The labour market and unemployment Flashcards
What are the three determinants of profits in this simplified labour market model?
Nominal wage (actual wage paid in currency).
Price of goods sold.
Average output per worker per hour (productivity).
Why must firms pay above-reservation wages?
To create employment rent, ensuring workers:
Fear job loss → work hard.
Accept the job over unemployment (cost of job loss > 0).
How does high employment in the economy affect wages?
Workers can easily find jobs if fired → weaker incentives.
Firms must pay higher wages to motivate effort (shifts wage-setting curve up).
What trade-off do firms face when setting prices?
Higher price: More profit per unit but lower sales (due to demand curve).
Lower price: More sales but less profit per unit.
Goal: Choose markup that maximizes profits (balances these effects)
What is the real wage, and how is it determined?
Real wage = Nominal wage ÷ Price level.
Depends on:
Wages set by firms.
Prices charged by firms.
What is the wage-setting curve?
Shows the real wage needed at each employment level to:
Incentivize worker effort (via employment rent).
Downward-sloping: Higher employment → higher wages needed (easier to find jobs).
What is the price-setting curve?
Shows the real wage firms actually pay when they:
Set profit-maximizing prices (markup over costs).
Hire workers based on productivity.
Typically horizontal: Real wage is stable if markup and productivity are constant.
How do the wage-setting and price-setting curves determine equilibrium?
Intersection of the two curves gives:
Equilibrium real wage.
Equilibrium employment level.
Unemployment exists if employment < labour force.
Why is there involuntary unemployment in equilibrium?
Firms won’t lower wages below wage-setting curve (would kill effort).
Price-setting curve limits jobs firms can profitably offer.
Result: Some workers can’t find jobs even if willing to work at current wages.
What are the key components of the labour market diagram?
Labour force: Vertical line (rightmost), shows working-age population participating.
Employment rate: Vertical line (left of labour force), shows actual employed workers.
Unemployment rate: Gap between employment and labour force lines.
Inactive workers: To the right of the labour force (not seeking work).
Why is the wage-setting curve upward-sloping?
Low unemployment (e.g., 5%): Workers have bargaining power → need higher wages to incentivize effort (reservation wage rises).
High unemployment (e.g., 12%): Workers fear job loss → accept lower wages (reservation wage falls).
How does unemployment rate shift the best response curve?
Higher unemployment (12%): Shifts curve LEFT (lower reservation wage, e.g., point F).
Lower unemployment (5%): Shifts curve RIGHT (higher reservation wage, e.g., point B).
What is the Nash equilibrium wage?
The wage W at employment rate X where:
Employers maximize profits (set optimal wage).
Workers provide effort (best response to wage).
How does the simplified model (work/shirk) represent effort?
Working: Provides firm’s required effort (like machine “on”).
Shirking: Zero effort (machine “off”).
Wage-setting curve: Boundary between work (above curve) and shirk (below curve).
What shifts the wage-setting curve DOWN?
Lower unemployment benefits: Reduces reservation wage.
Better monitoring: Raises fear of being caught shirking.
Reduced disutility of work: Effort becomes less costly.
Why does higher unemployment weaken worker bargaining power?
Longer job search if fired → lower reservation wage.
Firms can pay lower wages to maintain effort (employment rent still effective).
Compare Point A (12% unemployment) and Point B (5%) in the diagram
Point A: Low wage (workers desperate, high effort).
Point B: High wage (workers secure, need incentive to work).
In the simplified firm model, what determines output and hiring decisions?
Output depends on sales, which depends on price (demand curve).
Hiring depends on output (1 worker-hour = 1 unit output).
Profit-maximizing choice: Point where demand curve is tangent to highest isoprofit curve (Point B).
What is the slope of the isoprofit curve, and what does it represent?
Slope = (P - W) / q = Marginal rate of substitution.
Shows trade-off between price and quantity for constant profit.
How does the markup affect the division of revenue?
Markup = (P - W)/P = 1 - (W/P).
Higher markup (less competition) → larger profit share, smaller wage share.
What is the price-setting curve, and why is it horizontal?
Shows real wage (W/P) consistent with profit-maximizing markup.
Horizontal: Real wage is constant across employment levels (determined by markup/productivity).
What happens if the real wage is above (Point A) or below (Point C) the price-setting curve?
Point A: Wage too high → firms raise prices, reduce output → employment falls.
Point C: Wage too low → firms lower prices, expand output → employment rises.
What two factors determine the height of the price-setting curve?
Competition: Less competition → higher markup → lower real wage (curve shifts down).
Labour productivity: Higher productivity → higher real wage (curve shifts up).
Why is there always involuntary unemployment in equilibrium?
Zero unemployment → no employment rent → workers shirk.
Wage-setting curve must be left of labour supply to incentivize effort.
Equilibrium (Point X) requires unemployed workers to maintain discipline.
How does reduced competition affect the labour market equilibrium?
Higher markup → lower price-setting curve.
New equilibrium: Lower real wage, higher unemployment (intersection moves left).
What is the Nash equilibrium in the labour market?
Firms: Set profit-maximizing wages/prices (on wage- and price-setting curves).
Workers: Provide effort (due to employment rent).
Unemployed: Cannot find jobs even if willing to work at current wages
Why can’t policies eliminate unemployment entirely?
