Unit 9 - 'The labor market, wages, profit, and 
unemployment'. One of the very important markets

that we need to understand as economists is the 
job market, the labor market. What determines the

real wages in an economy? What determines the 
level of employment in a country? In order to

understand that we first need to understand what's 
going on at the level of firms, what factors

determine the wage that the firms offer to their 
workers or the number of workers that they decide

to hire. In order to understand what's going on 
at the firm level, we are going to do a role play

today with two actors: me, Ramin as the marketing 
manager, and Giacomo as the HR manager. So

Giacomo, what do you do as an HR manager? GIACOMO: 
As an HR manager, my job is to set the nominal

wage of my workers to ensure that they turn up to 
work and that they put in adequate effort in their

job. And then I communicate this nominal wage to 
you in the marketing department. RAMIN: Very good.

So once Giacomo, the HR manager, sets the nominal 
wage and communicates it to me, I need to find out

the price and the quantity that maximise 
our profit. I'll study the market and see

that given the wage level, what's the 
price that could maximise our profit?

So in order to understand the labor market we 
need to understand these two steps. Step one:

Giacomo, the HR manager, setting the nominal wage. 
Step two: me, the marketing manager, setting the

price and the quantity on the basis of the nominal 
wage that the HR manager gives to me. So from now

we're going to talk about each of these steps in 
more detail. Let's start with the first step and

for that we go to 9.3: 'The weight setting curve: 
employment and real wages'. Let me scroll down.

Now Giacomo, as an HR manager, can you explain the 
way you set wages for the workers? GIACOMO: Sure,

sure, it's interesting. So the way I set the 
nominal wage for my workers is: first of all,

I assume that the prices in the economy 
are given. I take them as they are.

Then I look at these curves, the ones in the 
upper graph, as you can see - you can see that

these curves tell you basically that as I 
offer a higher nominal wage to my workers,

they will put in a higher level of effort. Now it 
is important to notice that there are different

curves for different levels of unemployment 
and the way I- the reason why I care about

this is that at different levels of unemployment 
workers will have different incentives basically

to work for me. So, for example, at a level 
of unemployment of 12% I will have to offer

them a nominal wage w_L as shown on the graph to 
ensure that they turn up to work and that they

do not shirk, that they put in adequate effort, 
right? But then, if you look at the curve that

shows the situation when unemployment decreases 
to just 5%, the worker's incentives change because

now the worker clearly knows that they can 
easily find another job if I, for some reason,

don't hire them. So I need to offer them 
a higher nominal wage - so, in this case,

w_H, to ensure that they turn up to work, they do 
not shirk, so that they put in adequate effort.

So this is what I do in my firm. Then I mean, 
you can imagine that there're different 'me's',

there are different firms in the economy and there 
are different people that do my same job, so if

you imagine that this process is repeated across 
the whole economy and you aggregate the decisions

that we all do, you obtain the curve that is shown 
in the graph below - that is the wage setting

curve, that shows the real wage that workers 
will be paid at different levels of unemployment,

all else equal, which will make sure that they 
turn up to work and that they do not shirk - so

that they put in adequate effort. And clearly as 
you can see, for the reason that I've explained

previously, as the level of unemployment 
decreases, the real wage that

is consistent with the workers turning 
up and putting in effort has to increase.

So this is in essence the meaning of these two 
graphs. RAMIN: So that was step one: the HR  

manager setting the nominal wage. Step two begins 
when Giacomo communicates that wage to me and I'll

take it from there and in order to understand 
step two, we need to scroll down and go to 9.4:

'The firm's hiring decision'. So Giacomo, the 
HR manager, communicates the nominal wage to me

and this is our only cost of production. Why? 
Because we are assuming our firm only relies

on workers for its production. We're making 
another assumption as well: that each worker

produces one unit of output per hour and as we 
add more and more workers to our production,

their productivity remains the same. In other 
words, the marginal cost and the average cost

of our firm is the same as the nominal wage - 
just for simplification. Let's continue. So,

Giacomo communicates the nominal wage to 
me. As a marketing manager, now my job is to

basically find the price and the quantity that 
maximise our profit given this nominal wage.

And how do I find that price and quantity? I 
need to study the market. I need to study the

demand curve and that demand curve is determined 
by the level of competition that we're facing,

the elasticity of the demand curve 
and once I've studied the market,

I've realised that at this price and this 
quantity our firm maximises its profit

given this nominal wage. So I end up setting 
this price and this will be our markup - the  

difference between the nominal wage, our 
main cost, and the price that we're charging.

This was all happening at the level of one firm. 
Let's aggregate. Let's imagine all the marketing

managers doing the same thing. Let's multiply me 
as the marketing managers. Now we get something

very interesting. We get a price setting real 
wage out of these two nominal variables here:

the nominal price we're charging our 
product and the nominal wage that we are

offering to our workers. We get the price setting 
real wage and that real wage is consistent  

with a situation where all firms across the 
economy are maximising their profit. So let's  

go and look at this aggregate curve or aggregate 
line and for that we go to 9.5: 'The price setting

curve: wages and profit in the whole economy'. 
If we scroll down, we get this aggregate curve.

