Chapter 16

Wages and Unemployment

“Sir, who do we blame for low wages in Bahrain? The government? Or
Private Businesses?

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 Learning Objectives

1. Use supply and demand to understand the labor

market
2. Explain the relationship between the supply of labor
and demand of labor on real wages and employment
3. Understand the determinants of demand and supply of
labor and their effect on market equilibrium
4. Define and calculate the unemployment rate and the
labor force participation rate
5. Differentiate among the types of unemployment and
the costs associated with each.
6. Understand the causes of structural unemployment.
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 Sacking of UAE Nationals Banned
The Ministry of Labour passed a decision on Wednesday banning
the termination of Emiratis in the private sector
(The National, February 20, 2009).

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 From the national: Debate over Impact of Emirati Job
Protection (February 20, 2009)

private-sector companies are more likely to employ Emiratis

because of a new government policy that protects them from
being laid-off, a labor official said yesterday to counter claims to
the contrary.

Feddah Lootah, the acting director general of the national human

resource development and employment authority (TANMIA), said
Emiratis would feel more secure in their jobs knowing they cannot
be laid off. As a result, they will "increase their productivity,
performance, and loyalty." Companies will become aware of that
trend and will recruit more Emiratis, she said.
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 Supply and Demand in the Labor Market

 Supply and demand analysis can be used to

find the price of labor (real wages) and the
quantity of labor (employment)
 Labor market is an input market
 Firms buy labor to produce goods and services
 Macroeconomics look at aggregate levels of
employment and real wages

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 Wages and Demand for Labor

 The demand for labor depends upon:

 The productivity of workers
 Other things equal, greater productivity increases demand of labor thus
employment
 The price of the worker’s output
 Other things equal, higher real prices of workers’ output increases the demand
of labor thus employment
 Diminishing returns to labor
 Assumes non-labor inputs are held constant
 Adding one worker increases output but by less than the previous
worker added
 Explains why the demand for labor is downward sloping

 Value of Marginal Product (VMP) is extra revenue that an

added worker generates
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 Manama Computer Company (MCC)

 MCC can sell all its computers for $3,000 each

Number of Computers per Value of Marginal

Marginal Product
Workers Year Product

1 25 25 $75,000
2 48 23 69,000
3 69 21 63,000
4 88 19 57,000
5 105 17 51,000
6 120 15 45,000
7 133 13 39,000
8 144 11 33,000

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 Demand Curve for Labor

 Hire an extra worker, if

and only if, the VMP
is equal or exceeds the

Wage ($000s)
wage paid (wage ≤ VMP). 60
 If the market wage is
50
$60,000 per worker,
MCC will hire 3 workers Labor
 Ifthe market wage is Demand
$50,000, per worker MCC 3 5
hires 5 workers Employment

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 Summary: Shifts in the Demand for Labor

 Demand of labor shifts when:

 The real price of the company’s output changes.
 Other things equal, an increase in company’s output
price increases the demand for labor (the opposite is
true).
 The productivity of the workers changes.
 Other things equal, as workers become more
productive, their demand increases (the opposite is
true).

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 Price of Output Increases

 MCC can now sell all its computers for $5,000 each

Number of Computers per Value of Marginal

Marginal Product
Workers Year Product

1 25 25 $125,000
2 48 23 115,000
3 69 21 105,000
4 88 19 95,000
5 105 17 85,000
6 120 15 75,000
7 133 13 65,000
8 144 11 55,000

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 Price of Output Increases

 At $60,000 per worker, when

price was $3,000 per computer,
MCC hired 3 workers
 At $60,000 per worker now

Real Wage ($000s)

that the price per computer is
60
$5,000, MCC will hire 7
workers Labor
50
 Demand for labor increased from Demand
3 to 7 (P = $5,000)
 An increase in the Labor Demand
price of workers' output (P = $3,000)

increases the demand 3 5 7 8

for labor Employment

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 Higher Productivity

 Each worker builds 50% more machines given the same inputs (for example, time)

Number of Computers per Value of Marginal

Marginal Product
Workers Year Product

1 37.5 37.5 $112,500

2 72 34.5 103,500
3 103.5 31.5 94,500
4 132 28.5 85,500
5 157.5 25.5 76,500
6 180 22.5 67,500
7 199.5 19.5 58,500
8 216 16.5 49,500

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 Higher Productivity
 Increases in productivity
increase VMP
 At $60,000 per worker,
MCC hires 6 instead of 3
 Demand curve shifts right
 Employers hire more workers
Real Wage

at any given wage

Labor Demand
(after productivity
increase)
Labor Demand
(before productivity increase)
Employment

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 The Supply of Labor

 Reservation wage is the lowest wage a

worker would accept for a given job.
 Opportunity cost of working is your leisure
activity.
 Increasing opportunity cost of leisure explains
why the supply of labor is upward sloping.
 Work compensates you for lost leisure.
 If working conditions are unpleasant or dangerous, a
premium for that would be included in the wage.

