••••
THEMES AND CAPSTONE UNITS
17: History, instability, and growth
18: Global economy
19: Inequality
22: Politics and policy
UNIT 9
THE LABOUR MARKET:
WAGES, PROFITS, AND
UNEMPLOYMENT
HOW THE ECONOMY-WIDE MARKET FOR LABOUR
DETERMINES WAGES, EMPLOYMENT, AND THE
DISTRIBUTION OF INCOME
• The labour market functions quite differently from the bread market
described in the previous unit because firms cannot purchase the
work of employees directly but only hire their time.
• As we saw in Unit 6, the principal–agent model is used to explain the
conflict of interest between the employer and the employee over how
hard the worker works, and why this issue cannot be resolved by a con-
tract.
• The outcome of the wage-setting process across all firms in the economy
is the wage-setting curve, which shows the wage associated with each
unemployment rate.
• The prices that firms charge for their products are influenced by the
demand for their goods and the cost of labour, the wage.
• The outcome of the price-setting process across all firms is the price-
setting curve, which gives the value of the real wage that is consistent
with a firm’s profit-maximizing markup over production costs.
• Excess supply of labour (involuntary unemployment) is a feature of
labour markets, even in equilibrium.
• If economy-wide demand for goods and services is too low, unemploy-
ment will be higher than its equilibrium level and may persist.
• Unions and public policies can affect labour market equilibrium.
As in many parts of the world, mining was a way of life for Doug Grey, a
rigger who operated giant cranes at mines in the Northern Territory,
Australia. In the 1990s, he helped construct the MacArthur River zinc mine,
one of the world’s largest, where his son Rob got his first job. ‘I ended up
driving ore trucks,’ Rob reminisced, ‘That was an awesome opportunity.’
Rob, it seemed then, had been born at the right time. He entered the
labour market just as the worldwide natural resources boom was taking off,
Construction workers
361
driven by the demand from the rapidly growing economy of China. Rob
lived in Thailand for a time, spending little, and flying into his job in
Borroloola.
About when Rob started work, Doug, the elder Grey, took a job at the
Pilbara iron ore mine in Western Australia (WA), which paid about twice
the average family income in Australia at the time. Both father and son
were putting away substantial savings.
But by 2015 the natural resource boom was a distant memory, and the
price of ore and zinc continued to plummet. Rob and his fellow miners
were worried. ‘Everybody knew the economic downturn and commodity
prices were a problem. We had that in the back of our minds.’ Their dream
economy couldn’t last. ‘It was … obvious … that it was coming to an end,’
Doug said.
And it did. In late 2015, Rob got the bad news: ‘Two days into my break
the general manager called and said, “thanks for your service, we appreciate
it, we have to let you go.”’ His father, too, was laid off.
Driving ore trucks is Rob’s passion and he still hopes to get back behind
the wheel. But that is not going to happen, at least not at the Pilbara mine
where his dad once worked. Faced with collapsing demand, the mining
company cut production, and also sought to drastically reduce costs. As
part of this process, they replaced human labour by machines wherever
possible. In the Pilbara, nobody is behind the wheel of any of their giant
robot ore trucks that are now being ‘driven’ by university graduates with
joysticks 1,200 km away in Perth (we return to this process of automation
and its effects on the labour market in Units 16 and 19).
The rise and fall of the Grey family’s economic fortunes is all about the
workings of the labour market in the mining and construction industries in
Western Australia and the Northern Territory. Figure 9.1 shows that their
experience was far from unusual. The boom in ore prices (in the top figure)
made mining highly profitable, leading to strong demand for labour, which
eventually dried up the pool of unemployed riggers and truck-drivers.
Mining companies had no choice but to pay extraordinarily high salaries,
and while the mining boom lasted, the companies remained highly
profitable.
The downturn in commodity prices began in mid-2011 and unemploy-
ment began to rise. The Grey family’s good fortunes lasted another four
years.
In this unit, we describe how the labour market works and why even in
equilibrium, the supply of labour (number of people seeking jobs) exceeds
the demand for labour (number of jobs offered). Those without work in this
situation are termed the involuntary unemployed (to distinguish them
from those who are unemployed by choice, but are looking for a job).
9.1 THE WAGE-SETTING CURVE, THE PRICE-SETTING
CURVE, AND THE LABOUR MARKET
In previous units we have looked at particular markets—buying and selling
bread, for example—and sometimes at a single firm. Here we model the
labour market of an entire economy, which determines the amount of
unemployment in the population as a whole. We look at price-setting firms,
selling differentiated products (as described in Unit 7), and a large number
of identical workers who may be employed by the firms for the same wage
set by the firm (as studied in Unit 6).
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
362
nominal wage The actual amount
received in payment for work, in a
particular currency. Also known as:
money wage. See also: real wage.
We consider the simple case in which the only input to production is
labour, so that the only cost is the wage, and profits are determined by just
three things: the nominal wage (the actual amount received in a particular
currency), the price at which the firm sells its goods, and the average output
produced by a worker in an hour.
Real wage
Iron ore price
World iron ore price peak
800
900
1,000
1,100
1,200
1,300
1,400
1,500
1,600
1,700
0
50
100
150
200
250
1989 1994 1999 2004 2009 2014 2019
Year
Re
al
w
ee
kl
y
w
ag
e
fo
rm
al
es
in
W
A
(A
U
S$
)
W
or
ld
ir
on
or
e
pr
ic
e
(A
U
S$
)
Real wage
Unemployment rate
900
1,000
1,100
1,200
1,300
1,400
1,500
1,600
1,700
0
2
4
6
8
10
12
1989 1994 1999 2004 2009 2014 2019
Year
Re
al
w
ee
kl
y
w
ag
e
fo
rm
al
es
in
W
A
(A
U
S$
)
Au
st
ra
lia
n
un
em
pl
oy
m
en
tr
at
e
(%
)
Figure 9.1 Real weekly earnings for males in Western Australia (left axis), world
price of iron-ore and unemployment rate in Australia (right axis), (1989–2021).
Australian Bureau of Statistics
(https://tinyco.re/1648810) and Interna-
tional Monetary Fund (https://tinyco.re/
8213274). Note: Unemployment rates
are seasonally adjusted.
1. Weekly earnings
The chart shows real weekly earnings
for males in Western Australia,
together with the world price of iron-
ore in the top panel and the
unemployment rate in Australia in the
bottom panel.
2. Growth slows, unemployment rises
Following the peak in iron-ore prices,
real wage growth slowed and
unemployment began to rise.
9.1 THE WAGE-SETTING AND PRICE-SETTING CURVES AND THE LABOUR MARKET
363
employment rent The economic
rent a worker receives when the
net value of her job exceeds the
net value of her next best
alternative (that is, being
unemployed). Also known as: cost
of job loss.
real wage The nominal wage,
adjusted to take account of
changes in prices between different
time periods. It measures the
amount of goods and services the
worker can buy. See also: nominal
wage.
The labour market
The labour market brings together two earlier themes: the firm and its
employees (Unit 6) and the firm and its customers (Unit 7). Two things you
have learned will be essential to seeing how the labour market functions.
Firms and employees
In order to motivate employees to work hard and well, firms must set the
wage sufficiently high so that the worker receives an employment rent.
This means there is a cost of job loss: she is better off being employed than
being fired due to inadequate effort. If the worker is very likely to find
alternative work if she is fired, which will be the case if the employment
level in the economy is high, she will need a higher wage to work hard.
Think of wage-setting as the business of the human resources (HR)
department of the firm.
Firms and customers
In setting the price of the good they sell, firms face a trade-off between
selling more goods and setting a higher price, due to the demand curve they
face. To determine the price to set, the firm finds the markup over their
production cost that balances the gains from a higher price against the
losses from lower sales so as to maximize its profits. This profit-
maximizing markup determines the division of the firm’s revenues between
profits and wages. Think of price-setting as the business of the marketing
department of the firm.
Wages and employment
We want to know how the real wage and the level of employment in the
economy as a whole are determined. Keep in mind that the real wage is the
nominal wage divided by the price level of a standard bundle of consumer
goods, so it is determined both by the nominal wages paid by the firms and
the prices they each set. Think about this in two stages:
• First, each firm decides what wage to pay, what price to charge for its
products, and how many people to hire.
• Then, adding up all of these decisions across all firms gives the total
employment in the economy and the real wage.
Here is how the first stage (choosing the wage, price, and employment)
takes place in each firm:
• The human resources department determines the lowest wage it can pay: It
must not undermine the workers’ motivation to work, and its decision is
based on the prices of other firms’ products, the wages the other firms
are paying, and the unemployment rate in the economy. This is the
nominal wage set by the firm. It communicates this information to the
marketing department.
• The marketing department sets the price: This is based on the firm’s
nominal wage and the shape and position of the demand curve facing
the firm. For example, if the demand curve is elastic, indicating a high
level of competition from other firms, it will set a lower price. Setting
the price is the same thing as fixing the size of the markup over the cost
of hiring labour. Given the position of the demand curve, which
indicates the level of economy-wide demand, the marketing department
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
364
wage-setting curve The curve that
gives the real wage necessary at
each level of economy-wide
employment to provide workers
with incentives to work hard and
well.
price-setting curve The curve that
gives the real wage paid when
firms choose their profit-
maximizing price.
then determines the amount of output the firm will sell. It
communicates this information to the production department (PD).
• The production department then calculates how many employees have
to be hired to produce the output determined by the marketing
department, based on the firm’s production function.
The second stage—considering the outcome of all the firms’ decisions
added together—is more complicated. But the key idea is simple. Once all
firms in the economy have made their wage and price (markup) decisions,
the output per worker in the economy is divided into the real wage that a
worker receives, and the real profits that the owner receives. If all firms are
charging the same price and setting the same nominal wage, then a higher
real wage (W/P) means a lower markup (1 − (W/P)). To understand how the
real wage and employment are jointly determined in the labour market, we
need two basic concepts:
• The wage-setting curve: This gives the real wage necessary at each level
of economy-wide employment to provide workers with incentives to
work hard and well.
• The price-setting curve: This gives the real wage paid when firms choose
their profit-maximizing price.
In the next section we look at how employment and unemployment are
measured. After that, we introduce the wage-setting curve using the model
of wage-setting from Unit 6. Then we describe how a single firm
determines its employment level using the model of price-setting from Unit
7. This will provide a reason why the price-setting curve is essential to
understanding the labour market in the economy as a whole. We then show
how the two curves together determine the equilibrium level of employ-
ment, the real wage, and the distribution of income between wages and
profits. Finally, we use this model to explore the effect of changes in public
policy such as taxation of firms’ profits and workers’ wages, subsidies to
firms for hiring more labour, changes in the unemployment insurance
benefit received by those out of work, and changes in the degree of compet-
ition among firms.
QUESTION 9.1 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements is correct?
To maximize profits, firms set the wage at the level where the
workers are indifferent between working and not working.
Firms aim to set as high a price as possible.
In equilibrium, the wage clears the labour market, so there is no
unemployment.
If all firms set the same price and pay the same nominal wage, then
the higher the real wage that they pay, the lower is their markup.
9.1 THE WAGE-SETTING AND PRICE-SETTING CURVES AND THE LABOUR MARKET
365
unemployment A situation in
which a person who is able and
willing to work is not employed.
population of working age A statistical convention, which in
many countries is all people aged between 15 and 64 years.
inactive population People in the population of working age
who are neither employed nor actively looking for paid work.
Those working in the home raising children, for example, are
not considered as being in the labour force and therefore are
classified this way.
labour force The number of people in the population of
working age who are, or wish to be, in work outside the house-
hold. They are either employed (including self-employed) or
unemployed. See also: unemployment rate, employment rate,
participation rate.
participation rate The ratio of the
number of people in the labour
force to the population of working
age. See also: labour force, popula-
tion of working age.
