CH 29

The Labor Market In the Macroeconomy
CHAPTER 29 The Labor Market In the Macroeconomy
29 11
CHAPTER OUTLINE
The Labor Market: Basic Concepts
The Classical View of the Labor Market

The Classical Labor Market and the Aggregate Supply Curve The Unemployment Rate and the Classical View
Explaining the Existence of Unemployment

Sticky Wages Efficiency Wage Theory Imperfect Information Minimum Wage Laws An Open Question
The Short-Run Relationship Between the Unemployment Rate and Inflation

The Phillips Curve: A Historical Perspective Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve Expectations and the Phillips Curve Is There a Short-Run Trade-Off between Inflation and Unemployment?
The Long-Run Aggregate Supply Curve, Potential Output, and the Natural Rate of Unemployment
The Nonaccelerating Inflation Rate of Unemployment (NAIRU)
2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster
The Labor Market

In this chapter, we look further at the labor markets role in the macroeconomy. First, we consider the classical view, which holds that wages always adjust to clear the labor market, that is, to equate the supply and demand of labor. Then we analyze why the labor market might not always clear and why unemployment may exist. Finally, we discuss the relationship between unemployment and inflation.

The labor force (LF) is the number of employed plus unemployed: LF = E + U
unemployment rate The number of people unemployed as a percentage of the labor force. Unemployment rate = U/LF
To be unemployed, a person must be out of a job and actively looking for work. When a person stops looking for a job, she is considered out of the labor force.

Even if an economy is running at or near full capacity, the unemployment rate will never be zero. The natural rate of unemployment is the sum of frictional and structural unemployment.
frictional unemployment The portion of unemployment that is due to the normal working of the labor market; used to denote short-run job/skill matching problems. structural unemployment The portion of unemployment that is due to changes in the structure of the economy that result in a significant loss of jobs in certain industries. cyclical unemployment The increase in unemployment that occurs during recessions and depressions. In this chapter we are concerned with cyclical unemployment.

In one sense, the reason employment falls when the economy experiences a downturn is obvious. When firms cut back on production, they need fewer workers, so people get laid off.
Nevertheless, a decline in the demand for labor does not necessarily mean that unemployment will rise. A decline in the demand for labor will initially create an excess supply of labor. As a result, the wage rate will fall until the quantity of labor supplied again equals the quantity of labor demanded, restoring equilibrium in the labor market.
At the new lower wage rate, everyone who wants a job will have one. That is, there should be no persistent unemployment above the frictional and structural amount. This was the view held by the classical economists who precede Keynes, and it is still the view of a number of economists today. Other economists believe that wage rates adjust only slowly to decreases in the demand for labor and, as a result, economies can suffer from involuntary unemployment.

labor demand curve A graph that illustrates the amount of labor that firms want to employ at each given wage rate. Each firms decision about how much labor to demand is part of its overall profit maximizing decision. It will hire workers if the value of its output is sufficient to justify the wage that is being paid. labor supply curve A graph that illustrates the amount of labor that households want to supply at each given wage rate. Each households decision concerning how much labor to supply is part of the overall consumer choice problem of a household. Each household member looks at the market wage rate, the prices of outputs, and the value of leisure time and chooses the amount of labor to supply (if any). A household member not in the labor market has decided that his or her time is more valuable in non-market activities.

FIGURE 29.1 The Classical Labor Market
Classical economists believe that the labor market always clears. If the demand for labor shifts from D0 to D1, the equilibrium wage will fall from W0 to W1. Anyone who wants a job at W1 will have one.

At equilibrium, prices and wages reflect a trade-off between the value households place on outputs and the value of time spent in leisure and nonmarket work. At equilibrium, the people who are not working have chosen not to work at the market wage. There is always full employment in this sense.
The classical economists believed that the market would achieve this optimal result if left to its own devices, and there is nothing the government can do to make things better.

The Classical Labor Market and the Aggregate Supply Curve
The classical idea that wages adjust to clear the labor market is consistent with the view that wages respond quickly to price changes. This means that the AS curve is vertical. When the AS curve is vertical, monetary and fiscal policy cannot affect the level of output and employment in the economy. It therefore follows that those who believe that the wage rate adjusts quickly to clear the labor market believe also that monetary and fiscal policy have little or no effect on output and unemployment.

