Video tutorial: The labour market (WS/PS) model for the aggregate economy - YouTube

Unit 9 - 'The labor market, wages, profit, and  unemployment'. One of the very important markets

that we need to understand as economists is the  job market, the labor market. What determines the

real wages in an economy? What determines the  level of employment in a country? In order to

understand that we first need to understand what's  going on at the level of firms, what factors

determine the wage that the firms offer to their  workers or the number of workers that they decide

to hire. In order to understand what's going on  at the firm level, we are going to do a role play

today with two actors: me, Ramin as the marketing  manager, and Giacomo as the HR manager. So

Giacomo, what do you do as an HR manager? GIACOMO:  As an HR manager, my job is to set the nominal

wage of my workers to ensure that they turn up to  work and that they put in adequate effort in their

job. And then I communicate this nominal wage to  you in the marketing department. RAMIN: Very good.

So once Giacomo, the HR manager, sets the nominal  wage and communicates it to me, I need to find out

the price and the quantity that maximise  our profit. I'll study the market and see

that given the wage level, what's the  price that could maximise our profit?

So in order to understand the labor market we  need to understand these two steps. Step one:

Giacomo, the HR manager, setting the nominal wage.  Step two: me, the marketing manager, setting the

price and the quantity on the basis of the nominal  wage that the HR manager gives to me. So from now

we're going to talk about each of these steps in  more detail. Let's start with the first step and

for that we go to 9.3: 'The weight setting curve:  employment and real wages'. Let me scroll down.

Now Giacomo, as an HR manager, can you explain the  way you set wages for the workers? GIACOMO: Sure,

sure, it's interesting. So the way I set the  nominal wage for my workers is: first of all,

I assume that the prices in the economy  are given. I take them as they are.

Then I look at these curves, the ones in the  upper graph, as you can see - you can see that

these curves tell you basically that as I  offer a higher nominal wage to my workers,

they will put in a higher level of effort. Now it  is important to notice that there are different

curves for different levels of unemployment  and the way I- the reason why I care about

this is that at different levels of unemployment  workers will have different incentives basically

to work for me. So, for example, at a level  of unemployment of 12% I will have to offer

them a nominal wage w_L as shown on the graph to  ensure that they turn up to work and that they

do not shirk, that they put in adequate effort,  right? But then, if you look at the curve that

shows the situation when unemployment decreases  to just 5%, the worker's incentives change because

now the worker clearly knows that they can  easily find another job if I, for some reason,

don't hire them. So I need to offer them  a higher nominal wage - so, in this case,

w_H, to ensure that they turn up to work, they do  not shirk, so that they put in adequate effort.

So this is what I do in my firm. Then I mean,  you can imagine that there're different 'me's',

there are different firms in the economy and there  are different people that do my same job, so if

you imagine that this process is repeated across  the whole economy and you aggregate the decisions

that we all do, you obtain the curve that is shown  in the graph below - that is the wage setting

curve, that shows the real wage that workers  will be paid at different levels of unemployment,

all else equal, which will make sure that they  turn up to work and that they do not shirk - so

that they put in adequate effort. And clearly as  you can see, for the reason that I've explained

previously, as the level of unemployment  decreases, the real wage that

is consistent with the workers turning  up and putting in effort has to increase.

So this is in essence the meaning of these two  graphs. RAMIN: So that was step one: the HR  

manager setting the nominal wage. Step two begins  when Giacomo communicates that wage to me and I'll

take it from there and in order to understand  step two, we need to scroll down and go to 9.4:

'The firm's hiring decision'. So Giacomo, the  HR manager, communicates the nominal wage to me

and this is our only cost of production. Why?  Because we are assuming our firm only relies

on workers for its production. We're making  another assumption as well: that each worker

produces one unit of output per hour and as we  add more and more workers to our production,

their productivity remains the same. In other  words, the marginal cost and the average cost

of our firm is the same as the nominal wage -  just for simplification. Let's continue. So,

Giacomo communicates the nominal wage to  me. As a marketing manager, now my job is to

basically find the price and the quantity that  maximise our profit given this nominal wage.

And how do I find that price and quantity? I  need to study the market. I need to study the

demand curve and that demand curve is determined  by the level of competition that we're facing,

the elasticity of the demand curve  and once I've studied the market,

I've realised that at this price and this  quantity our firm maximises its profit

given this nominal wage. So I end up setting  this price and this will be our markup - the  

difference between the nominal wage, our  main cost, and the price that we're charging.

This was all happening at the level of one firm.  Let's aggregate. Let's imagine all the marketing

managers doing the same thing. Let's multiply me  as the marketing managers. Now we get something

very interesting. We get a price setting real  wage out of these two nominal variables here:

the nominal price we're charging our  product and the nominal wage that we are

offering to our workers. We get the price setting  real wage and that real wage is consistent  

with a situation where all firms across the  economy are maximising their profit. So let's  

go and look at this aggregate curve or aggregate  line and for that we go to 9.5: 'The price setting

curve: wages and profit in the whole economy'.  If we scroll down, we get this aggregate curve.

