Aggregate Supply

1
Aggregate Supply

• Part 1. The Labour Market

2
Competitive labour market equilibrium

• Demand for, and supply of, labour depends on real
  wage
• Assume fixed capital stock in short run. Then y
  f(E)
• Marginal product of labour (MPL ?y/?E) ? as E?
• Under perfect competition, firms take real wage
  as given and employ labour up to point
  where MPL W/P? downward sloping labour
  demand curve
• Upward sloping labour supply curve derived from
  optimising behaviour of households allocate
  time between work and leisure to maximise
  utility. Real wage given worker chooses amount
  of labour to supply

3
Competitive labour market equilibrium
Real wage
Labour supply
Real wage adjusts to clear labour market. At w0,
all unemployment is voluntary
Labour demand
Employment
Source Carlin Soskice, p45
4
Labour market under imperfect competition

• Involuntary unemployment occurs when real wage
  fails to clear labour market. May be the result
  of behaviour by firms or employees or both
• Equilibrium rate of unemployment is the
  unemployment rate at which the real wage is
  consistent with the real wage expectations of
  both wage and price setters

5
Wage setting

• Because of labour market imperfections,
  wage-setting curve (WS) lies above the labour
  supply curve
• Employers and employees bargain over the nominal
  wage. But workers evaluate wage offers in terms
  of real wage they expect to get W P
  b(E)? wWS b(E) wage-setting real
  wagewhere wWS W/P

6
Wage setting real wage curve WS curve and labour
supply curve
1. E0 is consistent with real wage w0. But higher
real wage is set at w1 under imperfect competition
3. w1 w0 is mark-up per worker associated with
labour market imperfections
2. At w1, employment is E0 (E1-E0) are
unemployed involuntarily
Source Carlin Soskice, p46
7
Two reasons for real wage markup

• Union powerUnion sets wage in interests of its
  members who are concerned with both real wage and
  employment
• Efficiency wage setting by firmsAs labour
  market tightens, it becomes more difficult for
  firms to recruit, retain and motivate. So
  efficiency wage rises as unemployment falls

8
Price setting (1)

• Firms maximise profits V PY WE
• dV/dY P Y(dP/dY) w(dE/dY) 0
• Note that elasticity of demand, ? percentage
  change in quantity / percentage change in price ?
  (?Y/Y)/(?P/P) ? 1/ ? (Y/P)(dP/dY). Note also
  that marginal product of labour dY/dE
• Rearranging, gives W/P (11/?)MPL
• Mark-up on marginal cost gets smaller as demand
  becomes more elastic
• Price-setting real wage is W/P (e
  1)/eMPLsetting e ? 1

9
Relationship between MPL, price elasticity of
demand and PS curve
PS curve is a fraction of the MPL. As the
elasticity of demand rises, the mark-up falls
until we get to perfect competition.
Source Carlin Soskice, p49
10
Price setting (2)

• Convenient to assume PS curve is horizontal?
  firms change prices only when costs change, not
  in response to variations in output
• Assume constant marginal product of labour
  (equals average product) and a constant mark-up
  ? P (1 m) unit cost
• Set ? Y/E (labour productivity) and µ
  m/(1m). Divide each side by P and rearrange
  gives ? µ? W/Poutput per head real
  profits per head real wages per head? wPS
  W/P ?(1 µ) price-setting real wage µ 1/?.
  As competition increases ??8, so µ?0

11
Price-setting real wage curve PS curve
Given the mark-up (µ), the level of labour
productivity (?), and the money wage (W), the
price level set by firms (P) implies a specific
value of the real wage.
Source Carlin Soskice, p50
12
Equilibrium employment and unemployment

• Labour market in equilibrium when WS and PS
  curves intersect
• Prices assumed to be set after wages, so always
  on PS curve

Suppose positive demand shock boosts employment
to E1. Wage setters aim for point A but firms
raise prices so economy moves to A. Then adjusts
back to EICE.
equilibrium rate of unemployment
ICE imperfect competition equilibrium
Source Carlin Soskice, p51
13
Concepts of unemployment
1. Distance AB measures real wage pushfulness.
Equals disparity between wage and price setting
curves at natural unemployment rate 2. Slope of
WS curve measures real wage rigidity. More real
wage rigidity as WS curve becomes flatter
A
B
Source Carlin Soskice, p52
14
UnemploymentActual and equilibrium rate
Source ONS, ILO. (a) Estimates of the
equilibrium rate of unemployment for 1971 to 2000
from Nickell (2001), for overlapping periods.
15
Real consumption wage vs. real product wage

• Real wage relevant to workers is real consumption
  wage post-tax wage paid to workers deflated by
  consumer prices
• Real wage relevant to firms is real product wage
  full cost of labour to firms divided by price
  firms get for their product (ie excluding
  indirect taxes)
• Tax wedge is difference between real consumption
  wage and real product wage
• Labour market diagram is shown in terms of W and
  PC the tax wedge shows up as a price push
  factor. Any increase in direct or indirect
  taxation reduces price-setting real wage and
  therefore shifts PS curve down

16
What shifts PS curve?

• PS curve can be written as W/PC ? .
  f(µ,zp)where zp is a set of price push
  variables
• PS curve shifts up when there is a fall in
  the tax wedge, included in zp fall in the
  mark-up, µ (eg increased competition) rise in
  productivity, ? fall in real interest rate
  (which boosts productivity) less employment
  regulation

17
What shifts WS curve?

• WS curve can be written as W/PC b(E,zw)where
  zw is a set of wage push variables
• WS curve shifts down when there is a fall in
  generosity of unemployment benefits unions are
  weaker (eg less legal protection or lower trade
  union density) unions agree to exercise
  bargaining restraint

18
Sources of unemployment persistence

• ERU shifted by supply-side factors? aggregate
  demand shocks have a short-run effect on
  unemployment but no medium-run effect? aggregate
  demand policies have role to play in stabilising
  economy around ERU but cant shift level
• Hysteresis argues that ERU is a function of U
• Insider-outsider modelLong-term
  unemployedCapital scrapping

19
Hysteresis the insider-outsider model
Source Carlin Soskice, p118
20
Unemployment persistence role of long-term
unemployment
Source Carlin Soskice, p120
21
Unemployment persistence capacity scrapping
effect
Source Carlin Soskice, p121
22
Further reading

• Carlin and Soskice, Macroeconomics, pp44-53,
  Chapters 4, 15, 18
• For an excellent survey of the causes of
  unemployment, seeBlanchard, O (2005), European
  unemployment the evolution of facts and ideas,
  NBER Working Paper 11750
• For a comparison between labour markets in
  Europe and the United States, seeNickell, S
  (1997), Unemployment and labour market
  rigidities Europe versus North America, Journal
  of Economic Perspectives, 11(3), pp55-74