intromacro 2014 m5 06 urate - rovira i virgili...

Introduction to macroeconomics 2 April 2014 · Version 2: 11 April 2014 Unemployment 1

1 Unemployment

Unemployment rate

• Important rates in an economy: interest rate, ex‐change rate, inflation rate, and unemployment rate.

• Employment number of people having a job.

• Unemployment number of people not having ajob but looking for one.

• Labour force Employment Unemployment

• Unemployment rate

• Participation rate

Unemployment

Labour forceLabour force

Economically active population2 Unemployment

0

4

8

12

16

20

24

28

32

36

40

44

48

52

56

60

64

68

72

76

IV/2013

III/2013

II/2013

I/2013

IV/2012

III/2012

II/2012

I/2012

IV/2011

III/2011

II/2011

I/2011

IV/2010

III/2010

II/2010

I/2010

IV/2009

III/2009

II/2009

I/2009

IV/2008

III/2008

II/2008

I/2008

IV/2007

III/2007

II/2007

I/2007

IV/2006

III/2006

II/2006

I/2006

IV/2005

III/2005

II/2005

I/2005

IV/2004

III/2004

II/2004

I/2004

IV/2003

III/2003

II/2003

I/2003

IV/2002

III/2002

II/2002

I/2002

IV/2001

III/2001

II/2001

I/2001

MEN CAT

WOMEN CAT

TOTAL CAT

TOTAL SPA

Catalonia, Spain, participation rate (%)http://www.idescat.cat/economia/inec?tc=5&id=0608&lang=es&cp=04&x=7&y=10

3 Unemployment

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

2005‐I

2005‐II

2005‐III

2005‐IV

2006‐I

2006‐II

2006‐III

2006‐IV

2007‐I

2007‐II

2007‐III

2007‐IV

2008‐I

2008‐II

2008‐III

2008‐IV

2009‐I

2009‐II

2009‐III

2009‐IV

2010‐I

2010‐II

2010‐III

2010‐IV

2011‐I

2011‐II

2011‐III

2011‐IV

2012‐I

2012‐II

2012‐III

2012‐IV

2013‐I

2013‐ II

2013‐III

2013‐IV

TOTAL

MEN

WOMEN

Spain, employment (millions of persons)http://www.ine.es/jaxiBD/tabla.do?per=03&type=db&divi=EPA&idtab=2089#nogo

4 Unemployment

0

0,2

0,4

0,6

0,8

1

1,2

1,4

1,6

1,8

2

2,2

2,4

2,6

2,8

3

3,2

3,4

3,6

3,8

4

4,2

4,4

4,6

4,8

5

5,2

1996M01

1996M07

1997M01

1997M07

1998M01

1998M07

1999M01

1999M07

2000M01

2000M07

2001M01

2001M07

2002M01

2002M07

2003M01

2003M07

2004M01

2004M07

2005M01

2005M07

2006M01

2006M07

2007M01

2007M07

2008M01

2008M07

2009M01

2009M07

2010M01

2010M07

2011M01

2011M07

2012M01

2012M07

2013M01

2013M07

2014M01

TOTAL

MEN

WOMEN

16‐24

Spain, registered unemployment (millions of persons)http://www.ine.es/jaxi/tabla.do?path=/t38/bme2/t22/a061/l0/&file=0202001.px&type=pcaxis&L=0

5 Unemployment

0

0,5

1

1,5

2

2,5

3

3,5

4

4,5

5

5,5

6

6,5

2005‐I

2005‐II

2005‐III

2005‐IV

2006‐I

2006‐II

2006‐III

2006‐IV

2007‐I

2007‐II

2007‐III

2007‐IV

2008‐I

2008‐II

2008‐III

2008‐IV

2009‐I

2009‐II

2009‐III

2009‐IV

2010‐I

2010‐II

2010‐III

2010‐IV

2011‐I

2011‐II

2011‐III

2011‐IV

2012‐I

2012‐II

2012‐III

2012‐IV

2013‐I

2013‐II

2013‐III

2013‐IV

TOTAL

MEN

WOMEN

20‐24

Spain, estimated unemployment (millions of persons)http://www.ine.es/jaxiBD/tabla.do?per=03&type=db&divi=EPA&idtab=2193#nogo

