Economy Topic 5: Labour Market: Aggregate Supply

Context

- Aggregate supply: It is obtained from the behaviour of wages and prices.

- Wage-setting curve: The result of the wage-setting process of all firms in an economy is
the wage-setting curve, which shows the wage level associated with each unemployment
rate.
- Prices that firms charge for their products are influenced by the demand for goods and
the cost of labour (wage)
- Pricing-setting curve: The result/outcome of pricing in the set of firms.Gives the value of
the real wage that is consistent with a firm’s profit-maximizing markup over production costs
-
What is the relationship between price, real wages and unemployment?

1. Labour market

We assume that the only input of production is labour, so the only cost is wages

Profits are determined by :

• Nominal Wage
• The price at which the firm sells its goods
• Average output produced by a worker in a given unit of time (Normally an hour)

It is necessary to understand two essential relationships in the labour market that are
related to each other:
Relationship between companies and their employees

Companies set wages high enough to motivate workers to work hard and well (Receiving
and employment rent)

• This means there is a cost of job loss: he/she is better off being employed than
being fired due to inadequate effort.
• If the worker is very likely to find alternative work if he/she is fired, which will be
the case if the employment level in the economy is high, he/she will need a higher
wage to work hard.

Relationship between firms and customers

When setting prices, companies face a trade-off: selling more goods or setting a
higher price according to the demand curve.

➔ Firm will find the markup over their production cost that maximize its profits.
➔ This profit-maximizing markup determines the division of the firm’s revenues between
profits and wages

- They calculate a Profit Margin on their costs in order to maximise those

benefits (balance that trade-off).

The determination of real wages (nominal wage divided by the price level) and
employment levels is done in two stages:

1. Each company decides what wage to pay, what price to charge and how many
people to hire and the sum of these decisions of all the companies gives the
total employment and real wage of the economy

2. For the second phase, you need to know two basic concepts:

• Wage-setting curve: Indicates the real wage needed at each level of

employment to incentivize workers to work hard and well

• Price-setting curve: Indicates the real wage paid when firms choose the
price that maximizes their profits.
2. Wage-Setting relation.

Changes in Unemployment Rate

How do changes in the unemployment rate affect employers' wage setting?

The level of effort of each worker is influenced by the salary set by the companies

• Reservation wage: Salary where it is indifferent whether you work or not

• Effort has cost (disutility of work) and benefit (increases your likelihood of
maintaining employment and income from employment)
• As the level of effort approaches the maximum possible level, the disutility of
effort becomes greater. In this case it takes a larger employment rent (and hence a
higher wage) to get effort from the employee.

Efficiency salary. Salary Negotiation

Knowing the factors that influence the decision of effort, companies look for units of
efficiency: To maximize the number of units of effort obtained for each € of wage cost.

This efficiency wage will be higher than the reserve wage and high enough to:
1. Motivate workers to make a certain effort to receive that income and
2. To generate fear of losing it if they do not make the effort. This fear causes the
employer to have some power over the workers and contribute to their profits.

This is known as wage negotiation. You should also study:

Changes in market situation

How does the market situation affect the determination of wages?

1. An higher unemployment rate reduces the reservation wage, as the worker faces
an expected period of longer unemployment if he or she loses his or her job.
 This weakens workers' bargaining power and reduces the salary fixed by the
employer.

2. A reduction in the unemployment rate increases the reservation wage, as the

worker faces an expected shorter period of unemployment if he or she loses his or her
job. This increases the bargaining power of workers and increases the wage set
by the employer

Expected price

Another essential element when determining salaries.

• When wages are set in nominal terms, the corresponding price level is not yet
known.
• Workers don't care how many euros they receive, but how many goods they
can buy with those euros, i.e. the real wage (W/P).
• If workers expect P to double, they will ask for their nominal wage to double as
well

SUMMARY EQUATION FOR DETERMINING SALARIES

→ That is, aggregate nominal wage W, depends on:

• Expected Price Level (Pe)- (when wages are set in nominal terms, the relevant
price level is not yet known. Nominal wages are set in advance)
• Unemployment rate, u (affects the bargaining power of workers)
• General variable z (captures the rest of the variables that can affect the
determination of salaries (cost of layoffs, employee insurance, etc.))

3. Pricing Equation

The prices that firms set depend on their costs, which depend on the production
function.

