Dr.

Moss
Work Set 016

Macroeconomics

Sticky Wages
The Labor Market with Rigid Wages
The question regarding whether all markets in the economy reach equilibrium in a timely fashion is important. If all the markets reach equilibrium, then the macro economy will be in equilibrium. Among other implications of timely macroeconomic equilibrium is that there is no role for government to manage the economy (discretionary monetary or fiscal policy). However, if all the markets do not reach equilibrium in a timely fashion, then there is a role for government to manage the economy. The labor market is one of the first places economists looked when they were looking for markets that do not appear to clear (reach equilibrium), even over long periods of time. The labor market seemed an obvious choice because as far as we can tell there is always some unemployment in the labor market. Even after accounting for frictional and structural unemployment (taken together called the natural rate of unemployment) there is cyclical unemployment. The question arises: Why would unemployment vary over the business cycle? One possible answer is that that wages are rigid. When wages are rigid downward, a decrease in either the demand for labor or an increase in the supply of labor will lead to unemployment. In other words, starting from equilibrium, a decrease in the demand for labor, or an increase in the supply of labor, will result in unemployment that would not occur if wages were flexible. Example: Illustrate a Labor Market Adjustment with Flexible wages
Nominal Wages (W)

Labor Market
S1

Step One: Start with a demand and supply diagram of a labor market in equilibrium. Such a diagram is shown to the right

W1

D1 L1

Labor (L)

Step two: Suppose the demand for labor falls, perhaps as a result of a decrease in aggregate demand. Draw the new demand curve and find the new equilibrium With flexible wages, if the demand for labor falls from D1 to D2, nominal wages fall from W1 to W2, and employment falls from L1 to L2. There is no unemployment because at W2 everyone who wants a job has a job. The quantity of labor demanded is equal to the quantity of labor supplied.

Nominal Wages (W)

Labor Market
S1

W1 W2 D2 L2 L1 D1

Labor (L)

W016 Rigid Wages.Docx

10/24/09

Dr. Moss
Work Set 016

Macroeconomics

Sticky Wages
Step three: If the decrease in demand is a Labor Market result of a strictly nominal change (a decrease Nominal Wages S1 (W) in output prices) and not due to a relative S2 price change (prices for this firms output decreased as a result of a decrease in demand for this firms output), there is an additional W1 step in the long run adjustment. This is a general equilibrium analysis (interrelated W2 D1 markets) as opposed to a partial equilibrium D2 analysis (only the labor market is considered). L2 L1 In the general equilibrium (macroeocnomic) Labor (L) analysis, price falls in the output market as a result of a decrease in aggregate demand. This leads to the decrease in the demand for labor in the labor market (as shown above). But the decrease in the price level leads to an increase in real wages. Some (maybe all) workers realize that a decrease in the nominal wage will not reduce their real standard of living. Therefore the labor supply curve shifts right (we expect until just as many workers are hired at the lower wages as were hired before the price level fell). Example: Show a Labor Market Adjustment with Inflexible (Rigid) wages
Nominal Wages (W)

Labor Market
S1

Step One: Start with a demand and supply diagram of a labor market in equilibrium. Such a diagram is shown to the right

W1

D1 L1

Labor (L)

Step two: Suppose the demand for labor falls, perhaps as a result of a decrease in aggregate demand. Draw the new demand curve but do not adjust the wage as it is assumed to be rigid. Find the new quantity of labor demanded and quantity of labor supplied. Show unemployment. With rigid wages, if the demand for labor falls from D1 to D2, nominal wages remain at W1. Employment falls from L1 to L3. L1 people want to work at W1, but employers only hire L3 (only L3 jobs are available). Unemployment is L1-L3.

