Econ3321 Chapter 6: The Labor Market ‫ةيرماع‬

‫دمحم‬
Think 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. Higher wages lead to further increases in prices, and so on.

An overview of the labor market

Population, Labor Force, Employment, and

Unemployment We divide the total population into

three groups.
 People under 16 years of age and who are
institutionalized, for example, mental hospital
(‫باحصأ ضارمأال‬
‫)ةيلقعال‬.

 Out of the Labor Force: is composed of adults who are potential workers but are not employed
and are not seeking work. For example, they are homemakers, full-time students, or retirees
(‫)نودعاقتمال‬.

 The labor force: the labor force consists of people who are able and willing to work. Both
those who are employed and those who are unemployed but actively seeking work.

The labor force consists of persons 16 years of age or older who are not in institutions and who are employed
or unemployed but seeking for work (‫)لمع ثحبي نع‬.

Labor Force = Employed + Unemployed

A person who is neither holding a job nor searching for a job is not counted as part of the labor force.

The flows of workers:

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Unemployment rate: ‫ةالطبال لدعم‬

Unemployment is the number of people who do not have a job but are
looking for job.
.‫لمع نع نوثحبي مهنكلو لمع مهيدل سيل نيذال صاخشأال ددع يه ةالطبال‬
𝑈𝑛𝑒𝑚𝑝𝑙𝑦𝑒𝑑
Unemployment rate𝐿𝑎𝑏𝑜𝑟
=
x 100 𝐹𝑜𝑟𝑐𝑒

Participation rate: ‫ةلماعال ىوقال يف‬

‫ةكراشمال ةبسن‬

The participation rate defined as the

𝐿𝑎𝑏𝑜𝑟
ratio of the labor force to persons 16

𝑂𝑢𝑡 𝑜𝑓 𝑡ℎ𝑒𝐹𝑜𝑟𝑐𝑒
𝐿𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒 +
years of age and older
Participation x
𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒
Rate = 100
Example:
Suppose the Palestinian population is 3,800,000 individuals, the number of individuals 16
years and above (manpower) is 2,000,000. Given that the labor force participation rate is 80%
and unemployment rate is 16%. Calculate the following:

a. The number of people in the labor force.

𝐿𝑎𝑏𝑜𝑟
𝑂𝑢𝑡 𝑜𝑓 𝑡ℎ𝑒𝐹𝑜𝑟𝑐𝑒
𝐿𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒 +
Participation x
𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒
Rate = 100
𝐿𝑎𝑏𝑜𝑟
80% 𝐹𝑜𝑟𝑐𝑒
2,000,00
0
=
𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒 = 2,000,000 * 0.8 =
1,600,000

b. The number of people who are

𝑈𝑛𝑒𝑚𝑝𝑙𝑦𝑒𝑑
Unemployment rate𝐿𝑎𝑏𝑜𝑟
unemployed.
=
x 100 𝐹𝑜𝑟𝑐𝑒
𝑈𝑛𝑒𝑚𝑝𝑙𝑦𝑒𝑑
16% =
1,600,000

Unemployed = 16% * 1600,000 =

256,000

c. The number of employed people.

1,600,000 = Employed
L.F = Employed +
+ Unemployed  Employed =
256,000 1,344,000

d. How many individuals are outside the labor force

The number of individuals 16 years and above = L.F + out of the

labor force 2,000,000 = 1,600,000 + out of the labor force

Out of the labor force = 2,000,000 – 1,600,000 = 400,000

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Palestinian Labor
Market

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Wage Determination ‫روجاال ديدحت‬

The relation between wages and unemployment:

Wages are set in many ways. They are set by collective bargaining that is, bargaining between
firms and unions. Wages are either set by employers, or by bargaining between the employer
and individual employees. The higher the skills needed to do the job, the more likely there is to
bargaining.

Workers are typically paid a wage that exceeds their reservation wage, the wage that would
make them indifference to working or becoming unemployed. In other words, most workers are
paid a high enough wage that they prefer to be employed than rather unemployed.

Wages typically depend on labor market conditions. The lower the unemployment rate, the higher
are wages.

To think about these facts, economists have focused on two broad lines of explanation. The first
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 wages. The second is
that firms themselves may, for a number of reasons, want to pay wages higher than the
reservation wage.

Bargaining:

How much bargaining power a worker has depends on two factors. The first is how costly it would
be for the firm to replace him, were he to lave the firm. The second is how hard it would be for
him to find another job, were he to leave the firm. The more costly it is for the firm to replace
him, and the easier it is for him to find another job, the more bargaining power he will have.

