croeconomics A European Text Second Edition Michael Burda and Charles Wyplosz OXFORD UNIVERSITY PRESS 6.1. Overwiejw 6 2. Demand aoa Mippiy m «■« Labour iVlarket 6.2.1. Labour Supply and the Labour-Leisure Trade-off 6.2.2. Labour Demand, Productivity, and Real Wages 6.2.3. Labour Market Equilibrium 6.2.4. The Interpretation of Unemployment abour Markets and Equilibrium Unemployment 6.3. AS1 Un£..-BT--.i, 6 3.1. irivoluntary Unemployment and fteal Wage Adjustment 6.3.2. Collective Bargaining and Real Wage Rigidity 6.3.3- Sbcial Minima and Real Wage Rigidity 6.3.4. Efficiency Wages and Real Wage Rigidity 6.4.1. Labour Market States and Transitions 6.4.2. Stocks, Flows and Frictional Unemployment 6.4.3. Job Finding and the Duration of I Unemployment 6.5. Theliq 6.5.4 6.6. Si The Concept The European Experience Actual and Equilibrium Unemployment Equilibrium Employment and Equilibrium Output Appendix BHBBSBS Labour is the source of all value. Karl Marx In our present day complicated economic life we are likely to be confused by the many industrial operations and money transactions. But net income remains exactly what it was to primitive Robinson Crusoe on his island—the enjoyment from eating the berries we pick, so to speak, less the discomfort or the labor of picking them. Irving Fisher n the last chapter, available output was determined !>y the endowment of capital and technical sophistica-ion. The supply of labour was simply taken as given, egardless of the wage or other variables. At any moment of time, therefore, the economy relied on what history had left, i.e. capital, labour, and knowledge. In practice, however, income is not derived just from fixed endowments. Even in storybooks, life is not so simple: Robinson Crusoe had to expend time and effort to gather and transport the fruits that he would eventually consume. Indeed, most people are able to I choose whether or not they will work, and sometimes how much they will work or at least how much effort they will put in their work. Households work so that they can consume, but they also desire to spend some time nor working, which is called leisure or free time. The supply of labour is presented as a trade-off between consumption and leisure. Labour must also be in demand. For that, it must have value to firms. How the markets value labour and how demand and supply interact is the subject matter of this chapter. This chapter deals with an important market. Marx had a point when he viewed labour as the most important factor of production. Everything we use stems from labour. Raw materials are drawn from the earth by human hands; equipment used in this process is produced from labour and previously manufactured equipment, itself the output of labourers and capital in a more distant past. Even the knowledge embodied in people—sometimes called 'human capital'—comes from our own efforts at mastering skills and techniques, as well as the time our teachers spend in trying to educate us. As before, we begin the analysis by studying the behaviour of a representative household that supplies labour. Next, we look at demand by a representative firm. This naturally leads into the standard confrontation of demand and supply. Yet, the labour market is not a standard 'market'. Workers are not identical, and the quality of labour services is difficult to ascertain and harder to monitor. Unlike machines or raw materials, workers can decide whether they would like to work for a particular employer and under which •_ ?j>; conditions to render labour services. In fact, the employment relationship involves explicit and implicit contractual arrangements with durable features such as personal bonds or firm-specific competence and-knowledge. The labour market is also characterized by unique institutions, such as labour law or collective bargaining, and is the object of complex legal and customary rules. Finally, the labour market is a dynamic market, with suppliers of labour entering and exiting unemployment at a remarkable rate. We show., how these interactions help understand the concep -of equihbrium unemployment, which may differ irony actual unemployment. m m Ví* f'Jr* -t ' í1"*! '"".* f> .''-'-■! rj '■ ** &^S ' -'S; Jíř-sáVi-ij 'Šiti ,': I ť^í&ť] SJItr LABOUR MARKETS AND EQUILIBRIUM UNEMPLOYMENT 137 6.2. Demand and Supply in the Labour Market 6.2.1. Labour Supply and the Labour-Leisure Trade-off In order Loiconsume, most households need income. In modern societies, earning income means working, or supplying labour to firms in return for a wage or salary. Supplying labour is something that milHons of families do every day. Labour has a cost too: every hour worked is an hour less of free time. Because households1 value both consumption and leisure, they balance thej two, just as they balance consumption of goods today against saving and goods tomorrow. As we focus oh the consumption-leisure trade-off, we ignore die intertemporal aspects which were considered in Chapters 3,4, and 5. In the now-familiar parable, Robinson Crusoe in this chapter is assumed to consume all that he earns during each period. 6.2.1.":. Preferences Crusoe's preferences with regard to consumption and leisure are shown in Figure 6.1 using indifference c o 5 0\ I t Leisure I Figure 6.1. Household Preferences An indifference curve shows the rate at which a representative household substitutes consumption for leisure, holding utility constant. Higher curves correspond to higher levels of utility. The maximum amount of time available is I hours. curves.1 Each indifference curve shows how readily Crusoe substitutes consumption for leisure, holding constant his level of utility or satisfaction. The shape of the indifference curves reflects a decreasing marginal rate of substitution: the greater a household's consumption relative to its leisure, the more consumption it is willing to give up for an additional unit of leisure, or the higher is the marginal rate of substitution of consumption for leisure. As always, higher indifference curves correspond to higher levels of utility. 6.2.1.2. The budget constraint Crusoe's 'budget constraint' is fixed by the total amount of time, denoted €, available over any given period (a day, a month, a year, or more). Time is a scarce resource and it has a price. The price of an hour of leisure is its opportunity cost: how much can be earned from working instead. Equivalently, the price of leisure is measured in terms of the consumption goods that cannot be consumed for lack of earned income: the price of leisure is then called the real (consumption) wage. In practice, it is measured as the ratio of nominal wages (W) to the consumer price index (P). With € hours at his disposal and facing an hourly real wage w - W/P, the value of Crusoe's total time endowment in terms of consumption is €w. The budget constraint states that this endowment can be allocated between consumption, with value C, and £ hours of leisure, with value € w? (6.1) Iw = tw+C. Alternatively, the budget constraint can be expressed in terms of'cash flow' (more accurately, coconut flow). When Crusoe spends €_hours of leisure, he works ■€ -í hours and earns w(£ - i) coconuts. Since Crusoe does not save, this income w(€ — €) is spent on consumption; so (6.2) w(€-€) = C, which is the same as (6.1). The budget constraint is shown in Figure 6.2 as AB. Its negative slope (-W) 1 This is the same idea as in Ch. 4, except that here we look at two 'goods' in a given period, rather than atdifferent points in time. 2 The nominal budget constraint is €W= iW+ PC. To write it in terms of consumption goods as in (6.1), we simply divide by P, the price of consumption goods. !ssffifflsös«a 138 THE REAL MACROECONOMY t n 41 «i «íl1 fjlj l;j i, (, "1 i Leisure Figure 6.2. The Household Budget Constraint The household has í hours at its *^™ZltZ Ihe distance OA) for either ^^q^l unit of .eisure that *^™^^L of consumpt.on goods. The real way the s'ope of the budget line AB. SN Consumption { Leisure Work Leisure measures the trade-off of consumption for leisure offered by the market: how much consumption must be given up to get an additional unit of leisure. The distance O A is Crusoe's endowment of time, or the fixed number of hours he has at his disposal. The distance OB measures the value ofthat endowment in terms of consumption goods. It is the total amount of consumption attainable when leisure is zero. If Crusoe had inherited some initial wealth, the budget constraint would be shifted vertically by that amount, which he could consume without having to work at all. If the real wage changes, the budget line rotatesaround point A, which measures his time endowments. With a wage increase, for example, more consumption can be afforded (OB increases) and the budget hne rotates clockwise. If instead the real wage falls, OB declines, and the line turns in a counter-clockwise direction. 