Clothing workers in Huaibei, East China

# Unit 8 The labour market: Wages, profits, and unemployment

## Introduction

• 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.
• The outcome of the wage-setting process across all firms in the economy is the wage-setting curve, which shows for each unemployment rate the lowest wage that will motivate employees to work.
• 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 the level of productivity and the extent of competition in markets for goods and services.
• These two curves determine the structural unemployment in the economy, which can be altered by public policies that change the productivity of labour, the degree of competition facing firms, the extent and nature of labour unions, labour market regulations, and the unemployment benefit.
• When the demand for goods and services in the economy as a whole fluctuates, this causes unemployment to be higher or lower than the structural level.
• Changes in how the labour market functions alter the distribution of income as measured by the Lorenz curve and the Gini coefficient.

Mining was not a job, it 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 recalled, ‘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, driven by the demand from China’s rapidly growing economy. Rob lived in Thailand for a time, spending little. He would take a flight to his job in Borroloola, a round trip of 10,000 km.

At about the time that Rob started work, Doug, the elder Grey, took a job at the Pilbara iron ore mine in Western Australia, 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, the company replaced human labour with machines wherever possible. In the Pilbara mine, 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.

The rise and fall of the Grey family’s economic fortunes is an example of the workings of the labour market in the mining and construction industries in Western Australia and the Northern Territory. Figure 8.1 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 unemployment began to rise. Born-at-the-right-time Rob Grey’s luck had run out.

Real weekly earnings for males in Western Australia (left-hand axis), world price of iron ore and unemployment rate in Australia (right-hand axis), (1989–2015).

Figure 8.1 Real weekly earnings for males in Western Australia (left-hand axis), world price of iron ore and unemployment rate in Australia (right-hand axis), (1989–2015).

Australian Bureau of Statistics and International Monetary Fund. Note: Unemployment rates are seasonally adjusted.

We learn from the patterns in the Australian labour market that wages increase when unemployment falls. From Unit 6, we know that firms have to set higher wages to ensure that employees work hard and well when unemployment in the economy is low. And from Unit 6, we also know that there will always be more people seeking jobs than the number of jobs offered. These are the involuntarily unemployed.

In this unit, we describe how the labour market works and what explains the unemployment rate. Figure 8.1 illustrates on how changes in the demand for minerals affected the demand for workers in Australia. Unemployment fell and rose as the mineral sector expanded and contracted.

The model we develop in this unit helps to explain why, over very long periods, unemployment rates differ between countries. Take, for example, two large European countries, Germany and Spain. These countries share many characteristics. As well as belonging to the European Union, which provides conditions for borderless trade, firms based in both countries compete in global markets on the same terms. They share access to the same robot technologies and other labour-saving innovations.

The two countries appear to be equally vulnerable to what are generally considered to be the two ‘job killers’’ for the high-income countries in the early twenty-first century—automation and globalization. Yet, for the period from 1960 to 2014, the unemployment rate in Germany averaged 5.6%, compared with a rate more than double this in Spain (13.3%).

The comparison of Spain and Germany directs attention at the contrasting ways labour markets work in different countries. The model we develop in this unit helps to explain these differences.

## 8.1 Measuring the economy: Employment and unemployment

What does it mean to say that the unemployment rate was 13.3% in Spain and 5.6% in Germany? What exactly is ‘unemployment’?

According to the standardized definition of the International Labour Organization (ILO), the unemployed are the people who:

• were without work during a reference period (usually four weeks); in other words, they were not in paid employment or self-employment
• were available for work
• were seeking work; in other words, they had taken specific steps in that period to seek paid employment or self-employment
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.
labour force
The number of people in the population of working age who are, or wish to be, in work outside the household. They are either employed (including self-employed) or unemployed. See also: unemployment rate, employment rate, participation rate.
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.

Figure 8.2 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 the inactive population). 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, students, or parents who stay at home to raise children. Only members of the labour force can be considered as employed or unemployed.

The labour market.

Figure 8.2 The labour market.

There are a number of statistics that are useful for evaluating labour market performance in a country and for comparing labour markets between countries. The statistics depend on the relative sizes of the boxes shown in Figure 8.2.

participation rate
The ratio of the number of people in the labour force to the population of working age. See also: labour force, population of working age.

### Participation rate

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:

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.

### Unemployment rate

Next is the most commonly cited labour market statistic—the unemployment rate. This shows the proportion of the labour force that is unemployed. It is calculated as follows:

employment rate
The ratio of the number of employed to the population of working age. See also: population of working age.

### Employment rate

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.

### Comparing labour markets

The table in Figure 8.3 provides a picture of the labour markets in four countries—Australia, Germany, Norway, and Spain—between 2000 and 2016, and shows how the labour market statistics relate to each other.

It also shows that the structure of the labour market differs widely among different countries. We can see that the Norwegian labour market worked better than the Spanish labour market in the last 17 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.

Australia Germany Norway Spain
Number of persons, millions
Population of working age 17.2 69.6 3.5 37.6
Labour force 11.1 41.0 2.5 21.6
Out of labour force (inactive) 6.1 28.5 1.0 16.0
Employed 10.5 38.0 2.4 18.1
Unemployed 0.6 3.1 0.1 3.5
Rates (%)
Participation rate 11.1/17.2 = 65% 41.0/69.6 = 59% 2.5/3.5 = 71% 21.6/37.6 = 58%
Employment rate 10.5/17.2 = 61% 38.0/69.6 = 55% 2.4/3.5 = 69% 18.1/37.6 = 48%
Unemployment rate 0.6/11.1 = 6% 3.1/41.0 = 7% 0.1/2.5 = 4% 3.5/21.6 = 16%

Labour market statistics for Australia, Germany, Norway and Spain (averages over 2000–2016).

Figure 8.3 Labour market statistics for Australia, Germany, Norway and Spain (averages over 2000–2016).

International Labour Organization. 2018. ILOSTAT Database.

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 in the table, Australia is the country most similar to Norway). Spain is a high-unemployment, low-employment economy (the other southern European economies—Portugal, Italy and Greece—are other examples). Other combinations are possible, however—Germany’s participation rate is low like Spain’s but its unemployment and employment rate performance are much better.

### Exercise 8.1 Using Excel: Employment, unemployment, and participation

1. Visit the ILO’s website and use the ILOSTAT Database to calculate the average employment, unemployment, and participation rates over the period 2000–2016, for two economies of your choice.
2. Create appropriate chart(s) to display these statistics for the countries in Figure 8.3 and your chosen countries. Using your chart(s), describe the similarities and differences in these statistics.
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 labour markets in your chosen countries.

### Question 8.1 Choose the correct answer(s)

Which of the following statements are 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
• participation rate = labour force ÷ population of working age
• unemployment rate = unemployed ÷ labour force
• This is the definition of the employment rate.
• unemployment rate = unemployed ÷ labour force, while employment rate = employed ÷ population of working age. They do not add up to 1 because the denominator is different.

## 8.2 The wage-setting curve: Employment and real wages

To see why, over the long run, some countries (like Spain) have much higher unemployment rates than others (like Germany), we will present a model of the labour market for an entire country. We start with the fact that Rob Grey and his father—the Australian miners—did well while the economy was booming, earning high wages and having little fear of unemployment, and not so well when the economy hit the doldrums.

We generalize their experience in Figure 8.4, where 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.
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.

The upward-sloping line is called the wage-setting (WS) curve. The wage-setting curve for the whole economy is based directly on the employer’s wage-setting decision and the employee’s effort decision in an economy that is composed of many firms, like the economy we modelled in Unit 6.