•9.2 MEASURING THE ECONOMY: EMPLOYMENT AND
UNEMPLOYMENT
According to the standardized definition of the International Labour
Organization (ILO) (https://tinyco.re/8208329), the unemployed are the
people who:
• were without work during a reference period (usually four weeks),
which means they were not in paid employment or self-employment
• were available for work
• were seeking work, which means they had taken specific steps in that
period to seek paid employment or self-employment
Figure 9.2 provides an overview of the labour
market and shows how these components fit
together. We begin on the left-hand side with the
population. The next box shows the population
of working age. This is the total population,
minus children and those over 64. It is divided
into two parts: the labour force and those out of
the labour force (known as inactive). People out
of the labour force are not employed or actively
looking for work, for example, people unable to
work due to sickness or disability, or parents who
stay at home to raise children. Only members of
the labour force can be considered as employed or
unemployed.
There are a number of statistics that are useful
for evaluating labour market performance in a country and for comparing
labour markets across countries. The statistics depend on the relative sizes
of the boxes shown in Figure 9.2. The first is the participation rate, which
shows the proportion of the working age population that is in the labour
force. It is calculated as follows:
Population
Population of
working age
Labour force
Employed
Unemployed
Out of labour
force (inactive)
Figure 9.2 The labour market.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
366
unemployment rate The ratio of
the number of the unemployed to
the total labour force. (Note that
the employment rate and
unemployment rate do not sum to
100%, as they have different
denominators.) See also: labour
force, employment rate.
employment rate The ratio of the
number of employed to the popula-
tion of working age. See also:
population of working age.
Next is the most commonly cited labour market statistic: the unemploy-
ment rate. This shows the proportion of the labour force that is
unemployed. It is calculated as follows:
Lastly, we come to the employment rate, which shows the proportion of
the population of working age that are in paid work or self-employed. It is
calculated as follows:
It is important to note that the denominator (the statistic on the bottom of
the fraction) is different for the unemployment and the employment rate.
Hence, two countries with the same unemployment rate can differ in their
employment rates if one has a high participation rate and the other has a
low one.
The table in Figure 9.3 provides a picture of the Norwegian and Spanish
labour markets between 2000 and 2015, and shows how the labour market
statistics relate to each other. It also shows that the structure of the labour
market differs widely across countries. We can see that the Norwegian
labour market worked better than the Spanish labour market in the last
15 years: Norway had a much higher employment rate and a much lower
unemployment rate. Norway also had a higher participation rate, which is a
reflection of the higher proportion of women in the labour force.
Norway and Spain are illustrations of two common cases. Norway is a
low-unemployment, high-employment economy (the other Scandinavian
countries—Sweden, Denmark, and Finland—are similar) and Spain is a high-
unemployment, low-employment economy (the other southern European
economies—Portugal, Italy and Greece—are other examples). Other combin-
ations are possible, however: South Korea is an example of an economy that
has both a low unemployment rate and a low employment rate.
Norway Spain
Number of persons, millions
Population of working age 3.5 37.6
Labour force 2.5 21.6
Out of labour force (inactive) 1.0 16.0
Employed 2.4 18.1
Unemployed 0.1 3.5
Rates (%)
Participation rate 2.5/3.5 = 71% 21.6/37.6 = 58%
Employment rate 2.4/3.5 = 69% 18.1/37.6 = 48%
Unemployment rate 0.1/2.5 = 4% 3.5/21.6 = 16%
Figure 9.3 Labour market statistics for Norway and Spain (averages over
2000–2015).
International Labour Association. 2015.
ILOSTAT Database (https://tinyco.re/
2173706).
9.2 MEASURING THE ECONOMY: EMPLOYMENT AND UNEMPLOYMENT
367
Nash equilibrium A set of
strategies, one for each player in
the game, such that each player’s
strategy is a best response to the
strategies chosen by everyone else.
EXERCISE 9.1 EMPLOYMENT, UNEMPLOYMENT, AND PARTICIPATION
1. Visit the ILO’s website and use the ILOSTAT Database (https://tinyco.re/
2173706) to calculate the employment, unemployment, and
participation rates for two economies of your choice.
2. Describe the differences in these two countries’ data and compare
them with Spain and Norway. Choose a visual representation of the
data (for example, using the graph function of your spreadsheet
software) and explain your choice.
3. After studying this unit, use the model of the labour market to suggest
possible reasons for the differences in unemployment rates in these
countries. You may need to find out more about the two countries’
labour markets.
QUESTION 9.2 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements is correct?
participation rate = employed ÷ labour force
unemployment rate = unemployed ÷ population of working age
employment rate = employed ÷ population of working age
employment rate + unemployment rate = 1
9.3 THE WAGE-SETTING CURVE: EMPLOYMENT AND
REAL WAGES
We now build a model of the labour market that can help to explain differ-
ences in unemployment rates across countries, and changes over time
within a country. To do this, we broaden the perspective from the single
firm in Unit 6 to the whole economy, and we ask how changes in the
unemployment rate affect the wage set by employers.
In Figure 9.4, the horizontal axis represents the proportion of the
working-age population, and goes up to a value of 1. The vertical axis is the
economy-wide wage.
• The labour force is the vertical line furthest to the right: it has a value less
than 1, depending on the participation rate.
• Inactive workers are to the right of the labour force line.
• The employment rate is the vertical line to the left of the labour force,
indicating the share of the population who are actually working.
• The unemployment rate is the proportion of those in the labour force who are
not employed: that is, those workers in between the employment rate line
and the labour force line.
The upward-sloping line is called the wage-setting curve. Like the
best-effort response function of the employee on which it is based, the
wage-setting curve is a mathematical version of an ‘if-then’ statement: if the
employment rate is x, then the Nash equilibrium wage will be w. This
means that at the employment rate x, the wage w is the result of both
employers and employees doing the best they can in setting wages and
responding to the wage with a given amount of effort, respectively.
This statement is true because the wage-setting curve for the whole eco-
nomy is based directly on the employer’s wage-setting decision and the
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
368
employee’s effort decision in an economy that is composed of many firms
like the one we modelled in Unit 6.
We show how to do this in Figure 9.5 by bringing together Figure 9.4
(the economy-wide wage-setting curve) and Figure 6.6 (how the firm sets
the wage). The top panel of Figure 9.5 shows the employee’s best response
curve at the two unemployment rates of 12% and 5%. As we saw in Unit 6, a
higher unemployment rate reduces the reservation wage, because a worker
faces a longer expected period of unemployment if he or she loses a job.
This weakens the employees’ bargaining power and shifts the best response
curve to the left. With an unemployment rate of 12%, the reservation wage
is shown by point F. The employer’s profit-maximizing choice is point A
with the low wage (wL).
In the lower panel, we plot point A. The dashed line from unemploy-
ment of 12% indicates that the wage is set at wL. We now assume a fixed size
for the labour force and the horizontal axis gives the number of workers
employed, N. As employment increases to the right, the unemployment
rate falls.
Using exactly the same reasoning, we find the profit-maximizing wage
set when unemployment is much lower at 5%. Both the reservation wage
Re
al
w
ag
e,
w
Proportion of working-age population
wH
0
1
Employment
rates
Wage-setting curve
Unemployment
rate = 12%
Unemployment
rate = 5%
Labour force
0.5
wL
Figure 9.4 The wage-setting curve: Labour discipline and unemployment in the
economy as a whole.
1. The wage-setting curve
The upward-sloping line is called the
wage-setting curve.
2. The profit-maximizing wage when
unemployment is high
At 12% unemployment in the economy,
the employee’s reservation wage is low
and the worker will put in a high level
of effort for a relatively low wage. The
firm’s profit-maximizing wage is there-
fore low.
3. The profit-maximizing wage when
unemployment is low
At 5% unemployment in the economy,
the employee’s reservation wage is
high and they will not put in much
effort unless the wage is high. The
firm’s profit-maximizing wage is there-
fore higher.
9.3 THE WAGE-SETTING CURVE: EMPLOYMENT AND REAL WAGES
369
and the wage set by the employer are higher, as shown by point B. This
gives the second point on the wage-setting curve in the lower panel.
We derived the wage-setting curve as part of the labour discipline model,
which was designed to illustrate how employees and firm owners (and their
managers) interact when setting wages and determining the level of work
effort. We will use the same model later when we describe policies to alter
the level of unemployment in the entire economy. Later in this unit and in
Units 16 and 17 we will look at the ways in which labour unions can affect
the wage-setting process and so alter the workings of the labour market.
Re
al
w
ag
e,
w
wH
wH
0
0.5 U = 12% U = 5%
At U= 5%,
wage is wH
1
wL
A
Wage-setting curve
B
At U= 12%,
wage is wL
Eff
or
t p
er
h
ou
r
0
0
Hourly wage
Best response function, U = 12%
Best response function, U = 5%
Reservation wages
Wages set
by employer
F G
wL
A B
Proportion of working-age population
Figure 9.5 Deriving the wage-setting curve: Varying the unemployment rate in the
economy.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
370
Figure 9.6 is a wage-setting curve estimated from data for the US. Note
that in Figure 9.6, the horizontal axis shows the unemployment rate
explicitly, falling from left to right. By using data on unemployment rates
and wages in local areas, economists can estimate and plot the wage-setting
curve for an economy.
Simplifying the model
We can simplify the worker motivation problem and the wage curve by
letting there be just two levels of effort:
• ‘working’: providing the level of effort that the firm’s owners and
managers have set as sufficient
• ‘shirking’: providing no effort at all.
This will be useful later because it will allow us to take the level of effort as
given with wages being set to ensure this.
In this case, the worker is represented as similar to a machine with just
one speed, and it is either ‘on’ or ‘off’. As shown in Figure 9.7, the wage
curve is the boundary between two ‘regions’: on and above the wage curve
are all the combinations of the real wage and employment level for which
employees work, and below it the combinations for which employees shirk.
We will use this ‘work or shirk’ simplification in the model from now on.
Wage-setting curves have been
estimated for many economies.
Read how it is done in an article by
David Blanchflower and Andrew
Oswald (https://tinyco.re/9574365).
Re
al
a
nn
ua
l e
ar
ni
ng
s
(2
01
3
$)
48,000
Unemployment rate (%)
47,000
46,000
45,000
44,000
43,000
42,000
20 15 10 5 0
Figure 9.6 A wage-setting curve estimated for the US economy (1979–2013).
Estimated by Stephen Machin (UCL,
2015) from Current Population Survey
microdata from the Outgoing Rotation
Groups for 1979 to 2013.
9.3 THE WAGE-SETTING CURVE: EMPLOYMENT AND REAL WAGES
371
EXERCISE 9.2 SHIFTS IN THE WAGE-SETTING CURVE
1. Referring back to Unit 6, provide a brief explanation of the shift in the
wage-setting curve for each row in the table below, using a diagram to
show the best response function and the wage-setting curve. For the
second and third rows, give an example from a real-world workplace.
2. Explain why a rise in the unemployment rate shifts the best response
function but not the wage-setting curve.
Change Shifts the wage-setting curve
Decrease in unemployment benefit Down
A monitoring device to detect shirking Down
A decrease in the disutility of working Down
QUESTION 9.3 CHOOSE THE CORRECT ANSWER(S)
Figure 9.5 (page 370) depicts the wage-setting curve and how it is
derived using the best response function of the employees and the iso-
cost lines for effort of the employers.
Based on this figure:
A cut in the unemployment benefit would shift the best response
function to the left, and raise the wage-setting curve.
If the expected period of unemployment increased, it would shift
the best response function to the right, raising the wage-setting
curve.
In a country where the stigma attached to unemployment is high,
the wage-setting curve would be lower.
A sudden drop in the working age population (due, for example, to
the retirement of the baby-boomer generation) would shift the
wage-setting curve lower.
Re
al
w
ag
e
Employment, N
Feasible set Wage-setting curve, WS
Below the wage-setting curve,
workers shirk; they do not work
Above the wage-setting curve,
workers work
0
Figure 9.7 The wage-setting curve: The wage level required to make employees
work rather than shirk.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
372
labour productivity Total output
divided by the number of hours or
some other measure of labour
input.
9.4 THE FIRM’S HIRING DECISION
In order to understand the second component of the labour market model—
the price-setting curve—we need to look more carefully at the firm’s decision
about how many people to hire, and how this depends on the amount that it
produces. The amount produced depends on the amount that the firm is able
to sell, which in turn depends on the price that it charges.
