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Unit 5
LABOR MARKET:
AGREGATE SUPPLY

Reference:
Core-economics (chapter 9) and Blanchard ad
Johnson, Macroeconomics, 6ª Edición,
Pearson, 2012 (Pages: 131-177 )

Introduction

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Context

Aggregate supply is obtained from the behavior of wages and prices. To do this, we must
understand how wages (labor market) and prices are set in the economy.

The result of the wage-setting process for all the firms in an economy is the wage-setting
curve, which shows the wage level associated with each unemployment rate.

The prices that companies charge for their products are influenced by the demand for
goods and the cost of labor: the wage

The outcome of the price-setting process across all firms is the price-setting curve, which
gives the value of the real wage that is consistent with a firm’s profit-maximizing markup
over production costs.

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Introduction
What is the relationship between price, real wage and
unemployment?
1. The boom in iron ore prices (in the top figure) made
mining highly profitable, leading to strong demand for
labour, which eventually dried up the pool of
unemployed riggers and truck-drivers.

2. Mining companies had no choice but to pay

extraordinarily high salaries, and while the mining
boom lasted, the companies remained highly
profitable.

3. The downturn in commodity prices began in mid-2011

and unemployment began to rise.

Figure 9.1 The chart shows real weekly earnings for males in Western Australia,
together with the world price of iron-ore in the top panel and the unemployment rate
in Australia in the bottom panel.
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This unit

1. The labour market

2. The wage-setting relation
3. The price-setting relation
4. Natural unemployment rate
5. The aggregate supply

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1. The labour market

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1. The labour market

• We consider the simple case in which the only input to production is labour
 the only cost is the wage

• Profits are determined by just three things:

• The nominal wage
• The price at which the firm sells its goods
• the average output produced by a worker in an hour.

• It is necessary to understand two relationships that are essential in the labor

market and are related to each other

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1. The labour market

The relationship between firms and their employees:

• In order to motivate employees to work hard and well, firms must set the
wage sufficiently high so that the worker receives an employment rent:

• This means there is a cost of job loss: he/she is better off being
employed than being fired due to inadequate effort.
• If the worker is very likely to find alternative work if he/she is fired,
which will be the case if the employment level in the economy is
high, he/she will need a higher wage to work hard.

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1. The labour market

The relationship between firms and their customer:

• In setting the price of the good they sell, firms face a trade-off between
selling more goods and setting a higher price, due to the demand curve
they face.
• Firm will find the markup over their production cost that maximize its
profits.
• This profit-maximizing markup determines the division of the firm’s
revenues between profits and wages.

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1. The labour market

• We want to know how the real wage (nominal wages divided by the price level)
and the level of employment in the economy as a whole are determined.

• The determination of these variables in the economy as a whole is carried out in

two stages:

1. First, each firm decides what wage to pay, what price to charge for its
products, and how many people to hire.
2. Then, adding up all of these decisions across all firms gives the total
employment in the economy and the real wage.

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1. The labour market

• To understand how the real wage and employment are jointly determined in the
labour market, we need two basic concepts:

1. The wage-setting curve⁠: This gives the real wage necessary at each level of
economy-wide employment to provide workers with incentives to work hard and
well.
2. The price-setting curve: This gives the real wage paid when firms choose their
profit-maximizing price.

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1. The labour market

Overview of the labour market:

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2. The wage-setting relation

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2. The wage-setting relation

• How changes in the unemployment rate affect the wage set by employers?

• We must first understand the level of effort that each worker will put in, given
the salary set by the company
• Reservation wage: wage at he/she is indifferent between work or
not.
• The effort has a cost– disutility of effort– and a benefit: increases
the likelihood that he will keep his job and the income from
employment.
• As the level of effort approaches the maximum possible level,
the disutility of effort becomes greater. In this case it takes a
larger employment rent (and hence a higher wage) to get effort from
the employee
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2. The wage-setting relation

• Second, knowing the factors that affect the effort decision, the firm will seek to
maximize the number of units of effort (sometimes called efficiency units) it
achieves for each dollar of wage costs, e/w.

