# Wage setting and price relationship standards

### The Economy: Unit 9 The labour market: Wages, profits, and unemployment

The estimation uses random effects with robust standard errors clustered by country. Philip Lowe reported that in relation to subdued price and wage- setting. Draw a standard diagram for wage-setting relation and price-setting relation. Suppose that for given labor market conditions, worker bargaining power. Firms set prices (and employment) to maximize profits, for given wages Equilibrium unemployment Un given by wage and price setting behaviour al ( ) (increased wage pressure from , the replacement ratio, real import price, no increase in standard deviation of annual industry employment changes), nor that.

This reduces the profit per worker. Since this leads to lower prices across the whole economy, it implies higher real wages, pushing up the price-setting curve. Higher labour productivity means a higher average product of labour curve. For any given markup this means a higher price-setting curve, which means a higher real wage. Einstein The price-setting curve There are several steps to show how the price-setting curve for the economy as a whole results from the decisions of individual firms.

The firm pays the worker a wage W in dollars. Both labour productivity and wages can be measured per hour, per day or per year. In our numerical examples, we typically use hourly wages and productivity.

### Wage Rates and the Supply and Demand for Labour

The unit labour cost is the wages paid to hire the amount of labour to produce one unit of the good. This is defined as: Recall from Unit 7 that the firm chooses its price so that the markup is inversely proportional to the elasticity of the demand curve it faces: In words, this says: When the firm sets its profit-maximizing price, this splits output per worker into the part that goes to employees as wages and the part that goes to owners as profits.

Since she buys many different goods and services, this depends on prices set by the firms throughout the economy, not just her own firm. We call the average price of the goods and services the worker consumes, P, which is an average of the different levels of p set by individual firms across the economy.

The real wage is the nominal wage divided by the economy-wide price level, P. Profits, wages, and the price-setting curve We assume that the entire economy is made up of firms facing competition conditions similar to the single firm we have just studied. This means the price-setting problem from Step 1 applies to all firms in the economy, so we can use the price-setting equation to determine the economy-wide real wage: In words, this says that: This is the wage indicated by the price-setting curve.

Equilibrium in the labour market. In this situation, there is no work done and no profits, so nobody is hired: These shaded points are not feasible. The equilibrium of the labour market is where the wage- and price-setting curves intersect. This is a Nash equilibrium because all parties are doing the best they can, given what everyone else is doing. Each firm is setting the nominal wage where the isocost curve is tangent to the best response function Unit 6and is setting the profit-maximizing price Unit 7.

Taking the economy as a whole, at the intersection of the wage and price setting curves point X: The firms are offering the wage that ensures effective work from employees at least cost that is, on the wage-setting curve. HR cannot recommend an alternative policy that would deliver higher profits.

Employment is the highest it can be on the price-setting curvegiven the wage offered. The marketing department cannot recommend a change in price or output. Those who have jobs cannot improve their situation by changing their behaviour.

If they worked less on the job, they would run the risk of becoming one of the unemployed, and if they demanded more pay, their employer would refuse or hire someone else. Those who fail to get jobs would rather have a job, but there is no way they can get one—not even by offering to work at a lower wage than others. Unemployment as a characteristic of labour market equilibrium We have shown that unemployment can exist in Nash equilibrium in the labour market.

This is the Nash equilibrium of the labour market because neither employers nor workers could do better by changing their behaviour. This is the Nash equilibrium of the labour market where neither employers nor workers could do better by changing their behaviour. We now show why there will always be unemployment in labour market equilibrium, using the argument from Unit 6. This is called equilibrium unemployment. Unemployment means that there are people seeking work but not finding it.

This is also termed excess supply in the labour market, meaning that demand for labour at the given wage is lower than the number of workers willing to work at that wage. To understand why there will always be unemployment in labour market equilibrium, we refer to the labour supply curve. In our model, we assume that the labour supply curve is vertical, meaning that higher wages do not lead more people to offer more hours at work.

At higher wages some people seek and find more hours of work, and others seek and find shorter hours. You know from Unit 3 that the substitution effect of a wage increase leading to the choice of more hours of work and less of free time may be offset by the income effect. For simplicity we draw a supply curve such that the wage has no effect on the labour supply.