6.2.1.3. Optimal choice: the individual labour supply schedule Crusoe maximizes his utility by choosing the highest possible indifference curve without violating his budget constraint. This is achieved at point R in Figure 6.3, where the indifference curve is tangent to the budget line. At this point, given the going market wage w, he cannot make himself better off by further trading leisure against consumption: the marginal rate of Figure 6.3. Optimal Choice is tangent to the budget hne. substitution of consumption for leisure and the «age are equal. K„„r, fi 4 an increase in the In the first panel of Figu f 6-4' a° ion_klsurc real wage ch^S%,^sefaltodisLguishtWo choice from R to E .It is uletui to °^ cost effects. First, Crusoe faces a higher oppor of leisure in terms of consumption goods become relatively more attr;*"e and more °m the wage allows Crusoe-»^^ effect- sumption and more leisure to s the m For this reason, moving from Et££ ^ sumption increases, but the effect on work) is ambiguous how how The right-hand side panels ot hgureo. tioD , the relative strengths of the «and subs ^ effects translate into different "ndrnduiOi nlv curves. The labour supply curve shows ho t oftherealwage.Inpane(a)dre^»m^abour tion effects exactiy cairita« benchmark'case ply_remam unchanged. This is the bencn0 where labour supply is ^T'tTv^^^ Crusoe responds to higher real wag by jD leisure time: labour supply is elastic tpa p paneUc)themcomeeffectdormn^^ upply, íion and leisure increase. In this case lao LABOUR MARKETS AND EQUILIBRIUM UNEMPLOYMENT 1 Leisure (a) Labour supply Leisure (b) Laboui supply Leisure Labour supply (c) Figure 6.4. Labour Supply When the real wage increases, the budget line rotates around point A (the endowment of time remains unchanged) and becomes steeper, because a unit of leisure is exchanged for more units of consumption. This allows both consumption and leisure to increase at the same time (income effect). Because leisure is more expensive, however, some is given up (substitution effect). In case (a) income and substitution effects exactly cancel in the left-hand panel and labour supply, shown in the right-hand panel, is vertical. In case (Jb) the substitution effect dominates, leisure is reduced, and the labour supply schedule is upward-sloping. In case (c) the income effect dominates, leisure increases, and labour supply is backward-bending. 140 THE REAL MACROECONOMY | Table 6.1. Annual Total Hours Worked and Average Wages, 1870-1987 1870 1913 1938 1987 Annual hours worked per person France 2945 2588 1848 1543 Germany 2941 2584 2316 1620 UK 2984 2624 2267 1557 USA 2964 2605 2062 1608, Sweden 2945 2588 , 2204 1466 Real wage (index: 1870 = 100) France 100 205 335 1358 Germany 100 185 285 1227 UK 100 157 256 589 USA 100 189 325 643 Sweden 100 270 521 1439 Sources: Hours worked are from Maddison (1991); wages are from Mitchell (1978,1983) and OECD, Main Economic Indicators; German wage data from 1913-38 are approximated using average labour productivity growth backward-bending as increases in the real wage actually reduce the supply of labour. In practice, the response of labour supply to a change in wages depends on the time horizon under consideration. In the short run, individuals do not seem to react much to changes in the real wage (the inelastic case). In the next section, it is shown that aggregate labour supply is generally more elastic than individual supply in the short run. In the long run, labour supply is backward-bending. This is what Table 6.1 shows. Over the last 100 years, real wages have increased by five- to fifteen-fold, while working hours have declined by one-half. The evidence from Table 6.1 has to be interpreted carefully, though, as labour supply varies according lo sex. For men, the average work-week, the retirement age, and the rate of labour force participation (the proportion of working-age people working or registered as unemployed) have fallen secularly since 1900. Tor women, labour force participation and hours per week have clearly risen. One possible interpretation is that the income effect of higher wages dominates for men, whereas the substitution effect dominates for women. At the same time, changing customs and sociological factors, as well as publicly supplied services such as child care and schooling, must also play a key role in these developments. 6.2.1.4. The aggregate labour supply curve In practice, there is an important difference between individual and aggregate labour supply. The individual decision has been described as deciding how much time to spend working. In many instances, individuals cannot vary the hours of work that they supply; at best, they can choose between working or not -working at all. Most labour contracts specify a standard working time (length of the work-week, days of leave per year). It is a matter of 'take it or leave iť. Box 6.1 presents two cases where a worker actually prefers not to work at all. In both cases, wage increases are not enough to motivate him to take up a job, although large ones would do so. The aggregate labour supply curve is the sum of many individual decisions (to work or not work, and how many hours to work). While individual labour supply is measured in hours (for example per year), aggregate supply is measured in man-hours, the total amount of hours supplied by all workers (men and BOX 6.1. LUMPINESS IN THE LABOUR SUPPLY DECISION In Figure 6.5(b), Crusoe-the-Hermit is not willing to give up much leisure (lonely contemplation) for consumption. His indifference curve is too steep (his marginal rate of substitution of consumption for leisure is too high) for him to work at all at the going wage. He chooses corner point A. In panel (a) Crusoe has to commute to get to work, which costs him a quantity AA' of unpaid leisure. In this example, Crusoe chooses not to work unless the wage is sufficiently high. In both cases, there is a wage ^1 rate high enough to coax Crusoe out of hisdeášiQp|n0t; to work. If the actual labour force consists of a r™$^° .i workers of the types displayed in Figures 6.4 anpj^aj f^M increase in real wages will bring someindivldualf^íSÍř' work, while those already working may nP^H^flf -pi labour supply. A flatter aggregate supply, ,.cu,rv^J44| emerge from vertical or near-vertical iridi"viďuäl;|||rn curves. LABOUR MARKETS AND EQUILIBRIUM UNEMPLOYMENT 141 Poirvt chosen (b) Leisuie Figure 6.5. Crusoe Stays Home Crusoe may decide not to work at all, choosing point A. In panel (a), going to work costs him AA' (time and transportation). If lie stays home, only A is feasible; if he goes to work, his budget line is A'B', in which case R' is the best choice. He is better off at point A than at point R'. In panel (b), the real wage is simply too low to compensate his preference for leisure given by his indifference curves. Ill M i! ť n li n f í, li 1 'J Hli! ^^^ígr''*". ^^^^r^^^^^^^m^is^sm§m:w^^B i ní I 2'! lil: 142 THE REAL MACROECONOMY m Individual Aggregate Labour i figure 6.6. Individual and Aggregate Labour ! Supply i The aggregate labour supply curve is less steep than ! the individual one because new workers choose to I enter the labour force as wages rise. women, of course).3 When wages rise, even if those who already work do not modify their supply of labour (the benchmark case), others who had preferred ' not to work now decide to join the labour force. Figure 6.6 shows how it is then possible for a steep or even vertical (inelastic) individual supply curve to coexist with a flatter aggregate supply curve. 6.2.2. Labour Demand, Productivity, and Real Wages 6.2.2.1. Labour demand and the extended production function The analysis of labour demand has already been discussed briefly in Chapter 5. It is virtually identical to the analysis in Chapter 4 of the optimal stock of capital, in which a representative firm takes employment as given. Here, the capital stock is given and we study the optimal demand for labour. When the capital stock is constant, the firm can change the amount of output produced by adjusting the amount of labour (man- 3 Aggregate employment is sometimes measured as the number of people who have a job. Generally, we will use the first definition (man-hours), and make explicit mention when referring to the number of employed workers. Under any definition, when more workers enter the labour force, the labour supply curve shifts to the right independently of the wage level. Labour Figure 6.7. The Production Function When more work is added, output increases but at a declining rate. This additional output is the marginal productivity of labour (MPL). The ray OR represents the cost of using L hours bf work when the hourly real wage is w. The distance between the production curve and the cost line represents the firm's profit. It is at a , maximum at point A where the curve is parallel to OR, i.e. where MPL = w. hours) used. The link between output ľ and employment L is captured by the production function shown in Figure 6.7. The slope of the production function measures the marginal productivity of labour l>tPL), the quantity of additional output obtained when one more unit of input (an hour) is used. 1 he shape of the ' curve reflects the principle of decreasing marginal productivity; the MPL is declining as the amount of labour employed increases. In deciding how much labour to employ, the firm looks for the highest possible profit given the hourly real wage w. The line OR represents the cost of labour to the firm: its slope is w since L hours of work cost wL. For each level of employment, profit is measured as the vertical distance between the cune depicting the production function and the labour cost line OK •-----^n-mm at üoint A, where the curve is pat" i-offl. if the *0* i -.,„^0 hirinff OD*- illKJ ;«!,-■ . ->*» It is at a maximum at Fv,x*,— allel to OR and the MPL is equal to the real wage. u. -- - ,w MPL exceeds the real wage, hiring one more hour o , -•.,; work raises profits by MPL and costs by only w, fl^ ^ plying an increase in profits. The firm would tner _ j.ty fore hire the extra hour and would continue until the MPL has declined to the point wncreíc|.