5.2 Demand and Supply in the Labour Market

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1 Summary - Chapter 5 Labour Markets and Unemployment 5.2 Demand and Supply in the Labour Market Labour Supply and the Consumption Leisure Trade-off - The consumption leisure trade-off is the fundamental determinant of the labour supply decision: In order to consume, we need income and therefore we need to work, which means giving up leisure time - Indifference curves are graphic representations of all possible combinations of two items what will yield equivalent utility (satisfaction) [Indifference curves in microeconomics summary] - The marginal rate of substitution is the rate at which one commodity can be substituted for another without changing the level of utility - The price of leisure is an opportunity cost - The real (consumption) wage is the ratio of nominal wages to the consumer price index; a measure of the price of leisure (or the return to work) in terms of consumption - The equation of the budget constraint of a worker with all possible combinations of leisure and consumption can be written as: where w = W(wage)/C(consumer price index), C is consumption and l is leisure - The negative slope of the budget line (-w) measures the trade-off of consumption for leisure offered by the market - The real wage is often referred to as the relative price of leisure in terms of consumption - The relative price is the price of one good in terms of another, usually computed as the ratio of two nominal prices Optimal choice and the individual labour supply schedule - As real wage rises, the relative attractiveness of leisure declines - The substitution effect is the component of the total change quantity demanded that is attributable to the change in relative prices - The income effect is the portion of change in quantity demanded which is attributed to the change in real income that results from the price change - The household labour supply curve shows the number of hours a household is willing to work as a function of the wage per hour - The response by households to rising wages varies widely across individuals, depending on tastes, family circumstances, age and others - Labour force participation rate defines the proportion of working-age people who are in the labour force The aggregate labour supply curve - In most instances, individuals cannot vary the hours of work that they supply - The aggregate labour supply is the sum of many individual decisions (to work or not to work, how long to work etc) - Aggregate supply is measured in person-hours, the total amount of time supplied by all workers during a period of time Labour Demand, Productivity, and Real Wages

2 The labour demand curve and its slope - Holding capital constant, we can express the link between output (Y) and employment (L) using the production function - The production function measures the marginal productivity of labour (MLP) - The marginal productivity of labour shows the additional output produced by employing an additional unit of labour in the production process - Graphically, the profit of a firm is highest at a point where the slope of the production function is parallel to the line wl which measures labour cost line - Profit maximising firms hire additional labour hours as long as their MPL exceeds the wage - the labour demand curve shows the relationship between linking the number of man-hours that firms wish to hire and the cost of labour - If small changes in the wage will lead to large responses in the demand for labour, we call the labour demand curve elastic. It is inelastic if the demand curve for labour is nearly unresponsive for changes in the wage Shifts in the demand for labour - One reason for a shift in the labour demand curve is a change in the capital stock, which is exogenous - An increase in the capital stock tends to make additional labour more productive, whereas a reduction in the capital stock will cause the labour demand curve to shift inwards (i.e. reduction in labour) - In the case for labour-saving technical progress, it is possible for capital to increase, and labour to decrease Labour Market Equilibrium - In the long run, an increase in the supply of labour is eventually matched by an increase in the stock of productive capital and no reduction in real wages The Interpretation of Unemployment - If represents the potential labour supply and L is the actual employment, then is simply the unemployment rate - Voluntary unemployment includes those who do not wish to work at the current wage level - Voluntary unemployment is likely among low-skilled people who cannot earn much or in countries where taxes are so high that working yields little net gain 5.3 A Static Interpretation of Unemployment - Denoting the labour force by, gives the formula: - The unemployment rate u is the fraction of the labour force which is out of work, Involuntary Unemployment and Real Wage Adjustment - Involuntary unemployment includes those who wish to work at the current wage level but cannot find a job - The existence of involuntary unemployment must be explained by real wage rigidity - Real wage rigidity is rigidity arising when unemployment fails to cause real wages to decline

