EC 202 Chapter 3

Figure 9.17 is the Lorenz curve associated with a particular labour market equilibrium. In a population of 100, there are 10 firms, each with a single owner, 80 employed workers, and 10 unemployed workers. The employed workers receive 60% of the total income as wages. The Gini coefficient is 0.36. In which of the following cases would the Gini coefficient increase, keeping all other factors unchanged? A rise in the unemployment rate. A rise in the real wage. A rise in the workers' productivity while the real wage is unchanged. A rise in the degree of competition faced by the firms.

A rise in the unemployment rate. A rise in the workers' productivity while the real wage is unchanged. A rise in the unemployment rate would shift the first kink of the Lorenz curve to the right. This shifts the curve down, increasing the Gini coefficient. This implies a rise in the markup, or equivalently, a fall in the wage share in total income. This shifts the second kink of the Lorenz curve downwards, increasing the Gini coefficient.

trade union

An organization consisting predominantly of employees, the principal activities of which include the negotiation of rates of pay and conditions of employment for its members.

Figure 9.13 depicts the labour market when there has been a negative aggregate demand shock. Based on this information, which of the following statements is correct? The new equilibrium B is a Nash equilibrium. At B, unemployment is purely cyclical. At B, the firms are able to make higher profits by lowering the wage. The adjustment back from B to X is immediate.

At B, the firms are able to make higher profits by lowering the wage. At B, the real wage is above the wage-setting curve, so firms are able to lower the wage and still make the workers work hard. This leads to higher profits.

Which of the following statements is correct regarding the effects of a rise in the real wage on the labour supply of a worker? The income effect means that the worker will increase his labour supply. The substitution effect means that the worker will increase his consumption of free time. The income and substitution effects always enhance each other, leading to higher labour supply. At high wage levels, the income effect dominates the substitution effect, leading to lower labour supply.

At high wage levels, the income effect dominates the substitution effect, leading to lower labour supply. The negative income effect and the positive substitution effect always work against each other. At high wages the former more than offsets the latter, implying that the worker reduces his labour supply (he already earns enough).

The following diagram depicts the price-setting curve. Based on this information, which of the following statements is correct? At point A, the markup is too high, and therefore the firm will raise its price. This leads to lower demand for the good and hence lower employment towards B. At point C, the real wage is too low and the markup is too high. Therefore the firm is able to increase profit by lowering prices and hiring more workers. Higher competition implies a lower price-setting curve. For any given markup, higher labour productivity implies a lower price-setting curve, which means a lower real wage.

At point C, the real wage is too low and the markup is too high. Therefore the firm is able to increase profit by lowering prices and hiring more workers. Point B is the profit-maximizing point. Therefore the firm is able to increase its profit by moving from C to B, by lowering its price (which reduces the markup and increases the real wage) and hiring more workers.

monetary policy

Central bank (or government) actions aimed at influencing economic activity through changing interest rates or the prices of financial assets.

fiscal policy

Changes in taxes or government spending in order to stabilize the economy.

Profit-maximizing price

Firm's optimal price lies where the demand curve is tangent to an isoprofit curve (unit 7).The firm then hires a number of employees necessary to produce the quantity of output demanded at that price.

Which of the following statements is correct? To maximize profits, firms set the wage at the level where the workers are indifferent between working and not working. Firms aim to set as high a price as possible. In equilibrium, the wage clears the labour market, so there is no unemployment. If all firms set the same price and pay the same nominal wage, then the higher the real wage that they pay, the lower is their markup.

If all firms set the same price and pay the same nominal wage, then the higher the real wage that they pay, the lower is their markup. The real wage is W/P while the markup is (P − W)/P = 1 − (W/P). So the higher the former, the lower the latter.

Figure 9.9 depicts the market's demand curve and the firm's isoprofit curves. Based on this information, which of the following statements is correct? The slope of the demand curve is the firm's marginal rate of substitution. Between points A and C, the firm would prefer point A as the output is higher. Having chosen its profit-maximizing price p*, the firm would then set its nominal wage level. If the firm finds itself producing at point C, it can increase its profit by selling more units at a lower price.

If the firm finds itself producing at point C, it can increase its profit by selling more units at a lower price. The profit-maximizing point is B, in which the firm produces more and charges less than at point C.

Which of the following statements are correct? Contracts are complete in both competitive goods markets and labour markets. In a competitive goods market the buyers are price-takers, while in a labour market the buyers of employment (the firms) are price-setters. There is no economic rent for either the buyers or the sellers in competitive goods markets. In contrast, in labour markets the sellers receive economic rents. Social norms do not affect the outcomes in either goods markets or in labour markets.