6 Unemployment

0

0,5

1

1,5

2

2,5

3

3,5

4

4,5

5

5,5

6

6,5

2005‐I

2005‐II

2005‐III

2005‐IV

2006‐I

2006‐II

2006‐III

2006‐IV

2007‐I

2007‐II

2007‐III

2007‐IV

2008‐I

2008‐II

2008‐III

2008‐IV

2009‐I

2009‐II

2009‐III

2009‐IV

2010‐I

2010‐II

2010‐III

2010‐IV

2011‐I

2011‐II

2011‐III

2011‐IV

2012‐I

2012‐II

2012‐III

2012‐IV

2013‐I

2013‐II

2013‐III

2013‐IV

ESTIMATED

REGISTERED

Spain, registered and estimated unemployment(millions of persons)

http://www.ine.es/jaxi/tabla.do?path=/t38/bme2/t22/a061/l0/&file=0202001.px&type=pcaxis&L=0

http://www.ine.es/jaxiBD/tabla.do?per=03&type=db&divi=EPA&idtab=2193#nogo


7 Unemployment

0

2

4

6

8

10

12

14

16

18

20

22

24

26

28

2005‐I

2005‐II

2005‐III

2005‐IV

2006‐I

2006‐II

2006‐III

2006‐IV

2007‐I

2007‐II

2007‐III

2007‐IV

2008‐I

2008‐II

2008‐III

2008‐IV

2009‐I

2009‐II

2009‐III

2009‐IV

2010‐I

2010‐II

2010‐III

2010‐IV

2011‐I

2011‐II

2011‐III

2011‐IV

2012‐I

2012‐II

2012‐III

2012‐IV

2013‐I

2013‐II

2013‐III

2013‐IV

TOTAL

MEN

WOMEN

Spain, unemployment rate (%)http://www.ine.es/jaxiBD/tabla.do?per=03&type=db&divi=EPA&idtab=2194#nogo

8 Unemployment

0

5

10

15

20

25

30

35

40

45

50

55

60

65

70

75

80

2005‐I

2005‐II

2005‐III

2005‐IV

2006‐I

2006‐II

2006‐III

2006‐IV

2007‐I

2007‐II

2007‐III

2007‐IV

2008‐I

2008‐II

2008‐III

2008‐IV

2009‐I

2009‐II

2009‐III

2009‐IV

2010‐I

2010‐II

2010‐III

2010‐IV

2011‐I

2011‐II

2011‐III

2011‐IV

2012‐I

2012‐II

2012‐III

2012‐IV

2013‐I

2013‐ II

2013‐III

2013‐IV

TOTAL

16‐19

20‐24

Spain, unemployment rate (%)http://www.ine.es/jaxiBD/tabla.do?per=03&type=db&divi=EPA&idtab=2194#nogo

9 Unemployment

0

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

IV/2013

III/2013

II/2013

I/2013

IV/2012

III/2012

II/2012

I/2012

IV/2011

III/2011

II/2011

I/2011

IV/2010

III/2010

II/2010

I/2010

IV/2009

III/2009

II/2009

I/2009

IV/2008

III/2008

II/2008

I/2008

IV/2007

III/2007

II/2007

I/2007

IV/2006

III/2006

II/2006

I/2006

IV/2005

III/2005

II/2005

I/2005

IV/2004

III/2004

II/2004

I/2004

IV/2003

III/2003

II/2003

I/2003

IV/2002

III/2002

II/2002

I/2002

IV/2001

III/2001

II/2001

I/2001

TOTAL CAT

MEN CAT

WOMEN CAT

TOTAL SPACatalonia, Spain, unemployment rate (%)http://www.idescat.cat/economia/inec?tc=5&id=0608&lang=es&cp=04&x=7&y=10

10 Unemployment

Unemployment rate ∙ 7 February 2014http://www.tradingeconomics.com

4.3

23.9

26.03Ranking: 14

24.7

46.3Congo-Kinshasa

4.25

6.8

5.6

10.915.3 12.7

5.1

6.7

7.2

40.6 Haiti

7.48.44

5.610

19.5

5.6

4 3 3.7

3.8

10.3

7.1

3.5 7.5

13.4

9.727.8

44.5 Bosnia and Herzegovina

16

40

59.5Djibouti

4.6

5.8

6.25

0.1Cambodja

11 Unemploymenthttp://www.tradingeconomics.com ∙ 7 February 2014 12 Unemployment

http://w

ww.tradingeconomics.com

∙ 7 Feb

ruary 2014


13 Unemployment

Basic types of unemployment

• Actual unemployment is divided into three catego‐ries (the first two define “natural unemployment”).