On the x-axis we've got the overall level of  employment in the economy and on the y-axis we

get the real wage and here we got a price setting  real wage: this is the real wage that emerges in

an economy when all firms set their price in a way  that maximises profit for the shareholders, given

the nominal wage. So this is the real wage that is  consistent with all firms maximising their profit.

This line also communicates another important  thing for us. Let me explain. This is the

average labor productivity: how much each worker  produces per hour in real terms - real output.

We know that some of that output goes to the  workers themselves, the rest of it goes to

the shareholders. This is the part that goes to  the workers. We call that 'real wage per worker'

and the rest of the difference goes to the  shareholders. We call that 'real profit per

worker'. So, just to summarise, the second bit  - the price setting curve - communicates to us

the real wage that maximises profit for  the shareholders across firms. So far,

in step one, we talked about the real wage that  keeps the workers motivated and step two we talked

about the real wage that maximises profit for  the shareholders. Now, equilibrium in the labour

market emerges when these two real wages match  each other. So that's what we're going to look at

in the next part: the equilibrium in the labour  market. So let's scroll down, 9.6: 'Wages, profit,

and unemployment in the economy as a whole'. The  labor market reaches to the equilibrium level of

employment when the real wage that keeps the  workers motivated matches the real wage that

maximises profit for the shareholders and this  is represented in this graph. This curve is a

wage setting curve: the real wage that keeps the  workers motivated, and this line represents the

price setting real wage - the real wage that is  consistent with all firms maximizing profit. And

we reach to the equilibrium level of  employment when these two real wages

match each other and this equilibrium level of  employment is represented by X in this graph.

Now I'm going to explain to  you that whenever our economy

deviates from this level of employment,  it's going to come back to it after a while.

Let me explain. Let's assume that for whatever  reason, our economy experiences a negative shock.

For whatever reason, people start to consume less  goods, firms start to produce less, therefore

they start to reduce the number of people that  they're employing, so the economy as a whole

falls below the X level of employment. Now  what's going to happen next Giacomo? GIACOMO:

So what happens next is that I keep an eye on  the wage setting curve - remember that's what

I keep looking at when I do my job, and I realise  that as unemployment has increased, now workers'

incentive to be motivated to work has changed. Now  it's going to be tougher actually for them to find

a new job were they to lose the current one, so  this way, when they work for me, basically they're

earning a high employment rent. So I realise that  I can actually keep them motivated and I can keep

them to work adequately for me at a lower nominal  wage, so I will decide to set a nominal lower wage

and I communicate this decision to you in the  marketing department. RAMIN: Now, once Giacomo

lets me know that we are paying less wage - we've  lowered the nominal wage, I realise that actually,

as a marketing manager, I can also reduce  prices and at the same time keep the markup

the same - keep the share of output that is  going to the shareholders the same. And now,

by reducing the prices, I stimulate demand for our  goods, so therefore we start to produce more and

we start to employ more people and as all firms in  the economy do the same, they slash their prices

and start to boost demand, the economy overall  starts to get back to the X level of employment.

Now let's think of the opposite case. Let's assume  that our economy experiences a positive shock:

for whatever reason, people start to consume more.  The firms start to produce more, and we start to

go beyond the X level of employment. What's going  to happen next Giacomo? GIACOMO: I will still look

at the wage setting curve and at this high level  of employment, I actually realise that I'm under

a bit of pressure, because now workers can quite  easily find a new job were they to lose their

current job. So I need to keep them motivated - I  need to have them put in adequate effort at their

current job and I can do so only by increasing  the nominal wage that I pay them. So I decide to

increase the nominal wage that I pay them to keep  them motivated and I communicate this decision to

you in the marketing department. RAMIN: And once  you let me know that we increase the nominal

wages for the labour, I say that we can  actually increase our nominal prices

that we're charging for our goods and keep  the mark-up the same as before, and now by

charging higher prices I know I'm going to sell  less, but overall we're gonna make more profit,

so I'm going to increase nominal prices  and as all firms do the same thing,

they start to produce less but make more  profit, but employ less people. So overall,

if we aggregate- if all the firms do the  same thing, the economy is going to head

back to the X level of employment. Now, what I  described to you was that whenever our economy

deviates from the X level of employment,  the adjustments in nominal prices direct

the economy back to that level. For instance,  if you go below the X level of employment,

the downward pressure in prices pushes  the economy back to the next level of

employment. If you go above the X level of  employment, the upward pressure on prices directs

the economy back to the next level of employment.  And we're going to talk more about these things in

Unit 15, when we are discussing  inflation in the macroeconomy.