How Labour Market affect business

how labour market affect human resource planning and labour market economics 8th edition and how do labor market conditions affect recruitment
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Chapter 7 THE LABOUR MARKET Think about what happens when firms respond to an increase in demand by increasing pro- duction. Higher production leads to higher employment. Higher employment leads to lower unemployment. Lower unemployment leads to higher wages. Higher wages increase production costs, leading firms to increase prices. Higher prices lead workers to ask for higher wages. Higher wages lead to further increases in prices, and so on. So far, we have simply ignored this sequence of events: by assuming a constant price level, we have in effect assumed that firms were able and willing to supply any amount of output at a given price level. So long as our focus was on the short run, this assumption was acceptable. But as our attention turns to the medium run, we must now abandon this assumption, explore how prices and wages adjust over time, and explore how this, in turn, affects output. This will be our task in this and the next three chapters. At the centre of the sequence of events described here is the labour market, the market in which wages are determined. This chapter focuses on the labour market. It has five sections: ● Section 7.1 provides an overview of the labour market in Europe. ● Sections 7.2 and 7.3 look at wage and price determination. ● Section 7.4 looks at equilibrium in the labour market. It characterises the natural rate of unemployment, the rate of unemployment to which the economy tends to return in the medium run. ● Section 7.5 gives a map of where we will be going next.CHAPTER 7 THE LABOUR MARKET 137 7.1 A TOUR OF THE LABOUR MARKET The total EU27 population in 2008 was 490 million (Figure 7.1). Excluding those who were either under working age (under 15), or above the retirement age (65), the number of peo- ple potentially available for employment, the population in working age, was 330 million. The labour force – the sum of those either working or looking for work – was only Work in the home, such as cooking or raising children, is not classified as 238 million. The other 92 million people were out of the labour force, neither working in work in the official statistics. This is a the marketplace nor looking for work. The participation rate, defined as the ratio of the reflection of the difficulty of measuring labour force to the population in working age, was therefore 238/330, or 72%. Conversely, these activities – not a value judge- the non-participation rate, defined as the number of people out of the labour force divided ment about what constitutes work and by the population in working age, was 92/330, or 28%. In Europe, as in most of the other what doesn’t. OECD countries, the participation rate has steadily increased over time, reflecting mostly the increasing participation rate of women: in Western Europe, like in the USA, in 1950, one woman out of three was in the labour force; now the number is close to two out of three and not far from the participation rate of men (three out of four). However, this is not true in all European countries. Figure 7.2 shows the participation rates of men and women in Europe Figure 7.1 Population, labour force, employment and unemployment in the EU27 (in millions), 2008 Source: Eurostat. Figure 7.2 The participation rate of men and women in Europe, 2008 Source: Eurostat. ➤138 THE CORE THE MEDIUM RUN Figure 7.3 The participation rate of men and women between 55 and 64 years in Europe, 2008 Source: Eurostat. in 2008 (where countries are ranked from left to right in terms of the participation rate of women): in Northern European countries, the participation rates of men and women are pretty high and close to each other, whereas in Southern Europe, Central and Eastern Europe, and also in Ireland, the participation rate of women is much lower, down to just around 50%. Moreover, if we look at older workers, workers aged between 55 and 64, the differences among the participation rates of men and women are even more striking: the average for the EU27 is 39% for women and 58% for men. As shown in Figure 7.3, the ranking is pretty much the same as the one shown in Figure 7.2, but participation rates for both genders are much lower and the gap between men and women is even more pronounced. This in part reflects the differences in the retirement ages across European countries, many of which are still below 65 years, as in France, and the differences in the retirement ages between men and women, the latter often allowed to retire earlier (usually at 60 years) than men, as in Austria, Greece, Italy, Poland and the UK. Of those in the labour force, 222 million were employed, and 16 million were unem- ployed – looking for work. The unemployment rate, defined as the ratio of the unemployed to the labour force, was therefore 16/238 = 6.7%. Unemployment in Europe has not always been so high. Between the end of the Second World War and the end of the 1970s, European unemployment was very low, around 2%. It started to rise during the 1970s; it hit 8% in the 1980s and reached a peak of 10% in the 1990s. Today it is still rather high (6.7% in 2008), but the average unemployment rate actu- ally hides a lot of differences among European countries. Figure 7.4 shows unemployment rates in European countries together with the EU27 as a whole and the USA and Japan in 2008. In many of them unemployment is quite low: Austria, Denmark, the Netherlands and Norway have unemployment rates lower than the USA (5.8%). The high average unem- ployment rate in Europe reflects high unemployment rates in the four largest European economies: France, Germany, Italy and Spain. Among the latter there are yet big differ- ences: the unemployment rate in Germany has increased from the very low pre-unification rates and now hides huge regional differences between East and West Germany; in Spain, the unemployment rate went well above 20% in the early 1990s, then it decreased, and then it increased again in the last few year following the financial crisis which began in 2007.CHAPTER 7 THE LABOUR MARKET 139 Figure 7.4 The average unemployment rate in European countries, 2008(a) The average unemployment rate in Europe hides big differences among countries. Source: Eurostat. Figure 7.5 The average unemployment rate in European countries, 2008(b) The incidence of unemployment is usually higher among young workers ( 25 years). Source: Eurostat. The average unemployment rate also hides large differences among different groups of workers within the same country. The most notable one is the higher incidence of unem- ployment among young workers. Figure 7.5 shows the total unemployment rate (i.e. the unemployment rate computed for the total labour force) and the youth unemployment rate (i.e. the unemployment rate among worker younger than 25 years). The figure shows a dramatic incidence of unemployment among young workers compared to the average incidence of unemployment, and this is true in all European countries, especially in coun- tries with higher-than-average unemployment rates (such as Greece, Italy and Spain), but also where the total unemployment rate is very low (such as the Netherlands and Norway). Flows of workers between