and 92.000 stopped searching and dropped out ot the labour lorce. Put another way, the proportion ot unemployed leaving unemployment equalled 187,000 370,000, or about 50 per cent each month. The identity ol those in unemployment changes dramatically Irom month to month. Put yet another way, the average duration of unemployment—the average length ol time people spend unemployed is two months (I 0.50 .
I his lact has an important implication. You shouldn't think of the unemployed as a stagnant pool of workers waiting indefinitely lor jobs. For most (obviously not all) of the unemployed, being unemployed is more a quick transition than a long wail between jobs. In this respect, Australia is now quite similar to the Llnited States, where the average duration ol unemployment is between two and three months,- but this is unusual among rich countries. Evidence from Western Europe shows a much smaller proportion ol the unemployed leaving unemployment each month, and a much longer average duration ot unemployment. In any country, the average duration doesn't stay constant. For Australia, in the early 1990s at the height ot the recession, the average duration reached about twelve months, and thirty-live years ago it was a mere two weeks:
The average duration of unemployment equals the inverse of the proportion of unemployed leaving unemployment each month.To see why, consider this example. Suppose the number of ^ unemployed is corstant and equal to 100, and each unemployed person remains unemployed for cwo months. So. at any time there are 50 peop e who have been unemployed for one month and SO for two months. Each month, the 50 who have teen unemployed for two months leave unemployment. In this example, the proportion of unemployed leaving unemployment each month is 50/100 = 50 per cent.The duration of unemployment is two months—the inverse of 1/50 per cent.
Economists are particularly concerned about the long-term unemployed. These are usually thought of as people who have remained unemployed for more than twelve months. The reason lor the concern is that as someone's unemployment experience lengthens it becomes increasingly difficult to get a job. These people become less and less employable as their skills deteriorate and their confidence diminishes. Governments often recognise this and create labour market programs that offer training, work experience and counselling. II unemployment is permitted to rise and to persist at a high level, the number ol long-term unemployed is bound to increase. This is borne out in Figure (>.2, which displays the proportion of long-term unemployed people out ol total unemployment as well as the unemployment rate for Australia. You can see how the long-term unemployed proportion began to rise in early 1991, about one year alter the unemployment rate began to rise. Similarly, the long-term ratio began to fall in mid-1994, one year alter the
35
с 30 E >-
О
| 25
20
Long-term unemployment ratio
Unemployment rate
12 - 11 - 10 - 9 -8 -7 6 S -4
40
? 15 о
Figure 6.2 Long-term unemployment. 1986-2008
10 H—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—i—г3
Wor
really measure the number ol hours available in the economy that are not utilised. The ABS does provide a labour under-utilisation rate, which was about 9 per cent in 2008 compared with the unemployment rate ol just over -I per cent). We will follow tradition in this book and locus on the unemployment rale, but you should keep in mind that the unemployment rale isn't lhe best estimate ol people available for work
6.2 MOVEMENTS IN UNEMPLOYMENT
Let's now look more closely at movements in unemployment. Figure 6.3 shows the average value of the Australian unemployment rate lor each year since 1959. The shaded areas represent years during which there was a recession that is, at least two quarters of negative GDI' growth). Figure 6.3 has two important features:
• Until the mid-1980s, it looked as il the Australian unemployment rale was on an upward trend, Irom an average ot 2 per cent in thc 1960s, to 6 per cent in the late 1970s, and reaching peaks of 1 I per cent in lhe mid- 1980s and the early 1990s. Since then, however, thc unemployment rate has steadily declined, and in mid-2008 it was 4.25 per cent. This decrease led a number of economists to conclude that the trend had been reversed, and that the Australian economy was likely to operate al a lower average unemployment rate in the future than in the 1975—95 period. We will return to this issue in Chapter 8.
• Leaving aside these trend changes, year-to-year movements in the unemployment rate are closely associated with recessions and expansions. Note, for example, thc last two peaks in unemployment. The most recent, in wh.ch unemployment peaked at 10.7 percent (a post—World War II high), was associated with the recession of 1990-91 the peak in unemployment actually came one year alter the end ol the recession, in 1992 i. Thc peak bclore that in which unemployment peaked at 10.2 per cent, was during the recession of 1982-83.
I low do these fluctuations in the aggregate unemployment rate allect individual workers? This is an important question, because the answer determines:
4 The evolution of the unemployment rate has been very different in Western Europe. As we saw in Chapter I. the unemployment rate in the European Union, which was around 3 per cent in the 1960s. was around 7 per cent in 2008. More on this in Chapters 8 and 13.
• the ellect ol movements in the aggregate unemployment rate on the welfare of individual workers, and
• the ellect ot the aggregate unemployment rate on wages.
i l I I i l I I I I i i l i i г
I960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008
Figure 6.3
Movements in the Australian unemployment rate. 1959-2008
From 1959 to 1974. the Australian unemployment rate averaged I per cent: thereafter, it was just below 7 per cent
Think about how lirms can decrease their employment in response to a decrease in demand. They can hire fewer new workers, or they can lay oil the workers they currently employ. Typically, lirms prefer lirst to slow or stop the hiring of new workers, relying on quits and retirements to achieve a decrease in employment. But doing only this may not be enough il the decrease in demand is large, so lirms may then have to lay off workers.
Now think about the implications for both employed and unemployed workers.
• II the adjustment takes place through a decrease in hires, the effect is lo decrease thc chance that an unemployed worker will lind a job. Fewer hires mean lewer job openings,- higher unemployment means more job applicants. Fewer openings and more applicants combine to make it harder lor the unemployed to find jobs.
• If. instead, the adjustment takes place through higher layoffs, then the employed workers arc at a higher risk ol losing their jobs.
In general, as lirms use both margins ol adjustment, higher unemployment is associated with both a lower chance of finding a job il unemployed and a higher chance ol losing it if employed. Figures 6.4 and 6.5 show these two effects at work in Australia over the period 1980-2008.
Figure 6.4 plots two variables against time—the unemployment rate measured on the left vertical axis) and the proportion ol unemployed workers finding a job each month measured on the right vertical axis t. This proportion is constructed by dividing the flow Irom unemployment to employment during each month by thc number ol unemployed at the beginning ol the month. To show the relation between the two variables more clearly, the proportion ol unemployed finding jobs is plotted on an inverted scale. Be sure you see that on the right vertical scale the proportion is lowest at the top and highest at the bottom.
Thc relation between movements in the proportion ol unemployed workers finding jobs and the unemployment rate is striking Periods ol higher unemployment arc associated with much lower proportions of unemployed workers finding jobs. At the peak ol the 1982-83 and 1990-91 recessions for example, the proportion ol unemployed workers finding jobs was down to about 15 per cent per month, compared with an average value ol 20 per cent over the whole period, in September 2007 it reached its highest level in three decades, at 31 per cent. Another way ol thinking about this is that the median time taken lor an unemployed person to get a job was about nine weeks in 2007, much less than in the previous three decades.
Figure 6.4
The
unemployment rate and the proportion of unemployed finding jobs. Australia. 1980-2008
11 -i
10-
9-
6-
4-
Proportion of unemployed finding a job
I I 1 1 Г
-21
П 1 1 1 1 1 1 1—
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
17
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M'
?! s §
S 8
и -S
P
« о
Z * 3 2;
9 a 5' ro
19
=
о
E
! a
E
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23
■25
When unemployment is high, the proportion of unemployed finding jobs is low. Note that the scale on the right is the inverse scale.