The firm’s decision comes from the interaction between the firm’s three
departments. Recall in our model they are human resources (HR), the
marketing department, and the production department (PD). Remember
this firm has only one input—labour—so the wage is the only cost. And to
make things even simpler, we assume that one hour of labour produces one
unit of output (average product of labour = λ = 1). So the wage the firm pays
(W) is the cost of a unit of output (in the relevant currency unit). Note that
W is the nominal wage and w is the real wage.
The process is summarized in the table in Figure 9.8.
Once HR has set the wage at a level sufficient to motivate the workforce,
the marketing department proceeds in two steps. Remember that the firm
can set the price but not the quantity that it will be able to sell (quantity sold
depends on the amount demanded at each price on the firm’s demand
curve). So first, as in Unit 7, the marketing department asks: which combin-
ations of p and q are feasible? These combinations are shown by the
demand curve, which will depend on the amounts that other firms are
producing, the prices they are setting, the wages they are paying, and other
influences on the total level of demand for goods in the economy.
Step two is to pick a point on the demand curve, so the marketing
department looks at Figure 9.9 to determine how profitable each price-
quantity combination would be. Using the value of W chosen by HR, the
marketing department constructs the isoprofit curves shown. Recall that
each curve is the collection of all combinations of price and quantity that
will yield the firm the same level of profit, given the wage. Curves further
out from the origin (higher price and quantity) indicate higher profits.
Recall that:
As in Unit 7, maximum profits occur at point B, where the demand curve is
tangent to an isoprofit curve. The marketing department thus sets a price
p*, and calculates that it will be able to sell q* units of the goods.
Department … knows … and on this basis sets the firm’s
Human resources Prices, wages and employment in other firms Nominal wage, W
Marketing All of the above and firm’s demand function Price of output, p
Production All of the above, plus labour productivity and amount the firm can sell Employment, n
Figure 9.8 The three departments determine the firm’s hiring.
9.4 THE FIRM’S HIRING DECISION
373
When the firm sells q* goods at a price p*, its total revenue is p*q*. Notice
from the figure that once the firm has set a price, it has determined the
division of the total revenue between profits and wages. This is based on the
markup (p − W)/p (or 1 − (W/p)). As you have seen from Unit 7, this is greater
when the demand curve is less elastic, indicating less intense competition.
The PD knows that each hour of a worker’s time (working at the speed
they are motivated to work by their employment rent and the threat of
termination) produces a single unit of the good so it hires n* workers’ hours
of labour, where n* = q*. This is the firm’s (very simple) production function.
It will help in the next section to think about how the model explains
what the firm would do if it found itself at a point like A. The marketing
department would see that the firm was making lower profits because the
isoprofit curve at A is lower than at point B. The marketing department
would then raise the price and inform the PD that it should produce less.
Similarly, if the firm were at point C, the marketing department would
lower its price and the PD would get the message to produce more, to meet
the higher sales at the lower price.
Pr
ic
e,
p
($
)
W
p*
q*
Isoprofit curves Profit per unit output
Wage per unit output
Wage
C
B
Demand curve (given
economy-wide demand)
A
Units of output, q (and hours of labour, n)
Figure 9.9 The firm’s profit-maximizing choice of price, quantity, and employment.
1. Maximum profits
The maximum profits occur at point B
where the firm’s demand curve is
tangent to an isoprofit curve.
2. The firm’s price decision
This determines the division of the total
revenue between profits and wages.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
374
QUESTION 9.4 CHOOSE THE CORRECT ANSWER(S)
Figure 9.9 (page 374) depicts the market’s demand curve and the firm’s
isoprofit curves. Based on this information, which of the following
statements is correct?
The slope of the demand curve is the firm’s marginal rate of substi-
tution.
Between points A and C, the firm would prefer point A as the output
is higher.
Having chosen its profit-maximizing price p*, the firm would then
set its nominal wage level.
If the firm finds itself producing at point C, it can increase its profit
by selling more units at a lower price.
9.5 THE PRICE-SETTING CURVE: WAGES AND PROFITS
IN THE WHOLE ECONOMY
We have seen in Figure 9.9 that when the firm sets the price as a markup on
its wage cost, this means that the price per unit of output is split into the
profit per unit and the wage cost per unit. For the economy as a whole,
when all firms set prices this way, output per worker (labour productivity,
or equivalently, the average product of labour, called lambda, λ) is split into
real profit per worker Π/P and the real wage W/P.
Figure 9.10 shows the outcome of the price-setting decisions of firms in
the whole economy and we use P to represent the economy-wide price level.
The top horizontal line shows firms’ revenues per worker in real terms: the
average product of labour. What we call the price-setting ‘curve’ is not really
much of a curve: it is just a single number that gives the value of the real
wage that is consistent with the markup over costs, when all firms set their
price to maximize their profits. The value of the real wage consistent with
the markup does not depend on the level of employment in the economy, so
it is shown as in Figure 9.10 as a horizontal line at the height of wPS.
Point B in Figures 9.10 and 9.11 on the price-setting curve shows the
outcome of profit-maximizing price-setting behaviour of firms for the eco-
nomy as a whole.
Av
er
ag
e
pr
od
uc
t o
f l
ab
ou
r,
λ;
Re
al
w
ag
e,
W
/P
W/P= wPS
0
Output per
worker, λ
Average product
of labour, λ
Price-setting
curve
Labour supply
Employment, N (whole economy)
Real wage per
worker, W/P
Real profit per
worker, Π/P
B
Figure 9.10 The price-setting curve.
9.5 THE PRICE-SETTING CURVE: WAGES AND PROFITS IN THE WHOLE ECONOMY
375
Now think about point A in Figure 9.11, which corresponds to point A
in Figure 9.9. Follow the steps in Figure 9.11 to see why the firm will raise
its price so as to move towards higher profits at point B. The rise in price
and the reduction in employment are indicated by the arrow at point A in
Figure 9.11, which points down and to the left. It points down because the
rise in prices implies a fall in the real wage, that is, the nominal wage
divided by the price. It points left because a price increase implies a fall in
output and employment.
EXERCISE 9.3 THE PRICE-SETTING CURVE
In your own words and using a diagram like Figure 9.9 (page 374), explain
why prices would fall and employment would increase if the economy
were at point C in Figure 9.11 (the opposite of what happens at point A).
In Figure 9.10, above the price-setting curve, like point A, firms raise prices
and cut employment. Below the price-setting curve, at a point like C, firms
lower prices and hire more people. Given the level of demand in the eco-
nomy as a whole, firms’ pricing and hiring behavior will push the economy
to a point on the price-setting curve so that the level of employment and
real wage are at a point like B.
What will determine the height of the price-setting curve? There are
many influences once we consider the impact of public policies (as we will
0
At A, real wage too high and markup
too low; firms raise price; and given
demand, output falls
Labour supply
B
C
A
W/P= wPS
Av
er
ag
e
pr
od
uc
t o
f l
ab
ou
r,
λ;
Re
al
w
ag
e,
W
/P
Employment, N (whole economy)
Average product
of labour, λ
Price-setting
curve
At C, real wage too low and markup
too high; firms lower price; and given
demand, output rises
Figure 9.11 The price-setting curve.
1. Point A
Point A is above the price-setting curve,
which means that the real wage is
higher than is consistent with a firm’s
profit maximizing markup. If the real
wage is too high, it means the markup
is too low.
2. Point B
The firm will raise its price so as to
move towards higher profits at point B.
The increased price will mean that
fewer goods are sold, and as this is true
of all firms, total employment falls.
3. Point C
Below the price-setting curve, at a
point like C, firms lower their prices
and hire more people.
4. The profit-maximizing price
Point B is the firm’s profit-maximizing
price and profit margin. Given eco-
nomy-wide demand, total profits are
lower at A and C for firms facing the
demand curve in Figure 9.9.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
376
see later in this unit), but two things have an important influence on the
price-setting curve, even in the absence of government intervention:
• Competition: The intensity of competition in the economy determines the
extent to which firms can charge a price that exceeds their costs, that is,
the markup. The less the competition, the greater the markup. In Figure
9.9, a steeper demand curve, which results from less competition among
firms, will lead to a higher markup and increase the profit per worker.
Since this leads to higher prices across the whole economy, it implies
lower real wages, pushing down the price-setting curve.
• Labour productivity: For any given markup, the level of labour productiv-
ity—how much a worker produces in an hour—determines the real wage.
The greater the level of labour productivity (λ), the higher the real wage
that is consistent with a given markup. In Figure 9.10, higher labour pro-
ductivity shifts the dashed line upwards, and, keeping the markup un-
changed, the price-setting curve will shift upwards, raising the real wage.
To understand more about the price-setting curve, read the Einstein at the
end of this section.
QUESTION 9.5 CHOOSE THE CORRECT ANSWER(S)
The following diagram depicts the price-setting curve. Based on this
information, which of the following statements is correct?
0
Real wage too low and markup
too high; firms lower price; and given
demand, output rises
Real wage too high and markup
too low; firms raise price; and given
demand, output falls
Labour supply
B
C
A
W/P= wPS
Av
er
ag
e
pr
od
uc
t o
f l
ab
ou
r,
λ;
Re
al
w
ag
e,
W
/P
Employment, N (whole economy)
Average product
of labour, λ
Price-setting
curve
At point A, the markup is too high, and therefore the firm will raise
its price. This leads to lower demand for the good and hence lower
employment towards B.
At point C, the real wage is too low and the markup is too high.
Therefore the firm is able to increase profit by lowering prices and
hiring more workers.
Higher competition implies a lower price-setting curve.
For any given markup, higher labour productivity implies a lower
price-setting curve, which means a lower real wage.
9.5 THE PRICE-SETTING CURVE: WAGES AND PROFITS IN THE WHOLE ECONOMY
377
EINSTEIN
The price-setting curve
There are several steps to show how the price-setting curve for the eco-
nomy as a whole results from the decisions of individual firms.
Step 1: The firm sets its price
To focus on what is essential, we assume the firm’s only costs are the
wages it pays. (We are setting aside the opportunity cost of the capital
goods which the workers use in producing the firm’s output.) We assume
that on average a worker produces λ units of output, which does not
vary with the number of workers employed. We use the Greek letter
lambda (λ) for labour productivity. The firm pays the worker a wage W
in dollars. Both labour productivity and wages can be measured per
hour, per day or per year. In our numerical examples, we typically use
hourly wages and productivity.
The unit labour cost is the wages paid to hire the amount of labour to
produce one unit of the good. This is defined as:
For example: if W = $30 and λ = 10, then unit labour cost is $3, that is
$30/10 units = $3 per unit.
Recall from Unit 7 that the firm chooses its price so that the markup
is inversely proportional to the elasticity of the demand curve it faces:
Or because we have assumed that marginal and average costs are equal,
that is, MC = AC, we can say that the markup is just the fraction of the
price of a good that goes to the profits of the firm. The elasticity of the
firm’s demand curve is greater the more competition the firm faces from
other firms, so the higher the elasticity, the lower the firm’s price and
markup. We call the markup μ (the Greek letter mu, rhyming with ‘few’):
Using our assumptions, the firm’s marginal (and average) cost is its unit
labour cost (W/λ) , and we can say that the firm sets its price, p, so that:
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
378
Rearranging, and multiplying each side by λ gives:
In words, this says:
When the firm sets its profit-maximizing price, this splits output per
worker into the part that goes to employees as wages and the part that
goes to owners as profits.
Step 2: The price level in the economy as a whole and the real
wage
From the employee’s point of view, the real wage measures how much of
her typical consumption she can purchase with an hour’s earnings. Since
she buys many different goods and services, this depends on prices set
by the firms throughout the economy, not just her own firm. We call the
average price of the goods and services the worker consumes, P, which is
an average of the different levels of p set by individual firms across the
economy.
The real wage is the nominal wage divided by the economy-wide
price level, P.
Step 3: Profits, wages, and the price-setting curve
We assume that the entire economy is made up of firms facing competi-
tion conditions similar to the single firm we have just studied. This
means the price-setting problem from Step 1 applies to all firms in the
economy, so we can use the price-setting equation to determine the eco-
nomy-wide real wage:
In words, this says that:
This is the wage indicated by the price-setting curve.
