Advanced Macroeconomics: Lecture 5 - AS 1 Wage Setting Flashcards
Key phenomenon we want to understand in the AS block?
Unemployment.
Tell me more about unemployment
A common feature of capitalist economies
Very costly economically AND damaging to well-being
What causes unemployment?
- Wage (and price) pressures
- Insufficient demand for labour from firms
Real Wages
W/P
That is, wages / prices
So wages adjusted for price levels in the economy
Recap of the WS-PS model
Four lines:
- WS curve, upward sloping
- PS curve, flat horizontal
- Employment equilibrium (Ne) curve - vertical line that goes through the intersection of WS & PS
- L-curve - vertical line out on the right of the diagram
WS-PS model: Wage setting curve (WS)
Upward sloping curve labelled WS
We assume imperfect competition in the labour market which makes the real wage at which workers are willing to supply labour higher than that of the individual labour supply (Ns)
What is that imperfect competition in the labour market?
- Unions –> Give workers power to bargain for higher wages
- Efficiency wages –> Real wages above Ns to ensure maximum effort from workers
WS-PS model: Price setting curve (PS)
Horizontal line labelled PS
We assume imperfect competition in the goods market, so firms are price-makers and they set prices as a constant mark-up over their MC.
WS-PS model: The two vertical lines (Ne & L)
Ne = Employment equilibrium
Goes through intersection of WS & PS
Ue = L - Ne = Unemployment equilibrium (or NAIRU)
Horizontal distance between Ne and L
L = total labour supply
What are the 2 wage-setting models we are looking at?
- Monopoly union
- Efficiency wages
What are the 5 ASSUMPTIONS of wage-setting model 1: (Monopoly) Union
Assumptions of the (monopoly) union model:
- Workers negotiate nominal wages (W) once a year during “wage round” based on real wages (W/P)… Actually, EXPECTED real wages (W/Pe)
- Workers bargain NOMINAL wages (W), but labour supply (Ns) depends positively on REAL wages (W/P)
- Workers can UNIONIZE to negotiate nominal wages as a collective, with more bargaining power. Threat of strike. Thus Ws curve is higher than Ns curve. Whenn unionized, workers can get paid more than their individual labour supply (Ns)
- There is a SINGLE or MONOPOLY union, not multiple. This union sets the nominal wages (Wi), in industry i, to achieve a certain real wage. wi = Wi/P. Where wi = real wage in sector, Wi = nominal wage in sector, P = price levels in economy.
- Union chooses real wage that maximizes utility of representative worker subject to industry labour demand. Hence, the union labour problem (has it’s own flashcard).
What are the 2 main reasons that WS (Wage Setting) curve higher than Ns (Individual labour supply) curve?
- Monopoly union - Each sector has ONE union that can bargain for higher nominal wages and threaten to strike. Gets them more bargaining power as a collective.
- Efficiency wages - firms pay more (WS) than they necessarily have to (Ns) to ensure maximum effort from workers and avoid shirking.
Union Labour Problem
2 Efficiency Wages Models
- Shirking model:
Firms cannot closely monitor individual workers activity levels, so they pay above Ns (that is, WS) to ensure maximum effort and no shirking. A higher wage (WS) increases the opportunity cost for workers of losing their job.
- Fair wage-effort hypothesis:
Workers can “restrict effort” (i.e. be lazy) if they feel that they are not being fairly treated. So again, firms set real wages above Ns to ensure maximum effort.
What are the 8 ASSUMPTIONS of wage-setting model 2: Efficiency Wages Shirking Model
- Firms cannot (accurately) monitor workers effort (E) or productivity (imperfect information about effort)
- Firms desired or optimal effort is E > E-bar. Where E-bar is the minimal amount of effort required to not be fired.
- Work is unpleasant, there is a disutility of work: a > 0.
- Workers effort depends POSITIVELY on real wages and NEGATIVELY on employment. Positively on wages, because they work harder when they are paid more. Negatively on employment, because when employment increases, economy is in a state to hire, they don’t need their current job as badly.
Therefore, effort (E) is a function of wages, employment, and some other things, or: E = E(w, N, …)
Firms use unemployment threat and higher wages to motivate workers and ensure that E > E-bar
- To simplify, there are only two levels of effort:
E = 0 —> No effort, worker “shirks” —> a = 0, no disutility AS THEY ARE NOT WORKING.
E = E-bar —> Minimum effort to avoid being fired, “no shirking” —> a > 0, there is some disutility as they are actually working
Hence, workers utility of non-shirking is: Vns = w - a
That is, the value of NOT shirking is the difference between the utility of their wage and the disutility of working.
- Monitoring technology:
Identifies worker (E = 0) with probability 0 < T < 1 –> Fired immediately
Doesn’t identify worker (E = 0) with probability (1 - T) –> Not fired, continue earning wage (W)
- Outside the firm, fired worker…
Find equivalent job with probability 0 < H < 1 –> Earn W
Don’t find equivalent job with probability (1 - H) –> Receive benefits (B) where 0 < B < W
If we treat unemployment rate (u) as probability of not finding a job then u = (1 - H)
Hence, WORKERS UTILITY OF SHIRKING IS:
Vs = (1 - T)W + T[HW + (1 - H)b]
Where:
(1 - T)W = Probability of not being caught shirking x wage they keep if not caught shirking
T[HW + (1 - H)b] = Out of work income x probability of being caught shirking
(T = prob. caught)
(HW = equivalent job income x prob. job)
(1 - H)b = prob. unemployed x benefits
- To simplify, we view being caught (or not being caught) shirking as a one-off game. That is to say, workers choose their level of effort for the entire time. Either they always shirk or they always DON’T shirk.
Workers utility of NOT shirking
Workers utility/value of NOT shirking is Vns = w - a
Where:
w = wage
a = disutility of working
That is, value of not shirking = difference between utility of wage and disutility of working
Efficiency Wages - Shirking Model: WS curve
Firms want to set lowest wages (w) that max effort (E > E-bar). They are looking for the minimum cost of an efficient “unit” of labour. Thus, the efficiency wages model:
Vns = Vs
Becomes
w - a = (1 - T)w + T[HW + (1 - H)b]
Isolate for W (see pic)
And we get W^WS = b + (a/tu)… the optimal wage equation for firms.
What does the optimal wage equation tell us about the WS-curve?
Wage setting model 3: Efficiency Wages - Fair wage-effort hypothesis (FWH)
Behavioural approach to WS curve, draws on psychology and sociology.
Fair wage-effort hypothesis suggests for workers, effort (E) depends on how their pay (W) compares to what they judge to be a fair wage.
A fair wage depends on what OTHERS are paid (W*). Relative.
So, unnecessary maths way to write this:
E = min(W/W*,1)
If W = W*, then the min of the two inputs is 1. Thus E = 1… normal effort.
If W* > W, then the fraction becomes smaller than 1, so the fraction is the min of the two inputs. In this case, E < 1… there is a withdrawal of effort from the worker as they perceive their wage to be relatively worse than others.
Thus it is in the interest of firms to pay wages above Ns to show workers they are paid a fair wage and ensure E = 1. “The fair wage constraint.”
Wage-setting and Unemployment
What do these wage-setting models tell us about unemployment?