Nominal Wages (W)

Labor Market
S

W1

D1 D2 L3 L1 Labor (L)

W016 Rigid Wages.Docx

10/24/09

Dr. Moss
Work Set 016

Macroeconomics

Sticky Wages
Consequences Markets Cannot Reach Equilibrium
When wages are rigid (unable to adjust) or sticky (slow to adjust) the labor market cannot reach equilibrium. Some workers will be unemployed. If wages are truly rigid, the market may never reach equilibrium. But even if wages are just sticky or slow to adjust, the labor market may not reach equilibrium in a timely manner. Of course, the minimum wage, for markets were the minimum is binding, is an example of a market with a rigid wage. So are effective union wage contracts (unions that have won wage agreements that are above the market equilibrium wage). Efficiency wage theory is also used as an example of disequilibrium wages. From a macroeconomic perspective, the disequilibrium in the labor market requires that at least one other market not be in equilibrium, and maybe no markets are in equilibrium. It may be that a disequilibrium in the labor market (a factor or input market) results in a disequilibrium in the product market (an output market). And of course, if markets do not reach a timely equilibrium then there is a rational for the government to try to manage the economy through discretionary fiscal and monetary policy. There is also an impact on aggregate supply. Aggregate supply relates output (GDP) to the economys price level. In the long run, after all markets have adjusted to equilibrium, aggregate supply depends on the economys real resources (land, labor, capital, technology). Thus the long run aggregate supply curve (LRAS) is vertical. In the short run the aggregate supply curve (SRAS) will have a positive slope with respect to the price level, but only if there is a market that is not in equilibrium. There are several theories that provide for such a disequilibrium in the short run.
P level SR & LR Aggregate Supply
LRAS SRAS

The misperceptions theory posits that information frictions cause suppliers to misperceive price level changes. Changes in the price level (inflation/deflation) temporarily mislead supplies into believing the demand for their product has changed. The sticky price theory suggests that for a variety of reasons output prices adjust slowly to changes in the economy. An unexpected rise in the price level leads to increased sales for firms that do not, or cannot, raise their prices quickly. These firms react by increasing production. Rigid, or sticky wage theory hypothesizes that the disequilibrium market is in the labor market. Wages that are stuck above the equilibrium in the short run cause unemployment. As output prices decrease, unemployment increases and output decreases. As output prices rise, firms can tap these unemployed works to increase production. Hence an upward sloping short run supply curve.

W016 Rigid Wages.Docx

10/24/09

Dr. Moss
Work Set 016

Macroeconomics

Sticky Wages
Problems
1. Use sticky wage theory to explain why in the short run a decrease in the price level may decrease aggregate quantity supplied.
Workers resist a decrease in their nominal wage. But as the price for goods and services in the output market falls, the demand for labor in the input market falls. If wages are sticky, firms will reduce the amount of labor they hire, leading to unemployment and a decrease in output. The short term result is that price level decreases and output decreases. The increase in wages raises the costs of production. So firms will supply less at any price level.

2.

Use sticky wage theory to explain why in the short run an increase in the price level may increase aggregate quantity supplied.
Actually, there are two necessary conditions 1) sticky wages and 2) available unemployed workers. For some reason, wages are sticky and do not increase in a timely manner. Workers probably do not resist increases in their nominal wages, but it may be that employers do. Perhaps wages and salaries are fixed in the short run by contract (such as a union contract) or custom (such as wages are only increases after an annual review). As output prices increase, firms demand for labor also increases. But if wages are sticky, input prices do not increase. So firms produce more, leading to an increase in aggregate quantity supplied. Of course, in order to produce more in the short run there has to be slack in the economy. In the labor market, slack implies a pool of unemployed workers that firms can hire. The unemployed workers, now employed, produce the increase in output. If there was no slack, the economy would be constrained by the resources that it had; output could not be increased. With respect to the labor market, suppose there was no pool of available unemployed workers. As one firm tried to hire workers it would have to hire them away from firm B. The competition for workers would raise wages, which would violate the sticky wage assumption. But even if it did not raise wages, as firm a hired more workers it increased its output firm B would lose workers and its output would decrease. Without a pool of unemployed workers, the increase in the price level could not increase output. There could be no short run upward sloping aggregate supply.

W016 Rigid Wages.Docx

10/24/09