The labour market; wage and price setting
in the medium run; the natural rate of
unemployment.
Topic 3
(Blanchard and Sheen, Chapter 6)
ECON5002 Macroeconomic Theory
(S2 2023)
1
Source: Dhyne et al. WP 05
• The (non-institutional) civilian population are the
number of people potentially available for civilian
employment
• Note: this definition excludes those under working age
(<15 yrs old), in the armed forces or behind bars.
• The civilian labour force is the sum of those either
working or looking for work.
• Those who are neither working nor looking for work
are out of the labour force.
• The participation rate is the ratio of the labour
force to the non-institutional civilian population.
• The unemployment rate is the ratio of the
unemployed to the labour force.
Section 6.1: A Tour of the Labour Market
2
The Labour Market
Population, Labour Force, Employment and
Unemployment in Australia (in millions), June 2023
Total population: 26.3 mn (Dec 2022)
Civilian population:21.8 m
L = Labour force: 14.5 m Out of the labour force: 7.3 m
N = Employed: 14.0 m
U = Unemployed: 0.51 m
u=Unemployment rate
= 100*0.51/14.5 = 3.5%
Participation rate =
100*14.5/21.8 = 67%
3
Source: ABS (Australian Bureau of Statistics)
Movements in the Unemployment Rate
From 1960–74, the unemployment rate averaged
2%, thereafter 6.6%.
(The grey columns represent recessions.)
Shaded columns represent recessions
4
Movements in Unemployment
• Fluctuations in the aggregate unemployment rate affect:
1. The welfare of individual workers.
2. Wages.
• Higher unemployment affects workers:
1 Through a decrease in hires—more difficult to find jobs.
2 Through higher layoffs—higher risk of losing their jobs.
5
The Unemployment Rate and the Proportion of
Unemployed Finding Jobs in Australia, 1980–2012
When unemployment is high, the proportion of the
unemployed finding jobs is low.
Note, the scale on the left is an inverse scale.
6
The Unemployment Rate and the
Separation Rate
When unemployment is high, a higher proportion of workers lose their
jobs.
7
Wage Determination
In Australia, wages are set in 3 different ways:
1. Collective bargaining is bargaining between firms
and unions
– applied to 43.4% of Australian workers in 2010 (35.1% in 2021)
– since early 1990s, many workers have moved to enterprise
bargaining
2. Awards (or, industry award (IA))—legally
enforceable determinations made by federal or state
industrial tribunals that set the terms of employment,
including pay
– applied to 15.2% of Australian workers in 2010 (compared to
most before 1980) (23% in 2021)
3. Individual agreements between worker and
employer
– greatly facilitated by Howard government from 1996–2006
– applied to 37.3% of Australian workers in 2010 (37.8% in 2021)
6-3
8
Wage Determination
Two facts stand out in the determination
of wages:
 A tendency for the wage to exceed the
reservation wage, or the wage that makes
workers indifferent between working or
becoming unemployed.
 Dependency of wages on labour-market
conditions.
9
Explanation 1: Bargaining
How much bargaining power a worker has depends on:
1. How costly it would be for the firm to replace the
worker—the nature of the job.
2. How hard it would be for the worker to find another
job—labour market conditions.
10
Explanation 2: Efficiency Wages
• Efficiency wage theories are theories that link the
productivity or the efficiency of workers to the wage they
are paid.
• These theories also suggest that wages depend on both the
nature of the job and on labour-market conditions.
11
Wages, Prices and Unemployment
The aggregate nominal wage, W,
depends on three factors:
1. The expected price level, Pe
2. The unemployment rate, u
3. A catch-all variable, z, that catches all
other variables that may affect the
outcome of wage setting.
W P F u ze= ( , )
( , )− +
12
Wages, Prices and Unemployment
1. Both workers and firms care about real wages (W/P), not
nominal wages (W).
2. Higher unemployment weakens workers’ bargaining
power, forcing them to accept lower wages.
3. Among other factors that affect wages is unemployment
insurance—the payment of unemployment benefits to
workers who lose their jobs. Higher unemployment
insurance allows workers to hold out for higher wages.
Minimum wages and employment protection are other
factors.
13
Section 6.4: Price Determination
• The production function is the relation between
the inputs used in production and the quantity of
output produced.