employment, unemployment and non-participation To get a sense of what a given unemployment rate implies for individual workers, consider the following analogy. Take an airport full of passengers. It may be crowded because many planes are coming and going, and many passengers are quickly moving in and out of the air- port. Or it may be crowded because bad weather is delaying flights and passengers are stuck, waiting for the weather to improve. The number of passengers in the airport will be high in both cases, but their plights are quite different. Passengers in the second scenario are likely to be much less happy.140 THE CORE THE MEDIUM RUN Figure 7.6 Average flows between employment, unemployment and non-participation in a hypothetical country In the same way, a given unemployment rate may reflect two very different realities. It Sclerosis, a medical term, means ➤ may reflect an active labour market, with many separations and many hires, and so with hardening of tissue. By analogy, it is many workers entering and exiting unemployment; or it may reflect a sclerotic labour mar- used in economics to describe markets ket, with few separations, few hires and a stagnant unemployment pool. that function poorly and have few Finding out which reality hides behind the aggregate unemployment rate requires data transactions. on the movements of workers. These data are available in Europe from a quarterly survey called the Labour Force Survey (LFS). If you want to know more about how the LFS is conducted, see the Focus box ‘The European Union Labour Force Survey’ later in this chapter. Here, to see how these data can be used to study the labour market, let us imagine – to keep things simple – a hypothetical country whose flows are reported in Figure 7.6. Imagine that, out of an employment pool of 100 million, in a given month 2 million workers move directly from one job to another (shown by the circular arrow at the top of the figure). Another 1.5 million move from employment to unemployment (shown by the arrow from employment to unemployment). And 2.5 million move from employment out of the labour force (shown by the arrow from employment to out of the labour force). This means that, on average, there are 6 (2 + 1.5 + 2.5) million separations each month in this country. One third (2 out of 6 million) of all separations are leavers – workers leaving their jobs for a better alternative. The remaining two-thirds are layoffs. Layoffs may come from changes in employment levels across firms. At any given time, some firms are suffering decreases in demand and decreasing their employment; other firms are enjoying increases in demand and increasing employment. If aggregate employment numbers are stable, this does not mean nothing happens in the labour market, a high number of layoffs suggests a reality of continual job destruction and job creation across firms. In our hypothetical country, the flows in and out of the labour force are large: each month, 4 million workers drop out of the labour force (2.5 plus 1.5), and the same number join the labour force (2 plus 2). This fact has another important implication. The sharp focus on the unemployment rate by economists, policy makers and the news media is partly misdirected. Some of the people classified as ‘out of the labour force’ are very much like the unemployed. They are in effect discouraged workers. And while they are not actively looking for a job, they will take one Working in the opposite direction: ➤ if they find one. This is why economists sometimes focus on the non-employment rate, the Some of the unemployed may be ratio of population minus employment to population, rather than the unemployment rate. unwilling to accept any job offered to We will follow tradition in this book and focus on the unemployment rate, but you should them and should probably not be keep in mind that the unemployment rate is not the best estimate of the number of people counted as unemployed because they available for work. are not really looking for a job. Going back to our hypothetical country, the average flow out of unemployment each month is 2.8 million: 2 million people get a job and 0.8 million stop searching for one and drop out of the labour force. Put another way, the proportion of unemployed leaving unem- ployment equals 2.8/6 or about 47% each month. The proportion of unemployed leaving unemployment each month is a very useful piece of information, as it allows computing the average duration of unemployment, which is the average length of time people spend unemployed. To see why, consider an example. Suppose the number of unemployed is constant and equal to 100, and each unemployedCHAPTER 7 THE LABOUR MARKET 141 person remains unemployed for two months. So, at any given time, there are 50 people who have been unemployed for one month and 50 who have been unemployed for two months. Each month, the 50 unemployed who have been unemployed for two months leave unem- ployment. In this example, the proportion of unemployed leaving unemployment each month is 50/100, or 50%. The duration of unemployment is two months – the inverse of 1/50%. The average duration of unemployment equals the inverse of the proportion of unemployed leaving unemployment each month. Now, suppose that each unemployed person remains unemployed for five months. In this case, at any given time, there are 20 people who have been unemployed for one month, 20 who have been unemployed for two months, 20 who have been unemployed for three months, 20 who have been unemployed for four months and 20 who have been unemployed for five months. Each month, the 20 unemployed who have been unemployed for five months leave unemployment. In this case, the proportion of unemployed leaving unemployment each month is 20/100, or 20%. The duration of unemployment is five months – the inverse of 1/20%. In our hypothetical country, where the proportion of the unemployed leaving unemployment each month is 47%, the average duration of unemployment is 2.1 month – the inverse of 1/47%. The longer it takes for unemployed people to find a job, the higher is the average dur- ation of unemployment. Countries with a high percentage of long-term unemployment (usually defined as unemployment for more than 12 months) have high average duration, and vice versa. The average duration of unemployment has an important implication. In a country where the average duration is high, unemployment can be described as a stagnant pool of workers waiting indefinitely for jobs. In a country where the average duration is low, as in our example, for most (but obviously not all) of the unemployed, being unemployed is more a quick tran- sition than a long wait between jobs. Among rich countries, the USA has one of the lowest average duration of unemployment of all (and one of the lowest percentage of long-term unemployment on total unemployment, 9.9% in 2007). The average duration of unemploy- ment is much longer in Western Europe (where the incidence of long-term unemployment is much higher than in the USA, ranging from 12.9% in Sweden to 27.3% in the UK, to 40.3% in France, up to a dramatic 70.8% in the Slovak Republic). Figure 7.7 shows the average duration of unemployment in some European countries, compared to the USA, since 2000. The most striking feature of Figure 7.7 is the large difference between Europe and the USA: the average duration