|^ equal to the real wage. In the opposit c c&^c, in w -^Ä the real wage exceeds the MPL, the firm can increa^|f# its profit by reducing its demand for labour. ßecaU ^jW 'I "it is optimal to set labour such that MPL = w, the MPL schedule in Figure 6.8 is also the labour demand curve. ■ 6.2.2.2. Wage and profit shares The portion of GDP that goes to workers is called the wage share and is given by wLI Y. The rest, the profit, or capital share (1 - wL/Y), goes to firm owners.4 Obviously, these two shares move in opposite directions. But what is the effect of an increase in wages on the labour share? At the given employment level I, labour costs {wL) rise because an hour of work (w) costs more. With higher wages, however, total employment (L) is • reduced as firms move down their labour demand schedules. The effect on the numerator of the labour .- share is therefore ambiguous. At the same time, a decline in employment generally means a decline in output, and therefore a decline in the denominator. If the demand for labour is not very elastic, neither labour demand L nor output 7 change much in response to an increase in the real wage. Then both total labour costs and the labour share increase, while the profit share declines. Changes in the labour share are important for two reasons. First, the distribution of income between capital and labour has political elements that can affect the behaviour of governments. Second investment responds to profitability, which is related to the profit 4 This is not quite accurate: in fact, rental income, patent and royalty payments, and other minor factor incomes have been ignored. MARKETS AND EQUILIBRIUM UNEMPLOYMENT 143 share. Investment, in turn, affects growth.5 When labour demand is rather inelastic, therefore, exogenous wage increases may reduce profitability, Tobin's q, investment, and the standard of living. 6.2.2.3. Shifts in the demand for labour Now consider the effects of an increase in the capital stock K, which was assumed constant so far. Figure 6.9(a) shows that this normally raises MPL—the production function becomes steeper at every level of production. The labour demand curve shifts out in panel (b). A technological improvement that shifts out the production function produces a similar effect.6 This helps account for the fact that wages have grown secularly over time. 6.23. Labour Market Equilibrium We now have the building blocks for understanding the labour market: a supply curve derived from household behaviour, and a demand curve derived from firm behaviour. The interaction of supply and demand for labour is depicted in Figure 6.10. Equilibrium occurs at the intersection of the two curves (point A). At wage w* the market clears (there is no excess demand or supply): I* is the number of hours firms want to hire and households want to work. Both the real wage rate and employment are endogenously determined in the labour market. This simple characterization of the labour market will serve as the benchmark for the rest of the chapter. Figure 6.11(a) provides an example of its usefulness. It depicts an increase in labour productivity, which has occurred over centuries as the result of capital accumulation and technological advances. The labour demand curve shifts outward; the supply curve is unaffected. The effect is an increase in Hving standards as real wages increase. If the labour supply curve is perfectly vertical, employment remains unchanged and labour income wL rises proportionally to the real wage. If the supply curve is backward-bending, employment 5 The inverse relationship between real wages and the profit share is illustrated in Ch. 1, Fig. 1.4. The link between investment and profits is studied in Ch. 4. The growth effects were analysed in Ch. 5. The Appendix presents a formalization of this section. 6 Ch. 5 discussed technical change. An exception would be a labour-savingtechmcal change, such as robots, which would reduce the demand for labour at any wage and shift back the demand for labour. m^msm 144 THE REAL MACROECONOMY MPĽ MPL Labour Labour \ a) lh) Figure 6.9. An Increase in Labour Productivity Labour becomes more productive either because more capital is put in place or because of technological progress. In panel (a), at any level of labour input, more output is produced and the production function is everywhere steeper. The MPL increases and the demand for labour schedule shifts up in panel (fa). Supply Demand Laboui hours Figure 6.10. Equilibrium in the Labour Market Labour market equilibrium occurs at point A where demand and supply are equal. The real wage w" clears the market at employment level_Lx. If total labour endowment is I, the distance {L-Lk) is voluntaiy unemployment. (man-hours) declines while real wages increase. Table 6.1 seems to indicate that this has been the case over the past century. The second panel of Figure 6.11 shows that an exogenous increase in the supply of la- bour leads Hi an increase in employ men I in the short run, hul also lo a reduction in real wages. 5.2.4. The Interpretation of Unemployment \\ hile ihe suppU -and-domand apparatus allows us to evaluate the oiled ol various changes on equilibrium emplovment and i eal wages, it is disappointing in one crucial rcspecl. \t point i in 1 igure o.lO, labour supplied is equal to labour demanded. Any unemployed resources- correspond lo \ oluniary decisions of households and firms. If total available labour supply is U unemplox ment i measured as hours of work not hired, is measured as T - L . Since point A is on the labour supph curve, it corresponds to the optimal behaviour of households. "Ihe interpretation olTigureô.lOisthat the equilibrium real wage it' is too low to persuade w workers to gi\e up leisure: some may wish to worK onlv part-time, others ma\ not want to workal all. U might be disturbing lo ihink that unem ploy men could be chosen freely. Yet voluntary unemploymen ^ is an important phenomenon. It is not only the ver> 7 Ch. 5 gives alonger-run perspective on the effects of exog>-increases in the working population. iMJIAi'V'''' HSfájSa;'1'"' - ä-,JÍ4"r t"" Supply LABOUR MARKETS AND EQUILIBRIUM UNEMPLOYMENT 145 Supply Demand Demand Labour Labour t-ŕ- Ja) (b) Kaiř-í'' Figure 6.11. Shifting Labour Demand and Supply Wrjen labour demand increases (panel (a)), for example because of additional capital or technological progress, the real wage and the employment level both increase. When labour supply increases instead (panel (b))—because of new entries into the labour force, for example—employment rises but the real wage declines. wealthy who can afford not to work: those who receive an income from other sources (from a spouse or from the state, for example) may also find that the net wage they can earn does not compensate for lost leisure or nonmarket activities, including worldng at home or raising children. Voluntary unemployment is likely to be more widespread among low-skilled people who cannot hope to earn much, or in countries where taxes are so high that working yields little net gain. Box 6.2 shows that it may actually be costly to take up a paid job. The most obvious costs are faced by families with children. The cost of child care—or sim- BOX 6.2. HOW CAN A JOB COST MONEY? 'The social systems of most countries share two institutional features. First, poor people receive transfers—income maintenance programmes—f rom the state. Second, income taxes are progressive: the rate of taxation in- vcreases as income rises. Taking up a job implies receiving á salary, but also'paying taxes if the salary is high enough, and losing eligibility for income maintenance programmes. It is conceivable then that people can be f inan- ply the unavailability of such services—explains why two-earner families are not as common in some countries as in others. Table 6.2 presents the proportion of women of working age in the labour force, whether employed or not (the participation rate), the female unemployment rate, and the proportion of women of worldng age actually employed. The variation of these proportions is quite substantial across countries, and points to differences in both cultures and institutions. Female participation in the labour force is very high in countries like Denmark and Sweden, which have a highly developed and subsidized child care system. daily worse off by taking a job, not to mention incurring a loss of leisure, and possibly some activity in the underground (shadow) economy. Implicitly, these people face an effective marginal tax rate—considering the overall effect of work on their income—in excess of 100%. A study in Britain in 1986 reveals that 2% of households faced a marginal tax rate of 60% and above, in some cases above 100%. 