9.5 THE PRICE-SETTING CURVE: WAGES AND PROFITS IN THE WHOLE ECONOMY
379
9.6 WAGES, PROFITS, AND UNEMPLOYMENT IN THE
WHOLE ECONOMY
By superimposing the wage-setting curve on the price-setting curve in
Figure 9.12, we have a picture of the two sides of the labour market.
All of the points in the shaded area below the wage-setting curve are
labeled ‘no work done’ because in this region the real wage is insufficient to
motivate workers to work. In this situation, there is no work done and no
profits, so nobody is hired: the only outcome possible in the long run if the
real wage is below the wage-setting curve is zero employment. These
shaded points are not feasible.
The equilibrium of the labour market is where the wage- and price-
setting curves intersect. This is a Nash equilibrium because all parties are
doing the best they can, given what everyone else is doing. Each firm is
setting the nominal wage where the isocost curve is tangent to the best
response function (Unit 6), and is setting the profit-maximizing price (Unit
7). Taking the economy as a whole, at the intersection of the wage- and
price-setting curves (point X):
• The firms are offering the wage that ensures effective work from
employees at least cost (that is, on the wage-setting curve). HR cannot
recommend an alternative policy that would deliver higher profits.
• Employment is the highest it can be (on the price-setting curve), given
the wage offered. The marketing department cannot recommend a
change in price or output.
• Those who have jobs cannot improve their situation by changing their
behaviour. If they worked less on the job, they would run the risk of
becoming one of the unemployed, and if they demanded more pay, their
employer would refuse or hire someone else.
• Those who fail to get jobs would rather have a job, but there is no way
they can get one—not even by offering to work at a lower wage than
others.
Re
al
w
ag
e
Employed Unemployed
0
No work done: wage is
too low for adequate effort
Average product of labour, λ
Price-setting curve
Labour supply
Wage-setting curve
Employment, N
X
Figure 9.12 Equilibrium in the labour market.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
380
labour market equilibrium The combination of the real wage
and the level of employment determined by the intersection of
the wage-setting and the price-setting curves. This is the Nash
equilibrium of the labour market because neither employers
nor workers could do better by changing their behaviour. See
also: equilibrium unemployment, inflation-stabilizing rate of
unemployment.
equilibrium unemployment The number of people seeking
work but without jobs, which is determined by the intersection
of the wage-setting and price-setting curves. This is the Nash
equilibrium of the labour market where neither employers nor
workers could do better by changing their behaviour. See also:
involuntary unemployment, cyclical unemployment, wage-
setting curve, price-setting curve, inflation-stabilizing rate of
unemployment.
excess supply A situation in which the quantity of a good
supplied is greater than the quantity demanded at the current
price. See also: excess demand.
Unemployment as a characteristic of labour market equilibrium
We have shown that unemployment can exist in Nash equilibrium in the
labour market.
We now show why there will always be
unemployment in labour market equilibrium,
using the argument from Unit 6. This is called
equilibrium unemployment.
Unemployment means that there are people
seeking work but not finding it. This is also
termed excess supply in the labour market,
meaning that demand for labour at the given wage
is lower than the number of workers willing to
work at that wage. To understand why there will
always be unemployment in labour market equi-
librium, we refer to the labour supply curve.
In our model, we assume that the labour supply
curve is vertical, meaning that higher wages do
not lead more people to offer more hours at work.
At higher wages some people seek (and find) more
hours of work, and others seek (and find) shorter
hours. You know from Unit 3 that the substitution
effect of a wage increase (leading to the choice of
more hours of work and less of free time) may be
offset by the income effect. For simplicity we draw
a supply curve such that the wage has no effect on the labour supply. But
this is not important. The model would not be different if higher wages led
to either more or fewer people seeking work. To see this, you can
experiment with labour supply curves with different shapes in Figure 9.12.
Why will there always be some involuntary unemployment in labour
market equilibrium?
• If there was no unemployment: The cost of job loss is zero (no employment
rent) because a worker who loses her job can immediately get another
one at the same pay.
• Therefore some unemployment is necessary: It means the employer can
motivate workers to provide effort on the job.
• Therefore the wage-setting curve is always to the left of the labour supply
curve.
• It follows that in any equilibrium, where the wage and price-setting curves
intersect, there must be unemployed people: This is shown by the gap
between the wage-setting curve and the labour supply curve.
Another way to see this is to look again at Figure 9.12. Notice that the
wage-setting curve rises steeply when it comes close to the labour supply
line, exceeding both the price-setting and labour productivity curves. This
fact about our model highlights an important limit on policies to reduce
unemployment. According to our model, any policy that comes close to
entirely eliminating unemployment would put employers in a position that
the best they could do would be to pay wages so high they would eliminate
the employers’ profits and drive the firms out of business.
9.6 WAGES, PROFITS, AND UNEMPLOYMENT IN THE WHOLE ECONOMY
381
EXERCISE 9.4 IS THIS REALLY A NASH EQUILIBRIUM?
In this model, the unemployed are no different from the employed (except
for their bad luck). Imagine you are an employer, and one of the unem-
ployed comes to you and promises to work at the same effort level as your
current workers but at slightly lower wage.
1. How would you reply?
2. Does your reply help explain why unemployment must exist in a Nash
equilibrium?
QUESTION 9.6 CHOOSE THE CORRECT ANSWER(S)
Figure 9.12 (page 380) depicts the labour market model. Consider now
a reduction in the degree of competition faced by the firms. Which of
the following statements is correct regarding the effects of reduced
competition?
The price-setting curve shifts up.
The wage-setting curve shifts down.
The equilibrium real wage falls.
The unemployment level falls.
QUESTION 9.7 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements is correct regarding the effects of a
rise in the real wage on the labour supply of a worker?
The income effect means that the worker will increase his labour
supply.
The substitution effect means that the worker will increase his con-
sumption of free time.
The income and substitution effects always enhance each other,
leading to higher labour supply.
At high wage levels, the income effect dominates the substitution
effect, leading to lower labour supply.
•9.7 HOW CHANGES IN DEMAND FOR GOODS AND
SERVICES AFFECT UNEMPLOYMENT
At the beginning of this unit, you read about the father and son working in
the Australian minerals sector (Doug and Rob Grey). The boom and bust in
their lives reflected changes in economic conditions in the Australian eco-
nomy as a whole. The minerals boom had produced the large-scale
construction of mining facilities in Western Australia, Queensland, and the
Northern Territory. As construction was coming to an end on existing
projects, global iron ore prices collapsed, with the result that new mines,
ports and processing facilities were not started. In Figure 9.1, unemploy-
ment began to rise as the global price of iron ore plummeted.
Unemployment increased because the demand for labour in mining and
in the related service activities shrank. Not only did the demand for
minerals fall off, but demand also declined for the goods and services that
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
382
cyclical unemployment The
increase in unemployment above
equilibrium unemployment caused
by a fall in aggregate demand
associated with the business cycle.
Also known as: demand-deficient
unemployment. See also: equilib-
rium unemployment.
unemployment, involuntary The
state of being out of work, but pre-
ferring to have a job at the wages
and working conditions that other-
wise identical employed workers
have. See also: unemployment.
the Grey family and others like them would have purchased if they had kept
their jobs. As a result, demand for goods and services fell across the eco-
nomy, and with it the derived demand for labour. The term ‘derived
demand for labour’ is used to highlight the fact that the firms’ demand for
labour depends on the demand for their goods and services.
Economists use the term aggregate—meaning added up to measure the
whole, not just the parts—to describe economy-wide facts or variables.
Aggregate demand, for example, is the sum of the demand for all of the goods
and services produced in the economy, whether from consumers, firms, the
government, or buyers in other countries. The increase in unemployment
caused by the fall in aggregate demand is called ‘demand-deficient’
unemployment—or, as we shall learn in Unit 13, cyclical unemployment.
How does this demand-deficient unemployment appear in our model of
the labour market, and how does it relate to unemployment in the Nash
equilibrium of the labour market?
Follow the steps in Figure 9.13 to compare unemployment in the labour
market equilibrium (at X) with the unemployment caused by a low level of
aggregate demand (at B). An unemployed person at X is involuntarily
unemployed because that person would accept a job at the real wage
shown by the intersection of the wage and price-setting curves.
An unemployed person at point B is also involuntarily unemployed. In
fact, such a person would accept a job with a wage below the wage shown at
B, and still be willing to work hard on the job.
Re
al
w
ag
e
0
Average product of labour
Price-setting curve
Equilibrium unemployment
Demand-deficient or cyclical
unemployment, at B
Total involuntary
unemployment, at B
Labour supply
Wage-setting
curve
B X
Employment, N
Figure 9.13 Equilibrium and demand-deficient (cyclical) unemployment.
1. Point X
At X, unemployment is at its labour
market equilibrium level. Someone
losing a job at X is not indifferent
between being employed and
unemployed because they experience a
cost of losing the job.
2. Point B
At B, there are additional people
looking for work who are also
involuntarily unemployed. The addi-
tional unemployment at B is due to low
aggregate demand and is called
demand-deficient, or cyclical,
unemployment.
3. The Nash equilibrium
At point B, total involuntary unemploy-
ment is given by the sum of cyclical and
equilibrium unemployment. Point X is
the Nash equilibrium of the labour
market, which means that all actors are
doing the best they can, given the
actions of the other actors. No worker
or firm can improve their position by
changing their actions.
9.7 HOW CHANGES IN DEMAND FOR GOODS AND SERVICES AFFECT UNEMPLOYMENT
383
We term the level of joblessness at point X equilibrium unemployment,
but what about point B? Could high demand-deficient unemployment be a
long-term outcome? Will the behaviour of firms and workers result in the
disappearance of the unemployment caused by insufficient aggregate
demand?
We can see that B is not a Nash equilibrium. At this point the HR
department—noting the high unemployment rate—would definitely say:
‘With such high unemployment, we could pay our workers much less and
they would still do their work!’ Because the firm could make higher profits
by lowering the wage, as long as it remained above the wage-setting curve,
B is not a Nash equilibrium.
But even so, an outcome such as B could persist for a long time, without
public policies to expand employment.
To see why, we first need to understand how a decision to lower the
wage by HR departments across the economy could (under the right
circumstances) lead to the disappearance of cyclical unemployment.
Imagine the economy was at point B (with all firms at points like B in
Figure 9.9). Then the following sequence would take place, initiated by HR:
• Lower wages would lower costs.
• The degree of competition facing the firm has not changed, so it would
want to set a price to restore the profit-maximizing markup.
• Given the lower costs, firms would therefore cut prices.
• Because the demand curve facing the firm is downward-sloping they
would sell more, expanding output and employment.
Figure 9.14 shows the firm’s adjustment process. The wage is cut to the
lower level by HR, and given the lower costs, the marketing department
cuts the price to maximize profit. Firms would move to the right along their
demand curve. Output and employment increase.
To see where the firm’s price cutting will stop, think about the new iso-
profit curves once the cost of hiring labour has declined. Remember from
Unit 7 that as the cost (C) has fallen, at every point on the isoprofit curve is
now at a higher profit level than was the case prior to the decline in wages.
Importantly, it is also steeper than before. Recall that the slope of the
isoprofit curve is (p − C)/q so that for example, at point B (q*, p*) the slope
of the isoprofit curve with the lower wage is steeper.
Follow the steps in Figure 9.14 to see where the firm will set its price.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
384
What could go wrong?
This process explains how wage and price cutting might lead the economy
to move from B back to X. But real economies do not function so smoothly.
What could possibly go wrong?
Worker resistance to a reduction in the nominal wage
The HR department would know that lowering the nominal wages of its
employees would not be a simple matter, because it means that the actual
monetary amount received by all existing workers would have to be
smaller. As we saw in Unit 6, firms are often reluctant to cut nominal wages
because it may reduce worker morale and result in conflict with employees.
Strikes and worker resistance such as informal ‘go slow’ tactics would
disrupt the production process. For these reasons the HR department might
hesitate to impose nominal wage cuts on its workers.