Follow the analysis in Figure 8.4 to understand the upward-sloping wage-setting curve.

The wage-setting curve: Labour discipline and unemployment in the economy as a whole.

Figure 8.4 The wage-setting curve: Labour discipline and unemployment in the economy as a whole.

The wage-setting curve

The upward-sloping line is called the wage-setting curve.

Figure 8.4a The upward-sloping line is called the wage-setting curve.

The wage set by firms when unemployment is high

At 12% unemployment in the economy, the employee’s reservation wage is low and the worker will put in high effort for a relatively low wage. Therefore, the firm’s chosen wage is low.

Figure 8.4b At 12% unemployment in the economy, the employee’s reservation wage is low and the worker will put in high effort for a relatively low wage. Therefore, the firm’s chosen wage is low.

The wage set by firms when unemployment is low

At 5% unemployment in the economy, the employee’s reservation wage is high and he or she will not put in adequate effort unless the wage is high. Therefore, the firm’s chosen wage is higher.

Figure 8.4c At 5% unemployment in the economy, the employee’s reservation wage is high and he or she will not put in adequate effort unless the wage is high. Therefore, the firm’s chosen wage is higher.

Employment, unemployment, and out of the labour force

The right-most dotted blue line shows the total working-age population, which is divided into the employed, the unemployed, and those not participating in the labour force.

Figure 8.4d The right-most dotted blue line shows the total working-age population, which is divided into the employed, the unemployed, and those not participating in the labour force.

worker’s best response function (to wage)
The optimal amount of work that a worker chooses to perform for each wage that the employer may offer.

Figure 8.5 brings together Figure 8.4 (the economy-wide wage-setting curve) and Figure 6.7 (how the firm sets the wage). The top panel of Figure 8.5 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 bargaining power of the employee 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).

Deriving the wage-setting curve: Varying the unemployment rate in the economy.

Figure 8.5 Deriving the wage-setting curve: Varying the unemployment rate in the economy.

In the lower panel, we plot point A on the wage-setting curve. The dashed line from an unemployment rate of 12% indicates that the wage is set at wL. We 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 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.

When Rob and Doug Grey write their biography, they will label point B as the Golden Age early in this century, when Rob was living in Thailand and flying to his job at Borroloola, and his father was operating giant cranes at the Pilbara mine. Point A is Paradise Lost (the period after the minerals boom ended).

labour discipline model
A model that explains how employers set wages so that employees receive an economic rent (called employment rent), which provides workers an incentive to work hard in order to avoid job termination. See also: employment rent, efficiency wages.

We derived the wage-setting curve as part of the labour discipline model, which was designed to illustrate how employees and employers interact when setting wages and determining the level of work effort. We will use the same model later when we describe government policies to alter the level of unemployment in the entire economy. Later in this unit, 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.

### Real wages and nominal wages

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.

When the employer sets the wage, it is set in nominal terms, that is in euros, dollars, or pesos, for example. But workers care about what they can buy with their wages. They care about the real wage, which is written as w = W/P, where P is the price level in the economy. Throughout the analysis of the interaction between the employee and employer in wage-setting, we use the real wage, w, because it is the real wage that motivates the worker to work hard.

### The wage-setting curve for the US economy

Figure 8.6 is a wage-setting curve estimated from data for the US. Note that, in Figure 8.6, the horizontal axis shows the unemployment rate explicitly, falling from left to right. On the vertical axis is the real wage, measured by real annual earnings. By using data on unemployment rates and wages in local areas, economists can estimate and plot the wage-setting curve for an economy.

Wage-setting curves have been estimated for many economies. David Blanchflower and Andrew Oswald explain how it is done in their paper ‘The Wage Curve’.

### 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, and
• ‘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 8.7, the wage curve is the boundary between two ‘regions’: 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’.

The wage-setting curve: The wage level required to make employees work rather than shirk.

Figure 8.7 The wage-setting curve: The wage level required to make employees work rather than shirk.

We will use this “work or shirk” simplification in the model from now on.

### What shifts the wage-setting curve?

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.

What determines the height of the wage-setting curve? In Unit 6, we studied the determinants of the cost of job loss. For any particular unemployment rate, a change in any of the elements raising the employment rent a worker gets from their job (shown in the table in Figure 6.4) shifts the wage-setting curve downwards.

For example, because a lower unemployment benefit makes it more costly if you lose your job, your employment rent is higher and the firm can set a lower wage and you will work, rather than shirk. Another example is an increase in the labour force. If there are more people searching for jobs, then you can expect to remain without work for longer if you lose your job. This increases the rents you get from your current job and shifts the wage-setting curve downwards.

A new technology that allows easier monitoring of shirking (such as the use of GPS trackers in trucks, monitoring location at any time) makes detection of shirking less costly; the firm can set a lower wage and the worker will work rather than shirk. The wage-setting curve shifts downwards.

### Exercise 8.2 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 Figure 8.8, 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
Increase in social stigma attached to being unemployed Down
A decrease in the disutility of working Down

Shifts in the wage-setting curve.

Figure 8.8 Shifts in the wage-setting curve.

### Question 8.2 Choose the correct answer(s)

Figure 8.5 depicts the wage-setting curve and how it is derived using the best response function of the employees and the isocost 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 in which 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.
• A cut in the unemployment benefit would shift the best response function to the left. However, this would mean that the equilibrium wage falls for a given unemployment rate and lower the wage-setting curve.
• An extended expected unemployment period would shift the best response function to the left, lowering the wage-setting curve.
• If there is high stigma attached to unemployment, then the workers’ best response functions would move to the left. This reduces the equilibrium wage for a given unemployment rate, resulting in a lower wage-setting curve.
• With the balance of job seekers and vacancies shifting in favour of the workers, their best response function would shift to the right, resulting in the wage-setting curve moving upwards.

## 8.3 The price-setting curve: Wages and profits in the whole economy

The wage-setting curve alone does not fix the level of employment in the model—the economy could be anywhere on the wage-setting curve. To determine the real wage and the level of employment, we need a second piece of information.

price-setting curve
The curve that gives the real wage paid when firms choose their profit-maximizing price.

This is provided by what is called the price-setting (PS) curve. It gets its name because it gives the real wage that is the outcome of the choice by firms of a profit-maximizing price for their products.

Where the two curves intersect is the real wage and level of employment (and the associated rate of unemployment) the economy can sustain. It is an equilibrium in the labour market because:

• If the economy is on the wage-setting curve, workers won’t shirk: Then at this rate of unemployment, this is the real wage at which workers will provide adequate effort.
• If the economy is on the price-setting curve, firms are setting their profit-maximizing price: This is the real wage that is the result of that decision.

When the economy is at the intersection of the wage- and price-setting curves, employees provide adequate effort and firms are willing to employ that number of workers because, given the demand they face for their output and their costs, the firms are setting their profit-maximizing price.

### Price-setting and the price-setting real wage

marginal cost
The cost of producing one additional unit of output.
profit margin
The difference between the price and the marginal cost.

The firm will set the price in order to maximize its profits, as we saw in Unit 7. At its profit maximizing price—where the isoprofit curve is tangent to the demand curve—the price is above the firm’s marginal cost. This gap is called the profit margin, which the firm receives on each unit of output sold.

price elasticity of demand
The percentage change in demand that would occur in response to a 1% increase in price. We express this as a positive number. Demand is elastic if this is greater than 1, and inelastic if less than 1.