How much bargaining power a worker has depends on labor market conditions. When the
unemployment rate is low, it is more difficult for firms to find acceptable replacements; at the same
time, it is easier for workers to find other jobs. Workers are in a stronger bargaining position,
and may be able to obtain a higher wage. When the unemployment are is high, finding good
replacements is easier for firms while finding another job is harder for workers. Being in a weak
bargaining position, workers may have no choice but to accept a lower wage.

Efficiency Wages

Regardless of workers’ bargaining power, firms may want to pay more than the reservation
wage. They may want their workers to be productive, and a higher wage can help them
achieve that goal. If, for 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 between their staying or leaving. In this case, many of them will
quit, and the turnover rate will be high. Paying a wage above the reservation wage makes it
more attractive for workers to stay. It decreases turnover and increases productivity.

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 instrument the firm can use to
achieve these goals. Economists call the theories that link the productivity or the efficiency of
workers to the wage they are paid efficiency wage theories.

Like theories based on bargaining, efficiency wage theories suggest that wages depend on both
the nature of the job and on labor-market conditions:

 Firms that see employee morale and commitment as essential to the quality of their work will
4 | Ppay
a g emore than firms in sectors where workers’ activities are more routine.
 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. When this happens, lower
unemployment will again lead to higher wages. Conversely, higher unemployment will lead
to lower wages.

Wages, Prices, and Unemployment

We capture our discussion of wage determination by using the following equation:

𝑊 = 𝑃𝑒 𝐹(𝑢, 𝑧)
(− ,+)

The expected price level Pe

The aggregate nominal wage W depends on three factors:

The unemployment rate 𝑢

A catchall variable z that stands for all other variables that may affect the outcome

of wage setting The expected price level (Pe):

Why does the price level affect wages?

The answer: both workers and firms care about real wage, not nominal wages.

Workers care not about how many dollars they receive, but about how many goods they can
by with their wages. In other words, they care about their wage in terms of goods, about (W/P).

In the same way, firms do not care about the nominal wages they pay workers, but about the
nominal wages they pay in relation to the price of the output they sell. So firms also care about
W/P.

- If both workers and firms expected the price level were going to double, they would agree
to double the nominal wage, keeping the real wage constant.

- An increase in the expected price level leads to an increase in nominal wage. (Pe ↑ 
W ↑ ).

The Unemployment Rate (u)

The minus sign under u in wage determination equation indicate that an increase in the
unemployment rate decreases wage.

If wages as being determined by bargaining, then higher unemployment weakens workers

bargaining power, forcing workers to accept lower wages. If we thing of wages as being
determined by efficiency wage considerations, then higher unemployment allows firms to pay
lower wages and still keep workers willing to work.

- An increase in unemployment rate (u) leads to a decrease in nominal wage (W). ( u ↑  W

↓ ).

- A decrease in unemployment rate (u) leads to an increase in nominal wage (W). ( u ↓  W

↑ ).

The Other Factors (z)

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Z, is a catchall variable that stands for all the factors that affect wages given the expected
Unemployment insurance ( ‫خم‬w‫ل تاصص‬w‫)بتاطب‬: the payment of unemployment benefits to workers who
lose their jobs. The more unemployment benefit, the more wages at a given unemployment
rate. For example, suppose unemployment insurance did not 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 for higher wages.

 At a given unemployment rate, higher unemployment benefits increase the wage.

Minimum wages ( ‫)ودرول لدىددا ددحال‬: an increase in minimum wage increase wages just above the
minimum wage, leading to an increase in the average wage (W), at a given interest rate.

 At a given unemployment rate, higher minimum wage increase the wage.

Price Determination:

Prices depend on cost. Costs depend on the nature of the production function (the relation
between the inputs used in production and the quantity of output produced, and on the price of
these inputs.

We assume here that firms produce goods using labor as the only factor of production and
according to the production function:

Y = AN

Where Y is output, N is employment, and A is labor productivity (output per worker).

Given the assumption that labor productivity (A) is constant, we can make one further
simplification. We can choose the units for output so that one worker produce one unit of output
so that A = 1. With that assumption, the production function becomes: Y = N.

The production function Y = N, implies that the cost of producing one more unit of output
is the cost of employing one more worker at wage W. But the cost of producing one more
unit of output is referring to marginal cost. (MC = W).

marginal cost (P = MC). But 𝑀𝐶 = 𝑊 → 𝑃 = 𝑊.

If there were perfect competition in the goods market, the price of a unit of output would be equal to

But many goods markets are not competitive, and firms charge a price higher that their marginal
cost. Assume that firms set their price according to: P = (1 + μ) W. where μ is the markup of the
price over the cost. If goods markets were perfectly competitive, μ would be equal to zero, and
the price (P) would equal the wage (W).