But this is not important. The model would not be different if higher wages led to either more or fewer people seeking work.

To see this, you can experiment with labour supply curves with different shapes in Figure 9.

Why will there always be some involuntary unemployment in labour market equilibrium? If there was no unemployment: The cost of job loss is zero no employment rent because a worker who loses her job can immediately get another one at the same pay.

Therefore some unemployment is necessary: It means the employer can motivate workers to provide effort on the job. Therefore the wage-setting curve is always to the left of the labour supply curve. It follows that in any equilibrium, where the wage and price-setting curves intersect, there must be unemployed people: This is shown by the gap between the wage-setting curve and the labour supply curve.

Another way to see this is to look again at Figure 9. Notice that the wage-setting curve rises steeply when it comes close to the labour supply line, exceeding both the price-setting and labour productivity curves. This fact about our model highlights an important limit on policies to reduce unemployment. In this model, the unemployed are no different from the employed except for their bad luck.

## Wage-Setting, Price-Setting Relations

How would you reply? Does your reply help explain why unemployment must exist in a Nash equilibrium? Consider now a reduction in the degree of competition faced by the firms.

Which of the following statements is correct regarding the effects of reduced competition? The price-setting curve shifts up. The wage-setting curve shifts down. The equilibrium real wage falls.

The unemployment level falls. Decreased competition implies a higher markup. This decreases the share of output claimed by the workers, reducing their real wage. Hence the price-setting curve shifts down.

At low wage levels, higher wages induce people to work more because they make leisure more costly in terms of the income that must be given up at the margin to obtain it.

Workers substitute income for leisure. At higher wage and income levels, however, the increase in income that can be obtained by working more in response to a higher wage typically becomes less valuable than the leisure that is foregone.

A wage level will be reached beyond which workers will do less work for higher wages because they can maintain the same satisfaction as before, or even increase it, with less work effort. As people become wealthier they take more leisure and do less work. Thus, an increase in wages beyond some level, by further raising wealth, increases desired leisure by more than increased opportunity cost of leisure reduces it.

The wealth effect of higher wages on leisure offsets the substitution effect. This explains why the enormous growth of per capita income in western countries during the last century has been accompanied by substantial declines in hours worked per week.

Figure 3 shows clearly the effect of an institutionally fixed minimum wage, whether imposed by the government or by union power, on aggregate employment in the economy. Unlike the case where wages are fixed in some sector of the economy, the labour displaced here by the minimum wage has nowhere to go to bid down wages to obtain employment.

Industrialized economies like those of Canada and the United States are less than one-third unionized. Minimum wages are in force but they are quite low and would displace only the most unskilled workers from employment. Why then do we observe substantial unemployment in these economies from time to time?

What is it that is keeping wages too high, and preventing workers from bidding them down? This is the subject of our next three Topics. Before addressing it, however, there are two preliminary issues that must be dealt with. First, we must recognize that even under the best conditions there will always be some amount of unemployment.

Some people will be in the process of moving between jobs. Technological change inevitably leads to job losses in some areas of the economy and new jobs in other areas. It takes time for those displaced to relocate. Some degree of unemployment in the economy is thus inevitable and is not a signal that people who want jobs at current wages cannot find them.

The normal level of this frictional unemployment is termed the natural rate of unemployment. Frictional unemployment does not appear in Figure 3. Workers in the process of becoming informed are not part of the analysis. The fact that frictional unemployment does not appear in Figure 3 and play a role in the determination of the equilibrium wage rate in the economy highlights the second issue that we must address.

In other words, individual buyers and sellers have no influence on the market price. Market prices are determined by all buyers and sellers together. But this raises a fundamental question.

What is the process by which prices change? If every buyer and seller takes the price as given, there is no one in the market that performs the act of actually changing the price!

The supply and demand diagram assumes that prices get bid up and down while every market participant takes them as given. Indeed, it is as though there were an auctioneer in the background calling out prices to which suppliers and demanders respond. Such an auction mechanism can, in fact, be invoked to provide a rigorous basis for the analysis.