The Unemployment Rate and the Classical View How can we reconcile the fact that sometimes the unemployment rate is very high with the classical assumption about the labor market? Some economists argue that the unemployment rate is not necessarily an accurate indicator of whether the labor market is working properly. The measured unemployment rate may sometimes seem high even though the labor market is working well. They believe that the fact that there are people willing to work at a wage higher than the current wage does not mean that the labor market is not working. Economists who view unemployment this way do not see it as a major problem.

Sticky Wages sticky wages The downward rigidity of wages as an explanation for the existence of unemployment. That is, the equilibrium wage gets stuck at a particular level and does not fall when the demand for labor falls.
If wages stick at W0 instead of falling to the new equilibrium wage of W* following a shift of demand from D0 to D1, the result will be unemployment equal to L0 - L1. Why are wages sticky and why do wages not fall to clear the labor market during periods of high unemployment? Many answers have been proposed but there is no agreement on a certain one.
FIGURE 29.2 Sticky Wages

Sticky Wages Social, or Implicit, Contracts social, or implicit, contracts Unspoken agreements between workers and firms that firms will not cut wages. Empirical evidence suggests that extreme events- deep recession, deregulation, or threat of bankruptcy- are necessary for firms to cut wages. In a recent study, Truman Bewley of Yale University surveyed hundreds of managers about why they did not reduce wage rates in downturns. The most common response was that wage cuts hurt worker morale and thus negatively affect worker productivity. A related argument: relative-wage explanation of unemployment If workers are concerned about their wages relative to other workers in other firms and industries, they may be unwilling to accept a wage cut unless they know that all other workers are receiving similar cuts. Because it is difficult to reassure any one group of workers that all other workers are in the same situation, workers may resist any cut in their wages.

Sticky Wages Explicit Contracts explicit contracts Employment contracts that stipulate workers wages, usually for a period of 1 to 3 years. Wages set in this way do not fluctuate with economic conditions. If the economy slows down and firms demand fewer workers, the wage will not fall. Instead, some workers will be laid off. Why do firms and workers bind themselves in this way? One explanation is that negotiating wages is costly. Negotiating between firms and unions can take a considerable amount of time that could be spent producing output and it would be very costly to negotiate wages weekly or monthly. There is a trade-off between the costs of locking workers and firms into contracts for long periods of time and the costs of wage negotiations. Some multi year contracts adjust for unforeseen events by cost-of-living adjustments (COLAs) Contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised.

Efficiency Wage Theory efficiency wage theory An explanation for unemployment that holds that the productivity of workers increases with the wage rate. If this is so, firms may have an incentive to pay wages above the market-clearing rate.
Some economists consider this situation as a gift-exchange: firms pay a wage in excess of the market wage and in return workers work harder or more productively than they otherwise would. Under these circumstances, there will be people who want to work at the wage paid by firms and cannot find employment. Empirical studies of labor markets have identified several potential benefits that firms receive from paying workers more than the market clearing wage: lower turnover, improved morale and reduced shirking of work. Even though this theory predicts some unemployment, the behavior it is describing is unlikely to account for much of the observed large cyclical fluctuations in unemployment over time.

Imperfect Information Firms may not have enough information at their disposal to know what the market-clearing wage is. In this case, firms are said to have imperfect information.
If firms have imperfect or incomplete information, they may set wages wrongwages that do not clear the labor market. If a firm sets its wages too high, more workers will want to work for that firm than the firm wants to employ, resulting in unemployment. If the economy were simple, it should not take more than a few months for firms to correct their mistakes.
In reality, thousands of firms are setting wages and millions of workers are responding to these wages. It may take considerable time for the marketclearing wages to be determined after they have been disturbed from an equilibrium position.

Minimum Wage Laws minimum wage laws Laws that set a floor for wage ratesthat is, a minimum hourly rate (or weekly, or monthly rate) for any kind of labor. These laws explain at least a small fraction of unemployment. If the market-clearing wage is lower than the minimum wage there will be unemployment. These type of laws are more likely to hurt low-skilled groups whose productivity is lower. An Open Question The aggregate labor market is very complicated, and there are no simple answers to why there is unemployment. The theories we have just seen are not necessarily mutually exclusive and there might be elements of truth in all of them.