16 THE REAL MACROECONOMY Table 6.2. Female Labour Force Participation Rates, Unemployment Rates, and Employment Ratios, 1993 Participation rates Unemployment rates Employment ratios Belgium3 54.1 9.5 46.4 Canada 65.3 10.5 58.4 France 59.0 13.8 50.9 Germanyb,c 58.2 6.4 54.5 Ireland13 39.9 15.4 35.1 Luxemburg15 44.8 2.8 43.9 Netherlands3 55.5 7.3 50.6 Portugal 61.3 6.5 57.2 Spain 42.8 28.9 30.5 Sweden 75.7 6.6 70.7 UK '65.3 5.4 55.0 USA 69.1. 6.5 64.6 a 1992 b 1991 c West Germany only Source: OECD Labour Force Statistics Our first attempt at defining unemployment in the last section was somewhat unsatisfactory. Unemployment is more than simply labour voluntarily withheld from the market. The International Labour Organization (ILO) or the Organization for Economic Cooperation and Development (OECD) define an individual as unemployed if he does not have a job during the reference period and is actively looking for one and is ready to work. The labour force is then defined as the part of the population (N) that is either working (L) or unemployed (U). The labour force mainly excludes young people in school, the retired, and those who do not wish to work. Thus we can write: (6.3) N = L + U. labour force employment unemployment The rest of this chapter sets out to examine alternative reasons for unemployment as well as its implications for the well-being of society. 63.1. Involuntary Unemployment and Real Wage Adjustment One interpretation of unemployment is the failure of markets to clear. In contrast with the assumption that real wages adjust to clear the labour market, Figure 6.12 considers the case where the real wage is fixed at w', which is higher than the market-clearing level iv*. At W firms are willing to hire a quantity Ľ of labour, while workers supply I". Since firms cannot be forced to hire more than they wish, actual employment is L, and L" - Ľ is labour supplied but not demanded by the market. If the real wage were to decline to w>:> de- . mand would increase, supply would decrease, and full employment be restored at L*. In Figure 6.12, it is the failure of the real wage to ;-. decline that creates unemployment. Involuntary ufl" employment occurs when an individual is willing and > able to work at the wage w' but cannot find a job, no ; matter how hard he or she tries. This is a key result, the existence of involuntary unemployment must 0 . explained by real wage rigidity, which we exarnin , -. next. ' \ 63.2. Collective Bargaining and Real Waqe i **-i For sustained real wage rigidity to occur, maJ 5 jfel* cesses must be prevented from running their rdS t^-.i Somehow, involuntarily unemployed workers ni(; i:i i LABOUR MARKETS AND EQUILIBRIUM UNEMPLOYMENT 147 i \ í N, Sq Supply t / i s i r i i i i Demand 0 Ľ Ľ L" Involuntary unemployment Labour Figure 6.12. Involuntary Unemployment At the real wage rate w' workeis supply Ľ of labour but firms demand, and hire, only Ľ. The quantity I" U, which is supplied by households but not demanded by firms, represents involuntary unemployment. If the real wage were to adjust to the level w, the market would clear at point C. unable lo sap p U Lpcí- labour sen ices ji \\ jges below iv", or firms musi be unwilling Lo lake up Mich oilers, or be unable lo make the'ii own. What important in- ci;in'• In contrast to Section 6.2, union indifference curves '-replace the representative individual's indifference curves, symbolizing the fact that the active agent in '".foe labour market is not the individual, but his or her \fááde union—or, more generally, the collective bargaining process. The 'budget line' faced by the union ikthe demand for labour. From Section 6.2.2 we know that labour'demand is given by the MPL (either a firm's MPL, or that of an industry or the entire economy: if firms are all alike, their individual demand does not differ from the collective one defended by an employers' association). The optimal choice for the union is the tangency point between the highest indifference curve and labour demand. When the demand for labour shifts out—as a result of capital accumulation or technological progress, for example—the succesive tangency points map out a collective labour supply curve as represented in Figure 6.14. The curve describes the most desired joint evolution of real wages and employment from the union's viewpoint. The shape of the collective labour supply curve ■-.-• ' -'ffl£ňS*'~:-1 ;!p8ľ ■M$Sß 'rWí$Z • m, íftSiä£1-' ■~$ - '. .to .cc .- ~w& ::§píí. ;;i§§ísr;'. ,-Mľ<-!: Collective labour supply Employment Employment (a) (b) W'~ ^\ Collective labour supply (0 Employment ective labour id) Employment Figure 6.14. The Collective Labour Supply Curve The collective labour supply curve is obtained by connecting the points of tangency between the indifference curves and a shifting labour demand schedule. Panels (c) and (d) respectively describe unions with a target wage level wT and target employment level LT. Panels (a) and (of) give rise to steep schedules, whereas (b) and (c) are associated with real wage rigidity and a more elastic supply of labour. 150 THE REAL MACROECONOMY reflects the preferences of the union, as shown by the various panels of Figure 6.14.11 Panel (a) is an example of a 'hard-line' union with a steep trade-off of wages for employment; panel (b) is the counter-example of a jjobs-firsť union requiring only moderate wage increases to supply more labour. Panel (c) shows a union with a well defined real wage target ready to accept a wide latitude of employment outcomes, yielding a flat collective labour supply curve at the target level. The other extreme is panel (d), which aims at a given level or employment, and is willing to set wages at whatever level is necessary to keep this group employed.12 The appendix provides a formalization of these ideas. 6.3.2.3. Employment effects of collective bargaining The collective labour supply curve resembles the individual supply curve of Figure 6.6, but has different origins. Collectively, through their unions, workers feel that they have more strength and accordingly aim at better outcomes. In particular, for a given amount of labour supplied, they ask for higher real wages: the union-driven collective labour supply curve lies above the individual labour supply curves. In Figure 6.15, without the union equüibrium would occur at point B: individuals would be willing to provide employment L, at wage w2. They cannot, however, because the wage w1 is set through negotiations between the firms and the trade union, and individuals cannot simply underbid their employed colleagues. Unemployment (L[ - Lx) is involuntary for affected individuals, but voluntary from the union's point of view. Why do unions enforce wage rigidity apparently against the will of unemployed workers? One reason is that the leadership is elected by the employed. Unemployed workers are always a small minority of the membership, even at record high unemployment rates of 10% or even 20%. Furthermore, unemployed workers often give up their membership or lose interest in union affairs. Unions end up representing those who work, not those who are unemployed. Employed workers look for high real wages (for themselves) at the cost of some unemployment (for others). Box 6.3 illustrates how the relentless rise of unemployment in Europe after the two oil shocks can be explained by this effect. 11 A technical note: this is true only for a given shift of the labour demand curve. Here we consider only parallel shifts; one could imagine however, that other types of shifts would change both the position and the slope of the labour demand curve. 12 This group may be the current union members, or the subset of the membership that is employed, or some core of so-called 'insiders', those members with sufficient seniority. Collective supply curve / Individual / supply curve \i? !c 'if L. L, Ľ. .] .\.i.gk Employment , ■■_/ v.'r'cf Figure 6.15. Labour Market with a Trade ,.: :| j,^'| Union ":'';^':vftil When a labour union represents workers at wagehegjpM I^fl nations, labour market equilibrium occurs at'poir/fe^||; š^flÉ If the union collective labour r-----'----------:_ ~Ll~-*-tliJj>®: individual labour supply higher and employment ers) lower than at point B, which would -be, tr^e^uj come if individuals were negotiating individuäljýŕJfbS result is the existence of union-voluntary, ihdí«íclu^fe;^p^|i ;thedÍTfére^SfS|^ involuntary unemployment (Ľ, - i.,): it is between actual employment L% and the ämö'un|| work L\ that workers are individually willing ids. at the real wage rate wv ' - The split between unions and unemployed workers;^ cannot go too far, though. After unemployment ii|;^ creased to high levels in Europe in the 1970s and 19^|s||^ unions have become more employment-conscio^f|| and real wage growth has moderated. One reas°^f|ljp that members become worried that they too rni| ^ ^ become unemployed. Another is that the loss inmej||pj| bership revealed in Table 6.3 above has meant lo^|e|f| income for the union from dues as well as less ov%?