The size of the profit margin depends on the extent of competition in the market for the firm’s product, which is measured by the elasticity of demand. If demand is more elastic, the demand curve is flatter and, as we saw in Unit 7, this means there are more close competitors to the firm and its profit margin is lower.

price markup
The price minus the marginal cost divided by the price. It is inversely proportional to the elasticity of demand for this good.

By dividing the profit margin (a dollar amount) by the price (in dollars), we get the markup, μ (a number between zero and one), chosen by the firm when it sets its price. This summarizes the competitive conditions in the economy.

### A numerical example

labour productivity
Total output divided by the number of hours or some other measure of labour input.

A numerical example helps to explain the implications for the economy-wide real wage when firms set prices in this way. We assume a firm in which the only input is labour, so this is the only cost. The wage is $15 per hour and hourly labour productivity is 2—that is, a worker produces two units of output per hour—and we assume that this does not vary with the quantity produced. This means that the marginal (and average) cost of production is$15/2 = $7.50. The extent of competition in the firm’s market is such that the markup, called mu (μ), is 0.25, or equivalently, 25%. Profit maximization (when the isoprofit curve is tangential to the demand curve) means that: where MC is the firm’s marginal cost. (To see the underlying algebra, read the ‘Find out more’ box at the end of this section.) Applying the equation to our example, we have 0.25 = (P − 7.50)/P and from this, we can calculate that the firm sets the price at$10. Working back the other way, if the price is $10 and the marginal cost is$7.50, then we can confirm that the markup is 0.25, or 25%.

differentiated product
A product produced by a single firm that has some unique characteristics compared to similar products of other firms.

We now assume that all the firms in the economy are producing differentiated products and pay a wage of $15 per hour. Productivity is, on average, two units per hour and competitive conditions are approximated by a markup of 25%. Therefore, the economy-wide price level is$10.

Using this information, we can calculate the real wage in the economy, implied by firms setting prices to maximize their profits:

Notice that the real wage is in units of output, not dollars. It shows how much output workers can buy with their hourly wage. This is the price-setting real wage.

Since we are interested in seeing what happens to the real wage when productivity changes, we call average productivity (or output per worker per hour), lambda (λ).

The price-setting real wage can be written as:

Using the numbers in our example, the price-setting real wage is:

The output per worker per hour (2 units) is split up as 1.5, which goes to the employees in the real wage, and 0.5 that goes to owners as profit. Owners get one-quarter of the output per worker and workers get three-quarters.

Hence:

This equation shows that, as a consequence of firms setting prices to get a markup, μ, the output produced per worker in the economy is divided into the share that goes to workers as wages (1 − μ) and the share that goes to owners as profits (μ).

### The price-setting curve in a diagram

Figure 8.9 shows the outcome of the price-setting decisions of firms in the whole economy.

average product
Total output divided by a particular input, for example per worker (divided by the number of workers) or per worker per hour (total output divided by the total number of hours of labour put in).

The top horizontal dashed line shows firms’ revenues per hour worked in real terms—this is the average product of labour, λ (lambda). 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, when all firms set their price to maximize their profits. In our numerical example, this number is 1.5.

Using our assumptions that neither productivity nor the markup vary with the level of employment, the value of the price-setting real wage is constant and is therefore shown, as in Figure 8.9, as a horizontal line at the height of wPS.

The price-setting curve.

Figure 8.9 The price-setting curve.

### What shifts the price-setting curve?

Both from the diagram and the equation, we can see that the price-setting real wage will increase if productivity increases or if the markup falls. But what mechanisms bring this about?

#### Higher productivity

Returning to our example, if productivity doubles from 2 to 4 units produced per hour, then:

So the price-setting real wage doubles from 1.5 to 3.

nominal wage
The actual amount received in payment for work, in a particular currency. Also known as: money wage. See also: real wage.

Digging a bit deeper, we can see that the increase in productivity has halved the firm’s marginal cost (to $3.75). To keep its markup unchanged at 25% (since competitive conditions are unchanged), the firm reduces its price to 5—it halves its price. The nominal wage is unchanged at$15 per hour, so the real wage has doubled to 3.

The mechanism by which higher productivity raises the price-setting real wage is summarized as follows. Higher productivity reduces costs and firms cut their prices. The result is a higher real wage.

#### A lower markup, more competition

The price-setting real wage will increase if the demand curve becomes more elastic, that is if the markup in the economy falls as a result of more intense competition. This makes sense because, with fiercer competition, the share of profits will be lower and real wages will rise.

Suppose the markup falls from 0.25 to 0.2. Then:

In words, the real wage rises from 1.5 to 1.6.

The mechanism by which a lower markup raises the price-setting real wage is as follows—a lower markup reduces the price the firm can set because of the more intense competition. The result is a higher real wage.

#### What if the nominal wage rises?

What happens to the price-setting real wage if the nominal wage increases? Suppose the hourly wage increases from $15 to$16. This increases the marginal cost from $7.50 to$8.00. Hence:

So the real wage is:

The answer is that nothing happens to the real wage when the nominal wage increases. The reason is that, to maximize their profits, firms raise their prices to keep the markup (the profit margin divided by the price) unchanged, which means that prices increase by the same proportionate amount as wages.

### Summary

We now summarize what determines the height of the price-setting curve. Later in the unit, we will look at how government policy can affect this.

• Labour productivity: For any given markup, the level of labour productivity—how much a worker produces in an hour—determines the real wage. The greater the level of labour productivity (or equivalently, the average product of labour, called lambda, λ), the higher the real wage that is consistent with a given markup. In Figure 8.9, higher labour productivity shifts the dashed line upwards, and, keeping the markup unchanged, the price-setting curve will shift upwards, raising the real wage.

Higher productivity pushes the price-setting curve upwards. Shares stay the same; the price-setting real wage is higher.

• Competition: You know from the previous unit that the intensity of competition facing firms determines the extent to which they can charge a price that exceeds their costs, that is, their markup. The higher the competition, the lower the markup. Since this leads to lower prices across the whole economy, it implies higher real wages, pushing the price-setting curve upwards.

More competition in markets for goods and services pushes the price-setting curve upwards. Workers get a bigger share; the price-setting real wage is higher.

We summarize the influences on the price-setting curve in Figure 8.10.

Determinants of the price-setting curve.

Figure 8.10 Determinants of the price-setting curve.

### Find out more The size of the markup chosen by the firm

We can find a formula that shows that the markup is high when the elasticity of demand is low.

The firm maximizes its profits by setting its price where the slope of the isoprofit curve is equal to the slope of the demand curve, and we know that the slope of the demand curve is related to the price elasticity of demand:

Rearranging this formula:

We also know from Section 7.4:

When the two slopes are equal:

Rearranging this gives us:

The left-hand side is the profit margin as a proportion of the price, which is called the markup. Therefore:

The firm’s markup is inversely proportional to the elasticity of demand.

Hence:

In the example, if $\mu$ = 0.25 (the elasticity is 4) and MC = $7.50, then we can calculate the price: ### Question 8.3 Choose the correct answer(s) Suppose the nominal wage W =$10, the markup μ = 0.5, and the marginal cost is $5. Based on this information and the discussion in this section, which of the following statements are true? • The elasticity of demand is 4. • The marginal cost is equal to the price. • The real wage (W/P) is 1. • Average productivity (λ) is 2. • The elasticity of demand is the inverse of the markup, so is 1 / 0.5 = 2. • The marginal cost is equal to half of the price (MC = (1 − 0.5)P). • The price P is$10 and so is the nominal wage, so the real wage is 1.
• The real wage is equal to λ(1 − μ), which means 1 = λ(1 − 0.5), so λ is 2.