SOURCES Australian Bureau of Statistics, cat nos 6203.6291
Figure 6.5 The
unemployment rate and the monthly separation rate from employment. Australia. 1980-2008
4.6 4.4
Monthly separation rate
-3.8 я-
-i 1 1 1 1 1 1 1—
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
2
0
4.0 » В
и
3.6 S
3.4 3.2
To be precise, we learn from Figure 6.5 only that, when
unemployment is higher, separations are higher.
4 Separations equal quits plus layoffs.We knew from other sources that quits are lower when unemployment is high: it is more attractive to quit when there are plenty of jobs. So. if separations go up and quits go down, this implies that layoffs (which equal separations minus quits) go up even more than separations.
4 Collective bargaining: bargaining between a union (or a group of unions) and a firm (or a group of firms).
4 Enterprise bargaining: bargaining between a union or workers and the employer at the firm or enterprise level.
When unemployment is high, a higher proportion of workers lose their jobs. SOURCES: Australian Bureau of Statistics, cat. nos 6203. 6291.
Similarly, Figure 6.5 plots two variables against time—the unemployment rate (measured on the left vertical axis) and the seasonally-adjusted monthly separation rate Irom employment, constructed hy dividing the flow from employment (to unemployment and to Out ol the labour force during each month by the number of employed at the beginning ot thc month measured on the right vertical axis . The relation between the separation rale and lhe unemployment rate plotted in Figure 6.5 is less tight than the relation plotted in Figure 6.4. but it is nevertheless quite visible. I ligher unemployment implies a higher separation rate, a higher chance ol employed workers losing their jobs. To summarise: When unemployment is high, workers are worse oil in two ways:
• They are more likely to lose their job.
• If they become unemployed, the probability that they will find another iob is lower,- equivalently. thev can expect to be unemployed lor a longer length ol lime.
6.3 WAGE DETERMINATION
'above-award' wages outside ot the court. The awards system made it relatively easy lor the government to develop a wages policy—lor example introducing automatic wage indexation to inflation in the 1970s and politically negotiated Accords' with the unions in the 1980s and early 1990s. Now awards play a limited role, and in 2006 only 19 per cent ot workers' contracts were determined in awards. Indeed, union membership tell Irom a peak ol 61 per cent of all workers in 1962 to about 19 per cent in 2007.
• From 1996 to 2007 the Howard Coalition government made it easier tor wage negotiations to take place without the involvement of unions at all—that is, with individual agreements (Australian workplace agreements). Thus, in 2006, 40 per cent of all wage contracts were set by employers, or by bargaining between thc employer and individual employees, without reference to unions. At the end of 2005. the Howard government introduced new workplace relations laws, which made it easier for employers to dismiss workers and severely weakened industrial tribunals. These changes shitted thc bargaining power towards employers, but the new Rudd government in 2008 began to gradually roll back the Howard agenda. All of the labour market reforms by successive governments in Australia since 198.3 have actually led to a remarkably good industrial relations environment—in 2007, only 5.7 days of work per 1000 workers were lost in industrial disputes, compared with 219 lost in 1987. Bargaining between employers and employees works well in Australia today. The higher the skills needed to do the job. the more likely there is to be bargaining ol some type.
Wages offered lor entry-level jobs at McDonalds are on a take-it-or-leave-it basis. New university graduates can typically negotiate a lew aspects ot their contract. Chief executive officers (CEOs) and movie stars can negotiate a lot more.
There are also large differences across countries. In the United States today, fewer than 15 percent of workers have their wages set in collective bargaining agreements iwith most ol these in manu¬facturing). Collective bargaining plavs an important role in lapan and in most European countries.
Given these differences across workers and across countries can we hope for anything like a general theory ol wage determination? Yes. Although institutional differences influence wage determination, there are common forces at work in all countries. Two sets ol lacts stand out:
• Workers are typically paid a wage lhat exceeds their reservation wage, the wage that would make them indifferent to working or becoming unemployed. In other words, most workers are paid a high enough wage that they prefer to be employed rather than unemployed.
• Wages typically depend on labour-market conditions. The lower the unemployment rate, the higher are wages.
To think about these lacts economists have locused on two broad lines of explanation. The lirst is that even in the absence of collective bargaining workers have some bargaining power, which they can and do use to obtain wages above their reservation wage. The second is that firms themselves may, for a number ol reasons, want to pay wages higher than thc reservation wage. Let's look at cach explanation in turn.
Bargaining
How much bargaining power a worker has depends on two lactors. The lirst is how costly it would be tor the lirm to replace him, were he to leave the firm, l he second is how hard it would be for him to find another job, were he to leave the firm. The more costly it is lor the linn to replace him. and the easier it is lor him to find another job, the more bargaining power he will have. This has two implications.
• blow much bargaining power a worker has depends lirst on the nature ol his job. Replacing a worker at McDonald's isn't very costly,- the required skills can be taught quickly, and typically a large number of willing applicants have alreadv tilled out job application forms. In this situation, thc worker is unlikely to have much bargaining power. II he asks lor a higher wage the firm can lay him oil and lind a replacement at minimum cost. In contrast, a highly skilled worker who knows in detail how the firm operates may be very dilficult and costly to replace. I his gives him more bargaining power. It he asks for a higher wage, the lirm may decide that it is best to give it to him.
• How much bargaining power a worker has depends on labour-market conditions. When the unemployment rate is low, it is more diliicult for firms to find acceptable replacements; at thc same time, it is easier tor workers to find other jobs. Workers arc in a stronger bargaining position, and may be able to obtain a higher wage. When the unemployment rate is high, finding good replace¬ments is easier for firms, while finding another job is harder tor workers. Being in a weak bargaining position, workers may have no choice but to accept a lower wage.
Efficiency wages
Leaving aside workers' bargaining power firms themselves may want to pay more than the reservation wage. Firms want their workers to be productive, and a higher wage can help them to achieve that goal.
II, lor example, it takes a while for workers to learn how to do a job correctly, firms will want their workers to stay for some time. But if workers are paid only their reservation wage, they will be indifferent to staying or leaving. Many ol them will quit, and turnover will be high. Paying a wage above the reservation wage makes it financially attractive lor workers to stay. It decreases turnover and increases productivity. If there is lower turnover, there may also be better worker morale, which can help productivity.
Behind this example lies a more general proposition—most firms want their workers to feel good about their jobs. Feeling good promotes good work which leads to higher productivity. Paying a high wage is one instalment the lirm can use to achieve these goals. (See the focus box 'Henry Ford and elficiency wages'.) Economists call the theories that link the productivity or the efficiency ot workers to the wage they are paid efficiency wage theories.
Like theories based 011 bargaining, efficiency wage theories suggest that wages depend on both the nature ol the job and labou'-market conditions:
• Firms—such as high-tech firms—lhat see employees' morale and commitment as essential to the quality of their work will pay more than firms in sectors where workers' activity is more routine.
• Labour-market conditions will allcct the wage. A low unemployment rate makes it more attractive lor employed workers to quit. When unemployment is low it is easy to find another job. This means that when unemployment decreases a firm that wants to avoid an increase in quits will have to increase wages to induce workers to stay with the firm Thus, lower unemployment will again lead to higher wages.
Wages, prices and unemployment
We capture our discussion ol wage determination by the following equation:
W = f*F( u,z) (6.1)
(-,+)
The aggregate nominal wage IV depends on three factors:
• the expected price level P'~
• the unemployment rate, и
• a catch-all term z, that stands lor all other variables that may affect thc outcome of wage setting. Lets look at each factor.
The expected price level
First leave aside the difference between the expected and the actual price level, and ask: Why does the price level allcct wages?
The answer: Both workers and firms care about real wages, not nominal wages. • Workers care not about how many dollars they receive but about how many goods they can buy with their wages. In other words, they care about their wage in terms of goods, about W/P.