In the short run, the unemployment rate (U) and aggregate output (income) (Y) are negatively related since to increase aggregate output, firms must hire more labor. Thus, more output means greater employment.
FIGURE 29.3 The Aggregate Supply Curve
The AS curve shows a positive relationship between the price level (P) and aggregate output (income) (Y).

Consider an increase in AD. First, firms face an expected decline in inventories. They respond by increasing Y and hiring workers. At first, there will be little change in the price level. As the AD curve shifts more, the price level increases more and more and output begins to reach its limit. At the point where AS is vertical, output cannot rise any more. Thus, the unemployment rate cannot be pushed any lower. As the unemployment rate declines in response to the economys moving closer and closer to capacity output, the price level rises more and more.
FIGURE 29.4 The Relationship Between the Price Level and the Unemployment Rate

The AS curve shows the relationship between the price level and aggregate output and thus implicitly between the price level and the unemployment rate. In policy formulation and discussion however, economists have focused more on the relationship between the inflation rate and the unemployment rate. inflation rate The percentage change in the price level. Phillips Curve A curve showing the relationship between the inflation rate and the unemployment rate. This curve was named after British economist A.W. Philips who first examined it using data for the United Kingdom.

FIGURE 29.5 The Phillips Curve
The Phillips Curve shows the relationship between the inflation rate and the unemployment rate.

The Phillips Curve: A Historical Perspective During the 1960s, there seemed to be an obvious trade-off between inflation and unemployment. Data points fit fairly closely around a downward-sloping curve. Policy debates during the period revolved around this apparent trade-off. The role of the policy maker, it was thought, was to choose a point on the curve.
FIGURE 29.6 Unemployment and Inflation, US, 19601969

The Phillips Curve: A Historical Perspective
FIGURE 29.7 Unemployment and Inflation, US, 19702007
From the 1970s on, it became clear that the relationship between unemployment and inflation was anything but simple.

Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve
FIGURE 29.8 Changes in the Price Level and Aggregate Output Depend on Shifts in Both Aggregate Demand and Aggregate Supply
How can we explain the stability of the Philips curve in the 50s and the lack of it afterwards? Panel a. Suppose that only AD shifts from year to year. We would see a negative relationship between unemployment rate and inflation. Panel b. The relationship is positive. Panel c. No systematic relationship

Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve So, one explanation for the change in the Philips Curve between the 60s and later periods is that both the AS and the AD curves appear to be shifting in the later periods. Why might this be? One reason might be the role of import prices. One of the main factors that causes the AS curve to shift are energy prices. In US, much of its oil is imported. So, an increase in the oil prices would cause an increase in the price of imports and thus a shift in the AS curve.

Aggregate Supply and Aggregate Demand Analysis and the Phillips Curve The Role of Import Prices
FIGURE 29.9 The Price of US Imports, 1960 I2007 IV
The Philips Curve was stable in the 1960s because the primary source of variation in the economy was demand, not costs. In the 1970s, both demand and costs were varying so no obvious relationship between the unemployment rate and the inflation rate was apparent.

Expectations and the Phillips Curve Expectations are self-fulfilling. This means that wage inflation is affected by expectations of future price inflation. Because wages are input costs, prices rise as firms respond to the higher wage costs. Thus, price expectations that affect wage contracts eventually affect prices themselves. If the rate of inflation depends on expectations, the Phillips Curve will shift as expectations change. For example, if inflationary expectations increase, the result will be an increase in the rate of inflation even though the unemployment rate might mot have changed. In this case the Phillips Curve shifts to the right. If inflationary expectations decrease, the PC will shift to the left- there will be less inflation at any given unemployment rate. The inflationary expectations were quite stable in the 50s and 60s but they began to increase at the end of the 60s and increased more during 70s. These changing expectations might be another reason why the PC was not stable during to 70s.

