PowerPoint to accompany

Chapter 6

The Labour
Market
Section 6.1: A Tour of the Labour Market

• The (non-institutional) civilian population are the

number of people potentially available for civilian
employment.
• The civilian labour force is the sum of those
either working or looking for work.
• Those who are neither working nor looking for
work are out of the labour force.
• The participation rate is the ratio of the labour
force to the non-institutional civilian population.
• The unemployment rate is the ratio of the
unemployed to the labour force.

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 The Labour Market

Population, Labour Force, Employment, and

Unemployment in Australia (in millions), July 2008

Total population: 21.4 mn

Civilian population:17.2 mn

L = Labour force: 11.2 mn Out of the labour force: 6.0 mn

N = Employed: 10.7 mn

U = Unemployed: 0.48 mn

u=Unemployment
Participation rate = rate = 100*0.48/11.2 =
100*11.2/17.2 = 65% 4.3%

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The Large Flows of Workers

• An unemployment rate may reflect two

very different realities:
• An active labour market, with many
separations and many hires; or
• A sclerotic labour market, with few separations,
few hires, and a stagnant unemployment pool.
• The Labour Force Survey (LFS)
produces employment data, including the
movements (or flows) of workers.
(data is based on a monthly survey of 42000 matched households)

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The Large Flows of Workers

Average Monthly Flows

Between Employment,
Unemployment, & Non-
participation, Australia,
2007-2008
(1) The flows of workers in
and out of employment are
large
(2) The flows in and out of
unemployment are large in
relation to the number of
unemployed
(3) There are also large
flows in and out of the
labour force, much of them
directly to and from
employment

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The Large Flows of Workers

• From the LFS data we conclude that:

1. The flows of workers in and out of employment are large.
Separations consist of:
 Quits, or workers leaving their jobs for a better alternative; and
 Layoffs, which come from changes in employment levels across firms.

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The Large Flows of Workers

• From the LFS data we conclude that:

2. The flows in and out of unemployment are large in relation to the number of unemployed.
 The average duration of unemployment is about two months.
 Economists worry about the proportion of long-term unemployed (i.e. those whose duration of unemployment >12 months).
Why?
Diminishing employability due to loss of skills, confidence

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Long term Unemployment in Australia,
1986-2008

When the unemployment rate rises (or falls), the proportion

of long-term unemployed rises (or falls) with a lag.

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The Large Flows of Workers

• From the LFS data we conclude that:

3. There are large flows in and out of the labour force, much of them directly to and from employment.
 Discouraged workers are classified as “out of the labour force,” but they may take a job if they find it.
 The non-employment rate is the ratio of population minus employment to population.

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Section 6.2: Movements in Unemployment

• Fluctuations in the aggregate

unemployment rate affect:
• The welfare of individual workers.
• Wages.
• Higher unemployment affects workers:
1 Through a decrease in hires—more difficult to
find jobs.
2 Through higher layoffs—higher risk of losing
their jobs.
Let’s look at the Australian evidence

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Movements in the Unemployment Rate

Shaded columns represent recessions

From 1959-74, the unemployment rate averaged 2%,

thereafter just over 7%.

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The Unemployment Rate and the Proportion of
Unemployed Finding Jobs in Australia, 1980-2008

Note, the scale on the right is an inverse scale.

When unemployment is high, the proportion of the

unemployed finding jobs is low.

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 The Unemployment Rate and the
Separation Rate

When unemployment is high, a higher proportion of workers

lose their jobs.

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Section 6.3: Wage Determination

In Australia, wages are set in 3 different ways:

• Collective bargaining is bargaining between firms and
unions:
-applied to 41% of Australian workers in 2004
- since early 1990s, many workers have moved to enterprise
bargaining.

• Awards - legally enforceable determinations made by

federal or state industrial tribunals that set the terms of
employment, including pay:
-applied to 20% of Australian workers in 2004 (compared to most
before 1980).

• Individual agreements between worker and employer,

- greatly facilitated by Howard government from 1996-2006:
• Australian Workplace Agreements; easier for employers to dismiss
workers. Now replaced by Fairwork Australia

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Wage Determination

• Common forces at work in the

determination of wages include:
 A tendency for the wage to exceed the
reservation wage, or the wage that makes
workers indifferent between working or
becoming unemployed.
 Dependency of wages on labour-market
conditions.

