Unit 3.

The Labor Market

1. Introduction
Unemployment is the macroeconomic problem that affects people most directly and severely. For
most people, the loss of a job means a reduced living standard and psychological distress. It is no
surprise that unemployment is a frequent topic of political debate and that politicians often claim
that their proposed policies would help create jobs. Economists study unemployment to identify its
causes and to help improve the public policies that affect the unemployed. Some of these policies,
such as job-training programs, help people find employment. Others, such as unemployment
insurance, alleviate some of the hardships that the unemployed face. Still other policies affect the
prevalence of unemployment inadvertently. Laws mandating a high minimum wage, for instance,
are widely thought to raise unemployment among the least skilled and experienced members of the
labor force. In this chapter we give due emphasis on how labor demand and labor supply is
determined, types and causes of unemployment and classical and Keynesian theory of employment
determination.

3.1 The Macroeconomics of the Labor Market

The aggregate supply of labor curve (ASL) shows the number of workers willing to accept jobs at
each wage rate. The cure is up ward sloping showing the positive relationship between real wage
rate and number of working hour. Households have a fixed amount of hour which they spend by
working or spending their time doing luxuries activities. The allocation of time between these two
activities is determined by the utility they derive from each activity, so as real wage rate increases
the utility they drive from working out weights the utility they derive from leisure so they will
substitute leisure hour for work hour and increase the supply of labor. This curve is relatively
inelastic, since the size of the labor force at any one time cannot change significantly. Nevertheless
it is not totally inelastic because (a) a higher wage rate will encourage some people to enter the
labor market (e.g. parents raising children), and (b) the unemployed will be more willing to accept
job offers rather than continuing to search for a better-paid job.
The aggregate demand for labor shows the amount of labor firms are willing to hire for different wage rate.
The aggregate demand for labor curve (ADL) slopes downwards. The higher the wage rate, the more will
firms attempt to economize on labor and to substitute other factors of production for labor.
The following figure shows the aggregate demand for labor and aggregate supply of labor: that is, the total
demand and supply of labor in the whole economy. The real average wage rate is plotted on the vertical

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axis. This is the average wage rate expressed in terms of its purchasing power: in other words, after taking
prices into account.

Figure 3.1: The Aggregate

demand for labor and
aggregate supply of labor

3.2 Labor market search and Unemployment

i. The Employed: It includes everyone currently at work, including part-time workers.

Although some part-timers work less than a full week by choice, others do so only because
they cannot find suitable full-time jobs. Nevertheless, these workers are counted as
employed, even though many would consider them ―underemployed.‖
ii. The Unemployed: For persons not currently working, the survey first determines whether
they are temporarily laid off from a job to which they expect to return. If so, they are
counted as unemployed. The remaining workers are asked whether they actively sought
work during the previous four weeks. If they did, they are also counted as unemployed.
iii. Out of the Labor Force: But if they failed to look for a job, they are classified as out of
the labor force rather than unemployed. This seems a reasonable way to draw the
distinction—after all, not everyone wants to work. Yet there is a problem: Research shows
that many unemployed workers give up looking for jobs after a while. These so-called
discouraged workers are victims of poor job prospects, just like the officially
unemployed. But when they give up hope, the measured unemployment rate—which is
the ratio of the number of unemployed people to the total labor force— actually declines.

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Unemployment is one of macroeconomic problem that affect people most directly and severely.
Unemployment causes reduced living standard and psychological distress. This is why economists
study unemployment to come up with public policies that is used to reduce unemployment.

Unemployment is a situation in which able bodied persons willing to work at prevailing wage rate
do not able to find job. It is measured by rate of unemployment, which represents the percentage
of those people who wants to work but cannot get any job.

Unemployment rate =

Where labor force is all persons in working ages that are either working for paid job or actively
seeking paid employment.

iv. Natural rate of unemployment

To see what determine the unemployment rate, we assume that the labor force (L) is fixed and
focus on individual transition

Let L= Labor force U=no of unemployed

E=no of employed L= E + U

Rate of unemployment = U/L

Let S denote the rate of job separation (fraction of employed individuals who lose their job each
month) and F denote the rate of job finding (the fraction of unemployed individuals who find a
job each month) thus rate of employment will be

Rate of employment = F + S

Together S and F determine the rate of unemployment, if unemployment is nether falling nor rising
then S= F and we say the labor market is at steady state .Thus the number of people finding a job
must equal the number of people losing a job.