< Before 11 September 2001, the approach to airport security in the United States was to hire workers at low wages and accept the resulting high turnover. Now that airport security has become a much higher priority, the approach is to make the jobs more attractive and better paid, so as to get more motivated and more competent workers and reduce turnover.
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• In the same way. firms don t care about the nominal wages they pay workers but about the nominal wages they pay in relation to the price ol the output they sell. So. firms also care about W/P.
US BOX
Г n /~v
If workers expected the price level—the price of the goods they buy—to double, they would ask lor a doubling of their nominal wage. II lirms expected the price level—the price of the goods they sold— to double they would be willing to double the nominal wage. So. il both workers and firms expected the price level to double, they would agree to doubling the nominal wage, keeping the real wage constant. This is captured in equation (6.1 1—a doubling in the expected price level leads to a doubling ol the nominal wage chosen in wage setting.
>GES
In 1914, Henry Ford—the builder of the most popular car in the world at the time, the model-T—made a stunning announcement: his company would pay all qualified employees a minimum of $5 a day for an eight- hour day.This was a very large salary increase for most employees, who previously had earned, on average. $2.30 for a nine-hour day. Although company profits were substantial, this increase in pay was far from negligible—it represented about half of the company's profits at the time.
What Ford's motivations were aren't entirely clear. Ford himself gave too many reasons for us to know which ones he actually believed.The reason wasn't that the company had a hard time finding workers at the previous wage. But the company clearly had a hard time retaining workers.There was a very high turnover rate, as well as high dissatisfaction among workers.
Whatever the reasons behind Ford's decision, the results of the wage increase were astounding, as Table I shows.
The annual turnover rate (the ratio of separations to employment) plunged from a high of 370 per cent in 1913 to a low of 16 per cent in 1915. (An annual turnover rate of 370 per cent means that, on average. 3 I per cent of the company's workers left each month, so that over the year the ratio of separations to employment was 31 per cent x 12 = 370 per cent.) The layoff rate collapsed from 62 per cent to nearly 0 per cent. Other measures point in the same direction.The average rate of absenteeism (not shown in the table), which ran at 10 per cent in 1913, was down to 2.5 per cent one year later. There is little question that higher wages were the main source of these changes.
Did productivity at the Ford plant increase enough to offset the cost of increased wages? The answer to this question is less clear. Productivity was much higher in 1914 than in 1913: estimates of productivity increases range from 30 per cent to SO per cent. Despite higher wages, profits were also higher in 1914 than in 1913. But how much of this increase in profits was due to changes in workers' behaviour and how much was due to the increasing success of model-T cars is harder to establish.
What firms actually get ► for selling their goods and what workers actually pay when they buy those goods can be different This is discussed at the end of Section 6.5. In shore FT-» W1>
While the effects support efficiency wage theories, it may be that the increase in wages to $5 a day was excessive, at least from the point of view of profit maximisation. But Henry Ford probably had other objectives as well, from keeping the unions out—which he did—to generating publicity for himself and the company—which he surely did.
Table 1 Annual turnover and layoff rates (%) at Ford. 1913-15
1913 1914 1915
Turnover rate 370 Layoff rate 62 54 7 16
0.1
Source. Dan Raff and Lawrcncc Summers.'Did Henry Ford pay efficiency wages?. NBER Working Paper. 2101. December 1986
Returning to the distinction we put aside at the start ol the paragraph: Why do wages depend on the expected price level, P. rather than the actual price level. Pr The answer is that wages are set in nominal (dollar' terms, and when they are set. what the relevant price level will be isn't yet known.
lor example, in union contracts in Australia, nominal wages are often set in advance lor one year, and sometimes deals are struck for up lo three years. Taking lhe latter case, unions and firms have to decide what nominal wages will he over the following three years based on what they expect the price level to be over those three years. Even when wages are set by firms, or by bargaining between the firm and each worker, nominal wages are typically sei lor a year. Il the price level goes up unexpectedly during the year, nominal wages are typically not readjusted. (Thc way workers and lirms form expectations ol the price level will occupy much ol the next three chapters,- we leave the issue aside for the moment.)
The unemployment rate
Also allecting the aggregate wage in equation 1 (>. I through the function, F) is the unemployment rale, ii. The minus sign under tt indicates that an increase in the unemployment rate decreases wages.
«In shore zt=>WT
Unemployment
4 insurance began in 1945 in Australia. It is now called Newstart In 2008 the weekly allowance was $219 for a single person and it is indexed to the CPI.The payment tapers off to zero if a person works up to 29 hours at die minimum wage. To get the payment, a person has to be actively searching for a job and be able to show it.
4 The weekly minimum wage in Australia in 2008 is $544. and this hasn't changed in real terms in twenty years.
©
That wages depend on unemployment was one of the main conclusions ol our earlier discussion ol wage determination. II we think ol wages as being determined by bargaining, then higher unemploy¬ment weakens workers' bargaining power, forcing workers to accept lower wages. If we think of wages as being determined by efficiency wage considerations then higher unemployment allows firms to pay lower wages and still keep workers willing lo work. < In short ut=>Wl
The other factors
The third variable in equation 6.1 i, is a catch-all variable that stands for all the lactors lhat alfect wages given the expected price level and the unemployment rate. By convention, lets define : so that an increase in z implies an increase in the wage thus the positive sign under ; in the equation). Our earlier discussion suggests a long list of potential factors here.
Take lor example, unemployment insurance—the payment of unemployment benefits to workers who lose their iobs. There are good reasons why society should provide some insurance to workers who lose a job and find it dillicult lo find another one. But there is little question that generous unemploy¬ment benefits while making the prospect of unemployment less distressing, do increase wages ai a given unemployment rate. To take an extreme example, suppose unemployment insurance didn't exist. Workers would then be willing to accept very low wages to avoid remaining unemployed. But unemployment insurance does exist, and it allows unemployed workers to hold out tor higher wages. In this case we can think ol z as representing the level ol unemployment benefits—at a given unemploy¬ment rate, higher unemployment benefits increase the wage.
It is easy to think ol other factors. An increase in the minimum wage may increase not only the minimum wage itself but also wages just above the minimum wage, leading to an increase in the average- wage, IV, at a given unemployment rate.
Or lake a decrease in employment protection which makes il less expensive lor lirms to lay off workers. Such a change is likely to decrease the bargaining power ol workers covered by this protection laying them oil and hiring other workers is less costly lor lirms), decreasing the wage lor a given unemployment rate.
Another potentially important structural laclor is the proportions ol part-time and full-time employment In Australia, thc proportion ol part-time employees three-quarters ot whom are women) has increased dramatically, Irom 10 per cent in the 1960s to 28 per cent in 2008. The proportion of part-timers in Australia is the second highest in the OECD. which averages just 15 per cent. Even though unemployment measured in terms ol people) has been falling in recent years in Australia, there may be many people now working part time who would like lo work more hours. This structural shilt is also reflected in the tall in the average number ol hours worked per employee, from about 38 hours in the 1960s to just below 33 hours in 2007. II you believe that part-time workers (who arc mostly women) typically have less bargaining power than lull-time workers, particularly men. these lacts
suggest that, in aggregate workers bargaining power has been reduced, and also that wages have become less sensitive to unemployment.
Using a term from ► microeconomics, this assumption implies constant returns to labour in production. If firms double the number of workers they employ, they double the amount of output they produce.
We will explore some ol these factors as we go along.
6.4 PRICE DETERMINATION
Having looked at wage determination, let's now turn to price determination.