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Bargaining

• How much bargaining power a worker

has depends on:
1. How costly it would be for the firm to replace
the worker—the nature of the job.
2. How hard it would be for the worker to find
another job—labour market conditions.

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Wages, Prices and Unemployment

W  P eF (u ,z)
(  , )

• The aggregate nominal wage, W,

depends on three factors:
1. The expected price level, Pe
2. The unemployment rate, u
3. A catch-all variable, z, that catches all
other variables that may affect the
outcome of wage setting.

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Wages, Prices and Unemployment

1. Both workers and firms care about real wages (W/P), not
nominal wages (W).

2. Higher unemployment weakens workers’ bargaining power,

forcing them to accept lower wages.

3. Among other factors that affect wages is unemployment

insurance—the payment of unemployment benefits to
workers who lose their jobs. Higher unemployment
insurance allows workers to hold out for higher wages.
Minimum wages and employment protection are other
factors.

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Section 6.4: Price Determination

• The production function is the relation between

the inputs used in production and the quantity of
output produced.
• Assuming that firms produce goods using only
labour, the production function can be written as:
Y  AN
Y = output
N = employment
A = labour productivity, or output per worker
• For simplicity, assume that one worker produces one
unit of output—so that A = 1. Then, the production
function becomes: Y  N
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Price Determination

• Firms set their price according to:

P  (1   )W
• The term  is the markup of the price over the cost of production.
• If all markets were perfectly competitive,  = 0, and P =W.
  measures the extent of imperfect competition in goods markets.
• Australian Competition and Consumer Commission (ACCC) – tries to
reduce 

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Section 6.5: The Natural Rate of
Unemployment

• This section looks at the implications of

wage and price determination for
unemployment.
• We assume that Pe = P, and that nominal
wages depends on the actual price level,
P, rather than on the expected price level,
Pe.
• Wage setting and price setting determine
the equilibrium rate of unemployment.

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The Wage-Setting Relation

• Earlier, we stated that the nominal wage

rate was determined as follows:
W  P eF (u ,z)
(  , )

• Now, since Pe = P, then:

W  P F (u ,z)
• Dividing both sides by P, then:
W
 F (u ,z) The wage-setting
P (  , ) relation

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The Price-Setting Relation

• The price-determination equation is:

P  (1   )W
• If we divide both sides by W, we get:
P
 (1   )
W
• To state this equation in terms of the wage
rate, we invert both sides:
W 1 The price-setting
 relation
P (1   )
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Wage-Setting and Price-Setting

The Wage-Setting
Relation, the Price-
Setting Relation, and
the Real Wage

The real wage chosen

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

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 Equilibrium Real Wages and Unemployment

The Wage-Setting
Relation, the Price-
Setting Relation, and
the Natural Rate of
Unemployment
The natural rate of
unemployment is the
unemployment rate such
that the real wage chosen
in wage setting is equal
to the real wage implied
by price setting.

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 Equilibrium Real Wages and Unemployment

Eliminating W/P from

the wage-setting and
the price-setting
relations, we can obtain
the equilibrium
unemployment rate, or
natural rate of
unemployment, un:

1
F (u n ,z) 
1  

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 Equilibrium Real Wages and Unemployment

Unemployment
Benefits and the
Natural Rate of
Unemployment
An increase in
unemployment
benefits (z)
leads to an
increase in the
natural rate of
unemployment.

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 Equilibrium Real Wages and Unemployment

Markups and the

Natural Rate of
Unemployment
An increase in the
markup ()
decreases the real
wage, and leads to
an increase in the
natural rate of
unemployment.

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The Structural Rate of Unemployment

• Because the equilibrium rate of unemployment

reflects the structure of the economy, a better
name for the natural rate of unemployment is the
structural rate of unemployment.

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From Unemployment to Employment

• Associated with the natural rate of unemployment

is a natural level of employment.
U L  N N
u    1 
L L L

• Employment in terms of the labour force and the

unemployment rate equals:
N  L (1  u )

• The natural level of employment, Nn, is given by:

N n  L (1  u n )

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From Employment to Output

• Associated with the natural level of employment is a

natural level of output, (and since we assume Y=N,
then):
Y n  N n  L (1  u n )

• The natural level of output satisfies the following:

 Yn  1
F 1  ,z 
 L  1  
• In words, the natural level of output is such that, Y
n
at the associated rate of unemployment, u n  1  ,
L
the real wage chosen in wage setting is equal to
the real wage implied by price setting.

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