FU=SE

The steady state unemployment rate could be found by

L= E+ U.........=E= L - U

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 FU = SE

FU= S (L - U)

FU/L =S( 1 - U/L) solving for U/L......U/L=

This equation shows that the steady state unemployment depend on the rate of job separation and
the rate of job finding

Here‘s a numerical example. Suppose that 1 percent of the employed lose their jobs each month (s
= 0.01). This means that on average jobs last 100 months, or about 8 years. Suppose further that
20 percent of the unemployed find a job each month ( f=0.20), so that spells of unemployment last
5 months on average. Then the steady-state rate of unemployment is

3.3 Types and causes of unemployment

i. Frictional (unemployment

One reason for unemployment is that it takes time to match workers and jobs. Some frictional
unemployment is inevitable in a changing economy. For many reasons, the types of goods that
firms and households demand vary over time. As the demand for goods shifts, so does the demand
for the labor that produces those goods. The invention of the personal computer, for example,
reduced the demand for typewriters and the demand for labor by typewriter manufacturers. At the
same time, it increased the demand for labor in the electronics industry. Similarly, because
different regions produce different goods, the demand for labor may be rising in one part of the
country and falling in another. An increase in the price of oil may cause the demand for labor to
rise in oil-producing states, but because expensive oil makes driving less attractive, it may decrease
the demand for labor in auto-producing states .Economists call a change in the composition of
demand among industries or regions a sectoral shift. Because sectoral shifts are always occurring,
and because it takes time for workers to change sectors, there is always frictional unemployment.
Sectoral shifts are not the only cause of job separation and frictional unemployment. In addition,
workers find themselves unexpectedly out of work when their firms fail, when their job

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performance is deemed unacceptable, or when their particular skills are no longer needed. Workers
also may quit their jobs to change careers or to move to different parts of the country. Regardless
of the cause of the job separation, it will take time and effort for the worker to find a new job. As
long as the supply and demand for labor among firms is changing, frictional unemployment is
unavoidable.

Neoclassical focused on the imperfections in the labor and product markets in real world resulted
from lack of information to explain frictional unemployment. The flow of information about job
candidates and job vacancies is imperfect. Geographical mobility‘s of workers are not
instantaneous, in addition workers difference in preference and jobs have different attributes.

For all these reasons, searching for an appropriate job takes time and effort. Such type of
unemployment which created due to the time to get job is known frictional unemployment.

One obvious remedy for frictional unemployment is to provide better job information through
government job centers, private employment agencies, or local and national newspapers. Another
much more controversial remedy is for the government to reduce the level of unemployment
benefit. This will make the unemployed more desperate to get a job and thus prepared to accept a
lower wage.

ii. Structural unemployment

A second reason for unemployment is wage rigidity—the failure of wages to adjust until labor
supply equals labor demand. In the equilibrium model of the labor market, the real wage adjusts
to equilibrate supply and demand. Yet wages are not always flexible. Sometimes the real wage is
stuck above the market-clearing level. The unemployment resulting from wage rigidity and job
restricting is called structural unemployment. Workers are unemployed not because they are
actively searching for the jobs that best suit their individual skills but because, at the ongoing wage,
the supply of labor exceeds the demand. These workers are simply waiting for jobs to become
available. The wage rate did not adjust to full employment level due to different factors.
Some of them are presented as follows.

 Minimum wage law: Minimum wage law is a law which set a legal minimum wages that firms
pay their employee with different skills. This will cause wage rigidity not to adjust to
equilibrium level and creating unemployment.

