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THE LABOR MARKET

to simpli matters, we assumed thus far that households used only their own
labor to produce goods. In other words, we did not distinguish between
households and firms. Now we make the analysis more realistic by
introducing a market in which people exchange labor services. This market,
known as the labor market. can be thought of as a place in which people
supply and demand labor services. The people who buy labor services are the
firms or employers in the economy. Those who sell services are the
employees.
The clearing of the labor marketalong with the clearing of the markets for
commodities and creditdetermines the aggregates of work and output. One
objective of this chapter is to see how much the presence of the labor
market and the existence of firms change the way that these aggregates are
determined. For most macroeconomic questions. it turns out that the answer
is not much. Our previous simplified setting in which people work only on
their own production processes is satisfactory for most purposes. The
extensions in this chapter do, however, allow us to explore the

determination of wage rates and the manner in which a labor market promotes
economic efficiency. The extended framework will also be essential later when
we study unemployment (in chapter ioj.
SETUP OF THE LABOR MARKET

Suppose, for simplicity, that everyones labor services aro physically the
same. But instead of working on ones own production process, people now
sell their labor services on the Labor market. This market establishes a
single wage rate, which we denote by w and measure in units of dollars per
person-hour. (For convenience, we omit time subscripts here.) By the wage
rate we mean that buyers of labor services pay w dollars for each hour that
someone works for them. CorrespondingLy, sellers of labor services receive
w dollars for each hour of work. As in our treatment of the commodity
market, assume that each individual buyer and seller regards the wage
rate, w, as a given.
Denote by 5 the number of person-hours of labor services that a household
supplies to the labor market during a period. Correspondingly, this
household receives the dollar quantity wP of labor income.
Suppose that some of the householdswho are inclined to be entrepreneurs
set themselves up as firms. These firms hire other people as workers. Let
denote the number of person-hours of labor services : that a firm
demands from the labor market. Correspondingly, the firm pays the dollar
amount wid as wage payments to its workers.
Each firm uses its input of labor services, d, to produce commodi
ties. The quantity produced and supplied to the commodity market is
ysf(,d) (6.1)

where f is again the production function. Since the goods sell at the price
P. the firms gross revenue from sales is Py5. The firms profit (or
earnings) equals gross revenue less wage payments:
Profit = Pys wid = P f(jd) S
(6.2)
Note that firms do not issue or hold bonds at this stage of the analysis.
The potential to borrow becomes important in Chapter 9 when we allow for
investment.
A firms earnings go to the household or households that own the firm. Ve
could introduce a stock market, on which people bought and sold the
ownership rights in businesses. Then the profits would go to the current
shareholders in the form of dividend payments. To keep things simple, we do
not introduce a stock market and assume that the ownership rights in firms
are distributed in an unspecified manner among the households.1 In any
event, it is important to note that all firms must be owned 100% by some
households. Each households total income now includes its share of profits
from firms, as well as wage income, wP, and interest income.
THE DEMAND FOR LABOR
Think about a household that owns all or part of a firm. The households
utility depends on it consumption. d, and work. P. Hence, the firms demand
for labor, d, matters to the household-owner only through its effect on
the firms profIt, which appears in equation (6.2). f the firm acts to
benefit its ownersas we assumethen it sets its demand for labor, to
maximize profit in each period.
An increase in labor input. P, has two effects on profit. First, an extra
hour of work means that output. f(P1), increases by the marginal product of
labor, MPL. Gross saies revenue therefore rises by the dollar amount, P.
MPL. Second, the wage biLl increases by the dollar wage rate, w, Profit
rises on net with an increase in labor input if the value of labors
marginal product, P . MPL. exceeds w. To maximize profit a firm expands
employment, d, up to the point at which the value of the marginal product
ust equals the wage rate, that is, until P MPL = w. f
MPL

Notice that the right side of equation (6.3) Is the real wage rate, w/P.
This variable is the quantity of commodities that someone can buy with the
dollar amount w. Equation (6.3) says that a producer chooses the quantity
of labor input, P1,so that the marginal product, MPL, equals the real wage
rate. At that point, the last unit of labor contributes just ; enough to
output, MPL, so as to cover the extra cost of this labor in units of
commodities, which is the real wage rate.
Figure 6.1 illustrates the results. The curve shows the negative effect of
more labor input on the marginal product. MPL. Notice that firms set their
demand for labor, d, at the point where the marginal product equals the
real wage rate, w/P.