3 5.3.2 Collective Bargaining and Real Wage Rigidity - There are many reasons why wages do not adjust at all or only do so very slowly - Labour market institutions are formal and informal arrangements that regulate wage negotiations, working hours, health safety regulations, workers influence, etc. - Labour (or trade) unions are organizations of workers formed for the purpose of taking collective action against their employers to obtain improvements of pay and other working conditions - Trade unions exist because workers have less ability to influence working conditions than collectively - Employers associations are organizations of employers which represent their interests, especially in collective bargaining - The bargaining between trade unions and employers associations causes voluntary unemployment for trade unions, which might in fact, be involuntary for the households The rationale for labour unions - The influence of unions is usually much stronger than expected The economics of labour unions - Two economic objectives motivate unions, higher real wages and more jobs - Unions try to get to the highest indifference curve they can in order to see maximum satisfaction in terms of wages and employment - The collective labour supply curve is the link between the amount of man-hours that workers supply collectively (via wage negotiations or through their unions) and the real wage - The curve of the collective labour supply curve reflects the preferences of the union for employment and wages as well as its economic environment Employment effects of collective bargaining - As unions have a stronger bargaining power, their aim is to achieve better outcomes that workers alone - As unions set wages above the equilibrium point, jobs will be lost, and the unemployment figure will be which is involuntary for the union, but involuntary for the individuals affected - Some unions prefer higher wages for some, over jobs for others, as they are controlled by insiders, workers who are already employed in long-term employment relationships with job security - Outsiders are those who are affected by increased unemployment, these workers tend to give up their memberships in trade unions Social Minima and Real Wage Rigidity - Several other factors can also contribute to wage rigidity, and therefore involuntary unemployment - Minimum wages are lower bounds set on wage rates that may be paid to workers usually but not always by law - Even in countries without a legal minimum wage, it is frequently the case that collective agreements are extended to uncovered workers with the characteristics of minimum wages - The result of an effective minimum is employment equal to and unemployment equal to Efficiency Wages and Real Wage Rigidity - Often real wages do not decline in case of involuntary unemployment due to efficiency wages, wages paid in excess of the marginal productivity of labour in order to induce sufficient effort on the

4 part of the workers - In industries where the workforce has to be highly skilled and the work has to be of high quality, it is common to pay efficiency wages, to reduce labour turnover 5.4 A Dynamic Interpretation of Unemployment Labour Market States and Transitions - Labour markets are remarkably dynamic - There are three ways of becoming unemployed 1. Newly joining the labour market before finding a job, and are initially unsuccessful 2. Voluntary separations (quits, being laid-off, plant closures, etc.) can lead to unemployment. Workers either find a new job immediately, or leave the labour force for other reasons 3. Involuntary separations, or job losers, tend to flow into unemployment. These can result from unanticipated redundancies, or termination of contracts Stock, Flows, and Equilibrium Unemployment - The more efficient the labour markets are, the more quickly people can get back into employment - Equilibrium unemployment depends on the number of job separations and the number of vacancies - The separation rate (s) is the rate at which employed workers (L) become unemployed per unit of time - The job finding rate (f) is the rate at which unemployed workers find a job, calculated as a ratio of job finds (per month of per year to total unemployment (U) - The change in unemployment is given by: - The equilibrium unemployment rate (u) is the unemployment rate that occurs when employment and unemployment stabilize, i.e. when aggregate demand for labour is met by aggregate supply. Because labour supply may not perfectly reflect individuals preferences, this unemployment may in part be involuntary (structural unemployment) but it may also reflect the efficiency of the labour market (frictional unemployment). It s formula is: where s is the probability of losing their job when currently employed, and f as the probability of being unemployed and finding a job Job Separation and the Incidence of Unemployment - The separation rare s is a measure of the incidence of unemployment - Specific labour force groups that exhibit higher separation rates of inflow into unemployment tend to have higher unemployment rates Job Finding and the Duration of Unemployment - Like s, the job finding rate f has cyclical and structural components - Unemployment benefits is financial assistance to those seeking a job but unable to find suitable employment

5 - Unemployment benefits can act as a disincentive for looking for a job or as an incentive for being chosier 5.5 The Equilibrium Rate of Unemployment The Concept - High rates of involuntary unemployment show that labour markets are not working effectively - Equilibrium unemployment corresponds to the situation where the wage matches the collective preference of workers but leave some individuals without jobs - Frictional unemployment describes unemployment resulting from individuals changing jobs or entering the labour force - The rate of frictional unemployment depends on the efficiency of the labour market. It is part voluntary and part involuntary - Structural unemployment is unemployment arising as the result of a mismatch of demand and supply for labour - Parts of structural unemployment are also made up by involuntary unemployment as they would accept the current wages, but cannot find a job in their occupation The European Experience - Historic evidence suggests that the biggest problem for economies is not net safety itself, but the disincentives it can generate Actual and Equilibrium Unemployment - It can take many years for real wages to adjust to their long-run values - Actual employment is below and actual unemployment is above equilibrium when the real wage is above the equilibrium level

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