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 Unions and collective bargaining: The wages of unionized workers are determined not by the
equilibrium of supply and demand. It is determined by collective bargaining between labor
union leader and management. In most cases they agree on wage above equilibrium level
associated with a certain level of unemployment.
 Efficiency wage argument: According to efficiency wage theory higher wages make workers
more productive. So if wage increase the productivity of workers, firms will not cut the wage
of workers even though there is excess labor supply. As economists argue high wage increase
wage productivity in different ways:

 Higher wage enable workers to afford nutritious food and then have better health
condition. If workers become healthier they can supply more labor and effectively
undertake different activities they are assigned to.
 It also reduce labor turnover. The more firms pay its workers, the greater their
incentive to stay with the firm. Therefore firms reduce labor turn over (cost and
time of hiring and training new workers) by paying their employee higher wage.
 High wage reduce adverse selection in labor market. That is higher wage select
quality (better performing) workers among less efficient workers.
 High wage reduces the problem of moral hazard that exists between workers and
firms. This is because when workers paid high wage above equilibrium, it improve
workers effort with minimum monitoring.
All the above factors make wage rate rigid above the full employment equilibrium point resulting
in structural unemployment. The following figure shows why wage rigidity leads to
unemployment. When the real wage is above the level that equilibrates supply and demand, the
quantity of labor supplied exceeds the quantity demanded. Firms must in some way ration the
scarce jobs among workers. Real-wage rigidity reduces the rate of job finding and raises the level
of unemployment.

Figure 3.2 wage rigidity and unemployment

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 Structural unemployment also arises due to structural change in dynamic economy. Such structural
change includes change in the structure or sectoral composition of the economy due to
technological change. That is gradual decline of some kind of industries production and the
emergence of new industries. This situation makes some peoples with certain specific skill out of
the labor demand resulting in structural unemployment. Technological change also alters the
demand pattern of different kind of skills. Some skills become obsolete and less efficient resulting
mismatch between labor demand and supply.
iii. Cyclic (Demand-deficient) unemployment
Cyclical unemployment is unemployment created associated with short run fluctuation of the
economy. Workers become unemployed for some period when their job evaporates due to
recession and returns to job when there is expansion in economic activities.
As the economy moves into recession, consumer demand falls. Firms find that they are unable to
sell their current level of output. For a time they may be prepared to build up stocks of unsold
goods, but sooner or later they will start to cut back on production and cut back on the amount of
labour they employ. The deeper the recession becomes and the longer it lasts, the higher will
demand-deficient unemployment become. As the economy recovers and begins to grow again, so
demand deficit unemployment will start to fall again. Because demand-deficient unemployment
fluctuates with the business cycle, it is referred to as ‗cyclical unemployment‘.

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Demand-deficient unemployment is also referred to as ‗Keynesian unemployment‘, after John
Maynard Keynes, who saw a deficiency of aggregate demand as the cause of the high
unemployment between the two world wars. Today, many economists are known as ‗Keynesian‘.
Although there are many strands of Keynesian thinking, these economists all see aggregate demand
as important in determining a nation‘s output and employment.
Demand-deficient unemployment is illustrated in the following Figure. Assume initially that the
economy is at the peak of the business cycle. The aggregate demand for and supply of labour are
equal at the current wage rate of W1. There is no disequilibrium unemployment. Now assume that
the economy moves into recession. Consumer demand falls and as a result firms demand less
labour. The demand for labour shifts to ADL2. If there is a resistance to wage cuts, such that the
real wage rate remains fixed at W1, there will now be disequilibrium unemployment of Q 1-Q2.

Fig.3.3. Demand-deficient unemployment

Some Keynesians specifically focus on the reluctance of real wage rates to fall from W1 to W2.
This downward ‗stickiness‘ in real wage rates may be the result of unions seeking to protect the
living standards of their members (even though there are non-union members out of work), or of
firms worried about the demotivating effects of cutting the real wages of their workers. For such
economists, the problem of demand-deficient unemployment would be solved if there could
somehow be a fall in real wage rates.

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 iv. Seasonal unemployment

Seasonal unemployment occurs when the demand for certain types of labour fluctuates with the
seasons of the year. This problem is particularly severe in holiday areas .

v. Cost of unemployment

Employed workers produce goods and services whereas unemployed workers do not. Thus an
increase in the unemployment rate decreases the real GDP of an economy. This negative
relationship between unemployment and GDP is known as okun‘s law after the Arthur Okun, the
economist who first identified the relationship. Okun‘s law says that the unemployment rate
declines when growth is above the trend rate.