In a competitive goods market the buyers are price-takers, while in a labour market the buyers of employment (the firms) are price-setters. There is no economic rent for either the buyers or the sellers in competitive goods markets. In contrast, in labour markets the sellers receive economic rents. In a competitive goods market, individual buyers cannot bargain for a lower price than others are willing to pay. Therefore they are price-takers. In the labour market the firms set the wage to minimize the cost of getting the worker to work and would not benefit by offering the lowest wage at which the worker (the seller) would accept the job. Hence they are price-setters. In a competitive goods market, the buyers' next best alternative is to buy at another shop, while the sellers' next best alternative is to sell to another customer. Neither party is any worse off from leaving and therefore they do not receive economic rents. In contrast, in the labour market the sellers (the employees) are worse off in their alternative of being unemployed. Hence they receive employment rents.

Based on this figure: A cut in the unemployment benefit would shift the best response function to the left, and raise the wage-setting curve. If the expected period of unemployment increased, it would shift the best response function to the right, raising the wage-setting curve. In a country where the stigma attached to unemployment is high, the wage-setting curve would be lower. A sudden drop in the working age population (due, for example, to the retirement of the baby-boomer generation) would shift the wage-setting curve lower.

In a country where the stigma attached to unemployment is high, the wage-setting curve would be lower. If there is high stigma attached to unemployment, then the workers' best response functions would move to the left. This reduces the equilibrium wage for a given unemployment rate, resulting in a lower wage-setting curve.

Labour unions and unemployment

In equilibrium, wage is unchanged, but employment and firm's profits are lower.The model tells us that labour unions will increase unemployment rates.However, this is not clear in the data.

Figure 9.17 depicts the model of a labour market where there are 90 million workers. The current labour market equilibrium is at A. Now consider the case where the total labour supply is increased to 100 million. Based on this information, which of the following statements are correct regarding the adjustment process in the labour market? Initially, unemployment doubles. Higher unemployment results in a reduction in the employment rent enjoyed by workers employed at the current wage. The firms are required to raise wages to induce workers to work hard. The wage-setting curve shifts downward.

Initially, unemployment doubles. The wage-setting curve shifts downward. Before the labour supply increase there are 10 million unemployed. With the extra 10 million workers joining the labour supply, unemployment initially doubles to 20 million workers. Higher unemployment implies higher employment rent. This means that firms are able to pay a lower wage and can still induce workers to work hard. This is true of any point on the wage-setting curve, and therefore the wage-setting curve shifts downward.

Demand-deficient unemployment

Low aggregate demand moves the economy from labour market equilibrium (X) to point B. B is not a Nash equilibrium: • Firms could lower wages • Lower costs → lower prices • Increase output and employment

The chain of firm's decisions

Nominal wage = f(other firms' prices and wages, unemployment rate) Price = f(own nominal wage, demand for own product) Output = f(optimal price, demand curve) Number of employees = f(output, production function)

Deriving the price-setting curve

Once firms set their prices, this determines the level of output and markup in the economy. This then pins down the real wage. output/worker - real profit = real wage

inactive population

People in the population of working age who are neither employed nor actively looking for paid work. Those working in the home raising children, for example, are not considered as being in the labour force and therefore are classified this way

Automatic adjustment

Point B is not a Nash equilibrium: • Firms could lower wages without lowering workers' effort • Lower wages allow them to cut their prices • Lower prices stimulate demand → output rises • Firms hire more workers to produce more... unemployment falls back to X

The union voice effect

Providing employees with a voice in how decisions are made may induce them to provide more effort for the same wage. • The bargained wage curve shifts downward.• The overall effect of labour unions on employment is ambiguous.

Automatic adjustment in practice

Real economies do not function so smoothly:• Workers resist cuts to their nominal wage (lower morale, strikes) • Lower wages means people spend less → aggregate demand falls further • Falling prices across the economy may lead consumers to postpone their purchases in hope to get even better bargain later

Labour market policies

Shifts in the price-setting curve: 1.Education & training: labour productivity ↑ 2.Wage subsidy: Production costs and prices ↓ Shifts in the wage-setting curve: 1.Lower unemployment benefit: reservation wage ↓ Shifts in labour supply curve: 1.immigration policies: labour supply ↑ 2.childcare provision: female labour participation ↑

nominal wage

The actual amount received in payment for work, in a particular currency. Also known as: money wage.

wage-setting curve

The curve that gives the real wage necessary at each level of economy-wide employment to provide workers with incentives to work hard and well.

price-setting curve

The curve that gives the real wage paid when firms choose their profit-maximizing price.

Figure 9.12 depicts the labour market model. Consider now a reduction in the degree of competition faced by the firms. Which of the following statements is correct regarding the effects of reduced competition? The price-setting curve shifts up. The wage-setting curve shifts down. The equilibrium real wage falls. The unemployment level falls.

The equilibrium real wage falls. Decreased competition leads to a lower price-setting curve, while the wage-setting curve is unaffected. Therefore the equilibrium (the intersection of the two curves) shifts down and to the left, implying lower real wage and higher unemployment.