||| mfluence. t-T^i It would be unfair to assert that unions are sajp^gj responsible for real wage rigidity. As mentioned w0§z employers' associations often represent the ^te^|f| of firms. They provide a means for policing c0^^& bargaining agreements reached with unions. In-a^i end, employers' associations do not control ^ßm mand for labour: this is the prerogative of &e;|lj vidual companies. While it is in firms' mteresťfpj| wages low, it is also in their interest to keep me^i of their competition high, or at least to prevent^ competitors from hiring cheap labour. Thus, e-^ftjj| ers' associations also contribute to real wage rig^J LABOUR MARKETS AND EQUILIBRIUM UNEMPLOYMENT 151 f B^X"6.3. THE HYSTERESIS EFFECT "Il&ěi^b oil shocks of the mid-1970s and early 1980s cor--'fii^pönd, to |a significant inward shift of the aggregate 'Éjlbô'.ur dem'and curve in Figure 6.15, hence to less em- i^ljpyment. If trade unions respond to a narrower mem-Jf^rshiip by calling for higher wages, the collective labour ftŕaŔplý curve shifts upward. Owing to the behaviour of ^Sj^i^insiders' who have jobs, employment prospects for ^outsiders' á^e reduced. After the oil shocks are absorbed, the employment level is permanently reduced. That such an effect—dubbed the 'hysteresis effect'—has been observed in several European countries is suggested by the step-wise increase in the unemployment rate following each oil shock (Figure 6.16). In contrast, in the USA and Japan, where unions may have been less 'hard-line', unemployment rates increased at the time of each oil shock but then reverted towards earlier levels. m #/ " 8Í-V-. ' 1 Irr--. fr'"' - / •fix.! , Kí* '-* - írí' - "N1.' " ¥h Figure 6.16. Hysteresis in EC/EU Unemployment, 1965-1994 The unemployment rate increased in both the EC/EU and the USA after the two oil shocks. In the USA the rate has since come down, to about where it was in the early 1970s. In the EC/EU, 1jhe unemployment rate seems to suffer from hysteresis, stabilizing wherever unexpected shocks move it. Source: IMF, World Economic Outlook, October 1995 63.3. Sod ime: Involuntary are downwardly rii by trade unions other institutional to wage rigidity, suspected are for income and for reasons of social mployment occurs when real wages gid. Beyond monopolistic behaviour and employers' associations, several and economic factors contribute . Among institutional factors frequently social minima, or minimum standards earnings mandated by the government equity or protection. Minimum wages prevent wages from declining below some level. Many countries legislated minimum wages long ago for a variety of reasons. One was to prevent employers with too much market power from depressing wages artificially. Another reason was to protect young people from exploitation. With schooling rudimentary and poverty endemic, for many youngsters on-the-job training was the only way to get started; unscrupulous employers would offer very low wages, sometimes below minimal survival needs. Social protection was and still is justified; but, paradoxically, 152 THE REAL MACROECONOMY Individual supply curve i Employment j Figure 6.17. Minimum Wages ; Minimum wages reduce the demand for labour below i the level that would result with either union-negoti-I ated wages or individual-supplied labour. youth unemployment may be exacerbated by minimum wages. Their effect is to deter firms from hiring workers whose MPL is below the minimum wage rate. Those most likely to be hurt are poorly educated young people with no job experience and older workers with obsolete skills. The effect is quite widespread, because, once a floor is set, it pushes up the lower echelons of the wage pyramid, possibly affecting better qualified workers as well. The range of qualifications for which the MPL is below the real wage is wider than just the very lowest echelons. Figure 6.17 illustrates the effect of minimum wages. To serve any purpose at all, the minimum wage w, ln must be higher than the wage w0 that would obtain otherwise, and which is itself higher than what individuals would accept {wy) if only to cover their part of the cost of investing in human capital. The result is unemployment {Ln_ - Lmill) even higher than the le\ol {Ly — L0) implied by the union-set wage. Some evidence on the effect of minimum wages is presented in Box 6.4. 63.4. Efficiency Wages and Real Wage Rigidity Another reason why real wages may not decline in the presence of involuntary unemployment is that firms do not wish to reduce them. The phenomenon is often called efficiency wages, and it is related to the difficulty for firms to observe work effort. By paying a worker a wage in excess of his marginal productivity, firms may attempt to elicit more work. A worker who is dismissed for lack of effort is unlikely to obtain such a good deal elsewhere, especially if dismissals are.in- ^^ terpreted as a sign of poor work effort. Firms may alsQ^||j' pay efficiency wages to obtain a better selection of áp-|$||š plicants and to keep workers from quitting too ofténVí'i~f In capital-intensive industries, where shirking could,, :.^| seriously disrupt the production process and wheŕé;^^ high-quality work-force is of primary importances^!? firms have a strong incentive to offer efficiency wages^^ In this case, the function of real wages is not just, t||S§| equate demand and supply in labour markets. 'As^^j result, wages will not generally be able to satisfy opť|gi|| functions. Real wages will tend to be rigid and may 1?^^ set above the market-clearing level, as in Figure 6.15g^ 6.4.1. Labour Market States and Transitions Any person can find herself in one of three situations: employed, unemployed, or out of the labour force. Figure 6.18 displays these three states and the various flows that describe how workers shift from one situation to another. A striking aspect of labour markets in developed economies is the size of these flows. Table 6.5 shows that the flow of individuals moving into and out of unemployment per year is almost twice the stock of unemployment at any given time. In contrast to the ■£&£ static picture painted in Section 6.3, labour marte© are remarkably dynamic, even when unemployccie^ is high and stable. f '-'^!| There are three ways of becoming unemployÄ First, new entrants to the labour market join-fhe^||i bour force before they have found a job but ^^gf successful, at least initially. Second are separat!^ from jobs. Voluntary separations from the emPjp|j|j viewpoint (quits) account for roughly 50% to °6;« all separations from employment in the UK, an4 mg 70% in the USA. Yet quits rarely lead to ^emÄ|| ment: most workers who quit immediately Wf|j| ' '?íš& LABOUR MARKETS AND EQUILIBRIUM UNEMPLOYMENT 153 iŠaX. 6.4. MINIMUM WAGES AND YOUTH UNEMPLOYMENT <[t is striking that teenagers in the USA often work during fíífté-summer when their European counterparts go on ■^Vacation. One reason might be that wages that must be íšpaid for young, unskilled labour are too high in Europe. ľTfte US minimum wage amounts to about a third of the ^average manufacturing wage, while in many European jfeóuntries it exceeds 50%. This is one reason why filling Ration attendants and grocery shop assistants have all t$DCit disappeared in most European countries. Table 6.4 jršhbws non-employment and unemployment rates for poling people in a number of countries as well as the ^average minimum wage as a fraction of the average ^TJyage. In interpreting the table, it is important to note |;ihat Denmark exempts those below 18 from collective ^bargaining agreements. The UK does not have a mini-j'.mum wage, and teenagers are generally not unionized. It is especially noteworthy that in France, Belgium, the Netherlands, and Portugal, the minimum wage as a fraction of the median wage is high, meaning that a great many jobs are paid the minimum wage. In France the minimum wage, called the SMIC (Salaire Minimum Interpersonel de Croissance), is an important element of the collective bargaining system. It is set by a council on which both the government and unions are represented. Many government employees receive the SMIC. In 1987, roughly 8% of wage-earners in industry, commerce, and services were covered by the SMIC, a much higher proportion than in the USA (less than 4%). While the minimum wage in general has a negative effect on youth employment, it may lead to a substitution of adults for youths, at the same time increasing the employment of the former. Table 6.4. Youth Unemployment and Minimum Wages, 1990 f- . Minimum wage as % of: Nonemployment : ratioJ Unemployment rate ', Average wage Med ian wage Age 14-19 Age 20-24 Age 20-24 \Belgium _ 66 94.1 46.6 13.0 -.'Canada 34 — 45.2 21.4 11.7 '■Denmark Noneb 47.9 29.2 14.4 ^France 49 61 91.4 46.0 18.5 -'Germany None0 70.2 29.0 3.8 ' Italy Nonec 86.3 50.6 26.6 ' Netherlands 56 72 68.7 31.6 8.9 Portugal — 74 65.7 32.1 8.6 Spain 34* — 70.0 34.1 30.6 UK None 49.3 29 3 13.1 .USA 40 — 48.2 24.2 8.8 " The nonemployment ratio is defined as the fraction of the population in the specified age bracket that is currently not employed 'J Youths under 18 are exempted from union wage agreements ' Union agreements restrict employment of youths in industry and many service sectors. L' 1990 Sources: OECD Jobs 5tudy (1994), Part II; S. Eazen and G. Benhayoun, 'Low Pay and Wage Regulation in the European Community', British Journal of Industrial Relations, 30 (1992) 623-38; Eurostat, OECD Employment Outlook, 1995, Labour Force Statistics, 1971-91 another job (transition from employment to employment) and most of those who do not get a new job leave the labour force, often for reasons of pregnancy, return to school, retirement, etc. Finally, job losers— those who are i woluntarily separated—tend to flow into unemployment. Job loss may occur when short-term contracts expire (common in France and Spain), factories close o:: relocate, or because of layoffs (more common in the [USA and Denmark). 