Prices depend on costs. Costs depend on the nature ol the production function—the relation between the inputs used in production and the quantity ol output prodticed. and on the price ol these inputs
We will assume here that firms produce goods using labour as the only factor of production and according to the production iunction:
У AN
where У is output, .V is employment and Л is labour productivity. This way ol writing the production function implies that labour productivity—output per worker, Y/N—is constant and equal to A.
It should be clear that this is a strong simplilication. In reality, firms use factors ot production other than labour. They use capital—machines and factories. They use raw materials—oil, lor example. There is technological progress, so that labour productivity, A, is not constant but instead steadily increases over time. We will introduce these complications later. We will introduce raw materials in Chapter 7 when we discuss thc oil crises ot the 1970s. We will focus on the role of capital and technological progress in Chapters 10 to 13, when we turn lo the determination ot output in the long run. for the moment, however this simple relation between output and employment will make our lile easier, and still serve our purposes.
6.2)
Given the assumption that labour productivity, A. is constant, we can make one further simplili¬cation. We can choose the units lor output so that one worker produces one unit ol output—so that /1-1 'This way, we don't have to carry the letter A around, and this will simplify notation.) With that assumption, the production function becomes
У = N
The production Iunction У = Л' implies that the cost ol producing one more unit of output is the cost ol employing one more worker, at wage IV. Or, using the terminology introduced in your microeconomics course, the marginal cost of production is equal to IV.
If there were perfect competition in the goods market the price of a unit ot output would be equal to marginal cost: P would be equal to IV. This would mean that lirms are making neither profit nor loss. If they were, free entry ol new firms and tree exit would occur, and profit would be driven to zero. But hardly any goods markets are perfectly competitive, and lirms invariably charge a price higher than their marginal cost. A simple way ol capturing this fact ol imperfect competition is to assume that firms set their price according to
M'fV
(6.3)
P = II
where /x is the markup ol the price over the cost, IV. Il goods markets were perfectly competitive, ц would be equal to zero, and the price P. would simply equal the wage. IV. To the extent that they are not competitive and that lirms have market power, ц is positive, and the price, P, will exceed the cost, IV by a factor equal to ! I + fx..
6.5 THE NATURAL RATE OF UNEMPLOYMENT
Lets now look at the implications ol wage and price determination for unemployment.
The rest of the chapter is based on the assumption that P = P.This is required in medium-run
equilibrium. ► clear soon.'
To do so. let's make one additional assumption—namely that nominal wages depend on the actual price level, P, rather than on the expected price level, P'\ (Why we make this assumption will become
Under ibis additional assumption, wage setting and price setting determine the equilibrium rate ot unemployment. Let s see how.
The wage-setting relation
Given the assumption that nominal wages depend on the actual price level, P. rather than on the expected price level, P1', equation (6.1 which characterises wage determination, becomes
IV - PF(u,z)
Dividing both sides by thc price level
W P
(6.4)
= F(u,z)
Wage determination implies a negative relation between the real wage. W/P. and the unemployment rate, u: the higher thc unemployment rate, the lower thc real wage chosen by wage setters. (The intuition is straightforward: the higher the unemployment rate thc weaker workers are in bargaining, and so thc lower the real wage.
This relation between thc real wage and the rate ol unemployment—let's call it the wage-setting relation—is drawn in Figure 6.6. The real wage is measured on the vertical axis. Thc unemployment rate is measured on the horizontal axis. The wage-setting relation is drawn as the downward-sloping curve, WS (for wage setting : the higher the unemployment rate, the lower the real wage.
4 'Wage setters' means unions and firms if wages are set by collective bargaining, individual workers and firms if wages are set on a case-by-case basis, and firms if wages are set on a take-it-or-leave-it basis.
The price-setting relation
м
CL > \ Figure 6.6
The wage-setting relation, the price-setting relation and the natural rate of unemployment
4)" 1 2? д Price-setting relation
H 1 cc ^^ WS
Wage-setting relation
u„
Unemployment rate, и
The real wage chosen in wage setting is a decreasing function of the unemployment rate. The real wage implied by price setting is constant independent of the unemployment rate. The natural rate of unemployment is the unemployment rate such that the real woge chosen in woge setting ;s equal to the real wage implied by price setting.
©
Turn now to the implications ol price determination, Il we divide both sides of the price-determination equation 6.3 by the nominal wage, we get
(6.5)
The ratio of the price level to the wage implied by the price-setting behaviour of firms equals I plus the markup. Now invert both sides of this equation to get the implied real wage:
™ m _i_ (6,,) P (1 + M)
Note what this equation savs: Price-setting decisions determine the rcnl wage paid by firms. An increase in the markup leads firms to increase their price given the wage- equivalently, it leads to a decrease in the real wage.
The step from equation (6.51 to equation 6.6 is algebraically straightlorward. But how price setting actually determines the real wage paid by firms may not be intuitively obvious
Think of it this way: suppose the firm in which you work increases its markup and so increases the price of its product. Your real wage doesn't change very much. You are still paid the same nominal wage, and the product produced by the firm is likely to be a small part ol your consumption basket. Suppose now that not only the firm you work for but all the firms in the economy increase their markup. Now, all prices go up. Even if you are paid the same nominal wage, your real wage goes down. So, the higher the markup set by linns, the lower your real wage.
The price-setting relation in equation (6.6) is drawn as the horizontal line PS lor price setting in figure 6.6. The real wage implied by price setting is I I • fx it doesn't depend tin the unemployment rate.
Equilibrium real wages and unemployment
Equilibrium in the labour market requires that the real wage implied by wage setting be equal to the real wage implied by price setting. This way of stating equilibrium may sound strange if you learned to think in terms ol labour supply and labour demand in your microeconomics course. The relation between the wage-setting and price-setting relations on the one hand and labour supply and labour demand on the other, is closer than it looks at lirst and is explored lurthcr in the appendix at the end ol this chapter.
In Figure 6.6, equilibrium is therefore given by point A. The equilibrium unemployment rate is given by i/„. We can characterise the equilibrium unemployment rate algebraically; eliminating W/P between equations (6.4) and 6.6) gives
(6.7)
(I + м
F(u,„z) =
The equilibrium unemployment rate it,,, is such that the real wage chosen in wage setting—the left side of equation (6.7)—is equal to the real wage implied by price setting—thc right side ot equation
(6.7).
The equilibrium unemployment rate »,, is called the natural rate of unemployment which is why thc subscript n is used to denote if. The terminology has become standard, and we will adopt it, but this is a bad choice ol words. The word natural suggests a constant ol nature, one that is unaffected by institutions and policy. As its derivation makes clear, however, the natural rate ol unemployment is anything but natural. The positions of the wage-setting and price-setting curves and thus the equilibrium unemployment rate, depend on both z and ц. Consider two examples:
• An increase in unemployment benefits. An increase in unemployment benefits can be represented by an increase in z. Since an increase in benefits makes the prospect ot unemployment less painful it increases the wage set by wage setters at a given unemployment rate. So it shilts the wage setting relation tip. Irom l-VS to IVS' in Figure 6.7. The economy moves along the PS line, from A to A'. The natural rate ol unemployment increases Irom ;/„ to //'„.
'Natural', as defined by ► The Macquarie Dictionary. means 'existing in or formed by nature; not artificial'.
In Australia, unemployment benefits are called Newstart Allowances. For more details, go to
In words: 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 lo what firms are willing to pay.
