Wage Determination

1
Wage Determination

• Common forces at work in the determination of
  wages include
• A tendency for the wage to exceed the reservation
  wage, or the wage that makes workers indifferent
  between working or becoming unemployed.
• Dependency of wages on labor-market conditions.

• This suggests a perfectly competitive model
  will not capture key features of the labor
  market.

2
Bargaining

• How much bargaining power a worker has depends
  on
• How costly it would be for the firm to replace
  him the nature of the job.
• How hard it would be for him to find another job
  labor market conditions.

3
Efficiency Wages

• Efficiency wage theories are theories that link
  the productivity or the efficiency of workers to
  the wage they are paid.
• These theories also suggest that wages depend on
  both the nature of the job and on labor-market
  conditions.

4
Wages, Prices, and Unemployment

• The aggregate nominal wage, W, depends on three
  factors
• The expected price level, Pe
• The unemployment rate, u
• A catchall variable, z, that catches all other
  variables that may affect the outcome of wage
  setting.

5
Wages, Prices, and Unemployment

• Both workers and firms care about real wages
  (W/P), not nominal wages (W).
• Higher unemployment weakens workers bargaining
  power, forcing them to accept lower wages.
• Among other factors that affect wages is
  unemployment insurancethe payment of
  unemployment benefits to workers who lose their
  jobs. Higher unemployment insurance allows
  workers to hold out for higher wages. Minimum
  wages and employment protection are other factors.

6
Price Determination

• The production function is the relation between
  the inputs used in production and the quantity of
  output produced.
• Assuming that firms produce goods using only
  labor, the production function can be written as
• If we assume that A 1 then Y N and the
  marginal cost of producing an extra unit of
  output is equal to the cost of a unit of labor W.

Y outputN employmentA labor productivity,
or output per worker
7
Price Determination

• Firms set their price according to

The term ? is the markup of the price over the
cost of production. If all markets were
perfectly competitive, ? 0, and P W.
8
The Price-Setting Relation

• The price-setting equation is

• If we divide both sides by W, we get

• To state this equation in terms of the wage rate,
  we invert both sides

The price-setting relation
9
The Wage-Setting Relation

• Recall that the nominal wage rate was determined
  as follows
• Key assumption In medium run equilibrium, we
  assume that price expectations are being
  confirmed Pe P.
• Then, dividing both sides by P,

The wage-setting relation
10
Wages and Unemployment

• The real wage chosen in wage setting
  relation is a decreasing function of the
  unemployment rate. The real wage implied by the
  price setting relation is constant, independent
  of the unemployment rate.

11
Equilibrium Real Wagesand Unemployment

• The natural rate of unemployment is the
  unemployment rate such that the real wage chosen
  in wage setting is equal to the real wage implied
  by price setting.

12
An Example

• In general, for the wage setting relation we
  have
• An example is
• Recall, the price-setting relation
• Solving for the natural or equilibrium rate of
  unemployment by eliminating W/P

13
Unemployment Benefits and the Natural Rate of
Unemployment

• An increase in unemployment benefits leads to
  an increase in the natural rate of unemployment.

14
Markups and the Natural Rate of Unemployment

• An increase in markups decreases the real
  wage, and leads to an increase in the natural
  rate of unemployment.