• Frictional. Occurs while workers are changing jobs.

• Structural. Due to structural changes in theeconomy that create and eliminate jobs and to theinstitutions that match workers and firms (firingand hiring costs, minimum wages, unemploymentbenefits, mobility restrictions, lack of training…).

• Cyclical. Generated by the short‐run fluctuations ofGDP (rises with recessions, falls with booms).

14 Unemployment

Okun’s law

• Okun’s law is an empirical relationship suggestedin 1962 by the US economist Arthur Okun (1928‐80).

• Okun’s law: there is a negative relationship betwe‐en the change ∆ in the unemployment

rate and

, the rate of growth of real GDP

. A simple formal expression of the law is

∆

where and are positive constants that dependon the economy considered and the period withrespect to which the variables are measured.

15 Unemployment

Okun’s law (US version) /1

• Expressing the variables as annual percentages, inthe US, 1.5 and 0.5. Therefore:

∆ 1.5 /2 or 1.5 /2.

• represents the increase in that occurs when theeconomy does not grow: if 0, then ∆ .

• For instance, if 2% and 0, then/2 2 1.5 0/2 3.5. Hence, if the unem‐

ployment rate at the beginning of the year is 2%and the economy does not grow, at the end of theyear the rate is 3.5%.

16 Unemployment

Okun’s law (US version) /2

• measures the ability of the economy to transformGDP growth into a smaller unemployment rate:

0.5 means that increasing by one pointreduces by 0.5 points.

• If 2%, then 1.5 /2 1.52/2 0.5. If 3%, then 1.5/2 1.5 3/2 .

• Therefore, increasing from 2% to 3% reducesfrom 0.5 to . There is a gain of 0.5 points:an additional 1% in becomes 0.5 points less of .

17 Unemployment

Okun’s law, US, 1951‐2003

Okun’s law, US, 1951‐2008https://www2.bc.edu/~murphyro/EC204/PPT/CHAP09.ppt

Percentage chan

ge in real GDP

Change in unemployment rate

1975

19821991

2001

1984

1951 1966

2003

19872008

1971

∆3 2 ∆

18 Unemployment‐1

‐0,5

0

0,5

1

1,5

2

2,5

3

3,5

4

4,5

5

‐2 ‐1,5 ‐1 ‐0,5 0 0,5 1 1,5 2 2,5 3

∆

1998

1977

Okun’s law, Spain

(1977 1998)http://www.ine.es


19 Unemployment‐1

‐0,8

‐0,6

‐0,4

‐0,2

0

0,2

0,4

0,6

0,8

1

1,2

1,4

1,6

1,8

2

‐1 ‐0,8 ‐0,6 ‐0,4 ‐0,2 0 0,2 0,4 0,6 0,8 1 1,2 1,4 1,6 1,8 2

Okun’s law, Spain

(1976IV1998IV)http://www.ine.es

20 Unemployment

The Phillips curve

• It is an empirical relationship described in 1960 byPaul Samuelson and Robert Solow based on a 1958paper by the New Zealand economist AlbanWilliam Housego Phillips (19141975).

• The Phillips curve expresses a negative relationshipbetween the unemployment rate and the inflationrate : the lower , the higher .

• With and positive constants, a linear Phillipscurve is represented by an equation of the sort

.

21 Unemployment

Trade‐off between and

• Expressing and in percentage terms, thatmeans that, to reduce one percentage

point the unemployment rate , it is necessary toaccept an increase in the inflation rate of points.

• Let 10 and 2. If 4%, then 10 2 42%. Then, for to be reduced one point (from

4% to 3%), must be increased in two percentagepoints (from 2% to 10 2 3 4%).

• is the inflation rate that obtains with zero unem‐ployment. It is a measure of underlying inflation.

22 Unemployment

Unstability of the Phillips curve

• In contrast to Okun’s law, the Phillips curve is ingeneral unstable, since is a volatile parameter.

• depends on inflation expectations and the firms’cost structure: an increase in expected inflation orin the production costs rises . When rises, thecurve shifts upward, so more inflation must bepaid to reduce the unemployment rate.

• indicates how sensitive is to changes in . Itdepends on institutional factors, like the bargain‐ing power of trade unions (more power, higher ).