Figure 6.7 Unemployment benefits and the natural rate of unemployment
An increase in unemployment benefits leads to an increase in the natural rate of unemployment
• A less stringent enforcement of existing anti-trust legislation. In Australia, anti-competitive practices by firms arc monitored and regulated by state and federal pricing tribunals. The most important is the federal agency, the Australian Competition and Consumer Commission (ACCC). While it has the power to enforce anti-trust legislation, its effectiveness is limited by the resources it receives from thc government and by the rigour of the legislation. II the resources allocated lo the ACC.C are cut hack, we can expect less stringent enforcement ol the legislation. To thc extent that this allows firms to collude more easily, and so increases their market power, it leads to an increase in their markup -an increase in fx. The increase in \x implies a decrease in the real wage paid by firms, and so it shilts the price-setting relation down, from PS to PS' in figure 6.8. The economy moves
Figure 6.8 Markups and the natural rate of unemployment
Increase in markup
Un U n
Unemployment rate, и
1
Ф
£ *
"5 1 + ft
An increase in the markup decreases the real wage and leads to an increase in the natural rate of unemployment.
along WS. The equilibrium moves from A to A', and the natural rate of unemployment increases Ironi u„ to u'„.
In words; By letting firms increase their price given the wage, less stringent enforcement of anti-trust legislation leads to a decrease in the real wage. Higher unemployment is required to make workers accept this lower real wage, leading to an increase in the natural rate of unemployment.
Factors such as the generosity of unemployment benefits or anti trust legislation can hardly be thought of as the result of nature. Rather, they reflect various characteristics ot the structure ot the economy. For that reason, a better name for the equilibrium rate ot unemployment would be thc structural rate of unemployment but so far thc name hasn't caught on.
From unemployment to employment
Associated with the natural rate of unemployment is a natural level of employment, the level of employment that prevails when unemployment is equal to its natural rate.
This name has been ► suggested by Edmund Phelps, of Columbia University in the United States. For more on Phelps's contributions, see Chapters 8 and 28.
Let's review thc relation between unemployment, employment and the labour lorce. Let LI denote unemployment, N denote employment and L denote the labour force. Then
иш U = L
! L - N)
N_ L
The first step follows Irom the definition of the unemployment rate u. The second follows from the lact that, from thc definition of the labour force the level of unemployment. LI, equals the labour force, /.. minus employment, ,V. Thc third step follows from simplifying the fraction Putting all three steps together, the unemployment rate, u. equals I minus the ratio of employment, \, to the labour force, L.
Rearranging to gel employment in terms of the labour lorce and the unemployment rate gives
N L(l - »)
Employment, Л is equal to the labour force, L times I minus the unemployment rate. u.
So. il the natural rate of unemployment is u„, and the labour force is equal to L, the natural level of employment, N„, is given by
N„ = L(1 - и)
For example, il the labour force is 10 million people and the natural rate of unemployment is 5 per cent, then thc natural level of employment is 9.5 million.
From employment to output
Finally, associated with thc natural level ol employment is a natural level of output, thc level ol production when employment is equal to the natural level of employment. Given the special production function we have been using in this chapter (У = ,V the relation takes a simple form. The natural level of output У„ is given by
Y„ = N„ = L( 1 - u„)
For use in the next chapter, note that, using equation (6.7) and the relations between the unemployment rate, employment and output just derived, the natural level of output satisfies
F(t - Ii,2) = —1— 16.8)
L I + /JL
The natural level of output (Y„) is such that at the associated rate of unemployment (г/„ = I - Y„/L), the rea wage chosen in wage setting—the left side of equation (6.8)—is equal to the real wage implied by price setting—the right side of equation (6.8).
We have gone through many steps in this section, and il is time to summarise them. Suppose lhat thc expected price level is equal to the actual price level. Then:
• The real wage chosen in wage setting is a decreasing function of the unemployment rate.
• The real wage implied hy price setting is a constant, and thus independent ol unemployment.
• Equilibrium in the labour market requires that the real wage choscn in wage setting be equal to the real wage implied by price setting. This determines thc unemployment rate.
• This equilibrium unemployment rate is known as the 'natural rate of unemployment'.
• Associated with the natural rate of unemployment are a natural level of employment and a natural level ol output.
6.6 TAX DISTORTIONS AND THE NATURAL RATE OF UNEMPLOYMENT*
You have now seen how imperfect competition in goods markets, wage bargaining and efficiency wages contribute to determining thc natural unemployment rate. There is another factor that can have an important effect—taxes. Previous chapters treated tax revenues, T, as given. However, tax revenues are really dependent on what is happening lo the economy. This is because governments almost always set tax rates on incomes, sales, employment, and so on. Many of these tax rales will have an influence on the natural rate of unemployment—we will sec that higher tax rates raise n„.
We will think about only three taxes: a direct tax rate on income, tj; an indirect tax rate on purchases, tnuj: and a tax rate on employment creating on-costs for the employer, tmc. These taxes will aflect the after-tax real wage from the point ol view of both the worker and the employer. Without these taxes, the real wage that the employer pays and the worker receives is thc same, equal to W/P. With thc taxes imposed, the after-tax real wages will differ for the employer and the worker.
The after-tax real wage paid by the employer, or the alter-tax producer real wage, PW, includes tonc:
PW = (i + tmil)
As the tax on employment goes up, the employer linds that the cost of employing another worker is a larger burden.
Similarly, the after-tax real wage received by the worker, or the after tax consumer real wage, CW, is reduced by tj and f„,j:
CW - (l ~ ^ W (I + tind) P
Workers are also consumers of goods, and their take-home pay is reduced to pay income taxes. The purchasing power of that disposable income depends on the price level inclusive of the indirect taxes on their purchases of good and services. These taxes will mean lhat the after-tax producer real wage (PW) is typically greater than the consumer one (CW). To measure the difference, we can calculate the proportional tax wedge:
pw - CW PW (I + /,„„)(' + _ ,
CW CW (I - tj)
In Australia in 2008, the proportion of direct tax (including Medicare contributions) paid on domestic household income was about 20 per cent of labour income (tj). A general sales tax (GST) of 10 per cent was introduced in 2000 and applies to almost all products. However, there arc many other indirect taxes alfccting consumers (such as excisc, taxes on financial transactions and on motor vehicles) and the proportion paid out of all labour income was about 1 I per cent (/>,„/). Whenever employers take on another worker, they have to pay unavoidable on-costs over and above thc wage. These on-costs
* This section is optional.
include compulsory superannuation and workers' injury compensation. Though on costs vary across establishments, in aggregate in 2008 they represent a lax on producers ol about 12 per cent (f,„,f). Thcrelorc, the average tax wedge is (1 + 0,121 (I + 0.11) / (1 - 0.20) - I - 0.55, which is a big number that cannot be ignored. We could say that PW exceeds CW by at least 55 per cent.
How will these three taxes affect wage-setting and price-setting behaviour? The wage-setting curve, WS, and the price-setting curve, PS, will both shilt:
• Higher income and sales taxes (tj and tofll) lower CW, and so workers will demand higher wages, W, to compensate. Employers will also recognise that these taxes reduce the efficiency wage ol their workers, and so they will be willing to respond positively to these demands. This means that the WS curve shifts up to WS' in Figure 6.9.
• Higher taxes on employment (f,„lr) raise PW, which will lead to firms raising their prices to compensate. This will shift the PS curve down to PS' in 1 igurc 6.9.
All three taxes must therefore lead to an increase ol the natural rate of unemployment. In Figure 6.9, the equilibrium with the taxes is at A', compared to A when there were no taxes. The pre-tax real wage (W/P) falls, and the natural rate ol unemployment rises to u„'.
The importance ol taxes for unemployment outcomes has been appreciated by Australian governments. The Hawkc-Kcating labor government negotiated wage-tax deals in national Accords' with the trade union movement in 1986, 1990 and 1991. In the wage—tax deals, thc unions agreed to moderate their wage claims in collective bargaining and the government agreed to lower taxes. Both sides of the deals would have shifted the WS curve down, which, as you now know, reduces thc natural rate ol unemployment.