Du = -x (ya – yt)

Where Du is change in unemployment, x the magnitude in which unemployment declines due to a

percentage point growth, ya actual growth rate of output, and yt is trend output growth rate.

According to the original formulation of Okun‘s law, each additional percent of unemployment
translated to a loss of 3 percent in real output. More recent estimates of Okun‘s laws put the ratio
at about 1 to 2, largely due to the changing composition of both the labor force and output.

The other cost of unemployment is that it reduces living standard and causes psychological distress.
Unemployment has also income distribution effect. It causes inequality among employed and
unemployment workers.

3.4 Classical and Neoclassical Microeconomic Model of the Labor Market

To keep our analysis simple, we assume fixed amounts of capital and labor. We also assume here
that the factors of production are fully utilized—that is, no resources are wasted. Again, in the real
world, part of the labor force is unemployed, and some capital lies idle. We examine the reasons
for unemployment, but for now we assume that capital and labor are fully employed.
Assume the following production function:

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 Y= F (K, L)

 The marginal Product of Labor: the more labor the firm employs, the more output it
produces. The marginal product of labor (MPL) is the extra amount of output the firm‘s
gets from one extra unit of labor, holding the amount of capital fixed. (Refer your micro
economics I discussion)
 From the marginal product of labor to labor demand
When a competitive profit maximizing firm is deciding whether to hire an additional unit of labor,
it considers how that decision would affect profit. It there for compares the extra revenue from the
increased production that result from the added labor to the extra cost of higher spending on wage.
The increase in revenue from the additional unit of labor depends on two variables, the marginal
product of labor and the price of the output. Because an extra unit of labor produces MPL units
of output and each unit of output sells for P dollars, the extra revenue is P*MPL. The extra cost
of hiring one more unit of labor is the wage W. Thus the change in profit from hiring an additional
unit of labor is
∆profit = ∆revenue-∆cost
= (P*MPL)-W
The symbol ∆ (delta) denotes the change in a variable.
How much labor does the firm is hiring? The firm‘s manager knows that if the extra revenue
P*MPL exceeds the wage W, an extra unit of labor increase profit. Therefore the manager
continues to hire labor until the next unit would no longer be profitable, that is until the MPL falls
to the point where the extra revenue equals the wage. The firms demand for labor is determined by
P*MPL=W
We can also write this as MPL=W/P
W/P is the real wage-the payment to labor measured in units of output rather than in dollars.to
maximize profit the firm hires up to the point at which the marginal product of labor equals the
real wages. Thus in pure competition, profit maximization is written as

W = P x MPL or MPL=W/P

Where W – money wage

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 P – Price level
W/P – real wage
MPL – marginal product of labor.
The demand for labor may be written as

𝑾
𝑵𝒅 = 𝑫( 𝑷 )States that the demand for labor is a function of the real wage.
Since diminishing returns suggests that the marginal product of labor declines as more workers are
hired, there will be an increase in employment only if real wages fall. On the supply side – the
classical economists assume that the supply of labor, as well as the demand depends on the real
wage. The classical labor supply function is

𝑾
𝑵𝒔 = 𝑺( ) a change in the quantity of labor supplied will take place only if the real wage changes.
𝑷
Equilibrium on the labor market is established by the real wage which equates the supply of and
the demand for labor. Involuntary unemployment i.e., a state of affairs in which more people are
willing to work at the going real wage than entrepreneurs are willing to hire – will be eliminated
by a fall in real wages, brought on by money wage cuts, just as excess supply on any market is
eliminated by a fall in price. The real wage and the level of employment are determined by labor
market equilibrium

𝑊 𝑊
𝐷( ) = 𝑆( )
𝑃 𝑃
Figure 3.4. The labor market: classical case.

W/P S = S (W/P) In classical theory there is only one

equilibrium level of income and one
(W/P) equilibrium level of employment.
(W/P)*
This does not mean, however, that this
equilibrium is always achieved.
D = D (W/P)

0 N0 N* N1 N

The figure Above illustrates a possible disequilibrium situation.