23 Unemployment

‐2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

28

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

1976 IV

2013 IV

Spain, Phillips curve (1976IV 2013IV)http://www.ine.es/jaxi/menu.do?type=pcaxis&path=/t22/e308_mnu&file=inebase&N=&L=0

http://www.ine.es/jaxi/menu.do?type=pcaxis&path=%2Ft25%2Fp138&file=inebase&L=0

24 Unemployment

‐2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

28

4 6 8 10 12 14 16 18 20 22 24 26 28

2013 IV

1976 IV

Spain, Phillips curve(1976IV 2013IV)

Source: same as previous slide


25 Unemployment

7

9

11

13

15

17

19

21

23

25

27

4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

1976 IV

1986 IV

Spain, Phillips curve(1976IV 1986IV)


26 Unemployment

‐1

‐0,5

0

0,5

1

1,5

2

2,5

3

3,5

4

4,5

5

5,5

6

6,5

7

7,5

7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

1987 I

1994 IV

1996 I

2013 IV

Spain, Phillips curves(1987I 1994IV and1996I 2013IV)


27 Unemployment

‐2

0

2

4

6

8

10

12

14

16

18

20

22

24

26

28

1976III

1977III

1978III

1979III

1980III

1981III

1982III

1983III

1984III

1985III

1986III

1987III

1988III

1989III

1990III

1991III

1992III

1993III

1994III

1995III

1996III

1997III

1998III

1999III

2000III

2001III

2002III

2003III

2004III

2005III

2006III

2007III

2008III

2009III

2010III

2011III

2012III

2013III

Spain, inflation andunemployment rates(1976III 2013IV)


28 Unemployment

Japan’s Phillips curvelooks like Japan

(1980M1 2005M8)http://www.econ.yale.edu/smith/econ116a/japan.pdf

29 Unemployment

Internal and external balance

• Internal balance requires full employment ofresources (sufficiently low unemployment rate)and price stability (low and stable inflation rate).

• External balance corresponds to a balanced currentaccount (the supply and demand for the domesticcurrency are balanced). For simplicity, externalbalance is defined as zero trade balance.

• Internal balance and external balance both areassumed to depend on two variables: domesticexpenditures and the real exchange rate.

30 Unemployment

The internal balance (IB) function /1

• The IB function drawn on the next slide is assumedincreasing for the following reason.

• Suppose the economy is initially at point . If a realappreciation occurs (the real exchange rageincreases), then imports rise and exports fall. Thatis, there is a switch in demand from domestic toforeign goods. As a result, unemployment goes upand the economy moves from point to .

• To restore internal balance by reaching point ,unemployment must be eliminated. This requiresan increase in domestic expenditure.


31 Unemployment

Interpreting the IB function /1

′

32 Unemployment

The internal balance (IB) function /2

• If follows from the previous analysis that pointsabove the IB function (excessive expenditureabroad) imply the existence of unemployment.

• Below the IB function failure of internal balance isnot due to unemployment but to inflation.

• For instance, at point , given the correspondingreal exchange rate ′ , domestic expenditure isexcessive with respect to the level required toreach internal balance. This excess of domesticexpenditure manifests itself in the form of inflation.

33 Unemployment

Interpreting the IB function /2

34 Unemployment

The external balance (EB) function /1

• The EB function drawn on the next slide isassumed decreasing for the following reason.

• Suppose the economy is initially at point , wherethe trade balance is zero. If domestic expenditureincreases, GDP and, consequently, income alsoincrease. Part of this additional income is spentbuying foreign goods. A trade deficit ensues.

• To restore external balance by reaching point , thetrade deficit must be neutralized. This requires areduction of the real exchange rate: a realdepreciation (an improvement of competitiveness).

35 Unemployment

Interpreting the EB function /1

′

36 Unemployment

The external balance (EB) function /2

• If follows from the previous analysis that pointsabove the EB function (excessive domesticexpenditure) generate a trade deficit.

• Below the EB function failure of external balance isnot due to a trade deficit but to trade surplus.

• For instance, at point , given the correspondinglevel of domestic expenditure, the real exchangerate is smaller than the value ′ required to reachexternal balance with . That is, the economy istoo competitive and therefore runs a trade surplus.


37 Unemployment

Interpreting the EB function /2

38 Unemployment

The Swan (or Meade‐Swan) diagram

• The Swan diagram (due to Trevor W. Swan)combines the IB and EB functions.

• It separates the plane into four regions.

In region I, the economy experiences unemploy‐ment and trade deficit (Spain, Egypt, Poland).

In region II, inflation coexists with a trade deficit(Brazil, Turkey, Colombia, Morocco).

