the model that we're going to use for the labor market is all about two decisions that the firm is making so on the one hand the firm is making their wage decision right their wage setting decision and that comes from chapter 6 and so firms are basically deciding alright how much do I have to pay workers in order to get them to provide the profit maximizing level of effort because we can't write these complete contracts right so we have these incomplete contracts and so I have to figure out the wage that will motivate workers enough to provide them with enough employment rent so that they don't want to lose their job in order to maximize my profits and then on the other hand is the price setting decision and so this is comes from chapter 7 where firms are setting some mark-up above their cost that's based on you know how much competition they face what's the elasticity of demand they're facing and they're doing that to maximize their profits too right so remember that the cost of production is coming from the wage setting curve at least in part and the price setting decision is also then coming from the demand curve and so it's these two decisions working together that are going to bring us to our labor market equilibrium so one of the most important things to realize here is that what's important is the real wage and so this is going to be important both for firms right what they care about is really how much they have to pay workers in comparison to the price level and that should be important for workers too although as we'll talk about a lot of times workers focus more on their nominal wage just measured in dollars and don't worry about how much stuff that wage can actually buy right so that's the difference the nominal wage is measured in dollars the real wage is measured in Goods and so each firm is deciding on its price its wage and how many people hire and then you know adding all of those up across the economy gives us total employment and the real wage rate because that price in the bottom of the real wage is not just what firms but it's the average price of all goods and services in the economy that firms are charging so if we think about the the chain of events of firms decisions then we can think alright they're deciding on the nominal wage that's going to depend on other firms prices and wages and it's also going to determine it's also going to come from the unemployment rate why is the unemployment rate important here it's because remember the unemployment rate influences how much employment rent workers get because when the unemployment rate is high it's going to be harder to find a new job if you lose the one you have so your employment rent is higher whereas when the unemployment rate is really low it's going to be much easier to find a new job if you lose your own and so the employment rent is lower and so firms are gonna have to pay a higher wage when the unemployment rate is lower and a lower wage when the unemployment rate is higher then they're going to set their price that's going to depend on their own nominal wage right because that's one of their costs of production and it's also going to depend on the demand for their own product that's going to determine what their markup is then they're going to determine how much to produce right the output what is that's based on the optimal price and the demand curve right remember if you're facing it downward sloping demand curve then choosing a point on that demand curve is both choosing a price and an output because you can't sell more than what's on the demand curve at that price and then based on how much you want to produce that's going to determine how many workers you need right so the output then influences how many people are going to be working at that firm based on that firms own production function and so this will give us our wage setting curve where we have the proportion of the working age population from zero to one although it really it goes from 0.5 to 1 in this graph and then the real wage the vertical axis and it's the real wage necessary each employment level or unemployment level to get workers to work hard and well now so this is a little bit tricky graph because it's in is going from left to right and unemployment is going from right to left and so you know if we're here at a high wage then that's a low unemployment rate right that says it's an unemployment rate of five percent if we're here at a lower real wage that's an unemployment rate of 12 percent and remember the reason that we can do that is that the employment rent is higher when the unemployment rate is 12 percent so you don't have to pay as much to workers whereas the employment rate is lower when the unemployment rate is is lower because it's easier to find a new job so you have to pay more in order to get workers to work hard so how do we get there well it's really just from the best response function right the best response function shifts when the unemployment rate changes so it shifts to the right for a lower unemployment rate it's just to the left for a higher unemployment rate and that determines the wage that will be paid and so you can see a higher unemployment rate at point a this point a corresponds to this point a and the wage setting curve and then similarly point B and the shifted right best response function with the lower unemployment rate corresponds to this point B in the wage setting curve so this is an estimated wage curve from us data going from 1979 to 2013 it basically takes a weighted average of lots of different places in the country it adjusts for inflation so this is based on 2013 dollars and you can see that the unemployment rate just to match our model goes from zero on the right to 20% on the left we've never had a national unemployment rate of 20% in this time frame the highest that's been nationally was about 11% in the early 1980s but locally we've had higher unemployment rate so we can estimate that and you can see we get this upward sloping wage setting curve just like in the model so that gives us a little more confidence that this might be a reasonable to be using so remember how firms come up with their profit maximizing price the optimal price depends on demand elasticity and the point on the demand curve that maximizes profits and so if we are at point B right and we're selling at Point we're selling a price P star and we're producing a Q star and the wage is W then workers are getting this amount that's the wage bill this rectangle here W times Q star and revenue is this amount P star times Q star and so if we're gonna usually simplify things and sort of ignore capital and we're talking about the labor market and so this part would be the cost for the firms and the income for the workers and the rectangle on top of it would be the profit for the firms and so that's how we're dividing up the output all right and so that's what this line is saying is that if we're selling at say 20 dot $20 per unit and the nominal wage is $15 then the profit would be five dollars right and so output per worker is divided up into real profit plus the real wage once we divide everything through by the price so how do we get the price setting curve so all that we have to remember is that all right four workers are going to produce a certain amount we're gonna call this lambda this letter here is lambda the Greek letter lambda and that's going to depend on technology in the production function of the firm and then there's going to be some wage right and so if we take the nominal wage capital W and divide it by the price level we get the real wage which will usually be a little W and so workers are producing this much they're getting paid this much which means that firms are earning a profit of the difference there so the way we look at this price setting curve is to think about all right well we have this wage coming from the demand curve and the wage setting curve and that gives us our price setting curve right this is the place that will maximize profits for firms that's going to depend on how much competition there is in the economy it's going to depend on the role of labor unions it's going to depend on the role of trade it's going to depend on a lot of things but it's not going to depend on the level of employment right so the wage setting curve depends on the level of employment but the price setting curve does not all right so that's what this just says right it's C you know if we were here the wage would be too low in the mark-up too high that the markup remember is the difference between how much the worker produces and how much they are paid so we're going from top to bottom rather than bottom to top if we are at point a the real wage would be too high in the markup too low and so the firm's would raise their price and output would fall at point B we're at an equilibrium where the mark-up is appropriate based on the demand curve and workers are getting paid their equilibrium wheel real wage and firms are earning their equilibrium real profit so how do we get to the equilibrium well the the labor market equilibrium is just where the price setting curve and the wage setting curve intersect and so you can see that the real wage is actually determined by the price setting curve it's just a horizontal line but the unemployment rate is determined by the wage setting curve right and so where the two intersect that gives us our real wage and reading from right to left gives us our unemployment rate right and that's a Nash equilibrium and if you don't know what a Nash equilibrium is it just means it's a mutual best response workers and firms are doing the best they can based on how what the other one is doing so that's what this next slide says is that all parties are doing the best they can right so workers can't do any better firms can't do any better employment is the highest that can be given the wage and those who have jobs can't of their situation by either asking for higher pay or working less hard and those who do not have jobs but would like to work cannot persuade firms to hire them by accepting lower wages because firms would be worried that they wouldn't work hard enough based on the best response curve