Labor Market Model: Wage and Price Setting Decisions

Key Decisions by Firms

• Wage Setting Decision (Chapter 6)

  • Firms decide on the wages to pay workers to incentivize them to provide the profit-maximizing level of effort.
  • Incomplete contracts necessitate figuring out wages that provide enough employment rent to workers.
  • Employment rent: motivation for workers to avoid job loss.

• Price Setting Decision (Chapter 7)

  • Firms set a markup over their costs based on the competition and demand elasticity.
  • Cost of production influenced by the wage setting curve.
  • Price setting influenced by the demand curve.

Real Wage Importance

• Real wage matters for both firms and workers.
  • Real wage: measured in goods, not dollars.
  • Nominal wage: measured in dollars.
  • Firms and workers care about the real purchasing power of wages.

Firm Decisions and Labor Market Equilibrium

• Firms decide on:

  • Nominal wage influenced by other firms' prices/wages and unemployment rate.
  • Price based on nominal wage and product demand.
  • Output based on price and demand curve.
  • Number of workers based on output and production function.

• Unemployment Rate Impact

  • High unemployment rate = higher employment rent = firms pay lower wages.
  • Low unemployment rate = lower employment rent = firms pay higher wages.

Wage Setting Curve

• Plots employment level (0 to 1) against the real wage.

  • Higher wage = lower unemployment rate.
  • Lower wage = higher unemployment rate.

• Best Response Function

  • Shifts with changes in the unemployment rate.
  • Higher unemployment = lower wage (left shift).
  • Lower unemployment = higher wage (right shift).

Empirical Data

• US data (1979-2013) shows an upward-sloping wage setting curve.
  • Unemployment rates mapped from 0 to 20% (historically max ~11% nationally).
  • Curve supports the model's validity.

Profit Maximizing Price

• Optimal price depends on demand elasticity and profit-maximizing point on the demand curve.
  • Revenue and wage bill relationship.
  • Simplified model: profit = revenue - wage bill.

Price Setting Curve

• Firms' profit determined by workers' production (lambda) and real wage.
  • Price setting curve maximizes firms' profits, influenced by competition, labor unions, trade, but not employment level.

Labor Market Equilibrium

• Intersection of wage setting and price setting curves.
  • Real wage determined by the price setting curve (horizontal line).
  • Unemployment rate determined by the wage setting curve.
  • Nash equilibrium: mutual best response from workers and firms.

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• Nash Equilibrium Characteristics
  • Workers and firms optimize their situations given the best response of the other.
  • Employment level is optimal given wages.
  • Job seekers cannot convince firms to hire them at lower wages due to concerns about effort levels.