## 8.4 Wages, profits, and unemployment in the whole economy

Putting the wage-setting and the price-setting curves together, we have a model for the whole economy from which we can directly determine the real wage and the level of employment.

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.

We ask what the equilibrium of an economy will be, as depicted by the two curves. Remember, a Nash equilibrium is a situation in which none of the actors would like to change what they are doing, given what the others are doing.

The actors include the workers and the owners/managers of each firm. But inside the firm, there are two distinct actors: the Human Resources Department (HR) is in charge of setting wages to ensure that employees ‘work’, while the marketing department is tasked with setting a price that will maximize the firm’s profits. Their interaction is summarized in Figure 8.11.

Department … knows … and on this basis sets the firm’s
Human resources Prices and wages in other firms, and the unemployment rate in the economy Nominal wage, W
Marketing All of the above, and firm’s demand function Price of output, P

The two departments determine the wage and price set by the firm.

Figure 8.11 The two departments determine the wage and price set by the firm.

### Can anybody do better?

To determine the equilibrium of this economy, we need to ask the question: ‘Can anybody do better?’ In the left-hand panel of Figure 8.12, we ask if the HR Department can do better. We see that, for any combination of wage and employment below the wage-setting curve, they are sounding the alarm—nobody is working, we need to raise wages. Above the wage-setting curve, they are sounding a different alarm—the firm is throwing away money by paying too much.

In the right-hand panel, we ask if the marketing department can do better. We see that, for any combination of wage and employment above the price-setting wage, the firm can charge a higher price and make more profits. Below the price-setting curve, the marketing department is alarmed because the firm is losing customers and should lower the price.

Can anybody do better? The HR and marketing departments of the firm.

Figure 8.12 Can anybody do better? The HR and marketing departments of the firm.

### The Nash equilibrium of the labour market

By superimposing the wage-setting curve on the price-setting curve in the right-hand panel of Figure 8.12, we have a picture of the whole labour market, illustrated in Figure 8.13.

Equilibrium in the labour market.

Figure 8.13 Equilibrium in the labour market.

The equilibrium of the labour market is the point at which the wage- and price-setting curves intersect, shown by X in the figure.

incentive
Economic reward or punishment, which influences the benefits and costs of alternative courses of action.
• Workers are working: They have no incentive to shirk. If they demanded higher pay, their employer would refuse, or replace them.
• Human resources does not want to change the wage: The workers are motivated, at the lowest possible cost.
• The marketing department is satisfied: Prices have been set at the profit-maximizing level.

What about the unemployed? They are surely unhappy in this situation. Those who fail to get jobs would rather have a job, but in this situation there is no way for them to get one—not even if they offer to work at a lower wage than others.

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.

This is a Nash equilibrium because all parties are doing the best they can (even the unfortunate unemployed), given what everyone else is doing.

### Question 8.4 Choose the correct answer(s)

Which of the following statements about outcome X in Figure 8.13 are correct?

• Once they jobs, employees are better off not exerting any effort in their work.
• The firms’ wage offered is at the point of tangency between their isocost line and the workers’ best response function curve for effort.
• The unemployed can get jobs by offering to work for a wage lower than the equilibrium wage.
• Above the price-setting curve, the Marketing Department can do better by raising prices.
• At X, employees are on their best response function for effort. This means that putting effort in is their best strategy. A positive employment rent ensures this.
• X is on the wage-setting curve, which is determined by the point of tangency between a firm’s isocost and the workers’ best response function curve for effort.
• The employers know that once the unemployed get jobs at a lower wage, they will shirk. Therefore, the unemployed will not be offered a job at a lower wage.
• Above the price-setting curve, the markup is too low, so the firm can increase profits by raising prices.
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.

## 8.5 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 for that wage. To understand why there will always be unemployment in labour market equilibrium, 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—in the economy as a whole—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. The first is the substitution effect of a wage increase, and the second is the income effect. We studied these effects in Unit 4. 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 8.13.

unemployment, involuntary
The state of being out of work, but pre­ferring to have a job at the wages and working conditions that other­wise identical employed workers have. See also: unemployment.

Why will there always be some involuntary unemployment in labour market equilibrium?

• If there was no unemployment: The cost of job loss would be 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.

### Exercise 8.3 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 unemployed comes to you and promises to work at the same effort level as your current workers, but for a slightly lower wage.

2. Does your reply help explain why unemployment must exist in a Nash equilibrium?

### Question 8.5 Choose the correct answer(s)

Figure 8.13 depicts the labour market model. Consider a reduction in the degree of competition faced by the firms. Which of the following statements regarding the effects of reduced competition are correct?

• The price-setting curve shifts upwards.
• The wage-setting curve shifts downwards.
• The equilibrium real wage falls.
• The unemployment level falls.
• Decreased competition implies a higher markup. This decreases the share of output claimed by the workers, reducing their real wage. Hence, the price-setting curve shifts downwards.
• The wage-setting curve is determined by the supply of labour. Therefore, it is unaffected.
• Decreased competition leads to a lower price-setting curve, while the wage-setting curve is unaffected. Therefore, the equilibrium (the intersection of the two curves) shifts downwards and to the left, implying lower real wage and higher unemployment.
• With the price-setting curve shifting downwards, the intersection of the two curves moves down the wage-setting curve to where there is higher unemployment.

### Question 8.6 Choose the correct answer(s)

Suppose the real wage increases. Which of the following statements about the labour supply of a worker are correct?

• The income effect means that the worker will increase his labour supply.
• The substitution effect means that the worker will increase his consumption of leisure.
• The income and substitution effects always enhance each other, leading to higher labour supply.
• At high wages, the income effect dominates the substitution effect, leading to lower labour supply.
• As the real wage rises, the worker feels richer. This would induce him to work less, that is the income effect is negative.
• The real wage is the price of consuming leisure. Therefore, when the wage rises, free time becomes more expensive relative to consumption goods (which are purchased using the wage income). Hence, the worker would substitute out of consuming leisure into consuming goods, implying lower free time and higher labour supply.
• The income and substitution effects always work against each other, leading to higher labour supply at lower wages, and lower labour supply at higher wages.
• The negative income effect and the positive substitution effect always work against each other. At high wages, the former more than offsets the latter, implying that the worker reduces his labour supply (he already earns enough).

## 8.6 Why was unemployment higher in Spain than in Germany?

Figure 8.14 compares unemployment in Germany and Spain from 1960 to 2014. We can use the model developed in this unit to propose some explanations for the wide gap between the unemployment rates in these two large European countries.

The model directs our attentions to the position of the wage- and price-setting curves. The point at which they cross pins down unemployment at the Nash equilibrium. The differences in the average unemployment rates over many decades between Germany and Spain suggests that equilibrium unemployment in the two countries must be different.

The table in Figure 8.15 brings together summary data that helps to explain the Germany–Spain comparison. The data covers the period from 1976–2011.

Unemployment rate (%) Generosity of unemployment benefits (%) Openness of the economy to global competition (% of GDP) Labour productivity in manufacturing (2005 US$) Germany 6.8 26.9 71.0 43.3 Spain 15.4 31.9 65.1 30.6 Determinants of structural unemployment in Spain and Germany (1976–2011). Figure 8.15 Determinants of structural unemployment in Spain and Germany (1976–2011). Data from 1976–2004: David R Howell, Dean Baker, Andrew Glyn, and John Schmitt. 2007. ‘Are Protective Labor Market Institutions at the Root of Unemployment? A Critical Review of the Evidence’Capitalism and Society 2 (1) (January). Data from 2005 to 2011: OECD. 2015. OECD Statistics. Note: Generosity of unemployment benefits is measured as Gross Unemployment Benefit Replacement Rates. Openness of the economy to global competition is export plus imports as a share of GDP. Labour productivity is gross value added per hour worker, in manufacturing sector, measured in 2005 US$. All data is averaged over the period 1976–2011.

structural unemployment
The level of unemployment at the Nash equilibrium of the labour market model.

