Chapter 7

The Labor Market

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Unemployment
Italy, 2016 - thousands of units

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Wage determination
Three ’facts’:

1 Although …rms and workers agree on a nominal wage W, in deciding

if and how much to work workers look at the corresponding real
wage W/P (they do not su¤er from money illusion)
2 At the prevailing wage, rather than being indi¤erent between working
and being unemployed, most workers prefer being employed to being
unemployed
3 Wages depend on labor-market conditions (# u !" W, where
u = U/L = rate of unemployment)

Two complementary explanations for ’facts’2 and 3.

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Workers have bargaining power. How much depends on the
’nature of the job’and skills of the individual worker. In any
case, workers’barganing power is greater the lower is u.

Firms may have an incentive to pay wages higher than those at

which workers would be willing to work [to lower the costs
associated with a high turn-over rate, to induce workers to work
hard and be productive on the job ) ’e¢ ciency wages
theories’].
This incentive faced by …rms is higher the lower is u.

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Therefore:

The nominal wage W is set through a bargaining process between

workers and …rms
This wage is predetermined for the term of the labor contract (for
instance, if contracts have a one-year duration, on January 1 …rms
and workers agree on a W that will prevail until December 31)
Since they do not su¤er from money illusion, and care about the pay
in real terms they receive, workers base their decision on which W to
demand/accept also on Pe , the level of prices they expect will prevail
during the term of the contract
Given Pe , W is decreasing in u (’fact’3 above).

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The Wage-Setting equation (WS)
W = Pe F( u , z )
( ) (+)

or, dividing both sides by P,

W Pe
= F( u , z )
P P ( ) (+)

where:

z = ’other factors’
[e.g.: unemployment insurance, minimum wage,
laws on hiring and lay-o¤s, employment protection, etc.]

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Price determination

Production function:
Y = AN,
where:
Y = output
N = employment
A = labor productivity

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Unit price set by …rms by applying a mark-up m (> 0) to the
unit variable costs of production (unit labor costs):

WN
P = (1 + m)
Y
W
= (1 + m)
Y/N
W
= (1 + m)
A
So, if for instance both the wage rate and labor productivity rise
by 5%, unit labor costs do not change (labor is 5% more
expensive, true, but thanks to the increase in productivity it is
now possible to produce the same quantity of output as before
with 5% fewer workers)

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We shall assume that A is constant and > 0. From

Y = AN

it follows that:

cost of producing one additional unit of output = W/A

if there was perfect competition, P = W/A

... but if goods markets not perfectly competitive,

W
P = (1 + m) ,
A
where the level of the mark-up m is increasing in the degree of
market power held by …rms [perfect competition: m = 0]

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For simplicity, let’s take A = 1, so that

The Price-Setting equation (PS)

P = (1 + m)W
Equivalently, rearranging terms,
W 1
=
P 1+m
[Notice that, with A 6= 1, the two equations above would be,
respectively, P = (1 + m) W W A
A and P = 1+m ]
The PS gives the wage that, give the labor productivity and the
conditions in the goods market (that a¤ect the level of the
mark-up) …rms are willing to pay
If A goes up, each worker is more productive/produces more, and
…rms can pay their employees a higher real wage
If m goes up, the real wage paid by …rms goes down
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Labor market equilibrium
Remember our de…nition of equilibrium: a position in which the
economy will tend to remain, unless disturbed by shocks

Labor market equilibrium requires P = Pe [reason: if the price

level turns out to be di¤erent from the expected one, in order to
get to their target real wage next period workers will demand
changes in their nominal wage]

However, correct expectations (P = Pe ) is something that it

makes sense only in the medium-long run. In the short run,
P 6= Pe is a concrete possibility

The characterization of the labor market equilibrium that follows

is there fore relevant in the medium-long run only.

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When P = Pe , the Wage-Setting equation becomes:
W
= F(u, z) (WS)
P
that gives the real wage chosen in wage setting.
On the other hand, the Price-Setting equation gives the real wage
implied by price-setting by …rms:
W 1
= (PS)
P 1+m

In labor market equilibrium, the real wage implied by wage setting

must be the same as that implied by price setting.

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Equilibrium (medium run)
graphically, it is at the intersection between the WS curve and
the PS curve.
This intersection determines the equilibrium pair ’real
wage/unemployment rate’ [ W P n , un ]

analytically, the equilibrium values of W/P and u are the

solution of the system of equations given by the WS and the PS.
It is easy to check that this solution is

(W/P)n = 1/(1 + m),

F(un , z) = 1/(1 + m),

where the second equation implicitly de…nes un .