6.4.2. Stocks, Flows, and Frictional Unemployment The fact that no two positions and no two persons are the same means that finding a job is not always easy and may take time. It requires pairing a worker and an unfilled job opening or vacancy. The matching of skills, occupation, industry, and geographical location requires a large amount of information. The more fifTOKTKTmKJT' 154 THE REAL MACROECONOMY i'f if i I i-1 ;HíiS Ihm 4#iľ Hilf" 1 4* Íl;f '•& it Job finds Quits to unemployment New entries Unsuccessful new entries Discouraged Retirements FigUre6.1B. A Map of Ubour Markets outofthe,abourforce. (6 4) AU=sL-fU. actional unen^^ stock ^tÄii^hqua1" rShsTX Ä«f unemployment occurs when AU-0 in (6.4), or when (6.5) f It is convenient to express unemployment as d proportion of the labour force N= I + U.l hen (6.5) shows that the frictional rate of unemployment is (6.6) uf = UflN = efficient the labour markets are, the faster the match is achieved. In the mean time, frictional unemployment occurs. This is an unavoidable result of the dynamics of labour force movements, the normal process of job loss and creation. In addition to the efficiency of the job matching process, frictional unemployment depends on the number of job separations and the number of vacancies. If we ignore the flows from and to 'Not in the labour force' in Figure 6.18, the number of workers who become unemployed (per month or per year) represents a fraction s, called the separation rate, of existing jobs (I). While unemployment rises by sL workers, it declines as unemployed workers find jobs. If we use /to denote the job finding rate, i.e. the fraction of the unemployed (U) who go into employment, the change in unemployment in a given period is given by Both separation and finding *%??£'$$*** I probabilities: the average P^abtoyj b iot.when currently employed, and the av ^ d unemployment is larger, the less hequfiri na «ne rnľre frequent are J»^*^ stt* The separation rate s has two comV°^icitoti# tur JUndcyclical. The structural aspect»tart j, ease rth which firms dismiss.««*£»£ exist iß countries where legal and ^«f^i« <*£ in most European counmes) than m co Q^\ redundancies are more acceptable te.g , sinceN=L+U(see(6.3))a = ^+|^ '^i^ WN^substitutingiyN^-^^^u Uggb i' Naturally, as averages, these tena be^ exiting unemployment. ■ ^ II LABOUR MARKETS AND EQUILIBRIUM UNEMPLOYMENT 155 & Table 6.6. Inflows into U nemployment and Unemployment Rates in the.UK w SPI ' w Inflow rate into Unemployment rate unemployment (% of relevant labour (% per month) force) Jä ' By region: Britain, 1988 South East 0.80 5.3 ■'- East Anglia South West 0.83 4.9 1.03 6.2 , West Midlands 0.97 9.0 East Midlands 0.97 7.5 Yorkshire/Humberside 1.20 9.7 Northwest 1.30 10.9 North 1.47 12.2 Wales 1:40 10.6 Scotland 1.50 11.7 TOTAL 1.07 8.0 - , By demographic group: UK, Aged 16-19 Aged 20-24 Aged 25-54 Aged 55-64 White 1984 3.33 22.1 1.33 16.9 0.74 8.8 0.47 8.3 0.92 10.4 Non-white 1.43 20.1 Male 0.78 11.2 Female 1.17 10.2. By skill: UK, 1984 Professional/managerial Clerical 0.50 5.3 0.88 8.0 Other non-manual 1.14 12.2 Skilled manual 1.02 12.6 Other manual 1.32 15.5 Source: Layard etal. (1991) the USA). The cyclical aspect simply refers to the fact ,that during recessions the probability of losing a job rises and so, therefore, does frictional unemployment. Table 6.6 shows that for a given country (the UK), job separation rates vary considerably across, age, region, and skill groups. Those specific labour force groups that exhibit higher separation rates of inflow into unemployment have higher frictional, and probably therefore overall, unemployment rates. The finding matching prpcess rate/depends on the effectiveness of the It depends on how hard unem- ployed workers look for jobs, how many job openings are available, and how easy it is to spot an opportunity. It may also depend on incentives to remain unemployed, and unemployment insurance may therefore exert a perverse effect. Because unemployment often represents personal trauma, unemployment benefits or assistance respond to a widely perceived need for solidarity and social conscience. Table 6.7 shows that unemployment benefit systems vary considerably from country to country, with respect to eligibility criteria, income replacement, and the period over which they are paid. At the same time, unemployment benefits have adverse side-effects. They may encourage unemployed workers in declining industries to wait for an unlikely recovery rather than to retrain and change sectors. They also act as a disincentive for looking for a job, or t ri Ml .SI n i i I Pil i 1 ú I Of1 Hli .i >» 11 «m ť! 'f« p H .if I! r-r í k t I í,',; ľ-' 1 r I í ] \ S>: ' i ' i ',i , -i i- r li m f : 156 THE REAL MACROECONOMY Table 6.7. Unemployment: Conditions for Eligibility and Benefits Eligibility Maximum Replacement conditions"1 duration11 rateL Employment 156 wks Period 5 yrs Benefit 30 wks Assistance Single Married Austria a 41 44 Belgium 90wks 27 mos. - 60 60 Denmark W) 3 yrs 30 mos. 3C 64 64 Finland ,;,.:''' '' '■•,'-' " ŕ?'víyi;»'^iŕ«w» 158 THE REAL MACROECONOMY BOX 63. THE EUROPEAN WAGE SHOCK AND EUROSCLEROSIS *» ^witnessed an increase ^^J^ iBdl 'Hardline' European unions sue- rÄÄSfcr^nlithtneUS. Štence of high unemployment desprteproved led to the depressing bout of 'Eurosclerosis' in the early 1980s.16 Facing an apparently unstoppable rising tide of unemployment, many leaders simply accepted it as structural, and therefore beyond policy influence. Yet unions cannot overlook completely the plight of the unemployed. Over the latter part of the 1980s, unions gradually bowed to market pressure and in some countries, such as Mrs Thatcher's UK, to political pressure too. As real wage growth has slowed down, employment has started to grow faster, allowing a decline in the rate of unemployment. •3 Sl I I I l I I l 1 J l I l M I I....._______ 1970 72 74 76 78 80 82 84 86 88 90 92 85 1970 i i i i i i i...... 72 74 76 78 80 82 84 86 88 90 (a) USA (Ď) EC/EU SA Figure6.20.EMo^^^ Over the period 1970-92, real wages ^^^^^^. employment rose by 50%. (Real wages = total compensat.on per empi y Source: OECD, The OECD Job Study (1994) has followed the same pattern. To begin to understand this dramatic evolution, we return to the two components of the equilibrium rate of unemployment. 16 The term 'Eurosclerosis' was coined by German economist Herbert Giersch of the Kiel Institute of World Economics. 6.5.2. The Eoropeao Experience . - The evidence suggests that f^te^^t ' rose when large numbers of workers loj * uent, the time of the on shocks. The expected * ^ * return to pre-oil-shock levels has been & LABOl P ; j> ny £C countries by a fall in the finding rate, so exit f r mi unemployment has become increasingly harder. í * Is []w. development of the social safety net to be blamed ľ' j- |iaving provided workers with the incentive to wait r n]t [heir unemployment? Circumstantial evidence— :' j01 example Figure 6.20—points in that direction | r|1L T t based on a comparison between Europe, where ' the safety net has become extensive, and the USA. Yet ihci i is some disturbing counter-evidence. The social f sdl cl v net is even more developed in Sweden and Nor- i wa\, where long-term unemployment has remained í i luu e f. This implies that what really matters is not the ! -.aid v net itself, but the disincentives that it may gen- \ ;\aW. Unemployment benefits, for example, provide an alternative to finding a job, and help transform temporary! unemployment into permanent—struc- ' lliril|—unemployment. Long-term unemployment has become increasingly widespread, and as workers gradually lbse their human capital and contact with lne active labour force, they become unsuitable for any \,Kaucy. , I he strikingly different evolution of the equilibrium miLiiiployment rate across countries also points to the imp» rtance of institutions in shaping the levels of •will's. This concerns the process of wage bargaining. I Ik comparison between the EC and the USA in Box i-».