Firms can set the price but not the quantity they will be able to sell (there is a trade-off)

To understand how they set prices, we assume that the firm's only costs are the wages they
pay per hour (W) and on average what a worker produces from A units of output (labour
productivity)

The aggregate output function will be Y=A*N (Y = output and N = employment)

If we assume that A = 1, then Y = N, this production function implies that the cost of
producing one more unit of output is the cost of employing an additional worker at the
wage W
Equation

In perfect competition P=W, although many goods are not produced in perfect competition,
they are the ones that firms charge a price higher than their marginal cost

P = (1+ μ) W Where μ is the markup of price over cost. It depends on the level of
competition in the market, so if it's not competitive, it's positive: firms have
market power.

If we divide both terms by W and invert them, the equation tells us that pricing by firms
determines real wage: If all firms increase their markup, prices would rise, reducing the real
wage

4. Natural Rate of Unemployment

Equilibrium in the labor market requires that the real wage determined in the wage-setting
equation be = the real wage determined in the price-setting equation

To do this, P e = P. Under this equality, the natural unemployment rate or equilibrium

unemployment rate is determined.

Wage Fixing Equation Pricing Equation

The natural rate of unemployment (un) is the level of unemployment that equals the
real wage in both equations.

The above equation tells us that the equilibrium unemployment rate depends on z and μ:

• (z) An increase in unemployment allowance will affect z. This makes any

unemployment process less painful, so it increases the wage set by the workers.
For the price set by the firms, the increase in W leads to hiring fewer workers.
Therefore, natural unemployment in the economy increases

• (μ) An increase in the market power of firms increases markup μ. This

reduces the W wage paid by firms, thereby increasing natural unemployment in
the economy
Given a labor force, equilibrium unemployment determines the level of employment and
this determines the level of production. We can call it the natural level of production (Yn)

5. Aggregate Supply

It shows the relationship between production (Output) and price level. It is obtained from
the equations:

Using these two equations we can obtain the aggregate supply in three steps:

1. We replace the wage determination equation in the PRICING equation

→ That is, the price level depends on the expected price

level and on the unemployment rate u assuming that z
and μ are constant.

2. Given the labor force, we can express unemployment in terms of employment N, and
hence the level of output Y=N

→ The higher the production/output, the lower the

unemployment rate

→ When the labour market is in equilibrium, it implies that the unemployment rate
is at its natural level. To this natural rate if unemployment we can associate a natural
level of employment and therefore a natural level of production

3. Substituting the unemployment rate into the equation obtained in step 1, we obtain the
aggregate supply relationship.

The price level P depends on the expected price

→ level, Pe , and the level of output Y (and also on
the markup 𝜇, the catchall variable z and the labor
force L, which we take as constant here).

Aggregate Supply Curve Properties

The relationship between the price level (P) and output (Y) given the value of the expected
price level (Pe ), is represented by the AS curve. The AS curve has two important
properties:
 • PROPERTY 1: An increase in production leads to a rise in the price level:

1. Increase in production = Increase in employment

2. Employment Increase = Unemployment Decrease = Lower Unemployment Rate
3. Reduction in the unemployment rate = Increase in nominal wages
4. Nominal wage rise = Rise in prices set by firms = the price level will rise

• PROPERTY 2 : A rise in the expected level of prices causes : A rise in the

expected price level causes a rise in the effective price level by the same
amount:

1. If wage fixers expect the price level to be higher: They set a higher nominal
wage
2. The rise in nominal wages = Increased costs.This leads companies to set
higher prices and raises the price level

Aggregate Supply Curve

The aggregate supply curve is upward sloping: an increase in output Y leads to an

increase in the price level P (an Increase of Y = Rise of P), price level. Curve passes
through point A, where Y=Yn and P=Pe

Given the expected price level: An increase in Y

causes an increase in P.

If Y = Yn (natural level of production), P = Pe

(expected price level)

A rise in Pe shifts the AS curve upwards

A decrease in Pe shifts the AS curve downwards

Explanation: Suppose the Pe increases from Pe to

Pe’ At a given level of output, and correspondingly, at
a given u rate, the increase in the expected price
level leads to an increase in wages, which leads to
an increase in prices. So, at any level of output, the
price level is higher: the AS curve shifts up
RESUME :

• Starting from wage determination and price determination in the labor market, we
have derived the aggregate supply relation.
• This relation implies that for a given expected level or prices, the price level is an
increasing function of the level of output. It is represented by an upward-sloping curve,
called the aggregate supply curve
• Increases in the expected price level shift the aggregate supply curve up.
Decreases in the expected price level shift the aggregate supply curve down.