Lecture Notes: LABOR MARKETS

The labor market should be viewed at both the macroeconomic and microeconomic levels.

Labor market – a factor market – a place where supply and demand for jobs meet, with
workers or labor providing the services that employers demand

- The worker is then comparable to a seller while the employer is the

buyer

Labor Markets: (Micro level introduction)

A. In economics, we deal with:

a. Product Markets
b. Resource markets - where firms hire workers capital and land from households in
exchange for money incomes. (Firms demand
i. Labor (wages) – as determined by demand of labor and supply of labor by firms
ii. Land (rent)
iii. Capital (interest)
B. Demand for a resource of Producers (firms)
a. Price of good being produced
b. Productivity of resource employed
i. Marginal product - ∆TP/∆QL – additional output created as a result of additional
input (labor)
ii. Marginal revenue product – demand of firms for labors
1. As employment increases, the revenues generated by additional workers
decrease.

As WR falls, Quantity demand for

Cloth Production labor (QDL) increases because MRP
decreases as employment increases
No. of Quantity Marginal Price Marginal MRP
workers producer Product Revenue Wage rate
At higher wage rate, fewer workers
(wr)
(QL) per hour (MP) product are demanded, at lower wage rate,
(MRP=MP x price) more workers are demanded
1 6 6 6 36
2 10 4 6 24
3 15 5 6 30
4 19 4 6 24
5 22 3 6 18 D =MRPL
6 24 2 6 12
7 25 1 6 6 QL
8 25 0 6 0
The profit maximizing level of employment occurs when a firm hires workers up to the point where the marginal
cost of employing an extra worker equals the marginal revenue product of labor. I.e. MCL = MRPL.

Shifts in the Demand for Labor:

The curve shifts when there is a change in the conditions of demand in the jobs market:

 A change in demand for a product which means that a business needs to take on fewer
workers
 A change in the productivity of labor
 A change in the level of national insurance contributions made by employers or other costs of
employing people such as health and safety legislation and training levies
 A change in cost and productivity of machinery and technology which might be able to
produce or provide a good or service in place of the labor input
 The demand for labor is a derived demand i.e. the demand depends on the demand for the
products they produce.
 When the economy is expanding, we expect to see a rise in the aggregate demand for labor
providing that the rise in output is greater than the increase in labor productivity.
 In contrast, during a recession or a slowdown, the aggregate demand for labor will decline as
businesses look to cut their operations costs and scale back on production. In a recession,
business failures, plant shut downs and short-term redundancies lead to a reduction in the
 derived demand for labor. The construction industry is an example of the derived demand for
labor.

Labor Supply:
A. How is labor supply determined?
a. Households supply labor in the resource markets
b. Direct relationship between wage rate in one industry and number of workers willing and
able to work in that industry

If the wage rate for workers in the

cloth industry is low, very few will be
willing to work here.

So if wage rate is high, more will

work in this cloth industry as more
are attracted to work here, hence
upward sloping supply curve

Labor supply shifts to the right given

same wage rate (w1) due to
immigration policies (+), etc.

Key factors affecting labor supply. The supply of labor to a particular occupation is influenced by:

1. The real wage rate on offer in the industry itself – higher wages should boost the number of people
willing and able to work.
2. Overtime: Opportunities to boost earnings come through overtime, productivity-related pay schemes,
and share option schemes.
3. Substitute occupations: The real wage rate on offer in competing jobs is another factor because this
affects the wage and earnings differential that exists between two or more occupations. So for example
an increase in the relative earnings available to trained plumbers and electricians may cause some
people to switch their jobs.
4. Barriers to entry: Artificial limits through the introduction of minimum entry requirements or other
legal barriers to entry can restrict labor supply and force average pay levels higher e.g. legal services and
medicine where there are strict “entry criteria” to the professions.
5. Improvements in the occupational mobility of labor: For example if more people are trained with the
necessary skills required to work in a particular occupation.
6. Non-monetary characteristics of specific jobs – include factors such as the level of risk, the
requirement to work anti-social hours, job security, opportunities for promotion and the chance to live
 and work overseas, employer-provided in-work training, subsidized health and leisure facilities and
occupational pension schemes.