Wage and price reductions might not lead to higher sales and
employment
For the adjustment from B to X to occur, firms across the economy have to
adjust wages and prices downward, and in response, firms and households
have to increase their demand for goods and services by enough to restore
economy-wide (or aggregate) demand to its level at point X. For the indi-
vidual firm, a fall in price leads to higher sales. But falling prices across the
economy can lead to cutbacks in spending, which shift the demand curves
facing firms to the left. Falling prices can lead households to postpone
T. Bewley. 2007. ‘Fairness,
Reciprocity and Wage Rigidity’.
Behavioral Economics and its
Applications, edited by Peter
Diamond and Hannu Vartiainen,
pp. 157–188. Princeton, NJ:
Princeton University Press.
C. M. Campbell and K. S. Kamlani.
1997. ‘The reasons for wage
rigidity: Evidence from a survey of
firms’. The Quarterly Journal of
Economics 112 (3) (August):
pp. 759–789.
Pr
ic
e,
p
($
)
Units of output, q (and hours of labour, n)
W
WL
p*
p**
q* q**
Isoprofit curve
(initial wage)
B
X
Price
Lower price
Wage
Lower wage
Isoprofit curves
(lower wage)
Demand curve
Quantity, q: Employment,
n, given a production
function where APL = λ = 1
Low aggregate demand at B
Demand curve (aggregate demand
at B is low at the initial price level;
it is higher at X because the price
level is lower)
Figure 9.14 A firm raises output and employment following a cut in wages.
1. The new isoprofit curve
The new (lower wage) isoprofit curve
passing through the original point B is
now steeper than the demand curve, so
the firm can do better by lowering its
price and moving down the demand
curve, selling more.
2. Maximum profits
It will continue doing this until it
reaches a point on the demand curve
where one of the new darker blue iso-
profit curves is tangent to the demand
curve. The firm maximizes profits at
point X.
9.7 HOW CHANGES IN DEMAND FOR GOODS AND SERVICES AFFECT UNEMPLOYMENT
385
spending, as they hope to get better bargains later. The gap in spending
would be exacerbated by such behaviour. Moreover, as wages fall people
may spend less, reducing demand.
Thus, in the presence of deficient aggregate demand, the usual profit-
seeking decisions of firms and the responses of consumers, when added up
across the economy, cannot be guaranteed to move the economy from B to
the Nash equilibrium at X.
The role of government policy
Fortunately, there is another way to get from B back to the Nash equilib-
rium. The government could adopt policies to increase its own spending
and expand the demand facing the firms. In this case, at point B firms
would find that they were producing less than the profit-maximizing
amount and would employ more people, instead of wanting to reduce
wages. Policies to affect the total demand in the economy are considered in
Units 13–17.
Figure 9.15 illustrates this case. As before, the economy begins (follow-
ing the fall in economy-wide demand) at point B. Rather than either waiting
for a revival in aggregate demand (for example, through a recovery in global
demand for minerals) or waiting for the process of wage and price
reductions to spread across the economy, the government can increase the
level of aggregate demand.
Pr
ic
e,
p
($
)
W
p*
q* q**
B
Demand curve (aggregate demand
is higher at X than at B at an
unchanged price level)
X
Isoprofit curves
Low demand
Moderate demand
Units of output, q (and hours of labour, n)
Figure 9.15 A firm raises output and employment following an increase in demand
as a result of monetary or fiscal policy.
1. Before the increase in demand
As before, the firm begins at point B.
2. The demand curve shifts to the right
Remember, the isoprofit curves do not
shift when the demand curve shifts. The
firm moves on to a new higher isoprofit
curve if demand rises as a result of
higher economy-wide demand follow-
ing monetary or fiscal policy actions.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
386
monetary policy Central bank (or
government) actions aimed at
influencing economic activity
through changing interest rates or
the prices of financial assets. See
also: quantitative easing.
fiscal policy Changes in taxes or
government spending in order to
stabilize the economy. See also:
fiscal stimulus, fiscal multiplier,
aggregate demand.
One method is for the central bank to make borrowing cheaper by
reducing the interest rate. The aim is to provide incentives for people to
bring forward some of their spending decisions, particularly on things that
are often purchased with borrowed money such as housing and
automobiles. We look closely at this monetary policy in Unit 10 (Banks,
money and the credit market) and in Unit 15 (Inflation, unemployment and
monetary policy). Other methods are for the government to increase its
spending or reduce tax rates. These fiscal policies are the subject of Unit
14 (Unemployment and fiscal policy).
We can summarize what we have learned in Figures 9.16 a–c. When
aggregate demand in the economy is too low, unemployment is higher than
at the Nash equilibrium. The government or central bank can eliminate this
demand-deficient unemployment through fiscal or monetary policy. These
policies are likely to be a more rapid way of reducing unemployment
compared to solely relying on the combination of downward adjustment of
wages and prices by firms throughout the economy and increased demand
by households and firms for goods and services.
The adjustment via fiscal or monetary policy is shown in Figure 9.16a,
the adjustment via wage and price cuts is shown in Figure 9.16b, and the
aggregate labour market is shown in Figure 9.16c.
EXERCISE 9.5 WAGES AND AGGREGATE DEMAND
We saw that if an economy has low aggregate demand with high cyclical
unemployment, then automatic adjustment back to equilibrium could
occur through a process of wage and price cuts. Imagine you are a worker
and you see that many workers have lost their jobs while other workers
are having their wages cut.
1. How might this affect your spending and saving decisions?
2. How might this affect adjustment back to equilibrium?
Pr
ic
e,
p
($
)
Units of output, q (and hours of labour, n)
W
p*
q* q**
B
Demand curve (aggregate demand
is higher at X than at B at an
unchanged price level)
XPrice
Isoprofit curves
Low demand
Moderate demand
Figure 9.16a The firm: Adjustment to equilibrium unemployment at X via fiscal or
monetary policy.
9.7 HOW CHANGES IN DEMAND FOR GOODS AND SERVICES AFFECT UNEMPLOYMENT
387
QUESTION 9.8 CHOOSE THE CORRECT ANSWER(S)
Figure 9.13 (page 383) depicts the labour market when there has been
a negative aggregate demand shock. Based on this information, which
of the following statements is correct?
The new equilibrium B is a Nash equilibrium.
At B, unemployment is purely cyclical.
At B, the firms are able to make higher profits by lowering the wage.
The adjustment back from B to X is immediate.
WL
p**
Isoprofit curve
(initial wage)
B
Low aggregate demand at B
Demand curve (aggregate demand at B
is low at the initial price level; it is higher
at X because the price level is lower)
X
Price
Lower price
Wage
Lower wage
Isoprofit curves
(lower wage)
W
p*
q* q**
Units of output, q (and hours of labour, n)
Pr
ic
e,
p
($
)
Figure 9.16b The firm: Adjustment to equilibrium unemployment at X via wage and
price cuts.
Re
al
w
ag
e
0
Average product of labour
Price-setting curve
Equilibrium unemployment
Demand-deficient or cyclical
unemployment, at B
Total involuntary
unemployment, at B
Labour supply
Wage-setting
curve
B X
Employment, N
Figure 9.16c Aggregate labour market: cyclical and equilibrium unemployment.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
388
••9.8 LABOUR MARKET EQUILIBRIUM AND THE
DISTRIBUTION OF INCOME
As we have seen, the labour market model determines not only the level of
employment, unemployment, and the wage rate, but also the division of the
economy’s output between workers (both employed and unemployed) and
employers. So the labour market model is also a model of the distribution
of income in a simple economy in which there are just these two classes
(employers, who are the owners of the firms, and workers), where some of
the latter are without work.
As we did in Unit 5, we can construct the Lorenz curve and calculate the
Gini coefficient for the economy in this model. Refer back to the Einstein in
Unit 5 on the Lorenz curve and to the Einstein at the end of this section,
which explain how to calculate the Gini coefficient with different kinds of
information about a population.
In the left panel of Figure 9.17 we show the labour market of an economy
with 80 identical employees of 10 identical firms. As you can see, there are
10 unemployed people. Each firm has a single owner. The economy is in
equilibrium at point A, where the real wage is both sufficient to motivate
workers to work and consistent with the firm’s profit-maximizing price
markup over costs (w = 0.6 in this case).
The right-hand panel shows the Lorenz curve for income in this economy.
Because the unemployed people receive no income if there are no unemploy-
ment benefits, the Lorenz curve (the solid blue line) begins on the horizontal
axis to the right of the left-hand corner. The price-setting curve in the left
panel indicates that total output is divided up so that workers receive a 60%
share and their employers receive the rest. In the right panel this is shown by
the second ‘kink’ in the Lorenz curve, where we see that the poorest 90 people
in the population (the 10 unemployed workers and the 80 employees, shown
on the horizontal axis) receive 60% of the total output (on the vertical axis).
The size of the shaded area measures the extent of inequality, and the
Gini coefficient is 0.36. To learn how to calculate the Gini coefficient from
information like this see the Einstein at the end of this section.
The Lorenz curve is made up of three line segments with the beginning
point having coordinates of (0, 0) and the endpoint (1, 1). The first kink in
the curve occurs when we have counted all the unemployed people.
The second is the interior point, whose coordinates are (fraction of total
number of economically active population, fraction of total output received
1.0
0.6
0
40
0
60
100
0 10
Unemployed Employed Owners
90 10080 90
Labour supply
Average
product
of labour
Gini coefficient: 0.36
Profit
Wage
Price-
setting
curve
Employment, N
Wage-setting
curve
A
Cumulative share of the population
from lowest to highest income (%)
Cu
m
ul
at
iv
e
sh
ar
e
of
in
co
m
e
(%
)
Re
al
w
ag
e
Figure 9.17 The distribution of income at labour market equilibrium.
9.8 LABOUR MARKET EQUILIBRIUM AND THE DISTRIBUTION OF INCOME
389
in wages). The fraction of output received in wages, called the wage share in
total income, s, is:
Therefore the shaded area in the figure—and hence inequality measured by
the Gini coefficient—will increase if:
• A larger fraction of the employees are without work (higher unemployment
rate): The first kink shifts right.
• The real wage falls (or equivalently, the markup rises) and nothing else
changes: The second kink shifts down.
• Productivity rises and nothing else changes (real wages do not rise): This
implies that the markup rises, so again the second kink shifts down.
Factors that affect labour market equilibrium: Unemployment
and inequality
What can change the level of employment and the distribution of income
between profits and wages in equilibrium? Follow the steps in Figure 9.18
to see what would happen if there were an increase in the degree of com-
petition faced by firms, perhaps as a result of a decrease in the barriers to
firms from other countries competing in this economy’s markets.
1.0
0.6
0.76
0
40
0
60
100
0 10
UnemployedUnemployed Employed Owners
90 1008380 90
Labour supply
Average product
of labour
Gini coefficient: 0.36 before;
Gini coefficient 0.19 after
B
Price-setting
curve (wage
share: 0.6)
New price-setting
curve (lower
mark-up) wage
share: 0.76)
Employment, N
Wage-setting
curve
A
76
Cumulative share of the population
from lowest to highest income (%)
Cu
m
ul
at
iv
e
sh
ar
e
of
in
co
m
e
(%
)
Re
al
w
ag
e
Wage
share
before
Wage
share
after
Figure 9.18 The effect of an increase in the extent of competition faced by firms:
The price-setting curve shifts up and inequality falls.
1. The initial equilibrium
We start from the equilibrium at A with
a Gini coefficient of 0.36. Suppose that
the degree of competition faced by
firms is increased.
2. A new equilibrium
The markup charged by firms in the
market will decrease, and so the price-
setting curve will be higher. The new
equilibrium is at B.
3. A new Gini coefficient
At the new equilibrium there is a higher
wage and a higher level of employ-
ment. Stronger competition means that
firms have weaker market power: the
share going to profits falls, and the
share going to wages rises. Inequality
falls: the new Gini coefficient is 0.19.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
390
The markup would decrease, and as a result the real wage shown by the
price-setting curve would increase, leading to a new equilibrium at point B
with a higher wage and a higher level of employment. The share of output
going to profits falls, and the share going to wages rises.
QUESTION 9.9 CHOOSE THE CORRECT ANSWER(S)
Figure 9.17 (page 389) is the Lorenz curve associated
with a particular labour market equilibrium. In a pop-
ulation of 100, there are 10 firms, each with a single
owner, 80 employed workers, and 10 unemployed
workers. The employed workers receive 60% of the
total income as wages. The Gini coefficient is 0.36. In
which of the following cases would the Gini coeffi-
cient increase, keeping all other factors unchanged?