In region III, there is inflation and a tradesurplus (China, Russia, Korea).

In region IV, the economy has unemploymentand runs a trade surplus (Hungary, Slovakia).

39 Unemployment

The Swan diagram

40 Unemployment

The Swan diagram in action

• Suppose the economy is in Region I and, specifi‐cally, around the numeral “I” in “Region I”.

• At that point, the economy has unemployment. Itmay appear that more expenditure is needed toreduce unemployment.

• The diagram suggests that the unemploymentproblem this economy faces is not solved by chan‐ging expenditure (increasing it) but by shiftingexpenditure. To reach the intersection of the IB andEB lines, domestic expenditure must be reducedand net exports increased (through depreciation).

41 Unemployment

Principle of effective market classification

• Robert Mundell’s principle of effective marketclassification: “Policies should be paired with theobjectives on which they have the most influence”.

• “In countries where employment and balance‐of‐payments policies are restricted to monetary and fiscalinstruments, monetary policy should be reserved forattaining the desired level of the balance of paymentsand fiscal policy for preserving internal stability. Theopposite system would lead to a progressively worseningunemployment and balance‐of‐payments situation”.http://robertmundell.net/major‐works/the‐appropriate‐use‐of‐monetary‐and‐fiscal‐policy‐for‐internal‐and‐external‐stability

42 Unemployment

Explaining involuntary unemployment

• Involuntary unemployment occurs when, at theprevailing wage rate in the economy, there arepeople willing to work but are not given a job.

• The models developed next illustrate basic reasonsfor the existence of involuntary unemployment:

“too high” wage rates (classical explanation);

insufficient labour demand, due to insufficientaggregate demand (Keynesian explanation);

existence of market power (trade unions);

existence of labour discrimination; and

structural reasons (last model).


43 Unemployment

The classical labour market model /1

*

*

44 Unemployment

The classical labour market model /2

• It is a standard competitive model in which “price”is represented by the real wage (the nominal wa‐geW divided by some price level P) and “quantity”is labour (labour supplied and demanded).

• The higher , the higher the labour supply (upto the maximum labour that can be supplied: theeconomically active population ). The laboursupply function is therefore increasing.

• The labour demand function is decreasing: thehigher , the lower the labour demand .

45 Unemployment

Competitive labour demand /1

• A labour demand function can be constructed asfollows. Take any firm using labour to produce acertain commodity by means of the productionfunction that establishes the total amount ofthat can be produced using units of labour.

• Define the firm’s profit function as, where is the amount of labour the

firms hires, is the price at which the firm sells(in a competitive market for ), and is thenominal wage (the cost of hiring each unit oflabour).

46 Unemployment


• Suppose the aim of the firm is to choose tomaximize the profit function. Assuming thefunction differentiable, the first order condi‐

tion for a maximun is 0. Since the firm is a

price taker in the commodity market,

• The derivative is the marginal product of

labour MPL . Therefore, / implicitlydefines the firm’s labour demand function.

0 .

47 Unemployment


• is typically supposed to be decreasing: themore labour is hired, the smaller the contributionthat the last unit makes to production (eachadditional unit of labour is less productive).

• As a result, when represented graphically in the

space ( , ), the function is decrea‐

sing. This says that the firm hires labour until itsmarginal product coincides with the real cost of

hiring labour (the real wage ). Equivalently,

labour is paid according to the value of its marginalproductivity: .

48 Unemployment

Example

• If 2 / , 2/

/ . The firm’s labour demand function is

• Therefore, / . Solving for ,

1/

• Since/ /

0, the demand for labour

is a decreasing function of the real wage / .

Labourdemandstimulatedbyarisingpriceoftheproductorafallingwagerate

.


49 Unemployment

Equilibrium in the labour market

• Since the labour demand of each firm is inverselycorrelated with a certain wage rate, one may jumpto the conclusion that the aggregate demand forlabour in an economy is inversely correlated withthe economy’s real wage.

• The equilibrium real wage rate * is such thatlabour supplied at * equals labour demanded at*. Given *, there is no involuntary unemploy‐

ment: everyone willing to get hired at * is hired.The difference * can be viewed as voluntary

unemployment (∗would be the participation rate).

50 Unemployment

Unemployment in the classical model /1

• Establishing a mininum real wage above theequilibrium wage rate * generates involuntaryunemployment in a competitive labour market.