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 Aggregate Labor Supply

 People work for many reasons:

 Personalsatisfaction
 Opportunity to develop skills and talents
 Chance to socialize with co-workers

 Still, for most people, income is one of the principal

benefits of working
 The higher the real wage, the more willing they are to
sacrifice other possible uses of their time
 The fact that people are more willing to work when the
real wage they are offered is higher is captured in the
upward slope of the supply curve of labor
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 The Supply of Labor

Labor
Supply
Real Wage

The labor supply curve

slopes up because the
higher the real wage, the
more people are willing
to work (increasing
opportunity cost)
Employment

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 Shifts in Labor Supply

 A shift in labor supply is caused by any

change in the number of workers willing to
work at each wage.
 Increase in the working-age population
 Higher net immigration
 Increasing age at retirement
 Increase in the share of working-age population
willing to work.
 Women's participation in the labor force has
increased in the last 50 years
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 Explaining the Trends in Real Wages and
Employment

 We have discussed both the demand for and

supply of labor separately

 We are ready to apply supply and demand

analysis to real world labor markets

 To do so we need to examine supply and

demand of labor in the same graph

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 Trend 1: Increasing Real Wages

 Industrialized countries
have had sustained growth
in productivity over many
decades S
 Increases demand for labor

Real Wage
 Both real wages and
W'
employment increased W
 Productivity increases D
D'

were due to
N N'
 Technological progress Employment
 Increases in capital
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 Skill-Biased Technological Change

Unskilled Workers Skilled Workers

SU SS
Real Wage

W'S
WS
WS D'S
W'S

DU DS
D'U
N'U NU NS N'S
Employment Employment

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 Unemployment

 The problem of unemployment is usually divided

into two categories: the long-run problem, and the
short-run problem.
 The natural rate of unemployment or long-run
unemployment refers to the amount of
unemployment that the economy normally
experienced (never goes away). At the natural rate
of unemployment, the economy is said to be at full
employment. However, the economy can be at
full employment in the short-run.

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 Cyclical unemployment or short-run
unemployment refers to year-to-year fluctuations
of unemployment around its natural rate and it is
associated with short-run ups and down of
economic activity. It is possible for cyclical
unemployment to be temporarily below or above
the natural rate of unemployment (or full
employment).

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 How is Unemployment
Measured?
 A person is considered employed if he or she spent
most of the previous week working at a paid job.

 A person is unemployed if he or she is on temporary

lay off, is looking for a job, or is waiting for the start
date of a new job.

 A person who fits neither of the two categories, such

as full-time student, homemaker, or retiree, is not in
the labor force.

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 Labor Force = number employed + number unemployed.

 The unemployment rate is defined as the percentage of

labor force that is unemployed:

 Unemployment rate = number of unemployed x 100

Labor Force

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 Labor force participation rate is the percentage of the adult
population that is in the labor force.

 Labor force participation rate = Labor Force x 100

Adult population

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 Example

 Given:
* Adult population: 205 million
* Number of people employed: 131.5 million
* Number of people unemployed: 6.2 million

 Calculate:
a) The Labor Force?
b) The unemployment rate?
c) Labor force participation rate?

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Unemployment and Labor Force Participation
Rates

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 Problems with the
Unemployment Rate Measure
 Because of frequent movements in and out the labor force, the
measure of unemployment could be less than perfect.

 Some people counted as unemployed could in fact be working and

getting paid “ under the table”, they call themselves unemployed to
qualify for government unemployment benefits.

 Some people counted as unemployed may in fact wanted to work

but have become discouraged and gave up the job search.

 There is no easy way to fix the problem of calculating the

unemployment rate. However, despite this problem, it is a good
indicator of the standard of living.
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 Why are there Always some
People Unemployed?
 There are two ways to explain unemployment in the long-run.

 1.- Frictional Unemployment: Sometimes referred to

as “voluntary” unemployment occurs because people
may be in the process of relocating or changing career
fields. Economists view frictional unemployment as
temporary and tends to be higher during periods of
economic expansion and lower during periods of slow
economic growth or recessions. Frictional
unemployment is the unemployment that exists when
the economy is at full employment.

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 2. Structural Unemployment: The number of jobs
available in the labor market may be insufficient to give a
job to everyone who wants one (Quantity of labor supplied
is greater than quantity of labor demanded). This occurs
when a large portion of unemployed individuals do not
posses the skills employers are seeking. Major economic
changes in consumer demand and technological changes,
as well as government policies, employees and firms
behavior in the labor market have been blamed for
structural unemployment. Economists consider structural
unemployment as “non-voluntary” and more permanent
than frictional unemployment .

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 To be more specific about government policies, and
firms and employees behavior in the labor market,
let’s talk about 3 possible reasons for structural
unemployment generally observed in developed
countries:
 1.- Minimum- wage laws
 2.- Unions
 3.- Efficient wages
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 Minimum – Wage Laws

 When a minimum-wage law forces the wage to

remain above the level that balances supply and
demand, it raises the quantity of labor supplied
and reduces the quantity of labor demanded
compared to the equilibrium level. The result is
unemployment.

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 Unemployment from a Wage
above the Equilibrium Level
Wage

Labor
Surplus of labor =
Supply
Unemployment

Minimum wage

WE

Labor
demand

0 LD LE LS Quantity of
Labor

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 Unions and Collective
Bargaining
 A union is a worker’s association that bargains with employers over wages
and working conditions.

 Most workers discuss their wages, benefits, and working conditions with
their employers as individuals.

 By contrast, workers in a union do so as groups.

 The process by which unions and firms agree on the terms of employment is
called collective bargaining.

 Generally unions raise wages above the level that would prevail in
competitive markets, they reduce the quantity of labor demanded, and
causes some workers to be unemployed.
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 Efficient Wages

 Efficient wages are wages paid by firms above-

equilibrium wages in order to increase worker’s
productivity.

 The unemployment that arises from efficient

wages is similar to that of minimum-wages laws
and unions.

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 In all three cases, unemployment is the result of
wages above the level that balances the quantity of
labor supplied and the quantity of labor
demanded.

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Back to the Basics: Why Are Unemployment
Rates High among UAE Nationals in the
UAE?
 Structural rigidities explain persistently
high unemployment rates
 Highlyregulated labor markets
 High Reservation wage
 Generous public sector

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