A rise in the unemployment rate.
A rise in the real wage.
A rise in the workers’ productivity while the real
wage is unchanged.
A rise in the degree of competition faced by the
firms.
EINSTEIN
The Lorenz curve and the Gini coefficient in an economy with
unemployed, employed, and employers (owners)
0
s = w/q
100
0 u u + n
B1
A
B2
B3
100
Cumulative share of the population
from lowest to highest income (%)
Cu
m
ul
at
iv
e
sh
ar
e
of
in
co
m
e
(%
)
Y
X
We now use the figure to derive an equation for the value of the Gini
coefficient in terms of the following variables:
• u, the fraction of the population that is unemployed
• n, the fraction of the population that is employed
• w, the real wage
• q, output per employed worker
• s = w/q, the wage share received by workers
Recall that the Gini coefficient is equal to the area A divided by the area
under the 45-degree line, and so it is equal to A/0.5 = 2A. We calculate A
as 0.5 – B where B = B1 + B2 + B3:
9.8 LABOUR MARKET EQUILIBRIUM AND THE DISTRIBUTION OF INCOME
391
Rearranging these variables gives us:
This implies that the Gini coefficient is:
Recall that s = w/q. What can we learn from the expression:
• If the class of employers gets relatively smaller: Then u + n rises. This
implies that g rises, and point Y shifts right on the Lorenz curve:
inequality goes up. This is because the same amount of profit is
divided among fewer people, so they are even richer than before. This
could depict the early evolution of capitalism from an economy of
smallish family-owned firms and manufacturers, each employing a
few workers, to a modern economy with concentrated wealth.
• An increase in the wage share w/q, ceteris paribus, will reduce the Gini
coefficient: This shifts point Y upwards.
• If all firms are cooperatives: If there are no employers and the workers
keep all that they produce (w/q = 1), then the Gini coefficient declines
to g = 2u + n – 1 and point Y moves to the top right corner. If in
addition there is no unemployment, then u = 0 and n = 1, so g = 0:
there is perfect equality because everyone is a worker receiving an
identical wage. This assumes productivity remains unchanged.
• As we saw in the Einstein in Unit 5, this calculation does not work if the
population is small: In this case the formula we derived for the Gini
coefficient does not equal 1 when a single person receives all of the
income—as it should. To show this, suppose that w = 0, so the only
income goes to the employers. Then in our formula above g = u + n.
Now imagine that there are 10 people in the population, just one of
whom is the employer. Then g = 0.9 when the Gini is really equal
to 1. This is the small population bias. If you calculate the Gini coeffi-
cient by taking differences among pairs of people in the population,
your result for g will not be subject to this small population bias.
Alternatively, you can multiply the g calculated above by N/(N − 1) to
correct the bias, where N is the size of the population: multiplying 0.9
by 10/9 gives g = 1.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
392
•9.9 LABOUR SUPPLY, LABOUR DEMAND, AND
BARGAINING POWER
Even though the supply of labour must always exceed demand for labour at
the labour market equilibrium (there is always some involuntary unemploy-
ment), the supply of labour is still one of the important determinants of this
Nash equilibrium. To see why this is so, imagine that there is immigration
of people looking for employment (assume these immigrants are potential
employees, as opposed to people who intend to start up a business), or that
people who have stayed at home to raise children, or have retired, re-join
the labour force.
What effect would this have? Let’s look first at what happens to the
wage-setting curve following an increase in labour supply:
• new jobseekers would enter the pool of unemployed
• which would increase the expected duration of a spell of unemployment
• by raising the cost of job loss, this increases the employment rent en-
joyed by employed workers at the current wage and level of employment
• but firms would then be paying more than necessary to ensure worker
motivation on the job …
• … therefore firms would lower their wages
This process is true for any point on the wage-setting curve, so it must be
true of the entire curve. Therefore, the effect of an increase in labour supply
is to shift the wage-setting curve downward.
Changes in labour supply: The effects of immigration
We use an increase in the labour supply due to immigration as an example.
The labour supply curve would shift to the right, as shown in Figure 9.19.
In this story, the short-run impact of immigration is bad for existing
workers in that country: wages fall and the expected duration of unemploy-
ment increases. In the long run, however, the increased profitability of
firms leads to expanded employment that eventually (if no further changes
take place) will restore the real wage and return the economy to its initial
rate of unemployment. As a result, incumbent workers are no worse off.
Immigrants are likely to be economically better off too—especially if they
left their home country because it was difficult to make a living.
We summarize the effects of the increase in labour supply on the labour
market:
• The shift downward in the wage-setting curve at the initial level of
employment lowered the wage (to B).
• The reduction in the wage results in a reduction in the firms’ marginal
costs and with no change in the firm’s demand conditions, the firms will
hire additional workers.
• As a result, employment expands so that once again the economy is at
the intersection of the price-setting curve and the new wage-setting
curve, with higher employment.
• The increase in labour supply leads to a new equilibrium at higher
employment because it shifts the wage-setting curve down. New hiring
stops when the wage is once again at the level shown by the price-setting
curve (at C). In the new equilibrium, employment is higher and the real
wage is unchanged.
9.9 LABOUR SUPPLY, LABOUR DEMAND, AND BARGAINING POWER
393
EXERCISE 9.6 IMMIGRATION OF ENTREPRENEURS
Suppose that some of the immigrants to the country decide to set up busi-
nesses, rather than become employees. Explain how you expect this to
affect the wage-setting curve, the price-setting curve, and the labour
market equilibrium.
QUESTION 9.10 CHOOSE THE CORRECT ANSWER(S)
Figure 9.17 (page 389) depicts the model of a labour
market where there are 90 million workers. The
current labour market equilibrium is at A. Now con-
sider the case where the total labour supply is
increased to 100 million. Based on this information,
which of the following statements are correct
regarding the adjustment process in the labour
market?
Initially, unemployment doubles.
Higher unemployment results in a reduction in the
employment rent enjoyed by workers employed at
the current wage.
The firms are required to raise wages to induce
workers to work hard.
The wage-setting curve shifts downward.
0
20
13
3 5.554.54
A
6
B
C
U
U′
U′′
Price-setting
curve
Labour supply
(after immigration)
Labour supply
(before immigration)
Wage-setting curve
(before immigration)
Wage-setting curve
(after immigration)
Employment (millions of workers)
Re
al
w
ag
e
($
)
40
Figure 9.19 The effect of immigration on unemployment.
1. The initial situation
The economy starts at point A,
employing 4 million workers at a wage
of $20 per hour and a labour force of
5 million.
2. One million workers are unemployed
This is shown by the distance U.
3. Immigrant workers join the labour
force
This increases the labour force from
5 million to 5.5 million workers.
4. The wage-setting curve shifts
downward
At any level of employment there are
now more unemployed workers. The
rise in unemployment to 1.5 million is
shown by distance U′. The threat of job
loss is greater and firms can secure
effort from the workforce at a lower
wage.
5. Firms lower the wage
The wage is now set at point B on the
wage-setting curve in the figure, with
the wage at $13 an hour and employ-
ment still at 4 million.
6. Profits rise
This causes firms to hire more workers,
which requires rising wages along the
wage-setting curve. The labour market
moves from point B to point C.
7. Employment and wages rise
They rise until they reach the price-
setting curve, meaning profits are
consistent with market competition
again. At point C, employment is 4.5
million workers, the wage is $20, and
unemployment has fallen back to
1 million workers, as shown by distance
U″.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
394
trade union An organization
consisting predominantly of
employees, the principal activities
of which include the negotiation of
rates of pay and conditions of
employment for its members.
•••9.10 LABOUR UNIONS: BARGAINED WAGES AND THE
UNION VOICE EFFECT
The labour market model presented so far is about firms and individual
workers. But in many countries labour unions play a big part in how the
labour market works. A trade union is an organization that can represent
the interests of a group of workers in negotiations with employers over
issues such as pay, working conditions, and working hours. The resulting
contract is between the firm or organization representing employers and
the labour union.
As you can see from Figure 9.20, the fraction of the workforce employed
under collective bargaining agreements negotiated by labour unions varies
greatly across countries, from virtually all workers in France and some
northern European economies, to hardly any in the US and South Korea.
Labour unions and the bargained wage-setting curve
Where workers are organized into trade unions, the wage is not set by HR
but instead is determined through a process of negotiation between union
and firm. Although the wage must always be at least as high as the wage
indicated by the wage-setting curve for the given level of unemployment,
the bargained wage can be above the wage-setting curve. The reason is that
now the employer’s threat to dismiss the worker is not the only exercise of
power that is possible. The union can threaten to ‘dismiss’ the employer (at
least temporarily) by going on strike, that is, withdrawing the employees’
labour from the firm.
We can think of a ‘bargaining curve’ lying above the wage-setting curve,
which indicates the wage that the union-employer bargaining process will
produce for every level of employment.
The relative bargaining power of the union and the employer determ-
ines how much this bargaining curve lies above the wage-setting curve. The
union’s power depends on the ability to withhold labour from the firm, so
its bargaining strength will be greater if it can ensure that during a strike,
no other workers will offer their services to the firm. This and the other
Sunny Freeman. 2015. ‘What
Canada can learn from Sweden’s
unionized retail workers’
(https://tinyco.re/0808135).
Huffington Post Canada Business.
Updated 19 March 2015.
Barry T. Hirsch. 2008. ‘Sluggish
institutions in a dynamic world:
Can unions and industrial competi-
tion coexist?’ Journal of Economic
Perspectives 22 (1) (February):
pp. 153–176.
0
25
50
75
100
So
ut
h K
or
ea US
Po
lan
d
Ja
pa
n
Ca
na
da UK
Ge
rm
an
y
Au
str
ali
a
No
rw
ay
Sp
ain Ita
ly
Ne
th
er
lan
ds
Sw
ed
en
Au
str
ia
Fra
nc
e
Sh
ar
e
of
em
pl
oy
ee
s
co
ve
re
d
by
co
lle
ct
iv
e
ba
rg
ai
ni
ng
ag
re
em
en
ts
(%
)
Figure 9.20 Share of employees whose wages are covered by collective bargaining
agreements (early 2010s).
View this data at OWiD https://tinyco.re/
8246237
Jelle Visser. 2015. ‘ICTWSS Data base.
version 5.0.’ (https://tinyco.re/3654275).
Amsterdam: Amsterdam Institute for
Advanced Labour Studies AIAS. Updated
October 2015.
9.10 LABOUR UNIONS: BARGAINED WAGES AND THE UNION VOICE EFFECT
395
determinants of bargaining power depend on the laws and social norms
that are in force in an economy. In many countries, for example, it is a
serious violation of a social norm among workers to seek employment in a
firm whose workers are on strike.
A powerful union, however, may not choose to raise the wage even if it
has the power to do so. This is because even a very powerful union can only
set the wage, and it cannot determine how many people the firm hires. Too
high a wage may squeeze profits sufficiently to lead the firm to close down,
or cut back on employment.
Unions may choose to restrain their use of bargaining power. If their
wage-setting covers a substantial part of the economy, they will take into
account the effect of their wage decision on the wages and employment of
workers in the economy as a whole.
To see the difference that a labour union makes, let’s see how the labour
market would work if instead of the employer setting the wage and the
employees individually responding, the process would now be:
1. The union sets the wage.
2. The employer informs workers that insufficient work will result in job
termination.
3. Employees respond to the wage and the prospect of dismissal by
choosing how hard to work.
In this case, the employer no longer sets the wage that maximizes profits
(the point of tangency of the isocost line for effort and the best response
curve at point A in Figure 9.21). Use the steps in Figure 9.21 to see what
happens when the union rather than the firm sets the wage.
As shown in the figure, the wage will be higher than that preferred by
the employer. Workers will now be working harder, but wages increase by
more than productivity, so firms receive less effort for each dollar spent on
wages. It follows that profits will be lower than without the union, that is,
on the flatter isocost line passing through C.