• Assuming that firms produce goods using only
labour, the production function can be written as:
Y AN=
Y = output
N = employment
A = labour productivity, or output per worker
• For simplicity, assume that one worker produces
one unit of output—so that A = 1. Then, the
production function becomes: Y N=
14
Price Determination
Firms set their price according to:
(1 )P m W= +
The term m is the markup of the price over the cost
of production.
If all markets were perfectly competitive, m = 0, and
P =W.
m measures the extent of imperfect competition in
goods markets.
Australian Competition and Consumer Commission
(ACCC)—tries to reduce m.
15
Section 6.5: The Natural Rate of
Unemployment
• This section looks at the implications of wage
and price determination for unemployment.
• We assume that Pe = P, and that nominal wages
depends on the actual price level, P, rather than
on the expected price level, Pe.
• Wage setting and price setting determine the
equilibrium rate of unemployment.
16
The Wage-Setting Relation
W P F u ze= ( , )
( , )− +
• Now, since Pe = P, then:
W
P
F u z= ( , )
( , )− +
W PF u z= ( , )
• Dividing both sides by P, then:
The wage-setting
relation
Earlier, we stated that the nominal wage rate was determined
as follows:
17
The Price-Setting Relation
The price-determination equation is:
(1 )P m W= +
 If we divide both sides by W, we get:
(1 )P m
W
= +
 To state this equation in terms of the wage rate,
we invert both sides:
1
(1 )
W
P m
=
+
The price-setting
relation
18
Wage Setting and Price Setting
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 Wage-Setting
Relation, the Price-
Setting Relation,
and the Real Wage
19
Equilibrium Real Wages and Unemployment
The natural rate of
unemployment is the
unemployment rate such
that the real wage chosen
in wage setting is equal
to the real wage implied
by price setting.
The Wage-Setting
Relation, the Price-
Setting Relation, and
the Natural Rate of
Unemployment
20
The natural rate of unemployment
21
• The natural rate of unemployment is the unemployment rate
to which the economy tends to return in the medium run;
• The adjustment to the natural rate is partly facilitated by
changes in prices and wages.

• In the short run, the actual unemployment rate could be
different to the natural rate (note: this would be discussed in
Topic 4 and Topic 5).
Equilibrium Real Wages
and Unemployment
Eliminating W/P from
the wage-setting
and the price-
setting relations, we
can obtain the
equilibrium
unemployment rate,
or natural rate of
unemployment, un:
1( , )
1n
F u z
m
=
+
22
Equilibrium Real Wages
and Unemployment
An increase in
unemployment
benefits (z)
leads to an
increase in the
natural rate of
unemployment.
Unemployment
Benefits and the
Natural Rate of
Unemployment
23
Average unemployment rate & unemployment benefit
(The US vs. Euro area)
24
Unemployment benefits (share of previous income after 2 months)
US France Spain
51% 66% 79%
Source: OECD Data
Equilibrium Real Wages
and Unemployment
An increase in the
markup (m)
decreases the real
wage, and leads to
an increase in the
natural rate of
unemployment.
Markups and the
Natural Rate of
Unemployment
25
Equilibrium Real Wages and Unemployment
Practice question 1
Suppose the actual unemployment rate in the medium run
decreases. This will cause:
(A) an upward shift in the WS curve
(B) a downward shift in the WS curve
(C) an upward shift in the PS curve
(D) a downward shift in the PS curve
(E) none of the above
26
Because the equilibrium rate of unemployment
reflects the structure of the economy, a better
name for the natural rate of unemployment is
the structural rate of unemployment.
The Structural Rate of Unemployment
27
u
U
L
L N
L
N
L
= =
−
= −1
• Employment in terms of the labour force and
the unemployment rate equals:
N L u= −( )1
• The natural level of employment, Nn, is given by:
N L un n= −( )1
From Unemployment to Employment
Associated with the natural rate of unemployment
is a natural level of employment.
28
From Employment to Output
Associated with the natural level of employment is
the natural level of output, (and since we
assume Y=N, then):
Y N L un n n= = −( )1
• The natural level of output satisfies the
following:
• In words, the natural level of output is such
that, at the associated rate of unemployment,
the real wage chosen in wage setting is equal
to the real wage implied by price setting.
u
Y
Ln
n= −1 ,
29
Equilibrium Real Wages and Unemployment
Practice question 2
The natural level of employment (Nn) will increase
when which of the following occurs?
(A) an increase in the markup of prices over costs.
(B) a reduction in unemployment benefits.
(C) an increase in the actual unemployment rate.
(D) all of the above.
(E) none of the above