• That efficiency wage will be higher than the reserve wage and high enough to:
• motivate workers to make a certain effort in order to receive that rent
• generate fear of losing that rent if the workers do not make the necessary
effort

• Given this fear, the employer can exercise some power over his workers, and
contribute to their profits.

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2. The wage-setting relation

• Now that we understand how wage bargaining works, we can study how the labor
market situation affects wage determination:

1. A higher unemployment rate reduces the reservation wage, because a

worker faces a longer expected period of unemployment if he or she loses a job.
This weakens the employees’ bargaining power and reduce the salary fixed
by the employer.

2. A reduction in the unemployment rate increases the reservation wage

because the worker faces a shorter expected period of unemployment if he/she
loses his/her job. This increases the bargaining power of workers and
increases the wage set by the employer.

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2. The wage-setting relation

• Another essential element in wage determination is the expected price:

• When wages are set in nominal terms, the corresponding price level is
not yet known.
• Workers do not care how many euros they receive but how many goods
they can buy with those euros, i.e. the real wage (W/P).
• If workers expect P to double, they will ask for a doubling of their nominal
wage.

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2. The wage-setting relation

• The following equation captures the discussion of wage determination:

W  P e F ( u, z )

• The aggregate nominal wage, W, depends on three factors:

• The expected price level, Pe (when wages are set in nominal terms, the relevant
price level is not yet known. Nominal wages are set in advance)
• The unemployment rate, u
• A catchall variable z that stands for all other variables that may affect the outcome of
wage setting.

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3. The price-setting relation

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3. The price-setting relation

• The prices that firms charge depend on the costs they face, which depend on the production
function.

• Firms can set the price but not the quantity they will be able to sell (there is a trade-off).

• We assume the firm’s only costs are the wages it pays (W) and on average a worker
produces A units of output (labor productivity).

• Thus, the aggregate production function will be Y=A*N, where Y is output and N is
employment. If we assume that A=1, then Y=N.

• This production function implies that the cost of producing one more unit of output is the
cost of employing one additional worker at the wage W.

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3. The price-setting relation

• In perfect competition P=W, but many goods are not produced in perfect competition, where
firms charge a price above their marginal cost.

(1) 𝑃 = 1+𝜇 𝑊

Where  is the markup of price over cost  depends on the level of competition in the market, so
that if it is not competitive, it will be positive (firms have market power).

From equation (1) we can divide both terms by W and then invert them:
𝑃 𝑊 1
= 1+𝜇 → =
𝑊 𝑃 (1 + 𝜇)

This equation tells us that pricing by firms determines the real wage: if all firms increase their
markup, prices will increase, reducing the real wage.
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4. Natural rate of employment

• Equilibrium in the labor market requires that the real wage determined in the wage-setting equation
be equal to the real wage determined in the price-setting equation.

• This requires that Pe=P, and under this equality the natural rate of unemployment or equilibrium
unemployment rate can be determined:

𝑊
𝑊𝑎𝑔𝑒 − 𝑠𝑒𝑡𝑡𝑖𝑛𝑔 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛: 𝑊 = 𝑃𝐹 𝑢, 𝑧 → = 𝐹(𝑢, 𝑧)
𝑃
𝑊 1
𝑃𝑟𝑖𝑐𝑒 − 𝑠𝑒𝑡𝑡𝑖𝑛𝑔 𝑒𝑞𝑢𝑎𝑡𝑖𝑜𝑛: =
𝑃 (1 + 𝜇)

The natural rate of unemployment (𝑢 ) is the level of unemployment that equals the real wage in both
equations:

1
𝐹(𝑢 , 𝑧) =
(1 + 𝜇)

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4. Natural rate of employment

• The above equation tells us that the equilibrium unemployment rate depends on z and 𝜇:

• An increase in unemployment Benefit Will affect z. This will make the prospect of
unemployment less painful, which will increase the wage set by wage setters. Thus, the
natural unemployment rate will increase.