7. Net migration of labor -is the difference between the number of immigrants (people coming into an
area) and the number of emigrants (people leaving an area) throughout the year.

Equilibrium in Labor markets

B. Equilibrium wage rate and employment
- Intersection of Demand for Labor and Supply of labor
- At full employment, N* (Qe=N*), this means that everyone is working precisely as
much as he or she wants to at the real wage at pt. E. Firms are hiring precisely
the amount of labor they want at the real wage.
- Corresponding to the full-employment level of employment is the full
employment level of output Y*. This is the level of output that is produced
using the existing amounts of other factors (capital stock, land, and raw
materials) and the full employment amount of labor
-

E
Real
wage

The equilibrium price of labor (real wage rate) in a given market is determined by the interaction of the supply
and demand for labor. Employees are hired up to the point where the extra cost of hiring an employee (with
wage) is equal to the addition to sales revenue from hiring them, their MRP.
 C. Labor demand
Change can happen when:
a. The demand for labor is derived from: price of goods
i. higher price; higher labor demand - - moves the labor demand curve to the right
ii. lower price; lower labor demand - - moves the labor demand curve to the left
b. change in labor productivity
i. higher labor productivity (workers getting more productive); higher demand for
labor
ii. less productive; lower demand for labor

D. Labor supply
Change can happen when:
 Change in the wage rate in competing industry ( cloth vs candy industry)
i. Competing industry offers higher (lower) wages – decrease (increase) in the supply
of labor
b. Barriers to entry into the market – permits, licenses, trainings, skills, experience
c. Population (growth)
i. Since more people will look for jobs, supply of labor increases which in turn drive
down the wage rate and increasing the labor equilibrium

Some factors can influence labor supply and demand. For example, an increase in immigration to a
country can grow the labor supply and potentially depress wages, particularly if newly arrived workers
 are willing to accept lower pay. An aging population can deplete the supply of labor and potentially drive
up wages.

On Wage Differentials No one factor explains the gulf in pay that persists between occupations:
1. Compensating wage differentials - higher pay can often be reward for risk-taking in certain jobs,
working in poor conditions and having to work unsocial hours.
2. Equalizing difference and human capital - in a competitive labor market, wage differentials
compensate workers for the opportunity costs and direct costs of human capital acquisition.
3. Different skill levels - the gap between poorly skilled and highly skilled workers gets wider each year.
Market demand for skilled labor grows more quickly than for semi-skilled workers. This pushes up pay
levels. Highly skilled workers are often in inelastic supply and rising demand forces up the "going wage
rate" in an industry.
4. Differences in labor productivity and revenue creation - workers whose efficiency is highest and
ability to generate revenue for a firm should be rewarded with higher pay. E.g. sports stars can command
top wages because of their potential to generate extra revenue from ticket sales and merchandising.
5. Trade unions and their collective bargaining power - unions might exercise their bargaining power to
offset the power of an employer in a particular occupation and in doing so achieve a mark-up on wages
compared to those on offer to non-union members
6. Employer discrimination is a factor that cannot be ignored despite equal pay legislation

LABOR MARKETS
(Macroeconomic)
I. Unemployment rates and labor productivity rates are two important macroeconomic gauges.

A. Unemployment
- During times of economic stress, the demand for labor lags behind supply, driving unemployment
up.
- High rates of unemployment exacerbate economic stagnation, contribute to social upheaval, and
deprive large numbers of people the opportunity to lead fulfilling lives

B. Labor Productivity
- Measures the output produced per hour of labor. 
C. Labor Market in Macroeconomic Theory 

According to macroeconomic theory, the fact that wage growth lags productivity growth indicates that
supply of labor has outpaced demand. When that happens, there is downward pressure on wages, as
workers compete for a scarce number of jobs and employers have their pick of the labor force.
Conversely, if demand outpaces supply, there is upward pressure on wages, as workers have more
bargaining power and are more likely to be able to switch to a higher paying job, while employers must
compete for scarce labor.

Other factors influencing contemporary labor markets:

1. Threat of automation as computer programs gain the ability to do more-complex tasks;

2. Enhanced communication and better transport links allow work to be moved across borders;

3. Price, quality, and availability of education; and a whole array of policies such as the minimum
wage.

I. Model for the Labor Markets: Wage setting and Price setting

How are prices and wages set?