Is There a Short-Run Trade-Off between Inflation and Unemployment? Does the fact that the PC broke down during the 1970s mean that there is no trade-off between inflation and unemployment?
For ex. in US in 1975 both inflation and unemployment were very high because of expectations of continued inflation and high oil prices. In response to the situation, the FED pursued a contractionary monetary policy which shifted the AD curve to the left and led to even higher unemployment but the inflation rate decreased. So, the rise in unemployment did lead to a decrease in inflation, an outcome that reflects the trade-off.
There is a short-run trade-off between inflation and unemployment, but other factors besides unemployment affect inflation. Policy involves more than simply choosing a point along a nice smooth curve.
FIGURE 29.10 The Long-Run Phillips Curve: The Natural Rate of Unemployment
If the AS curve is vertical in the long run, so is the Phillips Curve. In the long run, the Phillips Curve corresponds to the natural rate of unemploymentthat is, the unemployment rate that is consistent with the notion of a fixed long-run output at potential output. U* is the natural rate of unemployment (frictional + structural unemployment). Whenever the unemployment rate is pushed below the natural rate, wages begin to rise, thus pushing up costs. This leads to a lower level of output, which pushes the unemployment rate back up to the natural rate.
natural rate of unemployment The unemployment that occurs as a normal part of the functioning of the economy. Generally taken as the sum of frictional unemployment and structural unemployment.
The Nonaccelerating Inflation Rate of Unemployment (NAIRU) To the left of the NAIRU, the price level is accelerating (positive changes in the inflation rate); to the right of the NAIRU, the price level is decelerating (negative changes in the inflation rate). Only when the unemployment rate is equal to the NAIRU is the price level changing at a constant rate (no change in the inflation rate). Suppose that the unemployment rate decreases from NAIRU to U1 and stays there for many periods. Assume that the inflation rate at NAIRU was 2%. Then, in the first period the inflation rate will increase from 2% to 3%. In the next period the inflation rate will increase from 3% to 4% and so on. The price level will be accelerating when the actual unemployment rate is below NAIRU.
FIGURE 29.11 The NAIRU Diagram
The Nonaccelerating Inflation Rate of Unemployment (NAIRU) The same factors that shift the AS curve, such as cost shocks, shift the PP curve. A favorable shift for the PP curve is to the left because the PP curve crosses 0 at a lower unemployment rate, indicating that the NAIRU is lower. Some have argued that one possible recent source of favorable shifts is increased foreign competition, which mat have kept wage costs and other input costs down.
REVIEW TERMS AND CONCEPTS
cost-of-living adjustments (COLAs)
NAIRU natural rate of unemployment
cyclical unemployment
Phillips Curve
relative-wage explanation of unemployment social, or implicit, contracts sticky wages structural unemployment unemployment rate
efficient wage theory explicit contracts frictional unemployment inflation rate labor demand curve labor supply curve minimum wage laws
Exercise 1: Which of the following may shift the labor demand curve? A) an increase in the value of leisure B) an increase in the retirement age C) more people entering the labor force D) an increase in the value of output that firms produce
Exercise 2: a. At wage rate $15, there is a ________ of labor equal to ________ million people. b. According to Classical economists if the wage rate is A) $15, the wage rate will decline to eliminate the surplus. B) $15, the wage rate will increase to eliminate the shortage. C) $6, the wage rate will decline to eliminate the surplus. D)Pearson $15, Education, the wage will as decline to eliminate the shortage. 2009 Inc.rate Publishing Prentice Hall Principles of Economics 9e by Case, Fair and Oster
Exercise 3: An increase in the productivity of workers shifts the labor ________ curve to the ________. A)supply; left B) supply; right C) demand; right D) demand; left Exercise 4: The government lowers the marginal income tax rates so that after-tax wages are increased. This most likely will shift the labor A) supply curve to the right. B) supply curve to the left. C) demand curve to the right. D) demand curve to the left.
Exercise 5: True or false? a. Those who believe that the wage rate does not adjust quickly to clear the labor market are likely to believe that the aggregate supply curve is vertical. b. If the minimum wage is set above the market clearing wage, wages will be "sticky" in the downward direction.
Exercise 6: As the unemployment rate increases in response to the economy moving away from capacity output, the aggregate price level A) is stable. B) falls. C) rises at an increasing rate. D) rises at a declining rate.
Exercise 7: If aggregate demand increases and expectations regarding inflation remain constant, A) the economy moves along the short-run Phillips curve. B) the short-run Phillips curve shifts to the right. C) the short-run Phillips curve shifts to the left. D) the long-run Phillips curve shifts to the right.
Exercise 8: If the AS curve shifts from year to year, but the AD curve does not, then the Phillips curve would show A) a positive relationship between the inflation and unemployment rates. B) a negative relationship between the inflation and unemployment rates. C) no particular relationship between the inflation and unemployment rates. D) a constant trade-off between the inflation and unemployment rates. Exercise 9: If the measured unemployment rate is 8% and the natural unemployment rate is 3%, then A) frictional unemployment is 5%. B) cyclical unemployment is 5%. C) frictional unemployment is 11%. D) cyclical unemployment is 11%.
Exercise 10: Changes in the price level don't affect the unemployment rate if A) the economy is operating below capacity. B) the economy is operating at capacity. C) the aggregate supply curve is flat. D) the aggregate demand curve is steep.
Exercise 11: In 2008, the country of Ruba was suffering high unemployment. The chief economist of the country estimated the following supply and demand curves for labor: QD=100-5W QS=10W-20 Where W is the wage rate in slugs, the currency of Ruba. a. Currently the law in Ruba says that no worker shall be paid less than 9 slugs per hour. Calculate the quantity of labor supplied, the number of unemployed and the unemployment rate. b. Suppose that the minimum wage rate is cancelled such that the wage rate is determined in the market. What would happen to total unemployment and the size of the labor force? Show the results graphically.