By translating Figure 9.21 to the model of the labour market in Figure
9.22, we see that the bargained wage-setting curve lies above the wage-
setting curve. Looking at the equilibrium where the bargained wage-setting
curve intersects with the price-setting curve, the wage is unaffected, but the
level of employment is lower.
Paradoxically, it seems that the union’s success in bargaining would
harm workers, since the real wage is unchanged and more people are out of
work. But if we look at the data on union bargaining coverage and
unemployment in Figure 9.23, it does not seem to be the case that
unemployment is higher in countries where union bargains are important
in wage-setting.
Austria, with almost all employees covered by union wage bargains, has
a lower unemployment rate (averaged over 2000–2014) than the US, where
fewer than one in five workers are covered by union contracts. Spain and
Poland both had massive unemployment over this period, but union
coverage was very high in Spain and very low in Poland.
So the fact that unions can push up the wage-setting curve to the new
‘bargained wage-setting curve’ must not be the entire story.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
396
The union voice effect
Suppose that over time, the employer and the trade union had developed a
constructive working relationship—for example, solving problems that
arise in ways that benefit both employees and the owners. The employees
may interpret the employer’s recognition of the trade union, and its
willingness to compromise with them over a higher wage, as a sign of
goodwill.
0
0.6
0.85
1
0 Union sets
the wage
Reservation
wage
Employer’s profit-
maximizing wage
(no union)
A
Eff
or
t p
er
h
ou
r
Isocost line for
effort (no union)
Isocost line for effort
(lower profits)
Best response function
C
Hourly wage ($)
Figure 9.21 The union sets the firm’s wage.
NUNION N*
A
Employment, N
Re
al
w
ag
e
Price-setting curve
Wage-setting curve (no union)
Bargained wage-setting
curve (union, no voice effect)
Average product of labour
B
Figure 9.22 The bargained wage-setting curve when there is no union voice effect.
1. The employer sets the wage
At point A, the employer sets the wage
that maximizes profits at the point of
tangency of the isocost line and the
best response function.
2. The union sets the wage instead
If the union sets the wage, it will be
higher than that preferred by the
employer, and effort levels
correspondingly higher …
3. Higher effort but lower profits
… but profits would be lower (indicated
by the flatter isocost line passing
through C).
9.10 LABOUR UNIONS: BARGAINED WAGES AND THE UNION VOICE EFFECT
397
As a result, they might identify more strongly with their firm and
experience effort as less of a burden than before, shifting their best
response curve in Figure 9.24 up.
The result of the greater bargaining power of the workers, and their
reciprocation of the company’s worker-friendly policy, is shown as point D
in Figure 9.24. The wage is the same as in the previous case but because
worker effort is higher, the firm’s profits are higher. Note that in the
example shown, the firm is still worse off than it was in the absence of the
union.
With the new best response function, there is of course an outcome for a
wage-setting firm that is even better than D—where the isocost curve is
tangent to it (not shown). However, this is not feasible. The workers will not
exert the higher effort in the absence of the negotiations about wages and
conditions opened up by the union’s role in wage-setting.
We have shown two effects of the presence of a labour union, which we
can now represent in the labour market diagram:
• It may be able to get the firm to pay a wage greater than the minimum
necessary to induce the employees to work (the bargaining curve is
above the wage-setting curve).
• Providing employees with both recognition and a voice in how decisions
are made may lower the disutility of effort and thus reduce the lowest
wage necessary to motivate employees to work effectively.
The two effects are illustrated in Figure 9.25. In this figure, we show the
case in which the equilibrium level of employment is higher and unemploy-
ment lower with the union (point Y) than without (point X). This is because
the second effect (called the ‘union voice effect’) that shifts the wage-setting
curve down was greater than the bargaining effect that shifts the wage-
setting curve up.
But it could have worked out the other way around. The bargained wage
effect could have been greater than the union voice effect, in which case the
TUR
US
KOR
POL
NZL
JPN
HUN
SVK
CAN
UK
IRL
GRC
CZE
SWI
GER
LUX
AUS
PRT
NOR
SPA
ITA
DNK
NLD
SWE
ISL
FIN
BEL
FRA
AUT
0
4
8
12
16
0 25 50 75 100
Employees covered by collective bargaining agreements (early 2010s, %)
U
ne
m
pl
oy
m
en
tr
at
e
(2
00
0–
20
14
av
er
ag
e,
%
)
Figure 9.23 Collective wage bargaining coverage and unemployment across the
OECD.
View this data at OWiD https://tinyco.re/
2742500
Jelle Visser. 2015. ‘ICTWSS Data base.
version 5.0.’ (https://tinyco.re/3654275).
Amsterdam: Amsterdam Institute for
Advanced Labour Studies AIAS. Updated
October 2015.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
398
effect of unions would have been to reduce employment in the labour
market equilibrium.
This provides a reason why the data in Figure 9.23 do not show any
clear correlation (either positive or negative) of the extent of union con-
tracts and the amount of unemployment.
Unions may also affect the average productivity of labour, which will
shift the price-setting curve. If unions foster cooperation with management
in solving production problems, average product and the price-setting curve
will rise (leading to higher wages and less unemployment). If unions resist
productivity improvements such as the introduction of new machinery or
changes in work rules, then the effect will go in the opposite direction.
0
0.6
1
0 Reservation
wage
Employer’s profit-
maximizing wage
(no union)
Union wage
Eff
or
t p
er
h
ou
r
Isocost line for
effort (no union)
Isocost line for effort (union sets the
wage and employees reciprocate)
Best response curve
(no union)
D
C
Hourly wage ($)
A
Best response curve
(union sets the wage and
the employees reciprocate)
Figure 9.24 Union sets the firm’s wage and employees reciprocate.
1. The employer sets the wage
At point A, the employer sets the wage
that maximizes profits at the point of
tangency of the isocost line and the
best response curve.
2. The employer recognizes a trade
union
If the employees interpret the
employer’s recognition of the trade
union, and its willingness to
compromise with them over a higher
wage, as a sign of goodwill, the best
response curve shifts up.
3. The effect of a worker-friendly policy
The result of the greater bargaining
power of the workers, and their
reciprocation of the company’s worker-
friendly policy, is shown as point D.
9.10 LABOUR UNIONS: BARGAINED WAGES AND THE UNION VOICE EFFECT
399
QUESTION 9.11 CHOOSE THE CORRECT ANSWER(S)
Figure 9.21 (page 397) depicts the effect of union wage-setting. What
can we conclude from this figure?
Compared to A, at C the effort per hour is higher and therefore the
firm’s profit is higher.
The resulting bargained wage-setting curve will be above the wage-
setting curve with no union.
The effect of a strong union will always be to increase unemploy-
ment.
Under union wage-setting, the firm is still setting the wage that
maximizes its profits.
••9.11 LABOUR MARKET POLICIES TO ADDRESS
UNEMPLOYMENT AND INEQUALITY
Like when we studied the effect of taxes on prices and quantities of goods
in Unit 8, we now use the labour market model we have constructed (the
two curves) to see how a policy change will shift one or both of these
curves. The effect of a policy is determined by how it changes the point of
intersection of the two curves.
The objectives of labour market policies typically include reducing unem-
ployment and raising wages (particularly of the least well off). Later (in Units
13–16) we will see that other objectives include reducing the economic insec-
urity to which families are exposed because of periods of unemployment.
The effect of policies that shift the price-setting curve
Education and training
Consider an improvement in the quality of education and training that
future employees receive, which increases the productivity of labour. What
is the effect of this productivity increase on real wages and equilibrium
employment?
NUNIONN*
X
Employment, N
Re
al
w
ag
e
Price-setting curve
Wage-setting curve (no union)
Wage-setting curve (union
wage bargaining effect)
Wage-setting curve (union
wage bargaining and voice effect)
Average product of labour
Y
Figure 9.25 The bargained wage-setting curve and labour market equilibrium when
there is a union voice effect.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
400
The markup chosen by the firm when it sets its price to maximize its
profits is determined by the amount of competition that the firm faces, so it
is unaffected by the increase in productivity.
This markup determines the distribution of the firm’s revenue between
the employees and the owners, and so this has not changed either—wages
remain the same fraction of revenue. So since the firm’s output per worker
has risen, real wages and the price-setting curve must also rise. The out-
come is a rise in both equilibrium employment and the real wage.
A wage subsidy
A policy that has been advocated to increase employment is a subsidy paid
to firms in proportion to the wages it pays its workers. For example,
suppose that hiring a worker for an hour would cost the firm $40 in wages,
but it would receive a 10% subsidy of that amount from the government, or
$4. So the net wage cost to the firm would now be $36.
How would this affect the price-setting curve? The costs of the firm have
now fallen, but as above, the optimal markup that the firm will use to
determine its price has not changed, so the firm will lower its price to
restore the old markup. When all firms do this, the prices of goods that the
worker consumes fall, and real wages rise.
The effect, as above, is to shift upwards the price-setting curve. In both
cases—education and training or a wage subsidy—the effect is to move the
new labour market equilibrium up and right along with wage-setting curve
to both higher wages and greater employment in the economy as a whole.
The full effect of each of these policies would have to take account of
how the education and training or the wage subsidy were financed, but to
allow a simple illustration of how the model works here, we assume that the
funds necessary for these programs could be raised without affecting the
labour market.
The effect of policies that shift the wage-setting curve
An example of how economic policy affects the wage-setting curve is
shown in Figure 9.26. Throughout this example, the unemployment rate is
held constant at 12% and we vary the unemployment benefit to which the
worker is entitled. A higher unemployment benefit increases the reserva-
tion wage and shifts the best response curve to the right: the higher
reservation wage at a higher unemployment benefit level is shown by point
G. The employer sets a higher wage (point C). Work through the steps to
see what happens to the wage-setting curve and unemployment.
There are policies that would affect the third curve in the figure (the
labour supply curve). We have already seen how immigration policies could
affect the supply of labour and hence the workings of the labour market.
Other policies affecting the supply of labour include policies to enhance
women’s employment opportunities such as subsidized childcare, and a
reduction in discrimination against disadvantaged minorities. These poli-
cies work initially by increasing the pool of people without jobs and
therefore shifting downwards the wage-setting curve, as in the case of
immigration.
9.11 LABOUR MARKET POLICIES TO ADDRESS UNEMPLOYMENT AND INEQUALITY
401
Re
al
w
ag
e
wH
WH
0
U = 12% U = 5%
wL
A
D
Eff
or
t p
er
h
ou
r
0
0
Hourly wage
Employment rate
Best response function with U = 12%
and low unemployment benefit
Best response function with U = 12%
and high unemployment benefit
Reservation wage Wage set by firm
Labour supply
Price-setting curve
Wage-setting curve, high
unemployment benefit
F G
WL
A C
C
Wage-setting curve, low
unemployment benefit
0.5
Figure 9.26 Deriving the wage-setting curve: Varying the unemployment benefit
level in the economy.
1. The firm sets the wage
When unemployment is 12%, and the
unemployment benefit is low, the firm
sets the wage at point A in the upper
panel, which corresponds to point A in
the lower panel.
2. Higher unemployment benefit
There is a new wage-setting curve,
which goes through point C.
3. The price-setting curve
We introduce the price-setting curve to
find the labour market equilibrium.
With the low unemployment benefit
the equilibrium unemployment rate is
5% at D, but with the higher unemploy-
ment benefit the rate rises to 12% at C.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
402
reservation wage What an
employee would get in alternative
employment, or from an unemploy-
ment benefit or other support, were
he or she not employed in his or
her current job.
9.12 LOOKING BACKWARD: BARISTAS AND BREAD
MARKETS
We have devoted an entire unit to the labour market for two reasons:
• Its functioning is very important for how well the economy serves the
interests of the population.
• It is different enough from the way that many familiar markets work
that it is essential to know these differences to understand how the eco-
nomy works.
A good way to review these differences is to contrast the market for bread
that we used to illustrate the model of a competitive equilibrium of price
takers in the previous unit with the market for, say, baristas (which, for
readers unfamiliar with Italian-inspired coffee shops, are those who make
espresso-based coffee drinks).