There are important limits to the argument about the distortionary effects of taxes on the economy. Introducing a lax for some purpose may simply replace an alternative means of funding lor lhat same purpose. In that case, we should expect no effects on the natural rale, l or example, suppose initially workers buy their medical insurance privately. Now suppose the government decides to provide all medical care free of charge and finances it through a payroll lax. Would you expect this new lax lo make
Figure 6.9 Tax distortions and the natural rate of
unemployment
Increase in
Increase in
a. ?
6 и Я
i
«
о се
Unemployment rate, и
An increase in the income lax rate, the indirect tax or the employment tax decreases the pre-tax real wage and leads to an increase in the natural rate of unemployment
a significant difference to the natural unemployment rate? Not if the public provision of medical care exactly replaces what was achieved with the private funding. Issues like this would be important it we were to try and compare tax wedges across countries.
The general conclusion is that taxes can create macroeconomic distortions that lead to a higher natural rate of unemployment. This doesn't mean that we should now advocate zero taxes. Governments provide many essential public services and our society is clearly better oil for these. And taxes are needed to kind them. However, as economists, we need to he aware of the possible macroeconomic implications ol the different taxes that governments propose and impose.
6.7 WHERE WE GO FROM HERE
• Wages arc set unilaterally hy firms, or by bargaining between workers and firms. They depend negatively on the unemployment rale, and positively on lhe expected price level. The reason why wages depend on the expected price level is that they are typically set in nominal terms tor some- period ol time. During that time, even il the price level turns out to be diflerent from what was expected, wages arc typically not readjusted.
• The price set by lirms depends on the wage and on the markup of prices over wages. The higher the markup chosen by firms, the lower the real wage implied by price-setting decisions.
• Equilibrium in the labour market requires lhat the real wage chosen in wage setting be equal to the real wage implied by price selling. Under the additional assumption that the expected price level is equal to the actual price level, equilibrium in thc labour market determines lhe unemployment rate. This unemployment rale is known as the natural rate of unemployment.
• The natural rale ol unemployment will be allected by thc degree of imperfect competition in goods markets (captured by thc size ol the markup , by factors affecting wage outcomes such as unemploy¬ment benefits and employment protection, and by taxes.
• In general, the actual price level may turn out to be different from ihe price level expected by wage setters. Therefore, lhe unemployment rale needn't be equal to the natural rate.
• The coming chapters will show that, in the short run, unemployment and output are determined by the factors focused on in the preceding three chapters, but thai, in thc medium run, unemployment tends lo return to the natural rate, and output tends to return to its natural level.
KEY TERMS
civilian population (non- labour undcr-utilisation • perlect compeiition,
institutional), 124 rale, 129 imperfect competition 136
labour force, not in the col lect i ve barga i n i ng, • markup, 136
labour force, 125 enterprise bargaining, 131 • wage-setting relation, 137
participation rate, 125 awards, 131 • price-setting relation, 138
unemployment rate, 125 individual agreements, 1.32 • natural rate ol
separations, hires, 125 reservation wage, 132 unemployment, 138
Labour Force Survey bargaining power, 132 • Australian Compeiition and
(LFS), 125 quits, layoffs, 127 efficiency wage- theories, 133 Consumer Commission
(ACCC), 139
duration of unemployment, 127 unemployment insurance, 135 • stnictural rate ol unemployment, 140
long-term unemployed, 127 discouraged workers. 128 non-employment rate, 128 part-time and full-time employment, 128 minimum wage, 135 employment protection, 1 35 production Iunction, 1 36 labour productivity, 136 • • • natural level of employment, 140 natural level of output, 140 producer real wage, consumer real wage, 141
• tax wedge, 141
QUESTIONS AND PROBLEMS
Quick check
I. Using the information in this chapter, label each of the following statements 'true', 'false' or 'uncertain'. Explain briefly.
a. Since 1950, the participation rate in Australia has remained roughly constant at 60 per cent.
h. Each month, lhe Hows in and out ot employment are very small compared with the size of the labour force.
c. One-third of all unemployed workers exit the unemployment pool each year.
d. The unemployment rate tends to be high in recessions, low in expansions.
e. Most workers are typically paid their reservation wage.
I. Workers who don't belong to unions have no bargaining power.
g. It may be in the best interest of employers to pay wages higher than their workers' reservation
wage.
h. The natural rate ol unemployment is unaffected by policy changes.
2. Answer the following questions using thc information provided in this chapter.
a. As a percentage ol the employed workers, what is the size of the llows in and out of employment 'that is, hires and separations) each month?
b. As a percentage til the unemployed workers, what is the size ol the flows from unemployment into employment each month?
c. As a percentage ol the unemployed, what is the size ot the total llows out of unemployment each month? What is the average duration ol unemployment?
d. As a percentage of the labour lorce, what is thc size of the total llows in and out of thc labour force each month?
e. What percentage ol flows into the labour force do new workers entering the labour force constitute?
3. The natural rate of unemployment
Suppose that the firms' markup over costs is 5 per cent, and the wage-setting equation is W = P [1 - u), where u is the unemployment rate.
a. What is the real wage as determined by the price-setting equation?
b. What is the natural rate of unemployment^
c. Suppose that the markup of prices over costs increases to 10 per cent. What happens to the natural rate ot unemployment? Explain the logic behind your answer.
Dig deeper
4. Reservation wages
In the mid-1980s, a famous supermodel once said that she would not get out of bed for less than $10,000 ipresumably per day).
a. What is your own reservation wage?
b. Did your first job pay more than your reservation wage at the time?
c. Relative to your reservation wage at the time you accept each job, which job pays more—your lirst tine or the one you expect to have in ten years?
d. Explain your answers in terms of the efficiency wage theory.
5. Bargaining power and wage determination
Even in the absence of collective bargaining, workers do have some bargaining power that allows them to receive wages higher than their reservation wage. Each worker's bargaining power depends both on the nature of the job and the economy-wide labour-market conditions. Let's consider each factor in turn.
a. Compare the job ol a delivery person and a computer network administrator. In which of these jobs does a worker have more bargaining power? Why?
b. lor any given job, how do labour-market conditions affect the worker's bargaining power? Which labour-market variable would you locus tin to assess labour-market conditions?
c. Suppose that for given labour-market conditions (the variable you identified in part [b]) worker bargaining power throughout the economy increases. What effect would this have on the real wage in thc medium run? In the short run? What determines thc real wage in the model described in this chapter?
6. The existence of unemployment
a. Suppose the unemployment rate is very low. How easy is it lor lirms to find workers to hire? How easy is it for workers to find jobs? What do your answers imply about the relative- bargaining power of workers and firms when the unemployment rate is very low? What do your answers imply about what happens to the wage as the unemployment rate gets very low?
b. Given your answer to part (a), why is there unemployment in the economy? I What would happen to real wages if the unemployment rale were equal to zero?)
7. The informal labour market
You learned in Chapter 2 that informal work at home (preparing meals, taking care of children and so on) is not counted as part of GDP. Such work also does not constitute employment in labour- market statistics. With these observations in mind, consider two economies, each with 100 people divided into 25 four-person households. In each household, one person prepares food, two people work- in the non-food sector, and one person is unemployed. Assume that the workers in the non-food sector produce the same actual and measured output in both economies.
In the first economy, Eatln, the 25 food-preparation workers lone per householdI cook for their families at home and do not work outside the house. All meals are prepared and eaten at home. The 25 food-preparation workers in this economy do not seek work in the formal labour market land, when asked, they say they are not looking for work).