of unemployment is now slightly more than one year in Europe compared to around four months in the USA. Unemployment is still a very different phe- nomenon in Europe, on average, than in the USA: being unemployed in Europe is often not a transitory condition as it is, on average, in the USA. The second feature of Figure 7.7 is the divergent trends between Western and Northern Europe, where the average duration has decreased since 2000, and Central and Eastern Europe, where it has increased since then. Figure 7.7 Average duration of unemployment in Europe and the USA Source: Eurostat.142 THE CORE THE MEDIUM RUN FOCUS The European Union Labour Force Survey The European Union Labour Force Survey (EU LFS) is a age, sex, educational attainment, temporary employ- quarterly sample survey covering the population in pri- ment, full-time/part-time distinction and many other vate households in the EU, EFTA (except Liechtenstein) dimensions. and Candidate Countries. It provides annual and quar- The quarterly EU LFS also forms the basis for Euro- terly information on labour participation of people stat’s calculation of monthly unemployment figures, aged 15 and over as well as persons outside the labour complemented by either monthly LFS estimates for the force. The EU LFS sample size amounts approximately unemployment rates or additional sources such as unem- to 1.5 million individuals each quarter. The quarterly ployment registers. The resulting monthly harmonised sampling rates vary between 0.2% and 3.3% in each unemployment rate – one of Eurostat’s key short-term country. Eurostat started the collection of these microdata indicators – is published in a news release and in the in 1983. The data range is from 1983 to 2005 depending online database. on the country. In providing data on employment, unemployment and inactivity, the EU LFS is an important source of Note: For more on the LFS, you can go to the LFS home page: information about the situation and trends in the labour ( market in the EU. Various breakdowns are available – by eu_lfs/index.htm). 7.2 WAGE DETERMINATION Having looked at unemployment, let’s turn to wage determination and to the relation between wages and unemployment. Wages are set in many ways. Sometimes they are set through collective bargaining – that is, bargaining between firms and unions. Negotiations may take place at the firm level, at the industry level or at the national level. Sometimes contract agreements apply only to firms that have signed the agreement. Sometimes they are automatically extended to all firms and all workers in the sector or the economy. In most of the countries in Europe, collective bargaining is the predominant mean by which wages are agreed. The percentage of workers covered by collective bargaining is as high as 98% in Austria, 95% in Finland and higher than 90% in Belgium, Germany and France. In the rest of Europe, it is slightly lower, generally between 60 and 80%, but still much higher than in the USA or in Japan, where the percentage of workers covered by col- lective bargaining is around 20%. In Europe, however, the UK stands out as an exception, as collective bargaining plays a limited role, especially outside the manufacturing sector. Today, just around one third of UK workers have their wages set by collective bargaining agreements. For the rest, wages are either set by employers or by bargaining between the employer and individual employees. The higher the skills needed to do the job, the more likely there is to be bargaining. Wages offered for entry-level jobs at McDonald’s are on a take-it-or-leave-it basis. New college graduates, on the other hand, can typically negotiate a few aspects of their compensation. CEOs and football stars can negotiate a lot more. Given these differences across workers and across countries, can we hope to formulate anything like a general theory of wage determination? Yes. Although institutional differ- ences influence wage determination, there are common forces at work in all countries. Two sets of facts stand out:CHAPTER 7 THE LABOUR MARKET 143 ● Workers are typically paid a wage that exceeds their reservation wage, the wage that would make them indifferent between working or being unemployed. In other words, most workers are paid a high enough wage that they prefer being employed to being unemployed. ● Wages typically depend on labour market conditions. The lower the unemployment rate, the higher the wages. (We will state this more precisely in the next section.) To think about these facts, economists have focused on two broad lines of explanation. The first is that even in the absence of collective bargaining, workers have some bargaining power, which they can and do use to obtain wages above their reservation wages. The sec- ond is that firms themselves may, for a number of reasons, want to pay wages higher than the reservation wage. Let’s look at each explanation in turn. Bargaining How much bargaining power a worker has depends on two factors. The first is how costly it would be for the firm to replace him or her, were he or she to leave the firm. The second is how hard it would be for him or her to find another job, were he or she to leave the firm. The more costly it is for the firm to replace the worker, and the easier it is for him or her to find another job, the more bargaining power he or she will have. This has two implications: ● How much bargaining power a worker has depends first on the nature of the job. Replacing a worker at McDonald’s is not very costly: the required skills can be taught quickly, and typically a large number of willing applicants have already filled out job application forms. In this situation, the worker is unlikely to have much bargaining power. If he or she asks for a higher wage, the firm can lay him or her off and find a replacement at minimum cost. In contrast, a highly skilled worker who knows in detail how the firm operates may be very difficult and costly to replace. This gives him or her more bargaining power. If he or she asks for a higher wage, the firm may decide that it is best to give it to him or her. ● How much bargaining power a worker has also depends on labour market conditions. When the unemployment rate is low, it is more difficult for firms to find acceptable replacement workers. At the same time, it is easier for workers to find other jobs. Under these conditions, workers are in a stronger bargaining position and may be able to obtain a higher wage. Conversely, when the unemployment rate is high, finding good replace- ment workers is easier for firms, while finding another job is harder for workers. Being in a weak bargaining position, workers may have no choice but to accept a lower wage. Efficiency wages Regardless of workers’ bargaining power, firms may want to pay more than the reservation Before 11 September 2001, the approach to airport security was to hire wage. They may want their workers to be productive, and a higher wage can help them workers at low wages and accept the achieve that goal. If, for example, it takes a while for workers to learn how to do a job correctly, resulting high turnover. Now that air- firms will want their workers to stay for some time. But if workers are paid only their reserva- port security has become a much tion wage, they will be indifferent between staying or leaving. In this case, many of them will