ť shows that high unemployment in the EC is re-la i a I to steep real wage increases, amounting to what has been dubbed the European wage shock'. Labour ldsI«. consist not only of wages: labour taxes (social slllii ity and retirement contributions) have also been allo\* ed to rise steeply. Of importance too is the regulation of the use of labour (length of the work-week, dismissal procedures, part-time work, etc.).17 6.5.3. Actual and Equilibrium Unemployment18 It can take a long time, often years, before real wages actually adjust to their long-run values shown in Figures 6.10 and 6.15. In the meantime, actual unemployment can deviate from equilibrium unemployment. 17 Ch. 17 provides a more detailed exposition. 18 This section briefly presents an issue to be explored at length m Ch. 12. R MARKETS AND EQUILIBRIUM UNEMPLOYMENT 159 Labour (hours) Figure 6.21. Actual and Equilibrium Employment When unions negotiate on behalf of workers, market equilibrium occurs at.point A and equilibrium unemployment is L - L Actual employment and unemployment may differ if the real wage is slow to move to its equilibrium level w. If it is above the market equilibrium level (w, > w), firms reduce employment.to /., and actual unemployment exceeds equilibrium unemployment. Conversely, below-equilibrium real wages (w2 < w) allow firms temporarily to find a way of connecting with structurally unemployed workers willing to work at lower wages than the union-set level* The resulting unemployment rate is lower than the equilibrium level. Actual employment is below, and actual unemployment above, equilibrium when the real wage is above the equilibrium level, as at point Al in Figure 6.21. When the real wage is low, firms may be able temporarily to move away from the union-set collective labour supply curve towards the individual labour supply curve (point A2), for example by using agencies specializing in temporary jobs or overtime work. Workers may have overestimated the real wage by underestimating the rise in the price level. Firms may be willing to hire more workers at the going wage. In such situations employment is above, and unemployment below, the equiHbrium level. 85 15 160 THE REAL MACROECONOMY 1. Households trade off leisure against consumption (more generally, labour income). An increase in wages can induce more labour supply if the substitution effect dominates (elastic labour supply), less labour supply if the income effect dominates (backward-bending), or no change at all (inelastic supply). 2. Individual labour supply seems to be inelastic in the short run and backward-bending in the long run as real wage gains are taken partly in the form of additional lcihure. Aggregate labour supply is more responsive in the short run as real wage increases draw new individuals into the labour force. 3. The demand for labour by firms depends on its (marginal) productivity which is determined by the available technology and the capital stock. Firms hire labour to the point at which the marginal productivity of labour is equal to the real wage. The labour demand schedule is shifted outwards by an improvement in technology or an increase in the capital stock. 4. Equilibrium employment and the wage level are given by the intersection of labour demand and labour supply. Improvements in technology or increases in capital will be reflected in higher wages if labour supply is inelastic, and in higher employment if labour supply is elastic. 5. Involuntary unemployment arises when real wages do not clear the market so that not all labour supplied by households is actually hired. 6. Labour unions care about real wages and employment. In determining their target wage, given the demand for labour firms, they ask for higher real wages than if the labour market were perfectly competitive. While the resulting unemployment rate lis (optimal and) voluntary for unions, it may be involuntary for individuals. 7. Very centralized or decentralized wage negotiations deliver lower real wages ana, less unemployment than negotiations taking place at intermediate levels of centralis- -^ ;* tion (industry by industry, or by craft). 8. Because firms cannot easily monitor work effort or wish to elicit lower turnover o. ;_^ improve worker quality, they may offer efficiency wages. This is yet another reas ^ .■ ..^ why real wages may be set above market-clearing levels. ~ ''' /' ~J 9. Labour markets are also characterized by widespread government interventi / ^vj Minimum wages, designed to protect workers, can actually cause unemploynien ■; ■ 10. The labour market is characterized by a considerable amount of flow bet\ve 7 - « - orchis-?1, al ütieM'- different states (employment, unemployment, not in the labour force). Sean- important aspect and results in frictional unemployment. Alongside structur ployment, it is a source of equilibrium unemployment. m jÄI 11. Search may be more or less efficient. It is affected by government labour ^i| policies. Unemployment benefits, designed to make unemployment more ^00 provide disincentives to quickly finding a new job, thereby increasing friction _,■*>: _ Jf LABOUR MARKETS AND EQUILIBRIUM UNEMPLOYMENT 161 ployment. Other programmes, such as training and relocation subsidies, reduce fric-tional unemployment. 12. Because of distortions and regulations, equilibrium unemployment is never zero or entirely voluntary. Individuals may be willing to work at lower wages than those prevailing in equilibrium, but they cannot underbid. This is the sense in which real wages are downwardly rigid. 13. Real wages are slow to adjust to disequilibria, if only because they fulfil many other roles. As a result, actual and equilibrium unemployment may differ for long periods of time. © leisure © consumption-leisure trade-off © real (consumption) wage @ income effect, substitution effect ® labour supply: individual and aggregate © labour force © participation rate © man-hours ® marginal productivity of labour (MPL) © labour demand ® wage and profit shares ® voluntary and involuntary unemployment ® real wage rigidity trade unions, labour unions collectively voluntary/individually involuntary unemployment collective labour supply curve hysteresis minimum wages efficiency wages unemployment benefits unemployment stocks and flows separation and separation rate finding rate factional unemployment equilibrium unemployment structural unemployment 1. Suppose that the household in Figure 6.3 receives an inheritance. What is the effect on its decision to work and to consume? According to this result, do rich people work more or less than poor people? THE REAL MACROECONOMY 2. Suppose Robinson Crusoe is paid a higher wage ('overtime') if he works more than 8 hours a day, but only has 16 hours at his disposal. (a) Draw his budget constraint in this case. (b) Does the existence of overtime necessarily make him better off? (c) ShowCrusoe's optimal behaviour for 'normal' indifference curves. Under which conditions will he choose to work overtime? Under which conditions will he refuse? 3. Normally Crusoe sleeps eight hours a day. Suppose it were possible for him to stay awake an extra hour per day without any impairment of his abilities. What would the effect be (a) on his consumption? (b) on the amount of leisure taken? How much would he be willing to pay for this innovation? 4. How should the equilibrium rate of unemployment respond (a) to an exogenous ' decrease in investment over several years? (Jo) to an exogenous increase in productivity? How does your answer depend on the institutions of wage determination? 5. What is the effect on the labour market of a minimum wage that is actually lower~ than the equilibrium wage? Show in your graphical answer the new equilibrium -wage and the level of employment. 6. A new labour tax is imposed which is proportional to wages. Individuals care about after-tax wages. (a) Draw the old and new individual supply curves. (b) What is the effect on the equilibrium wage and employment levels? (c) What is changed if wages are set through negotiations with a trade union which} also cares about after-tax wases? ■ :',i*. 7. Many countries have housing rent control; i.e. rent increases are tighúy controlled.^ below levels that would prevail in a free market. How might this affect equüibriürn';|| unemployment? {Hint: think about labour mobility and mismatch.) ,^J® 8. What is the effect on wages, employment, and unemployment of a wave of imů|Jg| gration: ?|| (a) in the absence of minimum wage legislation? (b) in the presence of minimum wage legislation? 9. How should Figure 6.13 be redrawn if unemployment benefits are generally avara able and provide a floor under which wages cannot fall? (Hint: the trade ^||| would never accept wages lower than the unemployment benefits.) What is | implication for the collective labour supply curve? LABOUR MARKETS AND EQUILIBRIUM UNEMPLOYMENT 163 Exercises: Applications 1. One of the immediate consequences of opening the borders between East and West Germany was the potential for migration between the two regions. Because of a more productive capital stock and more know-how, wages in the West were about three times as much as those in the East. Consequently many East Germans moved to the West. What are the consequences for this migration for real wages (a) in West Germany? (b) in East Germany? (c) for employment in the two regions? Can you explain why West German trade unions were eager to organize their comrades in the East? 2. It is often said that unemployment insurance in Europe was always generous and thus cannot be responsible for the present high unemployment on the Continent, which has emerged only since the mid-1970s. Examples are Germany, France, and Belgium. Evaluate this statement. 