Summary of topic - Imperfect labour market PDF

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Summary of topic - Imperfect labour market...

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The imperfect labour market Model In the perfect labour market, output is a function of A, K and L. A and K are considered fixed in the medium run. Perfect competition means that labour demand is exactly equal to the MPL at every given wage rate; labour supply is positively sloped since as real wage rises, agents switch leisure to labour (and both leisure and labour are normal goods) Real wage is

W Pc

(the consumer price index) and the labour market clears.

Employment is determined in the labour market that yields output according to the production function. Therefore vertical AS curve.

WS curve In the imperfect labour market, trade unions have some monopoly power and target real wage above the perfect labour supply curve. There is thus a wage-setting WS curve above labour supply. The size of the real wage premium reflects bargaining power of unions. Assume it diverges (since bargaining power increases as employment increases Bargaining power depends on unionisation rates, laws over industrial relations (strikes, restrictions on firing etc), dispersion of unemployment. The premium unions can exact depends on the risk that firms simply hire an non-unionised worker instead. If unemployment is concentrated by region and industry, or there are limits to labour mobility, higher union power. Conversely, if unemployment is diverse or there is high labour mobility, lower wages can be extracted by unions. Aspirations of trade unions depend on -labour productivity (unions may seek to share in the gains from rising output per worker) -wage accords (unions may agree to limit the wage premium in return for public investment in their industry, improved working conditions etc.) Since WS is a markup on the labour supply curve, shifts in labour supply such as migration, productivity or retirement age will shift the WS curve. But it need not be a proportional shift: these changes may affect union workers disproportionately, and new workers may not be perfect substitutes for union workers.

PS curve -Firms have the ability to set prices above marginal cost. -This means they aren’t paying the factors (i.e. labour and capital) their value of productivity. -Thus the price-setting curve is below the MPL, also representing monopsony in the labour market. -The difference between PS and MPL is the basis for firms’ profits (also the difference, if any, between MPK and the price firms pay for capital. -Increases with market power. -Slope of PS curve is empirically determined: while we assume it inherits the MPL’s downward slope, when firms’ profit share falls with employment, it may offset the declining MPL. (Thus, to simplify exposition, not wrong to use a horizontal PS curve – but EYA!)

-PS curve thus determined by firms’ degree of market power, and less obviously, market price/price setting ability in the factor markets. A rise in factor prices reduces the amount that firms can spend on wages, shifting PS left/down; same goes for increase in payroll taxes. -Changes in labour productivity shift MPL and PS because it is determined by pass-through on MPL (the extent of the pass-through depends on whether or not firms use changes of MPL to raise profit share)

Unemployment The equilibrium rate of unemployment is the intersection of WS and PS.

While wages might be higher or lower under imperfect competition, welfare is definitely lower under imperfect competition.

Deriving the short-run Phillips curve from the WS-PS model -Unions set nominal wage W to target real wage

W Pc

on the WS curve at prevailing

unemployment level. -In order to achieve this, unions formulate expectations over the price level: we take this to be last period’s price level plus expected inflation. -Firms accept the nominal wage, then set the price level to determine the real wage objective set by the PS curve. -At equilibrium the SRPC intersects the LRPC at π t= π e in order to deliver WS=PS (i.e. the trade union’s expected inflation is validated to deliver their target.) -What about outside equilibrium? Consider effect of a demand shock that raises employment and output:

Unions target a higher real wage, but firms aim for a lower real wage. Firms thus set higher prices in order to obtain their desired real wage – firms have last mover advantage, and in the SR economy always lies on the WS curve. (Adaptive wage-setting targets are rationalised either as adaptive expectations, or compensation for erosion of real wages through inflation in the previous period) Suppose there is an unexpected decline in the productivity of labour and that this change is observed as soon as it occurs. Use the WS-PS and IS-PC-MR models to analyse the responses of output, inflation and interest rates to such a shock (assuming that private sector inflation expectations are formed adaptively). How will the initial change in interest rates depend on the slope of the Phillips curve in output-inflation space? -Decline in labour productivity: Labour productivity equal to labour demand in perfect competition; all things equal decline in labour productivity means downward shift of PS curve. Find new equilibrium employment (supply shock that shifts the VPC inward) -Use ISPCMR to determine the policy response; comparative statics with steeper PC -Under imperfect competition will a permanent depreciation of the real exchange rate change the level of involuntary unemployment at the labour market equilibrium? -When q increases, Pc increases because import share of consumption increases. -PS and q move in opposite directions (PS falls) -Find new level of employment....