• The next slide illustrates this possibility. Marketequilibrium occurs at point . If the minimumwage rate is set, the market state is no longerrepresented by but by : although workers arewilling to be at , firms cannot be forced to hiremore workers than the amount given by .

• At the prevailing wage rate there is an excesssupply, interpreted as involuntary unemployment.

51 Unemployment


52 Unemployment


• Involuntary unemployment in a competitive labourmarket may also temporarily arise if the real wagerate adjusts sluggishly.

• The next slide illustrates this situation. Marketequilibrium occurs initially at , with wage rate .The demand for labour function shifts to the left.The new equilibrium would be represented by .

• But if the real wage rate takes time to adjust (de‐crease), the wage rate in the market may tempora‐rily remain at the initial level . The market isthen at , where involuntary unemployment exists.

53 Unemployment


′

54 Unemployment

An atypical example /1

• Suppose the function combines a flat with anupward sloping section, as shown in the next slide.

• The flact section at real wage * could be interpre‐ted in the sense that, when the real wage is *, (i)workers are, in principle, indifferent betweensupplying labour or not, and (ii) some randomvariable determines the amount actually supplied.

• Market equilibrium occurs at , where employ‐ment is *. If workers finally choose to supply ′(effective labour supply represented by ), there isinvoluntary unemployment given by *.


55 Unemployment

An atypical example /2

*

*

′ ′′

56 Unemployment

(Derived) demand for labour

• Firms do not hire workers because they aim ataccumulating workerts. The labour forces is a toolto produce commodities and obtain a profit byselling the commodities produced.

• For that reason, it is said that the demand forlabour by firms is a derived demand: it arises as anintermediate step in the process of reaching thefirms’ final goal, which is making profits.

• Hence, the demand for labour crucially depends onsales expectations: no matter how “cheap” labouris, workers will not be hired if firms do not expectto sell what these workers would produce.

57 Unemployment

Monopsony /1

• Since there are fewer firms than workers and firmstypically hire several workers, it seems reasonableto presume that firms enjoy some market power.

• To consider a simple benchmark case, supposethere is a unique firm: a monopsonist. In a monop‐sony, the buyer (the firm) dictates the terms to thesellers (workers). So suppose the firm chooses thewage rate to maximize profits.

• Assume also that the firm is competitive in the pro‐duct market (price of the commodity given) andworkers are price‐takers (take and as given).http://en.wikipedia.org/wiki/Monopsony

58 Unemployment

Monopsony /2

• In a monopoly, the monopolist’s problem is tochoose a point along the market demand function.

• Similarly, a monopsonist will choose a point alongthe market labour supply function.

• To see this, consider the supply function depic‐ted on the next slide. A monopsonist cannot choosea point below : at the corresponding wage rate

labour supply ′ is smaller than demand .

• A monopsonist will neither choose a point above: the firm could get the amount of labour

demanded at at a rate ′ smaller than .

59 Unemployment

The monopsonist is limited by

′

′

60 Unemployment

Monopsony /3

• The firm’s profit function is, where is the labour supply

function (in nominal terms): is the smallestnominal wage inducing workers to supply theamount of labour. Using the chain rule,

.

• To reach a maximum, it is necessary that 0.

Accordingly, since ,

.


61 Unemployment

Monopsony /4

• The left‐hand side is the marginalrevenue of labour or value of the marginal productof labour: the money revenue the firm obtains byselling what an additional unit of labour produces.

• The right‐hand side represents

the marginal cost of labour: the monetary cost ofhiring an additional unit of labour. This cost ishigher than the nominal wage rate . In realterms,

realmarginalrevenue realmarginalcost

.

62 Unemployment

Monopsony /5

• The left‐hand side is what the firm obtainsin real terms from one more unit of labour. The

right‐hand side is what one more

unit of labour costs to the firm in real terms.

• When the firm is competitive (wage taker), the

condition is , so the real wage

defines the real marginal cost for the firm. But, fora monopsonist, this cost is higher than the real

wage , for which reason the real marginal cost

function lies above the supply function .

63 Unemployment

Perfect competition vs monopsony

?

64 Unemployment

Example

• Let 15 , with 0 if 24,be the monopsonist’s production function. The

labour supply function is ; that is,

2 . Since 15 2

, 15 4 . Therefore,

0 implies 15 4 . The monopsonist

demands 3 ( ⁄ 6). If the firm is competi‐

tive, labour demand is obtained from ,

where comes from the labour supply function.

In sum, 15 and 5 ( ⁄ 10).