In the model, the structural unemployment rate (unemployment at the Nash equilibrium) is increased by factors that shift the wage-setting curve upwards and reduced by factors that shift the price-setting curve downwards.

Comparing these two countries, we can see that Spain has a more generous unemployment benefit regime. Ceteris paribus, the higher unemployment benefits in Spain shift the wage-setting curve upwards relative to the case of Germany.

Later in the unit, we shall see the importance of the ceteris paribus assumption. There are countries with more generous unemployment benefits than Spain with much lower structural unemployment. In those countries, generous unemployment benefits were not simply generous but were designed to help the unemployed re-enter employment quickly. This was not the case in Spain.

Turning to the price-setting curve, from the model we know that, if there is stronger competitive pressure on firms, the price-setting curve will shift upwards. In Figure 8.15, we use the measure of the openness of the economy to international trade, calculated as the sum of its exports plus its imports divided by GDP as a proxy for the pressure of competition. According to this indicator, the German economy is much more open to competition than is the Spanish economy. Ceteris paribus, this shifts the price-setting curve upwards in Germany relative to Spain.

The data in the final column of the table highlights the difference in output per worker hour between the two economies. The measure we use is hourly productivity in manufacturing because it is likely that productivity is better measured there than elsewhere in the economy. Productivity in Germany by this measure is 60% higher than in Spain. Ceteris paribus, this shifts the price-setting curve upwards in Germany relative to that in Spain.

Figure 8.16 illustrates how these differences can be shown in the labour market model. Spain’s structural unemployment at point X is higher than Germany’s at Y, as a result of a higher wage-setting and a lower price-setting curve. The model predicts that Germany’s real wage is higher than Spain’s.

Using the model to compare structural unemployment in Spain and Germany.

Figure 8.16 Using the model to compare structural unemployment in Spain and Germany.

## 8.7 Structural and cyclical unemployment: The role of demand

Look back at Figure 8.14. There are large changes in the rate of unemployment relative to its long-term average (much more so in Spain than in Germany). It seems unlikely that the Nash equilibrium rate of unemployment in our model for Spain would drop precipitously from the late 1990s to the first five years of this century, and then jump back up five years later. It looks like more is going on in the unemployment data than is captured in our model.

Another case in point. 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 economy 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 work was not started on new mines, ports, and processing facilities. In Figure 8.1, unemployment began to rise as the global price of iron ore plummeted.

### Demand fluctuates and causes cyclical unemployment

Unemployment increased because the demand for labour in mining and in the related service activities shrank. Not only did the demand for minerals fall, but demand also declined for the goods and services that 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 economy, 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.

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: equilibrium unemployment.

Economists use the term aggregate 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 a fall in aggregate demand is called ‘demand-deficient’ unemployment—or, cyclical unemployment.

Observed unemployment is the sum of the cyclical unemployment and the level of unemployment at the Nash equilibrium of the labour market, the structural unemployment:

Because the observed unemployment may fall below the equilibrium level—as it did during the mineral resources boom in Australia that underpinned the ‘good times’ for the Grey family—cyclical unemployment may be a negative number.

### Cyclical and structural unemployment

How does this cyclical unemployment appear in our model of the labour market, and how does it relate to structural unemployment?

Follow the analysis in Figure 8.17 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.

Notice that 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.

Equilibrium (structural) and demand-deficient (cyclical) unemployment.

Figure 8.17 Equilibrium (structural) and demand-deficient (cyclical) unemployment.

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 that person experiences a cost of losing the job.

Figure 8.17a 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 that person experiences a cost of losing the job.

Point B

At B, there are additional people looking for work who are also involuntarily unemployed. The additional unemployment at B is due to low aggregate demand and is called demand-deficient, or cyclical, unemployment.

Figure 8.17b At B, there are additional people looking for work who are also involuntarily unemployed. The additional unemployment at B is due to low aggregate demand and is called demand-deficient, or cyclical, unemployment.

The Nash equilibrium

At point B, total involuntary unemployment is given by the sum of cyclical and structural unemployment.

Figure 8.17c At point B, total involuntary unemployment is given by the sum of cyclical and structural unemployment.

### Question 8.7 Choose the correct answer(s)

Look again at Figure 8.17. Denote employment at point B as NB, employment at X as NX, and the total labour supply as NL. Which of the following statements about Figure 8.17 are correct?

• The demand-deficient unemployment at B is NLNB.
• The firms’ demand for labour is NX at X, and is NB at B.
• NLNX and NLNB are the levels of involuntary unemployment at X and B, respectively.
• The equilibrium level of unemployment is NLNB.
• The demand-deficient unemployment is the increase in unemployment caused by the fall in aggregate demand, which is NXNB.
• The firms’ demand for labour depends on the demand for their goods and services. These are NX at X and NB at B.
• At both B and X, all the unemployed workers are not out of work voluntarily.
• The equilibrium level of unemployment is NLNX; any unemployment above this is demand-deficient (cyclical) unemployment.

## 8.8 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. Therefore, 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. The classes are employers—who are the owners of the firms—and workers— some of whom are without work.

### The outcome in the labour market affects inequality

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 Unit 5’s ‘Find out more’ box on the Lorenz curve to revise how to calculate the Gini coefficient.

The distribution of income at labour market equilibrium.

Figure 8.18 The distribution of income at labour market equilibrium.

In the left-hand panel of Figure 8.18, 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, at which 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 there are no unemployment benefits, the unemployed people receive no income, 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-hand panel indicates that total output is divided up so that workers receive a 60% share and their employers receive the rest. In the right-hand 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.

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 in wages). The fraction of output received in wages, called the wage share in total income, s, is:

### When does inequality increase?

Therefore, the shaded area in the figure—and hence inequality measured by the Gini coefficient—will increase if:

• A larger fraction of the employees is without work (higher unemployment rate): The first kink shifts to the right.
• The real wage falls (or equivalently, the markup rises) and nothing else changes: The second kink shifts downwards.
• Productivity rises and nothing else changes (real wages do not rise): This implies that the markup rises, so again the second kink shifts downwards.

### More competition in markets for goods and services, lower inequality

What can change the level of employment and the distribution of income between profits and wages in equilibrium? Follow the analysis in Figure 8.19 to see what would happen if there were an increase in the degree of competition faced by firms, perhaps as a result of a fall in the barriers preventing firms from other countries competing in this economy’s markets.

The effect of an increase in the extent of competition faced by firms: The price-setting curve shifts upwards and inequality falls.

Figure 8.19 The effect of an increase in the extent of competition faced by firms: The price-setting curve shifts upwards and inequality falls.

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.

Figure 8.19a 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.

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.

Figure 8.19b 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.

A new, lower Gini coefficient

At the new equilibrium there is a higher wage and a higher level of employment. 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.

Figure 8.19c At the new equilibrium there is a higher wage and a higher level of employment. 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.

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—inequality falls.