higher priority, the approach is to make quit, and the turnover rate will be high. Paying a wage above the reservation wage makes it the jobs more attractive and better pay- ing so as to get more motivated and financially attractive for workers to stay. It decreases turnover and increases productivity. more competent workers, and reduce Behind this example lies a more general proposition: most firms want their workers to turnover. feel good about their jobs. Feeling good promotes good work, which leads to higher pro- ductivity. Paying a high wage is one instrument a firm can use to achieve these goals. (See the Focus box ‘Henry Ford and Efficiency Wages’.) Economists call the theories that link the productivity or the efficiency of workers to the wage they are paid efficiency wage theories. Like theories based on bargaining, efficiency wage theories suggest that wages depend on both the nature of a job and on labour market conditions: ● Firms – such as high-tech firms – that see employee morale and commitment as essential to the quality of their work will pay more than firms in sectors where workers’ activities are more routine. ➤144 THE CORE THE MEDIUM RUN FOCUS Henry Ford and efficiency wages In 1914, Henry Ford – the builder of the most popular car low of 16% in 1915. (An annual turnover rate of 370% in the world at the time, the Model T – made a stunning means that, on average, 31% of the company’s workers announcement. His company would pay every qualified left each month, so that over the course of a year, the ratio employee a minimum of 5 per day for an eight-hour day. of separations to employment was 31% × 12 = 370%.) The This was a very large salary increase for most employees, layoff rate collapsed from 62% to nearly 0%. The average who had been earning an average of 2.30 for a nine-hour rate of absenteeism (not shown in the table), which ran at day. From the point of view of the Ford company, this close to 10% in 1913, was down to 2.5% one year later. increase in pay was far from negligible – it represented There is little question that higher wages were the main about half of the company’s profits at the time. source of these changes. What Ford’s motivations were is not entirely clear. Ford Did productivity at the Ford plant increase enough to himself gave too many reasons for us to know which ones offset the cost of increased wages? The answer to this he actually believed. The reason was not that the com- question is less clear. Productivity was much higher in pany had a hard time finding workers at the previous 1914 than in 1913. Estimates of the productivity increases wage. But the company clearly had a hard time retaining range from 30% to 50%. Despite higher wages, profits workers. There was a very high turnover rate, and there were also higher in 1914 than in 1913. But how much of was much dissatisfaction among workers. this increase in profits was due to changes in workers’ Whatever the reasons behind Ford’s decision, the results behaviour and how much was due to the increasing suc- of the wage increase were astounding, as Table 7.1 shows. cess of Model T cars is harder to establish. The annual turnover rate (the ratio of separations to While the effects support efficiency wage theories, it employment) plunged from a high of 370% in 1913 to a may be that the increase in wages to 5 per day was exces- sive, at least from the point of view of profit maximisation. But Henry Ford probably had other objectives as well, Table 7.1 Annual turnover and layoff rates (%) at Ford, from keeping the unions out – which he did – to generat- 1913–1915 ing publicity for himself and the company – which he also 1913 1914 1915 surely did. Turnover rate 370 54 16 Source: Dan Raff and Lawrence Summers, ‘Did Henry Ford Pay Efficiency Layoff rate 62 7 0.1 Wages?’ Journal of Labour Economics, 1987, 5(4), 557–586. ● Labour market conditions will affect the wage. A low unemployment rate makes it more attractive for employed workers to leave: when unemployment is low, it is easy to find another job. This means that when unemployment decreases, a firm that wants to avoid an increase in leavers will have to increase wages to induce workers to stay with the firm. When this happens, lower unemployment will again lead to higher wages. Conversely, higher unemployment will lead to lower wages. Wages, prices and unemployment We capture our discussion of wage determination by using the following equation: e W = P F(u, z) 7.1 (−, +) The aggregate nominal wage, W, depends on three factors: e ● The expected price level, P . ● The unemployment rate, u. ● A catchall variable, z, that stands for all other variables that may affect the outcome of wage setting. Let’s look at each factor.CHAPTER 7 THE LABOUR MARKET 145 The expected price level First, ignore the difference between the expected and the actual price levels and ask: why does the price level affect nominal wages? Because both workers and firms care about real wages, not nominal wages: ● Workers do not care about how much money they receive but about how many goods they can buy with that money. In other words, they do not care about the nominal wages they receive but about the nominal wages, W, they receive relative to the price of the goods they buy, P. They care about W/P. ● In the same way, firms do not care about the nominal wages they pay but about the nom- inal wages, W, they pay relative to the price of the goods they sell, P. So they also care about W/P. Think of it another way: if workers expect the price level – the price of the goods they buy – to double, they will ask for a doubling of their nominal wage. If firms expect the price level – the price of the goods they sell – to double, they will be willing to double the nominal wage. So, if both workers and firms expect the price level to double, they will agree to double the nominal wage, keeping the real wage constant. This is captured in equation (7.1): An increase in the expected price level a doubling in the expected price level leads to a doubling of the nominal wage chosen when leads to an increase in the nominal wage, in the same proportion. wages are set. Return now to the distinction we set aside earlier: why do wages depend on the expected e , rather than the actual price level, P? Because wages are set in nominal (say, price level, P euro) terms, and when they are set, the relevant price level is not yet known. For example, in many union contracts in Europe, nominal wages are set in advance for a few years. Unions and firms have to decide what nominal wages will be over the following years based on what they expect the price level to be over those years. Even when wages are set by firms or by bargaining between the firm and each worker, nominal wages are typically set for a year. If the price level goes up unexpectedly during the year, nominal wages are typically not readjusted. (How workers and firms form expectations of the price level will occupy us for much of the next three chapters; we will leave this issue aside for the moment.) The unemployment rate Also affecting the aggregate wage in equation (7.1) is the unemployment rate, u. The minus sign under u indicates that an increase in the unemployment rate decreases wages. The fact that wages depend on the unemployment rate was one of the main conclusions An increase in unemployment leads to a decrease in the nominal