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.