What is the equilibrium real wage that clears the labor market?

First, it pays to know that wages are set through collective bargaining and afterwards, prices are set by firms

A. Wage setting – how much should be paid to workers to get them to provide profit maximizing level effort

W=Pe F (u, z)

1. Worker’s perspective: What’s behind wages?

Aggregate Nominal wage (W)

a. Expected Price level (Pe)– workers are after real wage (W/P) or the wage received with
respect to price level in the economy – how much wages can buy with the prices .
i. W = nominal wage
ii. P = prices
iii. When W/P, example nominal wage is 100 and 50 is price level in the economy, we
get 2 baskets of goods. Assuming price increased to 60, we now get 1.6 basket of
goods, so lesser goods.
 iv. So when price level increase, we expect nominal wage to increase and when price
is lower, nominal wage is expected to decrease
b. Adding up all the real wage across all firms give the total employment in the economy

2. u (-) –unemployment rate ( labor market condition – “bargaining power”) – if unemployment is

high, workers barg power is low hence just accept lower nominal wage and vice versa

3. Ƶ (+) catch all variable representing Other factors – minimum wage (the higher the min wage,
the higher the nominal wage); labor laws and regulations, institutional arrangements in labor
markets

B. Price setting – firms set a mark-up above their costs based on competition, elasticity of demand
while maximizing profit.

After wage is set through collective bargaining, and the scenario of output is only produced by
firm’s labor production function becomes Y = AN where A is some level of technology (affecting
productivity), the amount of output given a worker (N).
Firms look at relative cost of production (W/A) where W is the cost of hiring one worker and A is
the cost in the production of an output.
W
P = (1 + µ) A
W W
P= +µ
A A
W
Where is the relative cost of production ; the higher the W/A, the higher the prices
A
µ- is the mark up - -in the real world, firms have profits hence the mark-up cost
and determine the prices. A higher mark up, the higher prices

c. Price setting (PS) and wage setting (WS) relationship:

Now an important assumption in the medium run equilibrium is that prices are equal to expected price level
(P=Pe) - - rewriting the real wage formula
W= Pe F (u, z)
W/P = F (u, z)

Since workers and firms care about real wage, so taking into account the formula for price setting and
rearranging it to come up with the real wage:
W
P = (1 +µ)
A
 W
A = (1 +µ)
P
W A
P
= 1+ µ
A
W/P = F (u, z) = 1+ µ In a simple case where labor is the only
1
factor of production:
1+ µ

IMPT: When P= Pe, u = un (natural

unemployment)

Where price setting and wage setting intersect, labor market meets at the equilibrium. This corresponds to natural
rate of unemployment:

Price setting (PS) is independent of

unemployment rate. Equilibrium real
wage is fully determined by firms
wage-setting
relation
decrease A
s as unemployment 1+ µ
increases

price-setting
relation

The natural rate of unemployment is the rate of unemployment when the labor market is in
equilibrium, the economy is at full employment (a 4-5% unemployment rate is said to occur at full
employment that won’t cause inflation). It is unemployment caused by frictional and structural
unemployment (these are unavoidable), and not cyclical unemployment.

The natural rate of unemployment is related to two other important concepts: full employment and
potential real GDP.
1. The economy is considered to be at full employment when the actual unemployment rate is
equal to the natural rate.
2. When the economy is at full employment, real GDP is equal to potential real GDP.
 3. By contrast, when the economy is below full employment, the unemployment rate is greater
than the natural unemployment rate and real GDP is less than potential.
4. Finally, when the economy is above full employment, then the unemployment rate is less than
the natural unemployment rate and real GDP is greater than potential.

Changes in the labor market

1. Increase in Ƶ due to:
a.Increase in minimum wage (higher wages may hurt employers so fewer jobs) , or
insurance, or more unemployment benefits

A
1+ µ
WS2

Un2

2. Increased Market power, i.e., Higher mark up - µ : when level of competition in the economy is low,
A
mark up can be increased (and the ratio of goes down since µ rises) . So this would bring down price
1+ µ
setting. Less competition results lower real wage and unemployment goes up.