wage. of our earlier discussion. If we think of wages as being determined by bargaining, then higher unemployment weakens workers’ bargaining power, forcing them to accept lower wages. If we think of wages as being determined by efficiency wage considerations, then higher unemployment allows firms to pay lower wages and still keep workers willing to work. The other factors The third variable in equation (7.1), z, is a catchall variable that stands for all the factors By definition of z, an increase in z leads to an increase in the nominal wage. that affect wages, given the expected price level and the unemployment rate. By conven- tion, we will define z so that an increase in z implies an increase in the wage (hence the posi- tive sign under z in the equation). Our earlier discussion suggests a long list of potential factors here. Take, for example, unemployment insurance – the payment of unemployment benefits to workers who lose their jobs. There are very good reasons why society should provide some insurance to workers who lose their jobs and have a hard time finding new ones. But there is little question that, by making the prospects of unemployment less distressing, more generous unemployment benefits do increase wages at a given unemployment rate. To take an extreme example, suppose unemployment insurance did not exist. Some workers would have little to live on and would be willing to accept very low wages to avoid remaining unemployed. But unemployment insurance does exist, and it allows unemployed workers to hold out for higher wages. In this case, we can think of z as representing the level of ➤ ➤ ➤146 THE CORE THE MEDIUM RUN Table 7.2 Net replacement rates in Europe, 2002 Initial phase of unemployment Long-term unemployment One earner One earner Single married couple Single married couple person with 2 children person with 2 children Austria 55 73 51 78 Belgium 66 61 55 61 Czech Republic 50 54 31 71 Denmark 59 76 50 78 Finland 64 82 51 85 France 71 76 41 70 Germany 61 78 61 68 Greece 46 50 0 3 Hungary 44 54 24 30 Ireland 29 55 51 73 Italy 52 60 0 0 Netherlands 71 78 58 72 Norway 66 73 42 64 Poland 44 51 30 73 Slovak Republic 62 72 42 91 Spain 70 75 27 41 Sweden 81 83 51 78 UK 45 46 45 73 USA 56 53 7 41 Source: CESifo DICE database, based on data from EU Commission and MISSOC 2009. unemployment benefits: at a given unemployment rate, higher unemployment benefits increase the wage. In Europe, unemployment benefits – which are computed as the fraction of the last wage which the social security system provides to a person if he or she no longer works (and are called ‘net replacement rates’) – vary across countries and, within each country, vary basically according to the type of household (single person or couple with children) and the sector of industry. Table 7.2 shows the net replacement rates for an average production worker in the initial phase of unemployment and at the end of the fifth year of benefit receipt (the data refer to the year 2002). In practically all countries, the net replacement rate at the begin- ning of a spell of unemployment is usually higher for a couple with two children than for someone who is single. For instance in Finland, where the initial replacement rate is 82%, the unemployed have little incentive to seek regular work. The net replacement rates for long- term unemployed are lowest in Italy, Greece and the USA and highest in the Scandinavian countries (except Norway), the Slovak Republic, the Netherlands, Austria and Germany. Another aspect of unemployment insurance that is likely to affect wages is the duration of unemployment insurance, that is the number of months it is provided for by the social security system. At a given unemployment rate, a longer duration of unemployment benefits increases the wage. In Europe, the duration of unemployment insurance varies a lot across countries, much more than the level of the benefits provided. Figure 7.8 shows the duration of unemployment insurance in European countries in 2008. In most of the countries, un- employment benefits are granted for less than one year, with the noteworthy exceptions of Belgium, where the benefits are unlimited, and of Denmark and the Netherlands where the benefits are paid for four to five years. In the other European countries, there are a few cases of extended provision of unemployment benefits to long-term unemployed people depending on age, employment record or insurance payment. Another factor that affects wages, given the expected price level and the unemployment rate, is the level of employment protection. The higher State protection for workers is, the more expensive it is for firms to lay off workers. Higher employment protection is likely to lead to higher wages. This is because high employment protection is likely to increase theCHAPTER 7 THE LABOUR MARKET 147 Figure 7.8 Duration of unemployment insurance in Europe, 2008 (in months) Source: CESifo DICE database, based on data from EU Commission and MISSOC 2009. bargaining power of workers covered by this protection (laying them off and hiring other workers is now more costly for firms), increasing the wage for a given unemployment rate. In Europe, the level of State protection for workers is on average higher than in the USA. However, there are also wide variations within Europe itself: most notably, the UK has significantly reduced the level employment protection since the 1980s and is now rather dif- ferent from the so-called European social model which prevails in continental Europe. Figure 7.9 shows the level of employment protection in Europe, compared to other OECD countries. The indicator of employment protection ranges between 0 and 2 and it increases with strictness of employment protection (that is, the higher the indicator, the higher employment protection). In Europe, the UK ranks very low, followed by Ireland and the Scandinavian countries, while countries in Southern Europe – France, Spain, Italy and Portugal – have the highest level of employment protection of all. A further factor that is likely to affect wages, given the expected price level and unemploy- ment, is the presence of a minimum wage set by the law. The presence of a minimum wage can cause wage rigidity, as it prevents wages from falling below the legal minimum to restore equilibrium in the labour market. Although most workers earn well above the min- imum wage, for some groups of workers, especially for the unskilled, the presence of a min- imum wage is likely to reduce firms’ demand for unskilled labour. This is the reason why many economists argue that the presence of a minimum wage is largely responsible for higher than average youth unemployment. In fact, an increase in the minimum wage may increase not only the minimum wage itself but also wages just above the minimum wage, leading to an increase in the average wage, W, at a given unemployment rate. Europe, including the UK since April 1999, as well as the USA, has had a mandatory minimum wage. Figure 7.10 shows the gross minimum wage in euro per month in each European country in 2009. The striking feature of Figure 7.10 is the very low level of 148 THE CORE THE MEDIUM RUN Figure 7.9 Employment protection across European countries, 1995 Source: CESifo DICE database, based on data from EU Commission and MISSOC 2009. Figure 7.10 a Gross minimum wages, euro per month, 2009 