Taking a price, setting a price
Recall that in the equilibrium of the bread market, neither bread consumers
nor bakeries selling bread could benefit by offering to pay a different price
or setting a different price from the one that prevailed in other transactions
throughout the market. Buyers and sellers were price-takers in equilibrium:
• No buyer could benefit from offering to pay less than the prevailing price: No
bakery would agree to the sale.
• No buyer could benefit by offering to pay more than the going price: This
would just be throwing away money. Buyers in the bread market are
price-takers because they wish to purchase bread at the lowest possible
price.
• No seller (a bakery) could benefit from setting a higher price: There would be
no customers.
• No seller could benefit by offering a lower price: This would be throwing
away money. They can have as many customers as they like at the
existing price.
Now think about a buyer in the labour market. This is an employer who
buys the employee’s time. The price is the wage. An employer who acts like
a bread-buyer would offer the employee the lowest wage that the individual
would accept to take the job. This lowest possible wage is the reservation
wage.
We know from Unit 6 that an employer who did this would be
disappointed. The worker who is paid just a reservation wage does not
worry about losing the job, and so would have little incentive to work hard
for the employer. Instead, we saw that employers choose a wage to balance
their wage costs against the positive effects that a higher wage has on the
employee’s motivation to work.
Complete and incomplete contracts
In the bread market, the sales contract between buyer and seller is for
bread, and if you buy bread you get what you want. It’s a complete contract
(remember, a contract need not be in writing and it need not be signed to be
enforceable: your receipt is enough to get a refund if the bag labelled ‘fresh
bread’ turned out to contain a week-old loaf when you got home).
9.12 LOOKING BACKWARD: BARISTAS AND BREAD MARKETS
403
incomplete contract A contract
that does not specify, in an
enforceable way, every aspect of
the exchange that affects the
interests of parties to the exchange
(or of others).
In contrast, in the labour market, the employment contract is usually for
the employee’s work time and not for the work itself. Because it is the
employee’s work that produces the firm’s goods and is essential to the firm’s
profits, this means the contract is an incomplete contract: something that
matters to one of the parties to the exchange is not covered in the contract.
The implication is that, in contrast to the bread market, for a buyer in
the labour market, paying more than is necessary to buy the employee’s
time is not throwing away money; it is the way that employers get what
they want (work) and how they make profits. And because they are deciding
on the price (that is, the wage) that they will offer the worker, they are
price-setters and not price-takers. This is why Unit 8’s model of the com-
petitive equilibrium of price-takers does not work in the labour market.
Pareto efficiency and unexploited opportunities for mutual gains
In Unit 4, you encountered many situations in which the Nash equilibrium
of some social interaction is not Pareto efficient. Examples include the
prisoners’ dilemma and the public goods game.
• We use the Nash equilibrium: This concept helps us predict what out-
comes we will observe when people interact.
• We use Pareto efficiency: This concept evaluates whether there is some
other outcome in which all parties might have done better (or at least as
well).
Recall from Unit 8 that in the model we illustrated with the bread market,
there were no unexploited opportunities for mutual gain at the competitive
equilibrium (where the demand and supply curves intersect). In this situ-
ation, it is not possible to make one of the buyers or sellers better off—by
having one of them trade more or less with their exchange partner, for
example—without making at least one of them worse off. The outcome
therefore was Pareto efficient.
This is not the case in the labour market. Competition among many
buyers (firms hiring employees) and sellers (people seeking work) results in
an equilibrium outcome—the wage w* and the level of employment N*—
that is not Pareto efficient. What this means is that there is some other out-
come—a different wage and level of employment that is feasible from the
standpoint of the available resources and technology—that both employers
and employees would prefer.
To see this, imagine that we are at the equilibrium of the labour market
and one of the unemployed workers (identical to those employed) goes to
an employer and says: ‘Give me a break. I’ll work as hard as the rest of your
work force, but you can pay me a little less.’
The employer thinks: ‘If I pay him a slightly lower wage, and if he works
as hard as the rest, then my profits will go up.’
For the unemployed worker, getting a job makes a big difference. She
now receives an employment rent, which measures how much better it is
for her to have a job than not. The deal is a good one for her despite the fact
that the employment rent she receives is slightly lower than that received by
other workers (because her wage is slightly lower).
This little example shows that there is some other technically feasible
outcome—employ N* + 1 workers at the wage w* for N* of them and w*
minus a little bit for the last worker hired—that would be an improvement
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
404
for both the unemployed worker and the employer. So the outcome (N*,
w*) is Pareto inefficient.
But if that is the case, why doesn’t the employer hire the unemployed
person? The answer is that the deal, while technically feasible, is not eco-
nomically possible. This is because there is no way to enforce the
unemployed person’s promise to work as hard as the rest in return for a
slightly lower wage. Remember the w* on the wage-setting curve is the
minimum the firm can pay to identical workers to ensure work effort is
adequate. The problem thus goes back to a fundamental fact about the rela-
tionship between the firm and its employees: the contract is incomplete in
that it cannot ensure a given level of effort from the worker. The Nash
equilibrium in the labour market is Pareto inefficient.
The politics and sociology of markets
Here is another difference between the bread market and the barista
market. The baker probably does not know the name of the person buying
the bread, or anything about the buyer other than that he is offering the
right price for the loaf. The buyer most likely cares equally little about the
baker other than the taste of the bread.
Now think about the barista. What are the chances that she does not
know the name of her immediate supervisor? And vice versa?
Why the difference? The bread market tends to be a one-off interaction
among virtual strangers, while the labour market is an ongoing interaction
among people who not only know each other’s names but also care about
what the other person is like.
The barista’s supervisor cares about what the barista is like because
her personality, loyalty to the brand, and her respect for social norms
such as honesty and hard work will influence the quality and quantity of
effort that she puts into the job. The buyer of the bread does not care
about these aspects of the baker because what matters is the quality of
the loaf, which can be easily determined, and a new bakery readily found
if the taste is not right.
Another major difference is that the supervisor directs what the barista
does—to dress a certain way, to show up at work at a certain time, and to
not waste time on the job—with the expectation that she will comply with
his orders. Because she receives an employment rent which she would lose
if he were to dismiss her, he can exercise power over her, getting her to do
things that she might not do without the threat of dismissal.
This is not the case in the bread market. If the buyer complains about the
baker’s attire, he would be invited to shop elsewhere. The difference is that
neither the buyer nor the seller in the bread market is receiving a rent. For
each of them, the transaction they are undertaking yields them benefits
virtually identical to their next best alternative. When both can walk away
at virtually no cost, then neither can exercise power over the other.
These are some of the differences—both economic and also political and
sociological—between the bread market and the barista market. These are
also the reasons why the model of the bread market with price-taking
buyers and sellers, and market clearing in equilibrium, does not work for
the labour market. The table in Figure 9.27 summarizes the differences.
9.12 LOOKING BACKWARD: BARISTAS AND BREAD MARKETS
405
Market Bread: a market clearing equilibrium of
price-takers
Baristas: price-setting by employers and equilibrium
unemployment
Buyers Individual consumers Firms (employers)
Sellers Firms (shops) Individual workers
What is sold? A loaf of bread The worker’s time
What does the
buyer want?
A loaf of bread The employee’s effort on the job; not the worker’s time
Competition
among sellers?
Yes: There are many bakeries competing
to sell bread.
Yes: There are many actual or would-be baristas competing to
sell their time.
Is the contract
complete?
Yes: If the bag labeled bread did not
contain bread, you get your money back.
No: The firm’s profits depend on the worker’s effort per hour/
week/month worked, which is not in the contract.
Price-taking
buyers?
Yes: Individual buyers cannot bargain for
a lower price than others are willing to
pay (and would not want to pay more).
No: The buyer (the firm) sets the wage to minimize the cost of
getting the worker to work; it cannot benefit by offering the
lowest wage at which the worker (the seller) would accept the
job.
Is there excess
supply or
demand in
equilibrium?
No: The market clears. Sales take place
at the lowest price the seller would
accept.
Yes: Firms offer a wage higher than the worker’s reservation
wage (minimum price the seller would accept) to maximize their
profits.
Figure 9.27 Differences between the labour market and competitive goods markets.
QUESTION 9.12 CHOOSE THE CORRECT ANSWER(S)
Which of the following statements are correct?
Contracts are complete in both competitive goods markets and
labour markets.
In a competitive goods market the buyers are price-takers, while in
a labour market the buyers of employment (the firms) are price-
setters.
There is no economic rent for either the buyers or the sellers in
competitive goods markets. In contrast, in labour markets the
sellers receive economic rents.
Social norms do not affect the outcomes in either goods markets or
in labour markets.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
406
principal–agent relationship This
relationship exists when one party
(the principal) would like another
party (the agent) to act in some
way, or have some attribute that is
in the interest of the principal, and
that cannot be enforced or
guaranteed in a binding contract.
See also: incomplete contract. Also
known as: principal–agent problem.
9.13 CONCLUSION
The model of the labour market is quite different from the model of equi-
librium of price-taking buyers and sellers in Unit 8. The most obvious
difference is that the labour market does not clear, even in equilibrium.
Involuntary unemployment at labour market equilibrium is unavoidable,
because:
• Employers and workers have a conflict of interest: This is over how hard
employees work.
• Employers cannot write a complete contract with their employees: They
cannot specify the quality and quantity of work effort they will receive.
The extent of equilibrium unemployment is affected by how governments
regulate labour and other markets. In Units 16 and 17 we shall see how
these policies and the behaviour of labour unions and employers have
affected the unemployment experience of different countries over the past
few decades.
Unemployment can be higher than equilibrium unemployment as a
result of a fall in the economy-wide demand for goods and services. In the
example of the Greys in Australia, this was due to global movements in
demand for commodities. But there are many other causes of fluctuations
in aggregate demand that will be explored in the coming units.
Where unemployment is raised above the equilibrium level because of a
lack of aggregate demand, governments and central banks can use fiscal and
monetary policies to reduce it. This is likely to work better than relying on
firms to cut wages and prices, and on households and firms to respond to
those falling wages and prices by increasing their purchases.
The principal–agent model of the employer and the employee that we
have used in this unit will appear in a new setting in the next unit: the credit
market. Whereas in the labour market the principal is the employer and the
agent the worker, in the credit market the principal is the lender and the
agent the borrower. We saw here that in the labour market equilibrium
there will be some people involuntarily unemployed, seeking a job and
willing to work at the going wage rate. So, also, we will see that in the credit
market there will be people seeking loans and willing to pay the going rate
of interest, but unable to get a loan.
Concepts introduced in Unit 9
Before you move on, review these definitions:
• Wage-setting curve, price-setting curve
• Labour force, inactive population, participation rate
• Employment rate, unemployment rate
• Involuntary unemployment
• Equilibrium unemployment
• Cyclical unemployment
• Nominal wage, real wage
• Labour productivity
• Monetary policy, fiscal policy
• Trade union
9.13 CONCLUSION
407
9.14 REFERENCES
Consult CORE’s Fact checker for a detailed list of sources.
Bewley, T. 2007. ‘Fairness, Reciprocity and Wage Rigidity’. Behavioral Eco-
nomics and its Applications, eds. Peter Diamond and Hannu Vartiainen,
pp. 157–188. Princeton, NJ: Princeton University Press.
Campbell, C. M., and K. S. Kamlani. 1997. ‘The Reasons For Wage Rigidity:
Evidence From a Survey of Firms’. The Quarterly Journal of Economics
112 (3) (August): pp. 759–789.
Carlin, Wendy and David Soskice. 2015. Macroeconomics: Institutions,
Instability, and the Financial System. Oxford: Oxford University Press.
Chapters 2 and 15.
Council of Economic Advisers Issue Brief. 2016. Labor Market Monopsony:
Trends, Consequences, and Policy Responses (https://tinyco.re/6120587).
Freeman, Sunny. 2015. ‘What Canada can learn from Sweden’s unionized
retail workers’ (https://tinyco.re/0808135). Huffington Post Canada
Business. Updated 19 March 2015.
Hirsch, Barry T. 2008. ‘Sluggish institutions in a dynamic world: Can
unions and industrial competition coexist?’. Journal of Economic
Perspectives 22 (1) (February): pp. 153–176.
UNIT 9 THE LABOUR MARKET: WAGES, PROFITS, AND UNEMPLOYMENT
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