A
1+ µ WS2
3. Higher Productivity – price incurs goes up and real wages increase and natural rate of unemployment
declines

A
1+ µ

From Unemployment to Employment

Associated with the natural rate of unemployment (Un) is a natural level of employment (Nn).

Employment in terms of the labor force and the unemployment rate equals:

Recall U=Un

The natural level of employment, Nn , is given by:

If Un= Nn

From Employment to Output

Associated with the natural level of employment is the natural level of output (Yn), and since (Y=AN):
 Sub Nn to N

Yn
Yn = ANn = A L (1-Un) rearranging: Un = 1- AL

Yn A
Therefore: F (Un, Ƶ) = F = (1 - AL , Ƶ) =
1+ µ

Note: Labor production  - output Y considered proportional to size of employment  

 Y = AN
 Y = output, A = labor productivity, N = employment
 leads to simpler relation Y=N (redefining units so that A=1)

In words, the natural level of output is such that, at the associated rate of unemployment, the real
wage chosen in wage setting is equal to the real wage implied by price setting.

Sample Problem:
Given a simplified situation, labor is considered to be only factor of production:
Wage-setting relation - W/P = F(u, z) = If wage setting equation is W=P(1-u) --- rearranging to get
wage setting relation - -W/P= 1-u.
Price-setting relation - W/P = 1 / (1+µ);
µ = 5%

1. What is the real wage as determined the price setting relation?

2. What is the equilibrium condition for the labor market that will show the equilibrium
unemployment rate?
3. Suppose that the markup of prices over costs increases to 10%. What happens to the natural
rate of unemployment? (practice SW)

Solutions
1. Simply plug the mark up in the price setting equation to get the real wage (W/P)
W/P = 1 / (1+µ)
= 1/ (1 +0.05)
= 0.952
 2. Set the wage and price setting equal to derive equilibrium condition:

a.

b. Plug markup value

Key takeaways: Role of structural reforms

Structural reforms  tackle obstacles to the fundamental drivers of growth by liberalizing labor, product and
service markets, thereby encouraging job creation and investment and improving productivity. They are designed
to boost an  economy's  competitiveness, growth potential and adjustment capacity.

structural labor-market reforms = is usually used to indicate all measures aimed at removing the
restrictions that interfere with the spontaneous operation of market forces in order to generate a more
efficient allocation of scarce resources and a consequent growth of potential output (IMF, 2015)

1. Labor market reforms aimed at reducing the market power of trade unions and at increasing
efficiency tend to decrease the natural level of unemployment and so to increase the natural level
of output;
2. Pro-competitive reforms in the goods markets tend to decrease the natural level of
unemployment and so to increase the natural level of output;
3. Structural reforms aimed at improving the overall productivity of the economy (i.e. reduction of
the red-tape burden, more friendly business environment etc…) tend to decrease the natural level
of unemployment and so to increase the natural level of output.

Sticky wages in the labor market

Economists often refer to the existence of “sticky wages.”
In a fully flexible labor market, a decrease in the demand for labor should cause a fall in wages and a
contraction in employment - just like any demand curve shifting down.
• However, sticky wages refers to a situation in which the real wage level doesn't fall immediately,
partly because many employees have wages specified in employment contracts that cannot be re-
negotiated immediately, and because workers (perhaps protected by their trade unions) are resistant to
cuts in nominal wages.
• If the wage level cannot fall when demand falls, it leads to a much bigger drop in employment and,
more importantly, involuntary unemployment because of a failure of the labor market to clear.
• The evidence for sticky wages is a good counter-argument to neo-classical models of the labor market
that suggest that real wage levels respond flexibly to any changes in labor demand and supply
conditions.
• Will wages become less sticky during the recession? There are signs that workers, fearful for their jobs
at such a difficult time, have become more willing to consider and perhaps accept pay freezes or wage
cuts traded off against improved job security

###

ACTIVITY #3
1. Explain how productivity influences wages.
2. Discuss the graph below in terms of what is happening to potential output and labor productivity.
(N= full employment)
3. Looking at no. 2, what could affect such shifts in the production function and labor demand (in
red curves)?