Source: CESifo DICE database, based on data from EU Commission and MISSOC 2009. minimum wages in Eastern and Central European countries, where the statutory gross minimum wage per month is around a200. The size of the minimum wage in absolute terms varies a lot across countries, ranging from very low levels such as in Portugal and Spain (where the minimum wage is significantly lower than in the USA), to high levels such as in the Netherlands or in Ireland. (In the USA, the Federal minimum wage is 7.25 per hour. Individual states can and often do apply different minimum wages.)CHAPTER 7 THE LABOUR MARKET 149 It has been widely debated whether the European social model should be considered one of the sources of the higher unemployment rates in continental Europe compared to the UK or the USA. According to some labour economists, there is no doubt that high levels of unemployment insurance, employment protection and high minimum wages are partly responsible for the high unemployment rates in many European countries. Yet, it has also been argued that high employment protection need not necessarily be associated with high unemployment. Indeed, if it is true, on average, that countries with higher employ- ment protection have higher unemployment rates, it is also true that some countries with low unemployment rates do have high level of State protection of workers. The most notable case in Europe is Denmark. The Danish system, since the early 1980s, combines high levels of social welfare and unemployment protection with an effective system of job search assistance: the result is a low unemployment rate, one of the lowest in Europe. 7.3 PRICE DETERMINATION Having looked at wage determination, let’s now turn to price determination. The prices set by firms depend on the costs they face. These costs depend, in turn, on the nature of the production function – the relation between the inputs used in production and the quantity of output produced and on the prices of these inputs. For the moment, we will assume that firms produce goods using labour as the only factor of production. We will write the production function as follows: Y = AN We can use a term from microeco- where Y is output, N is employment and A is labour productivity. This way of writing the nomics here: this assumption implies production function implies that labour productivity – output per worker – is constant and constant returns to labour in produc- equal to A. tion. If firms double the number of It should be clear that this is very much simplified. In reality, firms use other factors of workers they employ, they double the production in addition to labour. They use capital – machines and factories. They use raw amount of output they produce. materials – oil, for example. Moreover, there is technological progress, so that labour pro- ductivity, A, is not constant but steadily increases over time. We shall introduce these complications later. We will introduce raw materials in Chapter 8, when we discuss changes in the price of oil. We will focus on the role of capital and technological progress when we turn to the determination of output in the long run in Chapters 11–13. For the moment, though, this simple relation between output and employment will make our lives easier and still serve our purposes. Given the assumption that labour productivity, A, is constant, we can make one further simplification. We can choose the units of output so that one worker produces one unit of output – in other words, so that A = 1. (This way, we do not have to carry the letter A around, and this will simplify notation.) With this assumption, the production function becomes Y = N 7.2 The production function, Y = N, implies that the cost of producing one more unit of out- put is the cost of employing one more worker, at wage W. Using the terminology introduced in your microeconomics course: the marginal cost of production – the cost of producing one more unit of output – is equal to W. If there were perfect competition in the goods market, the price of a unit of output would be equal to marginal cost: P would be equal to W. But many goods markets are not compet- itive, and firms charge a price higher than their marginal cost. A simple way of capturing this fact is to assume that firms set their prices according to µ)W 7.3 P = (1 + where µ is the mark-up of the price over the cost. If goods markets were perfectly com- petitive, µ would be equal to zero, and the price, P, would simply equal the cost, W. To the extent that they are not competitive, and firms have market power (that is, they can set ➤150 THE CORE THE MEDIUM RUN a price higher than the marginal cost, which would be the case in perfectly competitive markets), µ is positive, and the price, P, will exceed the cost, W, by a factor equal to (1 + µ). We can think of the mark-up as depending on the degree of competition in the product market. The higher the degree of competition, the lower the mark-up and, vice versa, the lower the degree of competition, the higher the mark-up. To keep things simple, we can assume that the degree of competition is higher the higher the number of competing prod- ucts in a market. In fact, a high number of competing products in a market forces producers to keep prices down in order not to lose market share. Moreover, the mark-up also depends on the degree of regulation of the product market. To see this, imagine a highly regulated product market with a lot of trade barriers: trade barriers will limit the number of foreign products that can be sold in that market, and therefore will reduce the degree of market competition. Therefore, the higher the degree of product market regulation, the lower the degree of competition. We can express this by writing the mark-up as a positive function of product market regulation (PMR): µ = f(PMR)(1) (+) µ depends positively on product market regulation, Equation (1) tells us that the mark-up thus it depends negatively on the level of competition in the market. In the context of European integration, for example, decreases in PMR may reflect the elimination of tariff barriers, or standardisation measures making it easier to sell domestic products in other EU countries. Suppose the government increases competition in the product market, for a given number of firms. Higher competition means that firms face a more elastic demand for their products (as consumers can more easily switch to other suppliers if they want to). Hence, to maintain their market share, they have to decrease their mark-up, lead- ing in turn to both an increase in real wages and a decrease in unemployment. Therefore, a lower product market regulation should be associated with higher real wages (as we shall see in Section 7.4). This is exactly what we observe in Europe, where the completion of the internal market has increased both competition and real wages. Figure 7.11 shows the evolution of product market regulation and real wages in Europe from 1998–2008. Since 1998, product market regulation has decreased everywhere, even more so in countries which started from higher levels, such as France, Italy and Spain. Today, the differences in the levels of product mar- ket regulation across European countries are very small compared to the end of the 1990s. Scandinavian countries show slightly lower levels – that is, higher internal competition. Figure 7.11 