3. In Japan the bonus system is widespread. Workers often receive 30% of their pay in the form of a profit-contingent payment, which can go up or down depending on the fortunes of the enterprise in which they work. What are the implications of such a system for real wage rigidity and equilibrium employment? 4. It is a fact that in fishing communities and tourist areas the average rate of unemployment over long periods of time is higher than in highly industrialized regions. How could our concept of rrictional unemployment explain this fact? 5. Many newly industrializing countries, such as Korea, have underdeveloped or repressed trade union movements. These countries also have a very low wage share, and thus a high rate of return on physical capital. How might this be explained? 6. Youth employment is very low in Germany, at least in comparison with other European countries. It is often asserted that this is because training for youth is subsidized by the state. Is this a good use of public money? 7. It is often the case that unemployment benefits are paid out of a fund financed by taxes levied on the firms proportionately to their wage bill. How might this affect equilibrium unemployment? 8. It is sometimes suggested that the massive influx of women into the labour force is a cause of unemployment. (a) Draw the effect on the labour market as described by Figure 6.10. What does it mean for real wages and employment? (b) Using Chapter 4, note that more available labour raises the MPK. Assuming that, as a result of more investment, the capital-stock increases: how does your answer to (a) change? REAL MACROECONOMY Two textbooks provide further analyses: Ehrenberg, Ronald, and Smith, Robert (1988), Modern Labour Economic, 3rd edn., Scott Foresman, Glenview, 111. and London. Layard, Richard, Nickell, Stephen, and Jackman, Richard (1991), Unemployment, Oxford University Press. High European unemployment has been studied in detail. A survey is: Bean, Charles (1994), 'European Unemployment: a Survey', Journal of Economic Literature, 32: 573-619. See also the special issue of the Swedish Economic Policy Review, 1 (1-2), Autumn 1994 (articles by Lars Calmfors, Jörgen Elmeskov, Charles Wyplosz, Patrick Minford, Rudiger Dornbusch, Jacques Drěze and Henri Sneessens, and Richard lackman). Some interesting contributions are Bentolila, Samuel, and Dolado, Juan (1994), 'Labour Flexibility and Wages: Lessons from Spain', Economic Policy, 18: 53-100. Blanchard, Olivier J., and Summers, Lawrence H. (1986), 'Hysteresis and the Huro- pean Unemployment Problem', NBER Macroeconomics Annual, 1: 15-77. Blanchflower, David, and Oswald, Andrew (1994), The Wage Curve, MIT Pnv?, Cambridge, Mass. Burda, Michael (1988), 'Wait Unemployment in Europe', Economic Policy, 7: 391— 426. Calmfors, Lars, and DriffiJl, John (1988), 'Bargaining Structure Corporal ism and Macroeconomic Performance', Economic Policy, 6:13-62. . . Lindbeck, Assar (1993), Unemployment and Macroeconomics, MIT Press, ('ambridge, ; Mass. Saint-Paul, Gilles (1993), 'On the Political Economy of Labour Market flexibility*, "., NBER Macroeconomic Annual, 8:151-86. A controversy on the effects on minimum wages has arisen: see Card, David, and Kraeger, Alan B. (1995), Myth and Measurement: the Nev.' Economics of the Minimum Wage, Princeton University Press. Machin, Steven, and Manning, Alan (1994), 'Minimum Wages, Wage Dispersion and ._ Employment: Evidence from the UK Wage Councils', Industrial and Labour Re &'> ^ tions Review, 47 (2): 319-29. ','.:;„ Kennan, John (1995), 'The Elusive Effects of Minimum Wages', Journal of Economy ^ Literature, 33:1949-65. ' •'': LABOUR MARKETS AND EQUILIBRIUM UNEMPLOYMENT 165 appendix: Labour Supply and Demand, and the Collective Labour (Household labour* Supply 1 "Robinson Crusoe maximizes his utility function defined over k consumption C and leisure Z: 1§(Ä6-1) U=U(CJ), Psubject to the budget constraint B ;(A6.2) w€ = w€ + C, M'Where w is the real (consumption) wage and € is Crusoe's Sfftime endowment. The first-order condition is found by sub- j|§l"stituting C from (A6.2) into (A6.1) and maximizing with ^fe'respect to i: Ut/Uc: | The ratio of the marginal utüities vis-ä-vis leisure (Uc) and §65 consumption (Uc) is the marginal rate of substitution and iplífyfcťhe (absolute value of the) slope of the indifference curve. p§Ííí;This measures the ratio of the changes in leisure and con- ||§|f sumption that keep the utihty level unchanged. At the opti- jj||fmum, the amounts substituted are such that this ratio is |l|[equal to the real wage rate. l|fei\ The individual labour supply curve is the (implicit) func-jpStion household labour supply I as to real wage w defined by IpA6-3): (A6.4) f-5,individua] __ Ľ(w), i'A where the wealth argument has been suppressed. Aggregation over many households results in (A6.5) r = r(w, I), where L is the number of individuals of working age. The Demand for Labour by Firms Since capital is fixed, we can write the production function simply as Y= F(K, Ľ) = F(L). Express the firm's profit in terms of units of output, or as (A6.6) n = F (L) - wL. Choosing employment to maximize (A6.6) gives (A6.7) MPL = F'(L) = w. The inverse of relationship (A6.7) determines the demand for labour; (A6.8) L = L(w) = F'-\w), with L'(w) < 0. Wages and the Labour Share The wage share is 5 = wL(w)/F(L). What is the effect of an increase in the real wage on 5? Differentiating this expression yields (A6.9) dw~ Y Define two elasticities as 1 + wU wF'U L Y T|Llv = elasticity of labour demand to the real wage _ dl w _ wU áw L L 0 YL - elasticity of output with respect to labour _ dY L _ FL ~ áLY~ Y (A6.9) can be rewritten as ds_ dw (A6.10) ¥ TW(i-eM)]. Since F' = w, Qn is ^s0 labour's share in value added and (1 -Qyi) is me profit share. Thus, the condition for the wage share to be increasing when the real wage rises is that T\Lw < 1/(1 — Qyi), or that the elasticity of labour demand be less than the inverse of the profit share. This is the more likely to happen the smaller is the profit share and the less elastic is the demand for labour, i.e. if the demand for labour does not decline £too much' in response to an increase in real wages. Collective Labour Supply Consider a labour union that has utihty given by U(w - w, L- I). In this formulation (sometimes known as a Stone-Geary specification), utility is dependent on the excess of wages and employment above exogenous reference levels, here w and L. We assume that Uw > 0, UL > 0 while Uww < 0, ULL < 0, and UwL > 0. We consider only the case of a monopoly labour union, which sets the wage unilaterally.19 The union maximizes utihty subject to the labour demand curve (A6.8), by choosing the real wage w that maximizes U(w— w,L(w)- I). The first-order condition is (A6.11) = -I'(w), 19 For more sophisticated treatments of the collective bargaining process, which allow for bargaining between unions and employer associations, see an advanced textbook, e.g. Booth (1995). 166 THE REAL MACROECONOMY where the derivatives are evaluated at the optimum value. Equation (A6.11) has an interpretation similar to that of (A6.3): the union picks a wage such that the marginal rate of substitution of employment for wages is equal to the slope of the labour demand curve. This corresponds to points of tangency in the various panels traced out in Figure 6.14. We can solve this condition by considering a specific form of the utility function:20 (A6.12) U{w- w,L - L) = [a(w_- w)1/p + (1 - a)(L - L)5p]up, with 1 > p > -°°. First consider the case 7 = ô = 1. It can be shown that the elasticity of substitution between adjusted employment and wages is given by (1 - p)~\ As p approaches 0, the function assumes the form (A6.13) U(w - w, I - I) = (w - w)a{L - I)tl-a), whereas the case p -» —«> gives 20 This form exhibits constant elasticity of substitution between isoelastic functions of'normalized' employment and wages. (A6.13') 17(w- w,L- L)= min[(w- w),{L- L)], and p = 1 yields the linear form (A6.13") U(w- w,L- L) = a(w- w) + (l-a)(L- I). An alternative class of union preferences arises when p = 1 with 7 or ô less than unity: (A6.14) U{w- w,L- L) = a{w- w)Y + (l-a)(L- L)5. Panels_(a) and {b) of Figure 6.14 correspond to the cdhc iv = 1=0. The union in panel (a) places relatively high weight on wages, whereas the union in panel (b) places more weight on employment. In panels (c) and (d), the reference level for wages and employment are nonzero, and p = 1 ib assumed. In (c) 7 = 1, 5 < 1, w = 0, but I > 0 would lead to vertical collective labour supply curves. L > 0 could be understood as the jnembership' or reference group. In panel (d),7< 1,6 = 1, L = 0,but w > 0; this implies ahori/onlal collective labour supply curve, where w can be thought of as the 'target wage' for the union.