On the x-axis we've got the overall level of 
employment in the economy and on the y-axis we

get the real wage and here we got a price setting 
real wage: this is the real wage that emerges in

an economy when all firms set their price in a way 
that maximises profit for the shareholders, given

the nominal wage. So this is the real wage that is 
consistent with all firms maximising their profit.

This line also communicates another important 
thing for us. Let me explain. This is the

average labor productivity: how much each worker 
produces per hour in real terms - real output.

We know that some of that output goes to the 
workers themselves, the rest of it goes to

the shareholders. This is the part that goes to 
the workers. We call that 'real wage per worker'

and the rest of the difference goes to the 
shareholders. We call that 'real profit per

worker'. So, just to summarise, the second bit 
- the price setting curve - communicates to us

the real wage that maximises profit for 
the shareholders across firms. So far,

in step one, we talked about the real wage that 
keeps the workers motivated and step two we talked

about the real wage that maximises profit for 
the shareholders. Now, equilibrium in the labour

market emerges when these two real wages match 
each other. So that's what we're going to look at

in the next part: the equilibrium in the labour 
market. So let's scroll down, 9.6: 'Wages, profit,

and unemployment in the economy as a whole'. The 
labor market reaches to the equilibrium level of

employment when the real wage that keeps the 
workers motivated matches the real wage that

maximises profit for the shareholders and this 
is represented in this graph. This curve is a

wage setting curve: the real wage that keeps the 
workers motivated, and this line represents the

price setting real wage - the real wage that is 
consistent with all firms maximizing profit. And

we reach to the equilibrium level of 
employment when these two real wages

match each other and this equilibrium level of 
employment is represented by X in this graph.

Now I'm going to explain to 
you that whenever our economy

deviates from this level of employment, 
it's going to come back to it after a while.

Let me explain. Let's assume that for whatever 
reason, our economy experiences a negative shock.

For whatever reason, people start to consume less 
goods, firms start to produce less, therefore

they start to reduce the number of people that 
they're employing, so the economy as a whole

falls below the X level of employment. Now 
what's going to happen next Giacomo? GIACOMO:

So what happens next is that I keep an eye on 
the wage setting curve - remember that's what

I keep looking at when I do my job, and I realise 
that as unemployment has increased, now workers'

incentive to be motivated to work has changed. Now 
it's going to be tougher actually for them to find

a new job were they to lose the current one, so 
this way, when they work for me, basically they're

earning a high employment rent. So I realise that 
I can actually keep them motivated and I can keep

them to work adequately for me at a lower nominal 
wage, so I will decide to set a nominal lower wage

and I communicate this decision to you in the 
marketing department. RAMIN: Now, once Giacomo

lets me know that we are paying less wage - we've 
lowered the nominal wage, I realise that actually,

as a marketing manager, I can also reduce 
prices and at the same time keep the markup

the same - keep the share of output that is 
going to the shareholders the same. And now,

by reducing the prices, I stimulate demand for our 
goods, so therefore we start to produce more and

we start to employ more people and as all firms in 
the economy do the same, they slash their prices

and start to boost demand, the economy overall 
starts to get back to the X level of employment.

Now let's think of the opposite case. Let's assume 
that our economy experiences a positive shock:

for whatever reason, people start to consume more. 
The firms start to produce more, and we start to

go beyond the X level of employment. What's going 
to happen next Giacomo? GIACOMO: I will still look

at the wage setting curve and at this high level 
of employment, I actually realise that I'm under

a bit of pressure, because now workers can quite 
easily find a new job were they to lose their

current job. So I need to keep them motivated - I 
need to have them put in adequate effort at their

current job and I can do so only by increasing 
the nominal wage that I pay them. So I decide to

increase the nominal wage that I pay them to keep 
them motivated and I communicate this decision to

you in the marketing department. RAMIN: And once 
you let me know that we increase the nominal

wages for the labour, I say that we can 
actually increase our nominal prices

that we're charging for our goods and keep 
the mark-up the same as before, and now by

charging higher prices I know I'm going to sell 
less, but overall we're gonna make more profit,

so I'm going to increase nominal prices 
and as all firms do the same thing,

they start to produce less but make more 
profit, but employ less people. So overall,

if we aggregate- if all the firms do the 
same thing, the economy is going to head

back to the X level of employment. Now, what I 
described to you was that whenever our economy

deviates from the X level of employment, 
the adjustments in nominal prices direct

the economy back to that level. For instance, 
if you go below the X level of employment,

the downward pressure in prices pushes 
the economy back to the next level of

employment. If you go above the X level of 
employment, the upward pressure on prices directs

the economy back to the next level of employment. 
And we're going to talk more about these things in

Unit 15, when we are discussing 
inflation in the macroeconomy.