### Question 8.8 Choose the correct answer(s)

Figure 8.18 is the Lorenz curve associated with a particular labour market equilibrium. In a population 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 coefficient 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
• A rise in the unemployment rate would shift the first kink of the Lorenz curve to the right. This shifts the curve downwards, increasing the Gini coefficient.
• A rise in the real wage would raise the second kink of the Lorenz curve. This shifts the curve upwards, decreasing the Gini coefficient.
• This implies a rise in the markup, or equivalently, a fall in the wage share in total income. This shifts the second kink of the Lorenz curve downwards, increasing the Gini coefficient.
• A rise in the degree of competition would raise the price-setting curve in the model of the labour market, resulting in higher employment and higher wage share. This shifts the first kink of the Lorenz curve to the left and the second kink upwards, reducing the Gini coefficient.

## 8.9 Labour unions: Bargained wages and the union voice effect

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.

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.1 A trade union (or labour 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.2

As you can see from Figure 8.20, the fraction of the workforce employed under collective bargaining agreements negotiated by labour unions varies greatly between 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 the HR department but instead is determined through a process of negotiation between a union representing workers and the firm’s HR department. 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 threat of going on strike

The reason is that the employer’s threat to dismiss the worker is now 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.

Therefore, the firm must agree to a wage that ensures that it will have the required work done to produce the goods or services on which its profits depend. This requires both that:

• The workers will provide sufficient effort when they come to work: The wage-setting curve determines this.
• The workers will come to work rather than go on strike: A bargained wage-setting curve will determine this.

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 determines how far 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 determinants of bargaining power depend on the laws and social norms 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.

To see the difference that a labour union can make, 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 as shown in Figure 8.21.

 The union sets the wage ⇨ The employer informs workers that insufficient work will result in job termination ⇨ Employees respond to the wage and the prospect of dismissal by choosing how hard to work

If the union set the wage.

Figure 8.21 If the union set the wage.

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 8.22). Use the analysis in Figure 8.22 to see what happens when the union, rather than the firm, sets the wage. To see the outcome for structural unemployment in the economy, see Figure 8.23.

If the union set the firm’s wage instead of the employer.

Figure 8.22 If the union set the firm’s wage instead of the employer.

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.

Figure 8.22a 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.

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 …

Figure 8.22b If the union sets the wage, it will be higher than that preferred by the employer, and effort levels correspondingly higher …

Higher effort but lower profits

… but profits would be lower (indicated by the flatter isocost line passing through C).

Figure 8.22c … but profits would be lower (indicated by the flatter isocost line passing through C).

As shown in Figure 8.22, 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 8.22 to the model of the labour market in Figure 8.23, 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.

The bargained wage-setting curve when there is union wage-setting.

Figure 8.23 The bargained wage-setting curve when there is union wage-setting.

### Unions in the model and in the data

Paradoxically, it seems from the model 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 8.24, unemployment does not seem to be 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 is 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.

Collective wage bargaining coverage and unemployment across the OECD.

Figure 8.24 Collective wage bargaining coverage and unemployment across the OECD.

Jelle Visser. 2015. ‘ICTWSS Data base. version 5.0.’. Amsterdam: Amsterdam Institute for Advanced Labour Studies AIAS. Updated October 2015.

Therefore, the fact that unions can push the wage-setting curve upwards to the new ‘bargained wage-setting curve’ must not be the entire story.

### A powerful union may choose restraint

One possible explanation is that a powerful union may choose not 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.

### The union voice effect

Unions differ in other ways.

Suppose that, over time, the employer and the trade union develop 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 over a higher wage, as a sign of goodwill.

As a result, the employees might identify more strongly with their firm and experience effort as less of a burden than before, shifting their best response curve upwards in Figure 8.25.

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 the Figure 8.25. 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.

The union sets the firm’s wage, and employees reciprocate.

Figure 8.25 The union sets the firm’s wage, and employees reciprocate.

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.

Figure 8.25a 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.

The employer recognizes a trade union

If the employees interpret the employer’s recognition of the trade union, and its willingness to compromise over a higher wage, as a sign of goodwill, the best response curve shifts upwards.

Figure 8.25b If the employees interpret the employer’s recognition of the trade union, and its willingness to compromise over a higher wage, as a sign of goodwill, the best response curve shifts upwards.

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.

Figure 8.25c 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.

### Unions may raise or lower structural unemployment

We have shown two effects of the presence of a labour union, which we can now represent in the labour market diagram:

• The union forces the firm to pay a wage greater than the minimum necessary to induce the employees to work: The bargaining curve is always above the wage-setting curve.
• The union provides employees with a voice in how decisions are made: This may lower the disutility of effort and therefore reduce the lowest wage necessary to motivate employees to work effectively.
union voice effect
The positive effect on labour effort (and hence labour productivity) of trade union members’ sense that they have a say (a voice) in how the firm is run.

The two effects are illustrated in Figure 8.26. In this figure, we show the case in which the equilibrium level of employment is higher and unemployment 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 downwards was greater than the bargaining effect that shifts the wage-setting curve upwards.

The bargained wage-setting curve and labour market equilibrium when there is a union voice effect.

Figure 8.26 The bargained wage-setting curve and labour market equilibrium when there is a union voice effect.

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 effect of unions would have been to reduce employment in the labour market equilibrium.

This provides a reason why the data in Figure 8.24 does not show any clear correlation (either positive or negative) between the extent of union contracts 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.

### Question 8.9 Choose the correct answer(s)

Figure 8.22 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 is always to increase unemployment.
• Under union wage-setting, the firm is still setting the wage that maximizes its profits.
• The isocost line is flatter through C than through A. This means that the firm receives less effort from workers for each dollar spent on wages. Therefore, the firm’s profit is lower at C.
• Due to the union effect, employees need to be paid a higher wage to work hard, compared to when there is no union. This shifts the wage-setting curve higher.
• If the employees reciprocate (for example, when they have a lower disutility of effort) and there is a ‘union voice effect’, this has an effect of shifting the wage-setting curve downwards. If this more than offsets the wage bargaining effect that shifts the wage-setting curve up, then there will be an overall decrease in unemployment.
• Unlike at A, at C the firm is not producing at the point of tangency between the isocost line and the best response curve. Therefore, it is no longer setting the profit-maximizing wage level.

### Question 8.10 Choose the correct answer(s)

Which of the following statements regarding labour unions and wage bargaining are correct?

• A labour union can set both the wage level and the employment level.
• The bargaining curve can be above or below the wage-setting curve.
• Unions may choose to restrain their use of bargaining power.
• The unions’ bargaining power comes from their ability to shut down firms.
• The unions cannot determine how many people the firm hires.
• The unions would not ask for a wage lower than the firms’ profit-maximizing level. Therefore, the bargaining curve is always above the wage-setting curve.
• Demanding too high a wage may squeeze profits sufficiently, leading the firm to close down or cut back on employment. Therefore, unions may choose to restrain their bargaining power.
• Shutting down firms does not help the workers. The unions’ bargaining power comes from their threat to ‘dismiss’ the employer (at least temporarily) by going on strike (withdrawing the employees’ labour from the firm).

## 8.10 Labour market policies to address unemployment and inequality

The objectives of labour market policies typically include reducing unemployment and raising wages (particularly of the least well off). Policies that shift the price-setting curve upwards reduce structural unemployment and raise the real wage; as we saw in Section 8.8, both of these outcomes reduce inequality.

### 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?

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 has not changed either—wages remain the same fraction of revenue. Therefore, since the firm’s output per worker has risen, real wages and the price-setting curve must also rise.

The outcome of an improvement in education and training is a fall in structural unemployment and a rise in 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. Therefore, 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 the price-setting curve upwards.

wage subsidy
A government payment either to firms or employees, to raise the wage received by workers or lower the wage costs paid by firms, with the objective of increasing hiring and workers’ incomes.