65 Unemployment

On the monopsony solution

• The monopsony solution, in analogy with themonopoly solution, is determined in two stages.First, marginal cost of labour is equated tomarginal revenue of labour (point ) to ascertainthe labour demanded . Second, the wage rate

chosen by the monopsonist is the one that thesupply of labour associates with .

• The result is not involuntary unemployment (given, workers would like to supply precisely )

but what could be considered underemployment:the compensation workers receive may be too lowcompared with their ability (their ) .

66 Unemployment

Supply‐side market power: unions /1

• The monopsony analysis shows that demand‐sidemarket power generates less employment andlower wages than perfect competition.

• Supply‐side market power is typically associatedwith the existence of trade unions. For any givenamount of labour , the wage rate unions demandto supply will be higher than the wage ratedictated by the supply of labour function.

• This follows from the fact that unions (since theycan organize strikes) have more bargaining powerover wages than individual workers.


67 Unemployment


• As a result, the function associating witheach amount of labour the wage rate that unionswill ask to be willing to supply must lie abovethe supply of labour function.

• The next slide combines the function witha competitive labour demand function . Withouttrade unions, market equilibrium is at . Withunions market equilibrium is at . The distancebetween and represents involuntary unemploy‐ment: given wage , workers would individuallylike to supply but the presence of the union onlyallows to be hired.

68 Unemployment


69 Unemployment

Fighting involuntary unemployment

• When the wage is “too high”, the obvious solutionto get rid of unemployment is to lower the wage(or let time pass by for the wage to adjust by itself).

• When unemployment is due to lack of labourdemand, the natural solution is an aggregatedemand expansion that induces firms to hire moreworkers to satisfy the additional demand.

• When the cause of unemployment is market power(unions), the solution seems harder to implement:how to reduce the unions’ bargaining powerwithout raising protests by part of the workers?

http://en.wikipedia.org/wiki/Trade_unions_in_the_United_Kingdom70 Unemployment

Price setting & wage setting model /1

• In modern economies, the nominal wage rate of asubstantial number of workers is determinedthrough collective bargaining involving unions.

• If workers are represented by unions, at any levelof employment, the real wage will be above thewage rate dictated by the labour supply function.

• It is assumed that unions establish the real wageusing a wage setting function sloping upwardand lying above the labour supply function . Thehigher the unions’ bargaining power, the larger thevertical distance between between and .

71 Unemployment


• Whereas workers (through unions) are assumed toset the nominal wage, firms are supposed to fix theprices of the commodities they produce.

• A simple price setting rule consists of adding a

mark‐up 0 to labour costs: 1 .

• is measured in money EUR and in units

of product per worker. Thus, is the money paid

to workers divided by what they produce. In other

words, is the (labour) cost of producing a unit

of the commodity.72 Unemployment


• It is convenient to define , so 1

can be equivalently expressed as .

• Clearly, 1 . In sum,

.

• is then a mark‐up over output: the fraction of theworkers’ productivity that the firm appropriates.

productionperworker

realwageperworker

realprofitperworker


73 Unemployment


• Under perfect competition in the labour and

product markets, .

• When prices are set by firms as the marking up of

labour costs per worker, 1 . This is

called the price setting function S. As 0 1, 1 means that .

• As the function is downward sloping, thefunction is downward sloping as well. liesbelow because is a fraction of (theconstant 1 is smaller than 1).

74 Unemployment

The WS and PSmodel

75 Unemployment

Example

• Supply of labour function: ω (ω is the real

wage rate).

• function: 20 5 .

• Demand for labour function: ω .

• function: ω 3 .

• function: ω 1 , with 0.4.

• Competitive solution: 20 5 3and ω 5.

• ‐ solution: 3 0.6 30.6 20 5 2 and ω 6.

76 Unemployment

Segmented labour market model

• Suppose workers may have or not someeconomically irrelevant feature that firms may likeor not (for instance, being a man or not).

• Firms classify workers in two types (I and II)depending on whether they possess the feature ornot. Some firms (type I firms) prefer type Iworkers; the rest (type II) prefer type II workers.

• Each type of firms defines a different (competitive)labour market. Workers are unaware of the factthat there are two types of firms. From theirperspective, the labour market is not segmented.

77 Unemployment

Example /1

• Supply of labour function of type I workers:4 ω (ω is the real wage rate).

• Demand for labour function of type I firms:60 2 ω ( 0 if ω 30).

• Market equilibrium (type I): , ω 40, 10 .

