Chapter 11 -Unemployment and Efficiency Wages

Define the labour force

Active participants in labour market L = E + U E - employed U - unemployed (don't have a job but are actively searching for work)

How does moral hazard encourage firms to use this efficiency wage?

Firms cannot directly control worker effort Workers don't like putting in effort but they fear being caught shirking (being lazy) and then fired The cost of losing a job depends on how high the current wage is compared to the wage of other jobs High wage discourages shirking (being lazy)

Now we have the wage which firms would choose, what is the labour demand N

For a given wage w the left hand side is decreasing as N increases. This is because the left handside essentially represents MPN as we have just swapped N for E

Where does this unemployment come from in the labour market?

Prevailing wage, w*is higher than market clearing wage, w** and this prevailing wage is sticky- it does not adjust to the market clearing wage So firms are willing to hire N* but households want to supply N₁ where N*< N₁ (i.e supply > demand)

Analyse the following graph showing employment and participation rate

BLUE - participation rate 1950 - 50-60% participation rate 1970 onwards - sharp increase in participation due to more women entering labour market 2000 - decline due to male participation falling BLACK - Employment rate Follows similar pattern to participation rate but fluctuates more than participation rate Unemployment is gap between these two lines

Define the working age population

Defined as P The size of the population are at an age to work (adult to retirement age) Potential participants in labour market

Define the employment rate

E/P

With the efficiency wage what happens to the unemployment level when the deamnd for labour falls (lefward shift)?

In the simple efficiency wage model, there is no incentive for firms to adjust wages Employment falls, but labour supply is unchanged Unemployment increases

Define the participation rate

L/P

How do we incorporate the efficiency wage into the firm's producution function?

Labour input in production function is not just the head count of number of people hired, N. We use E instead of N where E is effective labour input E = e(w)N e(w) is effort put in where wage effects amount of effort put in (or for adverse selection is the hidden productivity) So now for our production function we have Y = F(K,E) Note we are ignoring TFP in this model and assuming K to be fixed

Give the general trend of unemplyment rate amongst countries such as the UK

Low in the 1950-1970 Increases 1970 - 1990 Falls 1990-2000 2008 recession it increases Unemployment never seems to be zero

Manipulate the two expression you got previously to find out what the efficiency wage is

Take the 2nd equation and divide it by first equation So we have derivative of effort with respect to the wage, e'(w), is equal to the total effort divided by wage e(w)/w e'(w) - marginal effect of wages on effort e(w)/w - average amount of effort you get per dollar of wages page Intuitively we are maximising e(w)/w (the effect of wages on effort) Note: Maximising e(w)/w is the same as minimising w/e(w) where w/e(w) is cost of inducing effort from each worker

What is the objective function that the firm want to maximise and determines what wage and N they choose?

The profit function is what they want to maximise π = F(K,E) - wN Where E = e(w)N

Why is the labour force different to the working age population?

There are people in P who don't have jobs and are not trying to get jobs because in full time education or 'house wives' so they do not show up in L

If we plot the deviation of the unemployment rate from the trend line and the business cycle (deviation of GDP from trend line) what would you see?

They are mirror images of one another

How does efficiency wage create a sticky prevailing wage which is higher than the market clearing wage?

We assumed firms know exactly how productive/comitted/skilled each worker will be and this level of productivity is fixed But this is false in the real world we know the wage that the firm pays effects the effort that the workers put in The wage the firm pays also influences the kind of people who apply for the job - skilled people will apply to higher paid jobs. So higher wage improves the pool of applicants Hence why firms might set a higher wage despite there being unemployment

How does adverse selection encourage firms to use this efficiency wage?

When we have assymsetric information there are adverse selection probelems which the efficiency wage can solve: 1) Improve pool of applicants Higher wages attract better workers: Firm does not know which workers are really good and who will apply, so it offers higher wages to attract applications from good workers 2) Reduce staff turnover Higher wages retain better workers: Good workers get offers from outside, a high wage will stop them from quitting and saves the firm from incurring training costs again

We have always said that our efficiency wage is more than the marlet clearing wage but why do we do assume this? Why does it not make sense for the efficiency wage to be less than the market clearing wage?

if w* < w** we see in the graph there is no unemployment w* < w** does not provide an incentive not to shirk - if you lose your job you can always get another job and the wage of this new job will be the same as the old job The whole point of the efficiency wage is to stop shirking so it makes no sense for the efficiency wage to be lower than the market clearing

Define the unemployment rate

u = U/L This represents the people who are not employed and are actively searching for work