CH 29

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CH 29

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The Labor Market In the Macroeconomy

CHAPTER 29 The Labor Market In the Macroeconomy

The Classical View of the Labor Market

Explaining the Existence of Unemployment

The Short-Run Relationship Between the Unemployment Rate and Inflation

The Labor Market

CHAPTER 29 The Labor Market In the Macroeconomy

The Labor Market: Basic Concepts

The Labor Market: Basic Concepts

The Classical View of the Labor Market

CHAPTER 29 The Labor Market In the Macroeconomy

The Classical View of the Labor Market

CHAPTER 29 The Labor Market In the Macroeconomy

The Classical View of the Labor Market

CHAPTER 29 The Labor Market In the Macroeconomy

The Classical View of the Labor Market

CHAPTER 29 The Labor Market In the Macroeconomy

The Classical View of the Labor Market

CHAPTER 29 The Labor Market In the Macroeconomy

The Classical View of the Labor Market

CHAPTER 29 The Labor Market In the Macroeconomy

Explaining the Existence of Unemployment

FIGURE 29.2 Sticky Wages

Explaining the Existence of Unemployment

CHAPTER 29 The Labor Market In the Macroeconomy

Explaining the Existence of Unemployment

CHAPTER 29 The Labor Market In the Macroeconomy

Explaining the Existence of Unemployment

Explaining the Existence of Unemployment

Explaining the Existence of Unemployment

CHAPTER 29 The Labor Market In the Macroeconomy

The Short-Run Relationship Between the Unemployment Rate and Inflation

The Short-Run Relationship Between the Unemployment Rate and Inflation

CHAPTER 29 The Labor Market In the Macroeconomy

The Short-Run Relationship Between the Unemployment Rate and Inflation

CHAPTER 29 The Labor Market In the Macroeconomy

The Short-Run Relationship Between the Unemployment Rate and Inflation

CHAPTER 29 The Labor Market In the Macroeconomy

The Short-Run Relationship Between the Unemployment Rate and Inflation

CHAPTER 29 The Labor Market In the Macroeconomy

The Short-Run Relationship Between the Unemployment Rate and Inflation

CHAPTER 29 The Labor Market In the Macroeconomy

The Short-Run Relationship Between the Unemployment Rate and Inflation

CHAPTER 29 The Labor Market In the Macroeconomy

The Short-Run Relationship Between the Unemployment Rate and Inflation

CHAPTER 29 The Labor Market In the Macroeconomy

The Short-Run Relationship Between the Unemployment Rate and Inflation

The Short-Run Relationship Between the Unemployment Rate and Inflation

CHAPTER 29 The Labor Market In the Macroeconomy

The Short-Run Relationship Between the Unemployment Rate and Inflation

CHAPTER 29 The Labor Market In the Macroeconomy

CHAPTER 29 The Labor Market In the Macroeconomy

CHAPTER 29 The Labor Market In the Macroeconomy

CHAPTER 29 The Labor Market In the Macroeconomy

REVIEW TERMS AND CONCEPTS

cost-of-living adjustments (COLAs)

NAIRU natural rate of unemployment

CHAPTER 29 The Labor Market In the Macroeconomy

CHAPTER 29 The Labor Market In the Macroeconomy

CHAPTER 29 The Labor Market In the Macroeconomy

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