In the second economy, EatOut, the 25 food-preparation workers are employed by restaurants. All meals are purchased in restaurants.
a. Calculate measured employment and unemployment and the measured labour force for each economy. Calculate the measured unemployment rate and participation rate for each economy. In which economy is measured GDP higher?
b. Suppose now that l atins economy changes. A few restaurants open, and the food-preparation workers in 10 households take jobs in restaurants. The members ol these 10 households now eat all of their meals in restaurants. The lood preparation workers in the remaining 15 households continue to work at home and do not seek jobs in thc formal sector. The members ot these 15 households continue to eat all ol their meals at home. Without calculating the numbers, what will happen to measured employment and unemployment and lo the measured labour force, unemployment rate and participation rate in Hatln? What will happen to measured GDP in Catln?
c. Suppose that you want to include work at home in GDP and the employment statistics. How would you measure the value of work at home in GDP? How would you alter the definitions of employment', 'unemployment and out ol the labour force'?
d. Given your new definitions in part c), would the labour-market statistics diller for Latin and PatOut? Assuming that the food produced by these economies has thc same value, would measured GDP in these economics differ? Llnder your new definitions, would the experiment in part (b) have any ellect on the labour market or GDP statistics for Eatln?
Explore further
8. Unemployment spells and long-term unemployment
According to the flow data presented in this chapter, about one out of every two unemployed workers leaves unemployment each month.
a. What is the probability a worker will still be unemployed after one month? Two months? Six months?
Now consider the composition of the unemployment pool. Wt> will use a simple experiment lo determine the proportion of the unemployed who have been unemployed six months or more. Suppose the number of unemployed workers is constant and equal to x (where x is some constant). Each month, 50 per cent of the unemployed find jobs, and an equivalent number of previously employed workers become unemployed.
b. Consider the group of x workers who are unemployed this month. Alter a month, what percentage of this group will still be unemployed? (Hint: II 50 per cent of unemployed workers find jobs every month, what percentage of the original x unemployed workers did not find jobs in the first month?)
c. After a second month, what percentage of thc original .v unemployed workers has been unemployed lor at least two months? (Hint: Civcn your answer to part (b), what percentage of those unemployed tor at least one month do not find jobs in the second month?) Alter thc sixth month, what percentage of the original x unemployed workers have been unemployed for at least six months?
This percentage applies to the economy at any time Iremember that we started with an arbitrary month). Llnder our assumptions, the percentage of the unemployed who have been unemployed six months or more is constant.
c. Go to the ABS website
9. Go to the ABS website
a. What are the latest monthly data on the size of the Australian civilian labour force, on the number ol unemployed and on the unemployment rale?
b. I low many people are employed? What is the proportion ol part-time employment? How has that proportion changed over the past twenty years? What would be the implication ol lhat changing proportion for the natural rate ol unemployment?
c. Calculate the change in the number of unemployed from the first number available in ABS, cat, no. 6202 to the most recent month. Do the same for the number ot employed workers. Is the decline in unemployment equal to the increase in employment? Explain in words.
We invite you to visit the Blanchard-Sheen page on the Pearson Australia website at
www.pearson.com.au/highered/blanchardsheen3e
for many World Wide Web exercises relating to issues similar to those in this chapter.
FURTHER READING
APPENDIX: WAGE-AND PRICE-SETTING RELATIONS VERSUS LABOUR SUPPLY AND LABOUR DEMAND
In your microeconomics course, you probably saw a representation of labour-market equilibrium in terms of labour supply and labour demand. You may therefore be asking yourself how the representation in terms of wage setting and price setting relates to the representation of the labour market you saw in your microeconomics course.
In an important sense, the two representations are similar. To see why, let's redraw Figure 6.5. but in terms of the real wage and the level of employment (rather than the unemployment rate).
Employment, N, is measured on the horizontal axis. The level of employment must be somewhere between zero and L, the labour force; employment cannot exceed the number of people available for work, the labour force. For any employment level, N, unemployment is given by U = L - N. Knowing that, we can measure unemployment by starting from L and moving to the left on the horizontal axis: unemployment is given by the distance between L and N. The lower employment, N, is, the higher unemployment is, and by implication the higher the unemployment rate, u.
Let's now draw the wage-setting and price-setting relations and characterise the equilibrium:
• An increase in employment (a movement to the right along the horizontal axis) implies a decrease in unemployment, and so an increase in the real wage chosen in wage setting. Thus, the wage-setting relation is now upward sloping: higher employment implies a higher real wage.
• The price-setting relation is still a horizontal line at W/P = 1/(1 + ц).
• The equilibrium is given by point A, with 'natural' employment level Nn (and an implied natural unemployment rate equal to u„ = (L - NJ/L).
In this figure, the wage-setting relation looks like a labour-supply relation. As the level of employment increases, the real wage paid to workers increases as well. For that reason, the wage-setting relation is sometimes called the 'labour supply' relation (in quotes).
What we have called the price-setting relation looks like a flat labour-demand relation. The reason it is flat rather than downward sloping has to do with our simplifying assumption of constant returns to labour in production. Had we assumed, more conventionally, that there were decreasing returns to labour in production, our price-setting curve would, like the standard labour-demand curve, be downward sloping. As employment increased, the marginal cost of production would increase, forcing firms to increase their price given the wage. In other words, the real wage implied by price setting would decrease as employment increased.
Figure 6A. I Wage setting and price setting and the natural level of employment
Wage setting
Price
setting
w м a S
я v a.
1+f
4,
-4
Employment, N
But, in a number of ways, the two approaches are different:
• The standard labour-supply relation gives the wage at which a given number of workers are willing to work. The higher the wage, the larger the number of workers who are willing to work.
In contrast, the wage corresponding to a given level of employment in the wage-setting relation is the result of a process of bargaining between workers and firms, or unilateral wage setting by firms. Factors such as the structure of collective bargaining or the use of wages to deter quits affect the wage-setting relation. They seem to play an important role in reality, yet they play no role in the standard labour-supply relation.
• The standard labour-demand relation gives the level of employment chosen by firms at a given real wage. It is derived under the assumption that firms operate in competitive goods and labour markets and therefore take wages and prices—and. by implication, the real wage—as given.
In contrast, the price-setting relation takes into account the fact that in most markets firms actually set prices. They compete on price. Factors such as the degree of competition in the goods market affect the price-setting relation by affecting the markup: these factors have no place in the standard labour-demand relation.
• While the labour-supply/labour-demand framework generates unemployment in equilibrium, those who are unemployed are willingly unemployed. At the equilibrium real wage, they prefer to be unemployed rather than work.
In contrast, in the wage-setting/price-setting framework, unemployment is likely to be involuntary. In the efficiency wage interpretation we saw in the text, for example, firms pay a wage above the reservation wage, and thus workers would rather be employed than unemployed. Yet, in equilibrium, there is unemployment.Those who are unemployed are not indifferent. They would rather be working than be unemployed. This also seems to capture reality better than does the labour-supply/labour-demand framework.
These are the three reasons that this chapter has relied on the wage-setting and price-setting relations rather than on the labour-supply/labour-demand approach to characterise labour-market equilibrium.
CHAPTER ф
Putting All Markets
Together: The AS-AD Model
W
e looked in Chapter 5 at the determination of output in the short run. We looked in Chapter 6 at the determination of output in the medium run. We are now ready to put the two together, and look at the determination of output in the short run and the medium run.
To do so, we use the equilibrium conditions for all the markets we have looked at so far—the goods and financial markets in Chapter 5 and the labour market in Chapter 6. Then, using these equilibrium conditions, we derive two relations:
• The aggregate supply relation captures the implications of equilibrium in the labour market; it builds on what you saw in Chapter 6.