The Natural Rate of Unemployment

Assume that nominal wages depend on the actual price level (P), rather than on the
expected price level. Under this additional assumption, wage setting and price setting
determine the equilibrium rate of unemployment.

The Wage-Setting Relation

Given the assumption that nominal wages depends on the actual price level, rather than on the
expected price level, the wage determination becomes:

𝑊 = 𝑃 𝐹(𝑢, 𝑧).
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Dividing both sides by the price
level (P).

𝑊
�
= 𝐹 (𝑢, 𝑧)→ Wage Setting Relation
(WS)
� (−,+)

Wage determination implies a negative relation between the real wage (W/P), and the
unemployment rate (u): The higher the unemployment rate, the lower the real wage chosen by
wage setters.

The relation between the real wage and the rate of unemployment called the wage setting relation
(WS).

The Price Setting Relation

If𝑃we divide both side of the price determination equation, by the nominal wage, we get.
= 1
� + 𝜇
�
To state this equation in terms of the wage rate, we invert
both sides:

𝑊 → Price Setting Relation

𝑃 =
11+ 𝜇 (PS)
This equation says: Price setting decisions determine the real 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 Wage-Setting Relation, the Price-Setting Relation, and the Natural Rate of Unemployment

The wage setting relation is drawn as the downward sloping curve (WS): the higher the
unemployment rate, the lower the real wage.

The price setting relation is drawn as the horizontal line PS. The real wage implied by price
setting is (1 / (1 + μ); it does not depend on the unemployment rate.

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.

Equilibrium Real Wages and Unemployment

Equilibrium in the labor market requires that the real wage implied by wage setting be equal to
the real wage implied by price setting.

equilibrium unemployment rate, or natural rate of unemployment (𝑢𝑛).

Eliminating W/P from the wage-setting and the price-setting relations, we can obtain the

1
F(u n , z)
1
The equilibrium unemployment rate (𝑢𝑛) is called the natural rate of


unemployment.

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Suppose that the firms' markup over costs is 5%, and the wage-setting relation is 𝑊
Example

= 𝑃 (1 – 𝑢).

A. What is the real wage as determined by the price setting equation?

W/𝑃 = 1 / (1 + 𝜇) = 1 / (1 + 0.05) = 0.952

B. What is the natural rate of

unemployment? At natural

rate of unemployment: 𝑃𝑆 = 𝑊𝑆
𝑃𝑆: 𝑊/𝑃 =
𝑊𝑆:
0.952 𝑊/𝑃 = 1 – 𝑢
𝑢𝑛 = 1 – 0.952 = 0.048 =
1 – 𝑢𝑛 = 0.952 4.8%
→
Unemployment Benefits and the Natural Rate of Unemployment

The positions of the wage-setting and price-setting curves, and thus the equilibrium
unemployment rate, depend on both z and μ.

An increase in unemployment benefit (z) makes the

prospect of unemployment less painful, it increase
the wage set by wage setters at a given
unemployment rate. So it shifts the wage setting
relation up, from WS to WS'. The economy moves
along the PS line, from A to A'. This leads to the
natural rate of unemployment.

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 to what firms are willing to pay.

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Markup and the Natural Rate of Unemployment

An increase in the 𝜇 (increase in the price of oil) implies a decrease in the real wage paid by

from 𝐴 to 𝐴′, and the natural rate of unemployment increases from 𝑢𝑛 to 𝑢𝑛′
firms, and so it shifts the price setting relation down, from PS to PS'. The equilibrium moves

From Unemployment to Employment

Associated with the natural rate of unemployment (𝑢𝑛) is a natural level of employment
(𝑁𝑛), the level of employment that prevails when unemployment is equal to its natural rate.

Let 𝑈 denote unemployment, N denote employment, and L the labor force. Then,

𝑈 𝐿
𝑢 =−𝑁 = 1
𝐿
�
= −
𝐿 �
�

�
Rearranging to get employment in terms of the labor force and the unemployment rate gives:

N  L(1 u)

employment, 𝑁𝑛, is given by:

If the natural rate of unemployment is un, and the labor force is equal to L, the natural level of

N n  L(1  un )

For example, if the labor force is 100 million and the natural rate of unemployment is 5%,
then the natural level of employment is 95 million.

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From Employment to Output

Associated with the natural level of employment is a natural level of output (𝑌𝑛), (and since 𝑌
= 𝑁, then,)

Yn  N n  L(1  un )

The natural level of output satisfies the following:

 Yn  1
F
 1  , z 

L 1 

𝑛
The natural level of output is such that, at the associated rate of unemployment �
(𝑢 = 1 – 𝑌𝑛
),
the realin
chosen wage
wage setting is equal to the real wage implied by �
price setting.

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