Relationship between trends in product market regulation and wages in Europe (1998, 2003, 2008) Source: OECD, Eurostat.CHAPTER 7 THE LABOUR MARKET 151 Over the same decade, increased competition has been associated with higher wages. Wages increased all over Europe, more so in Scandinavian countries, Germany and the UK and much less in Southern Europe. An interesting question is to what extent a lower product market regulation leads to higher wages. Does a similar decrease in product market regulation, as one can deem must have happened in all the Europeans countries that joined the EU since the beginning (for- merly called European Economic Community), lead to similar increase in wages across Europe? Figure 7.11 shows the negative relation between product market regulation and wages. The figure has two interesting features. First, countries that started out with higher degree of product market regulation at the end of the 1990s, i.e. France, Italy and Spain, registered the largest improvement, and are now comparable to the rest of Western Europe. The second feature is the large difference among European countries in terms of the real wage increase associated with a given decrease in product market regulation. A decrease in regulation of the same size had very different impacts in different countries. In the UK, a small decrease in the PMR was associated with a large increase in wages, while in the rest of Europe the increase in wages was much less pronounced, as in Italy and Spain, where PMR decreased much more than in the rest of Europe, but real wages increased much less than elsewhere. 7.4 THE NATURAL RATE OF UNEMPLOYMENT Let’s now look at the implications of wage and price determination for unemployment. The rest of the chapter is based on the e assumption that P 5 P. For the rest of this chapter, let’s do so under the assumption that nominal wages depend e . (Why we make this on the actual price level, P, rather than on the expected price level, P assumption will become clear soon.) Under this additional assumption, wage setting and price setting determine the equilibrium rate of unemployment. Let’s see how. The wage-setting relation Given the assumption that nominal wages depend on the actual price level, P, rather than on e the expected price level, P , equation (7.1), which characterises wage determination, becomes W = PF(u, z) We can divide both sides by the price level: W = F(u, z) P (−, +) 7.4 Wage determination implies a negative relation between the real wage, W/P, and the unemployment rate, u: the higher the unemployment rate, the lower the real wage chosen by wage setters. The intuition is straightforward: the higher the unemployment rate, the weaker the position of workers in bargaining and the lower the real wage will be. This relation between the real wage and the rate of unemployment – let’s call it the Wage setters are unions and firms if wages are set by collective bargaining, wage-setting relation – is drawn in Figure 7.12. The real wage is measured on the vertical individual workers and firms if wages axis. The unemployment rate is measured on the horizontal axis. The wage-setting relation are set on a case-by-case basis, and is drawn as the downward-sloping curve WS (for wage setting): the higher the unemploy- firms if wages are set on a take-it-or- ment rate, the lower the real wage. leave-it basis. The price-setting relation Let’s now look at the implications of price determination. If we divide both sides of the price-determination equation (7.3), by the nominal wage, we get P µ 7.5 = 1 + W ➤ ➤152 THE CORE THE MEDIUM RUN Figure 7.12 Wages, prices and the natural rate of unemployment The ratio of the price level to the wage implied by the price-setting behaviour of firms equals 1 plus the mark-up. Now invert both sides of this equation to get the implied real wage: W 1 = 7.6 P 1 + µ Note what this equation says: price-setting decisions determine the real wage paid by firms. An increase in the mark-up leads firms to increase their prices, given the wage they have to pay; equivalently, it leads to a decrease in the real wage. The step from equation (7.5) to equation (7.6) is algebraically straightforward. But how price setting actually determines the real wage paid by firms may not be intuitively obvious. Think of it this way: suppose the firm you work for increases its mark-up and therefore increases the price of its product. Your real wage does not change very much: you are still paid the same nominal wage, and the product produced by the firm you work for is at most a small part of your consumption basket. Now suppose that not only the firm you work for but all the firms in the economy increase their mark-up. All prices go up. If you are paid the same nominal wage, your real wage goes down. So, the higher the mark-up set by firms, the lower your (and everyone else’s) real wage will be. The price-setting relation in equation (7.6) is drawn as the horizontal line PS (for price µ); it does not setting) in Figure 7.12. The real wage implied by price setting is 1/(1 + depend on the unemployment rate. Equilibrium real wages and unemployment Equilibrium in the labour market requires that the real wage chosen in wage setting be equal to the real wage implied by price setting. (This way of stating equilibrium may sound strange if you learned to think in terms of labour supply and labour demand in your microe- conomics course. The relation between wage setting and price setting on the one hand and labour supply and labour demand on the other is closer than it looks at first and is explored further in the appendix at the end of this chapter.) In Figure 7.12, equilibrium is therefore given by point A, and the equilibrium unemployment rate is given by u . n We can also characterise the equilibrium unemployment rate algebraically; eliminating W/P between equations (7.4) and (7.6) givesCHAPTER 7 THE LABOUR MARKET 153 Figure 7.13 Unemployment benefits and the natural rate of unemployment 1 F(u , z) = 7.7 n 1 + µ The equilibrium unemployment rate, u , is such that the real wage chosen in wage n setting – the left side of equation (7.8) – is equal to the real wage implied by price setting – the right side of equation (7.7). ) is called the natural rate of unemployment Natural, in Webster’s dictionary, means The equilibrium unemployment rate (u n ‘in a state provided by nature, without (which is why we have used the subscript n to denote it). The terminology has become man-made changes’. standard, so we will adopt it, but this is actually a bad choice of words. The word natural suggests a constant of nature, one that is unaffected by institutions and policy. As its deriva- tion makes clear, however, the ‘natural’ rate of unemployment is anything but natural. The positions of the wage-setting and price-setting curves, and thus the equilibrium unemploy- µ. Consider two examples: ment rate, depend on both z and ● An increase in unemployment benefits – An increase in unemployment benefits can be An increase in unemployment benefits shifts the wage-setting curve up. The represented by an increase in z: because an increase in benefits makes the prospect of economy moves along the price-setting unemployment less painful, it increases the wage set by wage setters at a given unem- curve. Equilibrium unemployment ′ in Figure 7.13. ployment rate. So it shifts the wage-setting