The outcome of a wage subsidy policy is a fall in structural unemployment and a rise in the real wage.

### Paying for labour market policies

The full effect of each of these policies should 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, we assume that the funds necessary for these programs could be raised without affecting the labour market.

## 8.11 Labour market policies: Shifting the Nash equilibrium

In Unit 3 you learned that many important economic actions cannot be simply enforced by the government. When the government decided to raise the tax rate to raise additional revenue for programs that improve the life chances of less well off children, it did not take account of the incentives it created for tax avoidance.

Two examples of important but ‘difficult to command’ economic activities are investing and working hard. Governments do not have the information or the legal authority to command wealthy individuals to use their financial resources to invest in new buildings, research, and equipment (other than in exceptional circumstances, such as wartime). Nor can governments command workers to work hard and well.

To understand why this can constrain policymakers, consider the case of the proposal to introduce an unemployment benefit. The aim of the policy is to improve the standard of living of the unemployed without increasing the unemployment rate. We assume that the government shifts its spending priorities in order to be able to finance the unemployment benefits.

### Unintended consequences

We begin by identifying the Nash equilibrium in the initial situation before the policy is introduced. In Figure 8.27, the economy is at the point marked N, where the wage- and price-setting curves intersect. This is a Nash equilibrium because neither a worker (employed or unemployed) nor a firm could be better off by setting a different wage or price, offering to work at a different wage, or hiring a different number of workers.

First, we look at the short-run impact of the policy using Figure 8.27.

• Initial equilibrium with no unemploment benefit: With no unemployment benefits, the Nash equilibrium is at point N.
• Voters succesfully demand an unemployment benefit: The workers—employed and unemployed—vote to elect a government that offers a new policy. Workers will receive it when they are out of work.
• The benefit raises the reservation option of employed workers: In the short run, this shifts the wage-setting curve upwards, so that employers now have to pay more to induce workers to work hard and well. This is shown by point C.

The policy has its intended effect—the unemployed receive a higher income, and employed workers’ wages have risen too, seemingly an unexpected feature of the policy. However, this unintended effect—raising wages—takes the economy away from its initial Nash equilibrium. We will see how the long-run effects can differ from the short-run effects.

Using the analysis in Figure 8.27, follow the logic of the model as the actors respond to the policy.

Introducing an unemployment benefit

Short- and long-run effects of introducing an unemployment benefit.

Figure 8.27 Short- and long-run effects of introducing an unemployment benefit.

The status quo

The Nash equilibrium is at point N. The new government introduces an unemployment benefit that workers will receive when out of work.

Figure 8.27a The Nash equilibrium is at point N. The new government introduces an unemployment benefit that workers will receive when out of work.

The unintended consequence

This raises the reservation option of employed workers, so that employers now have to pay more to induce workers to work hard and well. This is shown by point C.

Figure 8.27b This raises the reservation option of employed workers, so that employers now have to pay more to induce workers to work hard and well. This is shown by point C.

The result

The new Nash equilibrium is at N′, with higher unemployment.

Figure 8.27c The new Nash equilibrium is at N′, with higher unemployment.

We can summarize the impact of the policy:

• Short-run impact shifts the wage-setting curve upwards: The labour market shifts to point C.
• Long-run impact is higher unemployment: There is a new Nash equilibrium in the long run. The economy is at point N′. As intended, the unemployed now receive higher income when out of work. But fewer workers are employed, which was not intended.

### Unemployment benefits in the model and in the data

Surprisingly, when we look at the data, we find that countries with more generous unemployment benefits do not, on average, have higher unemployment rates. In Figure 8.28, for example, Sweden has quite generous unemployment benefits and a relatively low level of unemployment. The is even more the case for Norway, Denmark, and the Netherlands.

Unemployment benefit generosity and unemployment rates across the OECD (2001–2011).

Figure 8.28 Unemployment benefit generosity and unemployment rates across the OECD (2001–2011).

### Unemployment benefits, unions, and wage-setting in Sweden

This suggests that these countries were able to achieve a Nash equilibrium outcome different from either N or N′. Figure 8.29 shows how this may have happened—there is a third Nash equilibrium at N″, where a new higher price-setting curve intersects the post reform wage-setting curve.

Combining the introduction of an unemployment benefit with a solidarity wage policy to raise productivity in the economy.

Figure 8.29 Combining the introduction of an unemployment benefit with a solidarity wage policy to raise productivity in the economy.

The Swedish approach had its origins in the ‘solidarity wage policy’, devised in 1951 by Gösta Rehn and Rudolph Meidner, two economists who worked at the research institute of the Trade Union Confederation in Sweden.

They reasoned that workers and employers have a common interest in rapid productivity growth, and that workers could enjoy higher wages without the profits of firms being reduced if more of the economy’s output was prod­uced by high-productivity firms rather than by firms with low productivity.

In our ‘Economist in action’ video, John van Reenen uses the game of cricket to explain how the economy’s average productivity is affected by the survival of low productivity firms.

The solidarity wage policy in Sweden was actually three linked policies:

• Equal wages for equal work: This means that the wage for each job was set at the national level by negotiations between the employers’ association and the union. This had the effect of reducing wage differences among workers doing similar jobs. The lowest-productivity firms had survived by paying lower wages than other firms paid to equivalent workers. Under the new policy, these firms could not pay the negotiated wage and still remain profitable, so they had to exit the industry. Higher-productivity firms survived and took over the market share of the failed firms.
• Unemployment benefits: These were generous but were only available for a relatively short time.
• Active labour market policy: Retraining and mobility allowances helped displaced workers find new jobs.

The solidarity wage policy forced low-productivity firms out of the market. The remaining firms had higher productivity and could, therefore, maintain their profit margins at lower prices, pushing the price-setting curve upwards. Retraining and mobility allowances ensured that these high-productivity firms had access to a well-trained workforce, allowing them to cut costs and prices even further.

Figure 8.29 shows how this combination of policies results in a new equilibrium with higher real wages at N″, and without the rise in unemployment at N′.

### Question 8.11 Choose the correct answer(s)

Referring to Figure 8.29, which of the following statements are true?

• The upward shift in the wage-setting curve would have caused real wages to increase.
• Policies that shift the wage-setting curve without also changing the price-setting curve cannot increase real wages in equilibrium.
• The solidarity wage policy raises wages because it forces low productivity firms out of business.
• Increasing unemployment benefits (without a solidarity wage policy) made all workers worse off.
• Real wages would remain at the level they were before the policy was introduced and employment would decrease.
• The price-setting curve is horizontal; therefore, unless the price-setting curve moves up or down, any equilibrium will have real wages at the same level.
• Imposing a standard wage for the job through national wage negotiations led to firms with productivity levels below the new negotiated wage exiting the industry.
• Unemployment benefits offer valuable insurance to workers who could lose their jobs. While workers are clearly made worse off by the decrease in employment, they may still benefit overall from the policy.

## 8.12 Looking backward: Baristas and bread markets

We have devoted an entire unit to the labour market for two reasons:

• Its functioning is important to society: If the labour market works well, the economy better serves our interests.
• It does not function like markets for goods and services: It is essential to know the differences to understand how the economy as a whole works.

A good way to review these differences is to contrast the market for bread—used in the previous unit to illustrate the model of a competitive equilibrium of price-takers—with the market for, say, baristas (who, 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 (bread) 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 (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. Sellers 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. Instead, we saw that employers choose a wage to balance their wage costs against the positive effects of a higher wage 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; 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).