When the real wage(W/P)0. ,is No units of labor will be hired, although N1 workers are willing to
work. There is involuntary unemployment of N1 – N0. In a competitive labor market, money wage

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rates will fall, real wages will fall, and equilibrium will be established at a level of employment of
N* and a real wage of (W/P)*. But if competition is eliminated by trade unions a minimum wage
laws, or if various other institutional obstacles exist, money wage cuts can be resisted and the
movement to equilibrium can be frustrated. It is in this situation that monetary policy may come
to the rescue. If money wages do not fall, the necessary fall in the real wage may be achieved by
an increase in the price level. An increase in the money supply, by raising the price level, lowers
real wages so that the level of employment and real income increase.

Even when the labour market is in equilibrium, however, not everyone looking for work will be
employed. Some people will hold out, hoping to find a better job. This is illustrated in the following
Figure. The curve N shows the total number in the labour force. The horizontal difference between
it and the aggregate sup-ply of labour curve (ASL) represents the excess of people looking for
work over those actually willing to accept jobs. Q e represents the equilibrium level of employment
and the distance D – E represents the equilibrium level of unemployment. This is sometimes known
as the natural level of unemployment. It is the average rate of unemployment around which the
economy fluctuates.
The natural rate is the rate of unemployment
toward which the economy gravitates in the
Long run, given all the labor market
imperfections that impede workers from
instantly finding jobs. Every day some
workers lose or quit their jobs, and some
unemployed workers are hired. Note that the
ASL curve gets closer to the N curve at
higher wages. The reason for this is that the
unemployed will be more willing to accept
Fig.3.5. classical unemployment equilibrium
jobs, the higher the wages they are offered

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The Keynesian theory of labor market

The classical and neoclassical discussions of the labor market so far have ignored involuntary
unemployment. In particular, the model of national income was built with the assumption that the
economy was always at full employment. In reality, of course, not everyone in the labor force has
a job all the time: all free-market economies experience some unemployment

The distinguishing feature of Keynesian unemployment is that it is attributed to an insufficient

level of aggregate demand, the condition results from a different specification of the labor supply
function from that in neoclassical analysis .In the general theory Keynes assumed that workers are
unwilling to accept a cut in money wage in order to secure more employment, even though they
would accept an equivalent reduction in the real wage rate brought about by an increase in the
price level while the money wage rate remained unchanged. Keynes did not attribute this to the
irrationality on the parts of workers, but to a desire to preserve their wage relativeness. Workers
are concerned with the real wage they receive and not just its money value.

Because the price level is not determined in a single labor market, workers can only bargain directly
for money wage not real wage. There for workers are willing to accept a cut in real wage that steam
from a rising price level but not one caused by a cut in money wage because the former affect all
workers more or less equally and does not alter relative real wage. In contrast a cut in money wage
is seen as affecting only that particular group of workers and adversely affecting their real wage
relative to other income groups.

In the static interpretation of the Keynesian model the money wage is assumed to be fixed, it is
exogenous to the model and explained by institutional factors and past history. Therefor in a
Keynesian model the supply of labor is within limits perfectly elastic with respect to the current
money wage rate. An example of a Keynesian labor supply function is drawn. Figure 3.6.
Unemployment and the labor market

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In the above graph the labor supply curve position depend on the fixed money wage W1 and upon
a given price level which we take to be P1.Upto OLU a unit of labor are supplied. However to
induce more labor than OLU and more labor units to supply themselves when the price level is P1
the money wage has to rise above W1 so ensuring higher wage rate is a key to attract more workers
in the labor market .In the figure also the demand for labor is plotted with respect to the money
wage holding the price level fixed at P1,as money wage rises the real wage rate also rise along DD
since the price level is assuming fixed at P1.given money wage of W1 and price level of P1 only
OL1 labor unit are demanded while OLU are supplied .there is an excess supply of labor equal to
L1LU unit. The labor market is unclear and there is unemployment. This amount of unemployment
is involuntary unemployment. Thus for Keynesians even if the labor market is at equilibrium we
might face with the problem of involuntary unemployment due to nominal wage rigidity. To
achieve full employment cutting down nominal wage is ineffective, but by creating inflation in the
economy and reduce real wage we can induce firms to increase their demand for labor and employ
more labor force.

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