Week 4: The Medium Run [Labour Market, Phillips Curve] Flashcards
Unemployment criteria:
1 Without a job, have been actively seeking work in the past four weeks and are available to start work in the next two weeks;
2 Out of work, have found a job and are waiting to start it in the next two weeks;
u as a capacity utilization measure
■ When u is low, more (labour) resources are used;
■ Conversely, when it is high, less of an economy’s productive capacity is used;
What creates labour flows?
- Separation rate s – the share of employed losing jobs
- Less productive firms are competed out by their rivals (firm
churning), temporary contracts expire; On average, s ≈ 1.3% in the UK; - Finding rate f – the share of unemployed finding jobs
- Finding a job involves searching, applying, being interviewed, and
all those take time (search frictions); On average, f ≈ 50.1% in the UK;
Unemployment rate converges
U= s/(s+f)
Efficiency wages
■ There is a minimum wage acceptable for workers (e.g. no-one will work for a wage below unemployment benefits plus the compensation for the disutility of working);
■ This minimum level is called reservation wage;
■ At this wage, demand from labour from producers would be at
the highest level and the labour market would clear;
■ Why is this wage not offered?
■ Having the reservation wage might be detrimental to workers’ performance, and so firms pay more;
■ The link between wages and workers’ performance is explored by several efficiency wage theories;
Shapiro-Stieglitz interpretation
■ Working hard requires the inconvenience of exerting extra effort, and so employees are prone to shirk;
■ They are sacked if caught shirking, and upon that start receiving unemployment benefits;
■ If the wage is higher than the benefit, it can act as a disciplining tool (workers do not shirk because otherwise they will lose their wage);
■ If, however, the wage is at the reservation level, a worker has nothing to lose, and so firms are deprived of their leverage;
■ Naturally, having a higher reservation wage implies a higher wage (wage has to stay attractive enough to still act as a disciplining tool);
■ A higher unemployment rate drives wages down (higher unemployment rate would raise the prospect of staying out of work for longer for workers, and thus strengthens the firms’ position);
Bargaining
■ Finally, wages are not pushed all the way down to the reservation level because workers have a degree of bargaining power;
■ One source of power is the set of skills a worker possesses;
■ More unique skills make for a less substitutable employee;
■ The bargaining power also depends on the situation in the labour market: if unemployment is low, a worker can easily find another job if needed, while it would be difficult for the firm to find a replacement;
Labour market - quick summary
■ Labour markets are characterised by the degree to which labour resources are employed;
■ This degree is always below 100%, as reflected by the positivity of the unemployment rate;
■ A larger degree of utilisation is associated with moving above an economy’s trend;
Wage setting equation
■Equivalently, we can think of the WS equation in real terms W/ Pe =1−αu+z
■ W/ Pe is the expected real wage;
■ Workers and firms care about the wage not in monetary terms, but rather how much could be bought for it;
Price setting equation
■ Wages are a component of firms’ costs, and so deciding upon wages has bearing on firms’ prices;
■ To formalise, suppose output is produced according to a very simple technology
Y=N
■ Each single extra worker can create 1 unit of output;
■ The price of 1 worker’s labour is W;
■ Thus the marginal cost of 1 unit of output for a firm is exactly W;
Suppose the price is formed by charging mark-up m over a firm’s marginal cost W
P = (1 + m) W
■ m measures by how much (in percentage terms) the price
exceeds the marginal cost;
■ As an example, if the wage rate is 5 and the mark-up is 20%,
thepriceishigherthanW by20%:P =5·(1+0.2)=6;
Price-setting equation - real wage
■ Equivalently, we can think of the price-setting equation in terms of the real wage W/P
W/P=1/1+m
■ Charging a higher mark-up reduces the real wage: if every product costs now more, less can be bought for one wage;
Labour market in the medium run
■ We know that there is always some unemployment;
■ Let us first characterise it in the medium run;
■ We will express this by positing that P = Pe: informally, there is far less jumping around in the medium run, and so we can make accurate forecasts
Wage and price-setting together
■ Considering the WS and the PS relationship together allows us to pin down u in the medium run as the outcome of pricing decisions in the markets for goods and labour;
■ That medium run level of unemployment is denoted as un;
■ It is commonly called the natural rate of unemployment;
■ We will term it the structural rate of unemployment, as it depends on an economy’s structural features (which are not exactly ‘natural’, more on that in a moment)
the impact of higher unemployment benefits in words
■ If benefits increase, workers demand higher wages;
■ But their real wages are determined by the PS condition,
which is outside the labour market;
■ Thus, their bargaining power needs to decrease so that the equilibrium is achieved;
■ The only way for this to happen is through a higher equilibrium unemployment rate un;
Phillips curve
■ The first version of the Phillips curve was derived in 1958 by A.W.H. Phillips;
■ It connected unemployment with the growth rate of wages;
■ We are going to focus instead on unemployment and inflatio
(1/1+m)P = Pe(1-αu+z)
Final form:
■ Critically, the Phillips curve (PC) connects inflation, expected inflation and unemployment (capacity utilisation)
π = πe + (m + z) − αu
■ Lower u implies higher π: from WS, with a lower unemployment, workers demand higher wages, and those lead to higher prices;
■ Higher πe implies higher π: from WS, if higher prices are expected, workers demand higher wages to cover extra costs;