• The aggregate demand relation captures the implications of equilibrium in both the goods market and financial markets.The interpretation of this relation will depend on whether the central bank conducts monetary policy by keeping the nominal money supply fixed or by choosing the interest rate and keeping that fixed: thus we build on what you saw in Chapter 5. Combining these two relations gives us the AS-AD model (for aggregate supply-aggregate demand).This chapter presents
the basic version of the model. When confronted with a macroeconomic question.it is the version we typically use to organise our thoughts. For some questions, however (in particular, for the study of inflation), the basic AS-AD model must be extended—this is what we will do in the next two chapters. This chapter is organised as follows:
• Sections 7.1 and 7.2 derive the aggregate supply relation and the aggregate demand relation (for our two types of monetary policy).
• Section 7.3 combines the two to characterise equilibrium output in the short run and in the medium run.
• Sections 7.4 to 7.6 show how we can use the model to look at the dynamic effects of monetary policy, of fiscal policy and of changes in the price of oil.
• Section 7.7 summarises the chapter.
7.1 AGGREGATE SUPPLY
Thc aggregate supply (И5) relation captures the effects of output on the price level. It is derived from the behaviour ol wages and prices described in Chapter 6.
Recall thc equations lor wage determination (equation [6.1]) and for price determination (equation [6.3]) derived in Chapter 6:
IV = PrF(n,z) P = (1 + fi)W
• The nominal wage. fV. set by wage setters, depends on the expected price level, P', on the unemployment rate, if, and on the catch-all variable, z, which stands lor all the other factors that affect wage determination, from unemployment benefits to thc form ol collective bargaining.
• Thc price, P, set by firms (equivalently, the price level) is equal to the nominal wage, W, limes 1 plus the markup, fi.
In Section 6.5 we used these two relations together with the additional assumption that the price level was equal to the expected pricc level. Under this additional assumption, we derived the natural rate of unemployment and, by implication, the natural level ol output.
Thc difference in this chapter is that we don't impose this additional assumption. (It will turn out lhat the price level is equal to the expected price level in thc medium run, but will typically not be equal to the expected price level in thc short run.) Without this additional assumption, the price-setting relation and the wage-setting relation give us a relation, which we now derive, between the price level, the output level and the expected price level.
(7.1)
• The first step is to eliminate the nominal wage, W, between the two equations. Replacing the nominal wage in the second equation above by its expression from the lirst gives;
P = Pr(\ + pi) F(u,z)
This tells us that thc price level, P. depends on the expected price level. Pr, on the unemployment rate, и ias well as on the markup, fi, and on the catch-all variable, z: but we will take- both ft and z as constant here).
The second step is to replace the unemployment rate, u, by its expression in terms of output. To replace u. recall the relation between the unemployment rate, employment and output derived in Chapter 6;
U _ L_- N N Y
L ~ 1
и =
The first equality, и = U/L, follows Irom the definition of the unemployment rale. The second equality, U/l. = (L-N)/L, follows Irom the definition of unemployment (U = L-N). The third equality, (L - N)/L = I (N/L), just simplifies the fraction. The fourth equality, I - (N/L) = I - ('Y/L}, follows from the specification of the production function, which says that to produce one unit of output requires one worker, so that Y N.
A better name would be 'labour market relation'. But. because the relation looks graphically like a supply curve (there is a positive relation * between output and the price), it is called the aggregate supply relation'. We will follow tradition. But be aware: the aggregate supply curve is very different from a regular supply curve.
Y_ L
(7.2)
What we get, then, is:
и = I
In words: For a given labour force, the higher the output, the lower the unemployment rale. Replacing и by I - (Y/L) in equation (7.1) gives us the aggregate supply relation, or /IS relation lor
short:
P = P'( I + fi)F\ I -
The price level, P. depends on lhe expected pricc level, P', and on the level of output, Y(and also on the markup, ft, on the catch-all variable, л and on the labour lorce, L, but we take them as constant here).
The AS relation has two important properties: • An increase in output leads to an increase in the price level. This is the result of four underlying « V steps:
1. An increase in output leads to an increase in employment.
aU Т ТING AI: MARKE TS TOGETHER; "НЕ AS AD MODEL
chapter 7
2. Thc increase in employment leads lo a decrease in unemployment, and so to a decrease in ihe unemployment rate.
». r>wT ► 3. The lower unemployment rate leads to an increase in the nominal wage.
4. The increase in the nominal wage leads to an increase in the price set by firms—equivalently. an w1— PT ► increase in the price level.
/*"—Pi ► • An increase in the expected price level leads, one lor one, to an increase in the actual price level, For example, il the expected price level doubles, then the price level will also double. This effect works through wages:
P'-JW" ► I. If wage setters expect the pricc level to be higher, they set a higher nominal wage.
2. The increase in the nominal wage leads to an increase in costs, which leads to an increase in the W~=}P" ► price set by firms—equivalently, a higher price level.
The relation between the price level, P. and output, V for a given value of the expected price level, P', is represented by thc curve /IS in Figure 7.1. The Л5 curve has three properties that will prove useful in what follows:
'I'hс aggregate supply curve is upward sloping. Put another way, an increase in output, V, leads to an increase in the price level, P. You saw why earlier.
The aggregate supply curve goes through point A, where Y = Yn and P = Pc. Put another way, when output, Y, is equal to the natural level ol output, Y„, the price level, P, turns out to exactly equal the expected price level, P.
How do we know this? From the definition of the natural level ol output in Chapter 6. Recall, we defined the natural rate ot unemployment ' and. by implication, the natural level of output) as the rate ol unemployment (and. by implication, the level of output) that prevails it the price level and the expected price level are equal.
An informal way of ► saying the same thing: . high economic activity puts pressure on prices.
This property—that the price level equals the expected price level when output is equal to thc natural level of output has two straightforward implications-.
1. When output is above the natural level of output, the pricc level is higher than expected. In Figure 7.1, if Y is to the right of Y„, P is higher than P.
Figure 7.1 The aggregate supply curve
The demand for goods is an increasing function of output Equilibrium requires that the demand for goods be equal to output
©
2. Conversely, when output is below thc natural level of output, the price level is lower than expected. In Figure 7.1, it У is to the left ot Y„, P is lower than P' .
• Ail increase in the expected price level l)c shifts the aggregate supply curve up. Conversely, a decrease in the expected price level shifts the aggregate supply curve down.
This third property is shown in Figure 7.2. Suppose the expected price level increases from P lo P". At a given level ol output, and so ai a given unemployment rale the increase in the expected pricc level leads to an increase in wages, leading in turn to an increase in prices So, at any level of output, the pricc level is higher—the aggregate supply curve shilts up In particular, instead of going through point A (where У = У, and P - P'l, the aggregate supply curve now goes through point A' (where У = Y„, P = Pe').
To summarise:
• Starting from wage determination and price determination in the labour market, we have derived the aggregate supply relation.
• This relation implies lhat, lor a given expected price level, ihe price level is an increasing function ol the level ol output and ol the expected price level. Il is represented by an upward-sloping curve, called thc aggregate supply curve.
• Increases in thc expected price level shili the aggregate supply curve up- decreases in the expected price level shili the aggregate supply curve down.
AS'
/ (forPe'>Pe) Figure 7.2 The effect of an increase in the expected price level on the
a.
"5 P = Pe'
V AS
(for expected price level Pc) aggregate supply curve
a и
CL
P = PC 1
n,
Output, Y
An increase in the expected price level shifts the aggregate supply curve up.
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