relation up, from WS to WS increases. The economy moves along the PS line, from A to A′. The natural rate of unemployment to u′ . increases from u n n In words: at a given unemployment rate, higher unemployment benefits lead to a higher real wage. A higher unemployment rate is needed to bring the real wage back to what firms are willing to pay. ● A less stringent enforcement of existing competition law – To the extent that this allows An increase in the mark-up shifts the price-setting line down. The economy firms to collude more easily and increase their market power, it leads to an increase moves along the wage-setting curve. µ. The increase in µ implies a decrease in the real in their mark-up – an increase in Equilibrium unemployment increases. wage paid by firms, and so it shifts the price-setting relation down, from PS to PS′ in Figure 7.14. The economy moves along WS. The equilibrium moves from A to A′, and the natural rate of unemployment increases from u to u′. n n In words: by letting firms increase their prices given the wage, less stringent enforce- ment of competition law leads to a decrease in the real wage. Higher unemployment is required to make workers accept this lower real wage, leading to an increase in the natural rate of unemployment. ➤ ➤ ➤154 THE CORE THE MEDIUM RUN Figure 7.14 Mark-ups and the natural rate of unemployment An increase in mark-ups decreases the real wage and leads to an increase in the natural rate of unemployment. This name has been suggested by ➤ Factors such as the generosity of unemployment benefits or competition law can hardly Edmund Phelps from Columbia Univer- be thought of as the result of nature. Rather, they reflect various characteristics of the sity. Phelps was awarded the Nobel structure of the economy. For that reason, a better name for the equilibrium rate of unem- Prize in 2006. For more on some of his ployment would be the structural rate of unemployment, but so far the name has not contributions, see Chapter 9. caught on. From unemployment to employment Associated with the natural rate of unemployment is a natural level of employment, the level of employment that prevails when unemployment is equal to its natural rate. Let’s review the relation between unemployment/employment and the labour force. Let U denote unemployment, N denote employment and L the labour force. Then: U L − N N u== = 1 − L L L The first step follows from the definition of the unemployment rate, u. The second fol- lows from the fact that, from the definition of the labour force, the level of unemployment, U, equals the labour force, L, minus employment, N. The third step follows from simplifying the fraction. Putting all three steps together: the unemployment rate, u, equals 1 minus the ratio of employment, N, to the labour force, L. Rearranging to get employment in terms of the labour force and the unemployment rate gives: N = L(1 − u) Employment, N, is equal to the labour force, L, times 1 minus the unemployment rate, u. , and the labour force is equal to L, the So, if the natural rate of unemployment is u n natural level of employment, N , is given by n N = L(1 − u ) n n For example, if the labour force is 150 million and the natural rate of unemployment is 5%, then the natural level of employment is 150 × (1 – 0.05) = 142.5 million. From employment to output Finally, associated with the natural level of employment is the natural level of output, the level of production when employment is equal to the natural level of employment. GivenCHAPTER 7 THE LABOUR MARKET 155 the production function we have used in this chapter (Y = N), the natural level of output, Y , n is easy to derive. It is given by Y = N = L(1 − u ) n n n Using equation (7.6) and the relations between the unemployment rate, employment and the output we just derived, the natural level of output satisfies the following equation: Y 1 A D n F 1 − , z = 7.8 C F L 1 + µ The natural level of output, Y , is such that, at the associated rate of unemployment n = 1 − Y /L), the real wage chosen in wage setting – the left side of equation (7.8) – is equal (u n n to the real wage implied by price setting – the right side of equation (7.8). As you will see, equation (7.8) will turn out to be very useful in Chapter 8. Make sure you understand it. We have gone through many steps in this section. Let’s summarise: assume that the expected price level is equal to the actual price level. Then: ● The real wage chosen in wage setting is a decreasing function of the unemployment rate. ● The real wage implied by price setting is constant. ● Equilibrium in the labour market requires that the real wage chosen in wage setting be equal to the real wage implied by price setting. ● This determines the equilibrium unemployment rate. ● This equilibrium unemployment rate is known as the natural rate of unemployment. ● Associated with the natural rate of unemployment are a natural level of employment and a natural level of output. 7.5 WHERE WE GO FROM HERE We have just seen how equilibrium in the labour market determines the equilibrium unem- ployment rate (which we have called the natural rate of unemployment), which in turn determines the level of output (which we have called the natural level of output). So, you may ask, what did we do in Chapters 3–5? If equilibrium in the labour market determines the unemployment rate and, by implication, the level of output, why did we spend so much time looking at the goods and financial markets? What about our earlier con- clusions that the level of output was determined by factors such as monetary policy, fiscal policy, consumer confidence and so on – all factors that do not enter equation (7.8) and therefore do not affect the natural level of output? The key to the answer is simple: ● We have derived the natural rate of unemployment and the associated levels of employ- ment and output under two assumptions. First, we have assumed equilibrium in the labour market. Second, we have assumed that the price level was equal to the expected price level. ● However, there is no reason for the second assumption to be true in the short run. The In the short run, the factors that deter- mine movements in output are the price level may well turn out to be different from what was expected when nominal factors we focused on in Chapters 3–5: wages were set. Hence, in the short run, there is no reason for unemployment to be equal monetary policy, fiscal policy, and so on. to the natural rate, or for output to be equal to its natural level. As we will see in Chapter 8, the factors that determine movements in output in the short run are indeed the factors we focused on in Chapters 3–5: monetary policy, fiscal policy, and so on. Your time (and ours) was not wasted. ● Expectations are unlikely to be systematically wrong (say, too high or too low) forever. In the medium run, output tends to return to the natural level, and the That is why, in the medium run, unemployment tends to return to the natural rate, and factors that determine output are the output tends to return to the natural level. In the medium run, the factors that determine factors we have focused on in this unemployment and output are the factors that appear in equations (7.7) and (7.8). chapter. Developing these answers in detail will be our task in the next three chapters. ➤ ➤

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