Distribution of output

The firm's choice of profit-maximizing price also determines the firm's optimal markup above the marginal cost of production. price= profit/output + nominal wage/output For the economy as a whole, this translates into how output is distributed between the firm-owners and the workers. output/worker= real profit + real wage

Unemployment and aggregate demand

The firm's demand for labour depends on the demand for their goods and services (derived demand for labour). Aggregate demand = sum of the demand for all of the goods and services produced in the economy. The increase in unemployment caused by the fall in aggregate demand is called demand-deficient unemployment.

Government intervention

The government could increase its own spending to expand aggregate demand .•monetary policy • fiscal policy At B, firms would find it optimal to produce more (and hire more workers) instead of reducing wages.

cyclical unemployment

The increase in unemployment above equilibrium unemployment caused by a fall in aggregate demand associated with the business cycle. Also known as: demand-deficient unemployment.

Division of output

The labour market determines the division of the economy's output between employed workers, the unemployed, and firm-owners. Gini coefficient will rise with: • unemployment rate ↑ • real wage ↓ • markup ↑ • productivity ↑The labour market determines the

real wage

The nominal wage, adjusted to take account of changes in prices between different time periods. It measures the amount of goods and services the worker can buy.

labour force

The number of people in the population of working age who are, or wish to be, in work outside the household. They are either employed (including self-employed) or unemployed.

equilibrium unemployment

The number of people seeking work but without jobs, which is determined by the intersection of the wage-setting and price-setting curves. This is the Nash equilibrium of the labour market where neither employers nor workers could do better by changing their behaviour.

employment rate

The ratio of the number of employed to the population of working age.

participation rate

The ratio of the number of people in the labour force to the population of working age.

unemployment rate

The ratio of the number of the unemployed to the total labour force. (Note that the employment rate and unemployment rate do not sum to 100%, as they have different denominators.)

Figure 9.21 depicts the effect of union wage-setting. What can we conclude from this figure? Compared to A, at C the effort per hour is higher and therefore the firm's profit is higher. The resulting bargained wage-setting curve will be above the wage-setting curve with no union. The effect of a strong union will always be to increase unemployment. Under union wage-setting, the firm is still setting the wage that maximizes its profits.

The resulting bargained wage-setting curve will be above the wage-setting curve with no union. Due to the union effect, employees need to be paid a higher wage to work hard, compared to when there is no union. This shifts the wage-setting curve higher.

Labour supply

The supply of labour is another important determinant of labour market equilibrium.An increase in labour supply shifts the wage-setting curve downward: • greater pool of unemployed • higher employment rents • lower cost of effort

The labour market equilibrium

The wage-setting and price-setting curves are two sides of the economy. The Nash equilibrium of the labour market is where the wage- and price-setting curves intersect. All parties are doing the best they can, given what everyone else is doing:•The firms are offering the least wage to ensure workers' effort • Employment is the highest it can be, given the wage • Those who have jobs cannot improve their situation by asking for higher pay or working less hard• Those who do not have jobs would like to work, but cannot persuade firms to hire them by accepting lower wage (labour discipline concerns)

labour productivity

Total output divided by the number of hours or some other measure of labour input.

Involuntary unemployment

Unemployment = excess supply in the labour market There will always be unemployment in labour market equilibrium •No unemployment → zero cost of job loss → no effort Therefore some unemployment is necessary to motivate workers • These are the involuntarily unemployed

Wage bargaining

Where workers are organized into trade unions, the wage is not set by the employer but instead is negotiated between union and firm. The bargained wage can be above the wage-setting curve • the wage-setting curve is about the employer's threat of firing a worker • the union can threaten to "dismiss" the employer by going on strike

Labour union

an organization consisting predominantly of employees. Its main activities include the negotiation of rates of pay and conditions of employment for its members.

Which of the following statements is correct? participation rate = employed ÷ labour force unemployment rate = unemployed ÷ population of working age employment rate = employed ÷ population of working age employment rate + unemployment rate = 1

employment rate = employed ÷ population of working age

Bargained wage setting curve

indicates the wage that the union-employer bargaining process will produce for every level of employment. Its position above the wage-setting curve depends on the relative bargaining power of the union and the employer.

The real wage is the nominal wage divided by the price level of the bundle of consumer goods purchased.

real wage = W/P each firm decides on its: price, wage, how many people to hire adding up all of these across all firms gives the total employment in the economy and the real wage

The wage-setting curve

the real wage necessary at each level of economy-wide employment to provide workers with incentives to work hard and well. If the employment rate is X, then the equilibrium wage will be Y.

The price-setting curve

the real wage paid when firms choose their profit-maximizing price. It depends on:•competition, which determines markup•labour productivity, which determines real wage for given markup

Deriving the wage-setting curve

• Start with the labour discipline model (unit 6)• Lowering the unemployment rate will shift worker's best response curve to the right (reservation wage↑) and increase wage• This results in upward-sloping wage-setting curve

The unemployed are the people who

• are not in paid employment or self-employment • are available for work • are actively seeking work