Near-full employment → wages must rise to unsustainable levels (exceeding productivity).
Firms would earn zero profits and shut down.
What is demand-deficient (cyclical) unemployment?
Unemployment caused by low aggregate demand (e.g., recession).
Shown by point B in the labour market model, where unemployment exceeds Nash equilibrium (point X).
How does equilibrium unemployment (X) differ from cyclical unemployment (B)?
X (Nash equilibrium): “Normal” unemployment due to employment rent incentives.
B (Cyclical): Extra unemployment from low demand. Workers would accept jobs below current wage but can’t find them.
Why is point B not a Nash equilibrium?
Firms could lower wages (still above wage-setting curve) and increase profits.
Workers would still work (due to fear of job loss), but wages/prices adjust slowly.
What adjustments would occur if the economy is stuck at B?
Firms cut nominal wages → lower costs.
Firms then cut prices (to restore markup).
Lower prices → higher sales/employment (moving toward X).
What problems can block the return to equilibrium (X)?
Worker resistance: Wage cuts reduce morale/strike risk.
Deflationary spiral: Falling prices → delayed spending → lower demand.
Lower wages → reduced consumer spending → weaker demand.
How can government policy reduce cyclical unemployment?
Fiscal policy: Increase spending/cut taxes to boost demand.
Monetary policy: Lower interest rates to encourage borrowing/spending.
Shifts aggregate demand right, moving economy from B → X.
Why are policy interventions faster than wage/price adjustments?
Wages/prices are sticky downward (slow to fall).
Policies directly increase demand, bypassing deflation risks.
What happens to isoprofit curves when wages fall?
Steeper slope: (P - W)/q increases (higher profit per unit).
Firms maximize profits by lowering prices, expanding output (B → X).
How does lower competition affect cyclical unemployment?
Higher markups shift price-setting curve down.
Worse cyclical unemployment: Equilibrium moves left (higher natural unemployment).
What happens to the wage-setting curve when labor supply increases (e.g., immigration)?
Shifts downward: More unemployed workers → higher job loss threat → firms can pay lower wages for same effort.
Short-run: Wages fall (point B), unemployment rises.
Long-run: Profits rise → firms hire more → wages recover (point C).
How does immigration affect wages and employment in the long run?
Short-run: Wages drop (B), unemployment rises (U′).
Long-run: Higher profits → expanded employment → wages return to initial level (C), unemployment falls (U″).
What is the union bargained wage-setting curve?
Lies above standard wage-setting curve.
Reflects wages negotiated by unions via strikes/threats.
Union power depends on ability to block replacement workers during strikes.
How do unions alter the labor market equilibrium?
Bargaining effect: Higher wages → lower employment (if wage > price-setting curve).
Voice effect: Better worker morale → lower disutility of effort → wage-setting curve shifts down.
Net effect: Depends on which effect dominates (e.g., point Y vs. X).
Compare union vs. non-union labor markets.
Non-union: Firms set profit-maximizing wage (point A).
Union: Higher wage (point C) but lower profits (flatter isocost).
With voice effect: Potential for higher employment (point Y).
What is the union voice effect?
Unions improve worker-employer relations → effort feels less costly.
Shifts best response curve up: Workers provide more effort at same wage.
Can raise employment if strong enough (point D).
Why might unions reduce employment?
If bargaining effect > voice effect:
Wages rise above price-setting curve → firms hire fewer workers.
How do unions impact firm profits?
Without voice effect: Lower profits (higher wages, same effort).
With voice effect: May offset losses (higher effort compensates for wage hikes).
How does education/training affect the price-setting curve?
↑ Labor productivity → ↑ real wages (same markup).
Price-setting curve shifts up → higher employment & wages in equilibrium.
What is the effect of a wage subsidy?
Lowers firm costs → firms cut prices (restore markup).
↑ Real wages (price-setting curve shifts up).
Result: Higher employment + higher wages.
How do unemployment benefits shift the wage-setting curve?
Higher benefits → ↑ reservation wage → wage-setting curve shifts right.
Equilibrium: Higher unemployment (e.g., 12% vs. 5% at lower benefits).
What policies increase labor supply (e.g., for women/minorities)?
Subsidized childcare, anti-discrimination laws.
Effect: ↑ Job seekers → wage-setting curve shifts down → lower wages short-run, but long-run employment may rise.
Compare supply-side (labor market) vs. demand-side (multiplier) models.
Supply-side: Determines long-run equilibrium unemployment (wage/price-setting curves).
Demand-side: Explains short-run fluctuations (aggregate demand shifts → cyclical unemployment).
What is cyclical unemployment?
Unemployment due to low aggregate demand (e.g., point C).
Gap between actual employment and labor market equilibrium (point A).
How does a boom (high AD) affect unemployment?
AD shifts up → employment rises above equilibrium (point B).
Cyclical employment: Unemployment < natural rate (e.g., 3% vs. 5%).
Why is the multiplier model short-run but the labor market model medium-run?
Multiplier: Assumes fixed wages/prices (short-run).
Labor market: Allows wage/price adjustment (medium-run).
Disequilibrium: Short-run AD shifts ≠ labor market equilibrium.
What is the normal level of output?
Output at labor market equilibrium (point A, 5% unemployment).
Any other output level implies cyclical employment/unemployment.