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, a buyer in the labour market is not throwing money away by paying more than is necessary to buy the employee’s time; it is the way that employers get what they want (work) and how they make profits. And because employers 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 7’s model of the competitive equilibrium of price-takers does not work in the labour market.

### Pareto efficiency and unexploited opportunities for mutual gains

Pareto efficient
An allocation with the property that there is no alternative technically feasible allocation in which at least one person would be better off, and nobody worse off.

In Unit 3, 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 games.

• We use the Nash equilibrium: This concept helps us predict what outcomes 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 the model used to illustrate the bread market in Unit 7 that there were no unexploited opportunities for mutual gain at the competitive equilibrium (where the demand and supply curves intersect). In this situation, it is not possible to make one of the buyers or sellers better off without making at least one of them worse off. Therefore, the outcome 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 outcome—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 workforce, 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 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 for both the unemployed worker and the employer. Therefore, the outcome (N*, w*) is Pareto inefficient.

### Why not hire a worker who is prepared to take a lower wage?

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 economically 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 they work rather than shirk.

The problem, therefore, goes back to a fundamental fact about the relationship 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 he does not know the name of his 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 his personality, loyalty to the brand, and his respect for social norms—such as honesty and hard work—influence the quality and quantity of effort that he 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 he will comply with her orders. Because the barista receives an employment rent that he would lose if the supervisor were to dismiss him, the supervisor can exercise power over him, getting him to do things that he 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 yields benefits virtually identical to the next best alternative. When both can walk away at virtually no cost, 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 8.30 summarizes the differences.

Market Bread: a market clearing equilibrium of price takers Baristas: wage-setting by employers and equilibrium unemployment
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.

Differences between the labour market and competitive goods markets.

Figure 8.30 Differences between the labour market and competitive goods markets.

### Question 8.12 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.
• In a competitive goods market, if what you buy is not what is advertised, then you can pursue the seller in court to ensure that the contract is fulfilled. In a labour market, the contract is for the employee’s work time, and not for the work (or the effort) itself, and therefore it is incomplete.
• In a competitive goods market, individual buyers cannot bargain for a lower price than others are willing to pay. Therefore, they are price takers. In the labour market, the firms set the wage to minimize the cost of getting the worker to work; firms would not benefit by offering the lowest wage at which the worker (the seller) would accept the job. Hence, firms are price setters.
• In a competitive goods market, the buyer’s next best alternative is to buy at another shop, while the seller’s next best alternative is to sell to another customer. Neither party is any worse off from leaving and, therefore, neither receives economic rents. In contrast, in the labour market the sellers (the employees) are worse off in their alternative of being unemployed. Hence, they receive employment rents.
• In goods markets, contracts are enforced, if necessary, by courts and not by norms. On the other hand, in labour markets the employees’ work ethic and/or feelings of reciprocity towards their employer affect their productivity on the job.

## 8.13 Conclusion

Labour market statistics such as the participation rate, the employment rate and the unemployment rate vary over time and among countries. This unit has looked at the various factors that affect how labour markets work to help explain these differences.

To our economic toolkit we have added a labour market model. It incorporates both the labour discipline model, in which employers set wages to induce workers to exert effort, and the model in which firms set prices for differentiated products.

Wage-setting (WS) curve Price-setting (PS) curve
The WS curve indicates the minimum wage level required to make employees work rather than shirk.

It slopes upwards—higher wages are associated with low unemployment.

It is derived from the wage-setting decision by varying the unemployment rate and tracking how the chosen wage changes as the best response curve shifts.
The PS curve gives the real wage that is the outcome of the price-setting decisions of profit-maximizing firms.

It is a horizontal line, the position of which reflects certain features of the goods market.

It is derived from the fact that firms set prices as a markup over marginal cost, and it therefore indicates the portion of the average product of labour that workers get.
The WS curve shifts downwards if:

- unemployment benefits decrease
- disutility of working decreases
- social stigma of unemployment increases
- technology lowers the cost of monitoring the worker’s effort

Note that all these factors affect the employee’s employment rent.
The PS curve shifts downwards if:

- labour productivity decreases
- the markup increases as the result of demand becoming more inelastic and markets being less competitive

Note that the real wage does not change if the nominal wage changes— prices are adjusted accordingly, given the markup.
The equilibrium unemployment rate is determined by the intersection of WS and PS curves. In labour market equilibrium there is always involuntary unemployment, called structural unemployment. The outcome is Pareto inefficient due to incomplete contracts.

Trade unions can have different effects depending on size, bargaining power and behaviour:

• Bargained wage effect: How far the bargained WS curve lies above the employer-set curve depends on unions’ relative bargaining power, which is also influenced by laws and social norms.
• Union voice effect: The reciprocation of worker-friendly policies that reduce the disutility of effort shifts the best response curve as workers exert more effort.
• Labour productivity effect: By fostering a cooperative culture with management and encouraging productivity improvements unions can shift the PS curve.

Labour market policies that increase the real wage and lower structural unemployment reduce inequality. For example, education and training, as well as wage subsidies, shift the PS curve upwards. To avoid unintended effects of proposed policies, we must keep in mind how people will respond to the policy, and hence any effect on the Nash equilibrium of the labour market.

## 8.14 Doing Economics: Measuring the non-monetary cost of unemployment

In Section 8.5, we explained why there will always be involuntary unemploy­ment in labour market equilibrium, in order to create an employment rent that motivates employed workers. The employment rent takes into account both monetary and non-monetary costs and benefits, such as social status from being employed. On the other hand, being unemployed may be psychologically as well as financially detrimental because of the stress of looking for a new job, as well as social norms and expectations regarding work.

In Doing Economics Empirical Project 8, we will use self-reported well­being to measure the disutility from unemployment, and see whether social norms can explain any differences in wellbeing between the employed and unemployed in European countries.

Go to Doing Economics Empirical Project 8 to work on this project.

### Learning objectives

In this project you will:

• practise working with fairly large datasets
• detect and correct entries in a dataset
• recode variables to make them easier to analyse
• calculate percentiles for subsets of the data
• calculate confidence intervals for the difference in mean between groups.
participation rate
The ratio of the number of people in the labour force to the population of working age. See also: labour force, population of working age.
employment rate
The ratio of the number of employed to the population of working age. See also: population of working age.
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.
labour discipline model
A model that explains how employers set wages so that employees receive an economic rent (called employment rent), which provides workers an incentive to work hard in order to avoid job termination. See also: employment rent, efficiency wages.
differentiated product
A product produced by a single firm that has some unique characteristics compared to similar products of other firms.
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.
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.
worker’s best response function (to wage)
The optimal amount of work that a worker chooses to perform for each wage that the employer may offer.
price markup
The price minus the marginal cost divided by the price. It is inversely proportional to the elasticity of demand for this good.
marginal cost
The cost of producing one additional unit of output.
average product
Total output divided by a particular input, for example per worker (divided by the number of workers) or per worker per hour (total output divided by the total number of hours of labour put in).
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.
nominal wage
The actual amount received in payment for work, in a particular currency. Also known as: money wage. See also: real wage.
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.
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.
unemployment, involuntary
The state of being out of work, but pre­ferring to have a job at the wages and working conditions that other­wise identical employed workers have. See also: unemployment.
structural unemployment
The level of unemployment at the Nash equilibrium of the labour market model.
Pareto inefficient
An allocation with the property that there is some alternative technically feasible allocation in which at least one person would be better off, and nobody worse off.
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).