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The natural rate of unemployment (un )
= the value un of u for which the real wage implied by wage setting
is the same as the real wage implied by price setting

Example
1
If F(u, z) = 1 αu + z, (with α > 0), then F(u, z) = 1+m becomes

1
1 αu + z = .
1+m
Solving for u,
1 1
un = 1+z
α 1+m

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More generally,
un = u( z , m ).
(+) (+)

Since un is a¤ected – though z and µ – by the structural

characteristics of the economy, it is also referred to as the structural
rate of unemployment.

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How is the equilibrium reached?
If u < un , PS < WS ) the real wage demanded by workers is
greater then the one …rms are willing to pay, given labor
productivity and the degree of competition prevailing in the goods
market. It follows that:
…rms will reduce their labor demand ! unemployment rises,
inducing workers to accept lower wages (W #);
since wages are high, …rms will pass these high labor costs into
higher prices for the goods they produce. These higher prices will
tend to decrease the demand for goods and employment, and rise
unemployment..
=) W keeps falling, P rising e W/P falling until we get to un

Similarly, if u > un , PS > WS ) labor is cheap, so that …rms

increase their demand for labor, and W tends to rise. In addition,
since …rms face low unit labor costs, they can charge low unit
prices. This raises the demand for goods and lowers
unemployment.
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The natural level of output
The natural level of output (Yn )
Amount of goods produced when unemployment is at its natural level
(that is, when u = un ).

De…ning L = labor force, and U = unemployment,

U L N N
u= = =1 ,
L L L
from which
N = (1 u)L.
When u = un , N = Nn and (through the production function
Y = N), Y = Yn , where
Nn = (1 un )L
Yn = Nn
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Alternatively, recalling that
N
u=1
L
and that Y = N, the natural level of output Yn is implicitly de…ned
by:
Yn 1
F(1 , z) =
L 1+m

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Important caveat:

un , Nn , Yn have been derived under the assumption P = Pe ,

reasonabe in the medium-long run only.

In the medium run:

P = Pe
u = un
Y = Yn

However, in the short run ...

P can be di¤erent from Pe
u can deviate from un
Y can di¤er from Yn

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The short run - Incomplete information
Economy is initially at point En in the Figure on the last page of
these slides, with P = Pe and WS therefore given by:
W
= F( u , z )
P ( ) (+)

Suppose now that P rises by x% till P0 . However, workers still

expect Pe = P < P0 . Since the general expression of the WS is

W Pe
= F( u , z ),
P P ( ) (+)

and that now (Pe /P) < 1, the WS will shif down to WS0 , and,
in the short run, we shall go from En to E0 .
Employment will rise (unemployment will fall).
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What’s going on?
Suppose …rms face an increase in the demand for their goods. To
meet this extra demand, they must produce more, and therefore
hire more workers.
To entice the extra workers they need to accept the job, …rms
o¤er a nominal wage W greater (let’s say by x%) than the one
they were paying before the increase in demand. And, of course,
they will pass these higher labor costs into higher unit prices. It
follows that P, too, will rise by x% till P0 .
Workers can see that …rms are now willing to pay a higher nominal
wage, but do not immediately realize that the general price level
has gone up by the same percentage (in other words, Pe is still P,
while prices are now P0 > P). Erroneously thinking that their real
wage has gone up, they will supply more labor, employment will
rise and unemployment will fall.
(Two equivalent ways of explaining the downward shift of the WS
in the …gure: 1) now there are more workers willing to accept a
job for any given real wage, or 2) the same number of workers is
now willing to work at a lower, ’actual’real wage.)
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However, the WS curve will not remain WS0 for long. Sooner or
later, workers will realize that the general price level has gone
up, and that they are therefore working for a real wage lower
than the one they were convinced to earn.
When workers’expectations are revised, and Pe raised till P0 ,
the WS curve returns to its original position, and employment
and unemployment to their ’natural’levels.
Deviations of N and u from their natural levels are therefore
uniquely due, according to this approach, to a misperception on
the part of workers. Once these latter realize their real wages
have not risen, labor supply will return to the initial level.
It follows that deviations of N and u from their natural levels are
at most temporary. In the medium run, employment,
unemployment and output are always at their natural levels.

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 W
P

W 1 E0 En
P n = 1+m PS

WS jPe =P
WS0 jPe <P
0 u
u0 un

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