• Supply of labour function of type II workers:12 ω.

• Demand for labour function of type II firms:80 4 ω ( 0 if ω 20).

• Market equilibrium (type II): , ω 60, 5 .

78 Unemployment

Example /2

• 40% of employment corresponds to

type I workers and 60% to type II.

Using these weights, the average real wage rate

would be ω ω ω 10 5 7.

• At ω 7, no more type I workers than are actuallyemployed would like to be hired. But, at ω 7,type II workers would like to supply 12 ω84. Since employment of type II workers equals

60, involuntary unemployment appears to beω 7 84 60 24 (unemployment

rate 24 24 19.3%⁄ ); see next slide.


79 Unemployment

ω

40

10

30

60

60

5

7

20

84

24

Though each segment is in equilibrium, there is a sense in which involuntary unemployment exists.

80 Unemployment

The E‐PISmodel• It postulates three linear relations linking employ‐ment with production, income, and spending.

relation (production employment): esta‐blishes the amount of employment required toreach a certain GDP level.

relation (income employment): identifiesthe amount of labour supplied for every value ofaggregate income.

relation (employment expenditure): indi‐cates the aggregate level of spending associatedwith any given amount of employment.

81 Unemployment

EP (employment‐production) relation

′

′

employment

GDP

Firms expect aggre‐gate demand to be . They therefore

make plans to pro‐duce the amount ′.

To reach GDP level ′, firms require the amount ′ of labour.

Embodies theeconomy’saggregateproductionfunction

82 Unemployment

ES (employment‐spending) relation

′

′

employment

aggregatedemand

generatesaggregate

demand ′.

The level

of employment Embodies theeconomy’sspendingplans

Spending that does not depend on the employment level

83 Unemployment

EI (employment‐income) relation

′

′

labour

aggregateincome

When the economy generates

income ′

the amount of labour is supplied. Embodies the

economy’ssupply oflabour

Insufficient incometo supply labour

84 Unemployment

Solving the E‐PISmodel /1

′

′

′′


85 Unemployment

Solving the E‐PISmodel /2

• When drawn simultaneously, there is no point atwhich the three relations intersect.

• Without delving into details, let us assume that thesolution is found at a point when two linesintersect. Leaving the origin aside, there are twocandidates: point and point .

• Point is not stable (self‐sustained). At , employ‐ment is and aggregate demand is . But,according to , to produce , the economy onlyneeds the amount of labour. Hence, doesnot represent a consistent state of the economy.

86 Unemployment

Solving the E‐PISmodel /3• At , employment is and aggregate demand is

. To generate a GDP equal to firms demandexactly the amount of labour. In addition, thelevel of employment generates precisely thelevel of aggregate demand. This state of theeconomy appears self‐consistent and stable.

• The problem is that there is involuntary unemploy‐ment at point . Given income , workers wouldlike to supply the amount of labour. Sinceemployment at is only , defines thelevel of involuntary unemployment. Question:what shifts in the lines would reduce it?

87 Unemployment

Interpreting the E‐PISmodel /1• The arguably simplest description of an economy isgiven by the loop

production income expenditure production

• The E‐PIS model inserts labour in this loop. First,production creates a derived demand: the demandfor labour. Second, the income the economygenerates is a key variable helping workers todecide the amount of labour supplied.

• Lastly, the level of employment, once determined,significantly contributes to establish aggregatedemand, which in turn affects production.

88 Unemployment

‐

89 Unemployment

Interpreting the E‐PISmodel /2• The classical view of this process attributes to thelabour market the leading role. Employment is firstestablished, this next determines production, andproduction is finally used.

• The Keynesian view inverts the order. First, expen‐diture decisions are made. These decisions indicatethe necessary production level. Finally, the labourrequired to carry out the production plan is hired.

• The E‐PIS model aligns itself with the latter view.The state of the economy is foremost determinedby the firms’ expected level of aggregate demand.

90 Unemployment

Interpreting the E‐PISmodel /3• To meet the expected demand level , firms hirethe amount of labour necessary to produce . Aslong as the income level corresponding to produc‐tion level induces workers to supply at least ,the employment‐income relation is irrelevant.

• Since there is no obvious reason why the EI relationcannot be established independently of the otherrelations, it is highly unlikely that workers willexactly supply . Thus, the excess of labour sup‐plied constitutes involuntary unemployment. As itemerges from the very working of the economy, itwill be hard to eliminate it completely.

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