• An increase in power market of the firms Will increase the markup 𝝁. This will reduce the W
wage paid by firms, thereby increasing natural unemployment in the economy.

• For a given labor force, equilibrium unemployment determines the level of employment, and the
latter the level of production. In the same way, we can call it the natural level of production (Yn).

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5. The aggregate supply

• The aggregate supply shows the RELATION between production (output) and price level.

• It is obtained from the wage and price setting equations:

W  P e F ( u, z ) P  (1   )W
• Using this two equations we can obtain the aggregate supply in three steps:

• FIRST STEP:

Replace the wage determination equation in the pricing equation:

P  P e (1   ) F (u, z)
In words, the price level depends on the expected price level and on the unemployment
rate u. We assume both z y 𝝁 are constant.

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5. The aggregate supply

• SECOND STEP

Given the labor force, we can express unemployment in terms of employment (N), and hence the
level of production (Y=N).

U L N N Y
u   1  1
L L L L
 For a given labor force, the higher the output, the lower the unemployment rate.

Recall that when the labor market is in equilibrium, it implies that the unemployment rate is at its
natural level. To this natural rate of unemployment, we can also associate a natural level of
employment and therefore a natural level of production.

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5. The aggregate supply

• THIRD STEP

Substituting the unemployment rate in the equation obtained in the first step we obtain the
aggregate supply relationship
 Y 
P  P e (1   ) F  1  , z
 L 
 The price level P depends on the expected price level, Pe, and the level of output Y (and also
on the markup 𝜇, the catchall variable z and the labor force L, which we take as constant
here).

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5. The aggregate supply

• The relationship between the price level (P) and output (Y) given the value of the expected
price level (Pe), is represented by the AS curve:

The AS curve has two important properties:

Property 1: An increase in production causes a rise in the price level. This rise is the result
of four steps:

1. An increase in production leads to an increase in employment.

2. An increase in employment causes a decrease in unemployment and, therefore, a decrease
in the unemployment rate.
3. A decrease in the unemployment rate leads to a rise in the nominal wage.
4. A rise in the nominal wage causes a rise in the prices set by firms and, therefore, a rise in the
price level.

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5. The aggregate supply

Property 2: A rise in the expected price level causes a rise in the effective price level by the
same amount:

1. If wage setters expect the price level to be higher, they set a higher nominal wage.

2. The rise in the nominal wage causes an increase in costs, which leads firms to set higher
prices and raises the price level.

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5. The aggregate supply

• The aggregate supply curve is upward sloping: an

increase in output Y leads to an increase in the
price level P.

• The aggregate supply curve goes through point A,

where Y = Yn and P = Pe.

Figure, The aggregate supply curve

Given the expected price level, an increase in output (decrease
in unemployment, increase in nominal wage and prices) leads
to an increase in the price level. If output is equal to the natural
level of output, the Price level is equal to the expected Price
level
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5. The aggregate supply

• An increase in the expected price level, Pe, shifts the AS
OA curve up. Conversely: a decrease in the expected price
level shifts the AS curve down.

Explanation:
Suppose the Pe increases from Pe to Pe’

At a given level of output, and correspondingly, at a given u

rate, the increase in the expected price level leads to an
increase in wages, which leads to an increase in prices.

So, at any level of output, the price level is higher: the AS

curve shifts up

Figure. The Effect of an Increase in the Expected Price

Level on the Aggregate Supply Curve An increase in
the expected price level shifts the aggregate supply curve
up.

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RESUME

• Starting from wage determination and price determination in the labor

market, we have derived the aggregate supply relation.

• This relation implies that for a given expected level or prices, the price level
is an increasing function of the level of output. It is represented by an
upward-sloping curve, called the aggregate supply curve

• Increases in the expected price level shift the aggregate supply curve up.
Decreases in the expected price level shift the aggregate supply curve
down.

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