Properrties of the demand for labor


We can figure 6.1 to see how various changes effect the demand for labor.
It follow at once that decrease i the real wage, w/p. Means a higher
quantity of labor demanded. When the real cost of hiring workers
decreases, firm expand employment until labors ,marginal product falls by
as much as the decrease in w/p
An up ward shift in the schedule for labors marginal product- that is, an
upward shift of the curve in figure 6.1 leads to a greater quantity of
labor demand for any given real wage rate. Specifically, employment expands
until the marginal product again equals w/p
We can sumarize the result by writing down a function for the aggragate
demand for labor. This function takes the from
N = N (W/P)
Where the expresion... agains refers to chareacteristics
function

of the production

Recall that each firms choice of labor input determines its supply of
goods through the production function, y = f(n) Since labor demand
decrease with the real wage rate. We can write the function for the
aggragae supply of goods as
LABOR SUPPLY AND CONSUMPTION DEMAND
The introduction of the labor market does not greatly alter our earlier
analysis of work effort and consumption demand. The main modification
concerns the households choice between consumption and leisure at a point
in time. In our previous model the schedule for labors marginal product.
MPL. tells people the terms on which they can substitute consumption for
leisure. When someone works an extra hour on his or her own production
process, he or she can use the additional output (of MPL units) to raise
consumption. Now households sell their labor services at the real wage
rate, w/P, rather than working on their own production. The real wage rato
therefore indicates the terms on which people can substitute consumption
for leisure. Someone who works an extra hour can use the additional w/P
units of real income to expand consumption.
For a household, the real wage rate now appears where previously the
schedule for labors marginal product appeared. Specifically, an increase in
the real vage rate motivates households to increase labor supply and
consumption demand. But recall that the choice of labor demand by firms
guarantees that the real wage rato equals the economy- wide marginal
product of labor. Therefore, the effects from the real wage amount,
ultimately, to corresponding effects from the schedule for labors marginal
product.
As before, wealth effects can arise from shifts in production functions.
These effects show up first on firms profits (and on stock prices if we
had introduced a stock market). But it is important to remember that the
profits go to the households that own the firms. Therefore, the shifts in
production functions ultimately have wealth effects on households, as in
our earlier model that ignored firms.

One new consideration is the wealth effect from a change in the real wage
rate, given the position of the production function. An increase in w/P
benefits the households that sell labor services. But this benefit is
matched by an extra cost for the firms, which buy labor services. Since the
firms are owned by households, the overall wealth effect on households from
a change in w/P is nil. (Them would ho distributional effects if households
differ by their relative amounts of wage and profit income. But we follow
our usual practice of neglecting distributional effects on the aggregates
of labor supply and consumption demand.)
The interest rate, R. has the same intertumporal-substitution effect as
before. An increase in B motivates households to save more by reducing
current consumption demand and raising current labor supply. An additional
intertemporal-substitution effect arises if people anticipate variations
over time in the real wage rate. Suppose, for example, that workers regard
the current real wage rate as high relative to future values. Then they
increase current labor supply and pian to reduce labor supply in the
future. Before, we found similar effects if people anticipated changes in
the schedule for labors marginal product.
We can summarize the results in this section by writing down functions for
the aggregates of labor supply and consumption demand. These functions take
the forms
L = V(w/P, R, ,..) (6.6)
(+1 (+)
and
Cd = Cd(w/P, R,...) (6.7)
(+) (-)

The omitted terms, denoted by. . . , incLude characteristics of the


production function, as well as any elements that generate departures of
expected future real wage rates from the current value.
CLEARING OF THE LABOR MARKET
The labor market clears when the aggregate supply of labor, N. equals the
aggregate demand, N, Therefore, using equations (6.4) and (6.6), the
condition for the clearing the labor market is
N
Recall that the terms denoted by... include characteristics of the
production function
As before, there are also condition for the clearing the commodity market
and for ensuring that all money willingly held. These condition must hold
along with equation 6.8 to ensure the clearing of all markets. When we
take these conditions together, we shall be able to determine the nominal
wage rate,w, as well as the interet rate,R, and the price level,p, in other
wordsm we add one new market clearing condition, equation 6.8 and thereby
determine one more price- the price of labor services,w, for now, we focus
on the new conditions for clearing labor market

Figre 6.2 shows the clearing of the labor market. For convenience ,we place
the real wage, rate, w/p,on the vertical axis and labor demand and supply
on the horizontal. Notice that the quantity of lsbor demanded by firms
falls as w/p rise on the other hand , the qunatity of lsbor supplied by
households increase with w/p
Notice from figure 6.2 that the aggregate of labor demand and supply equal
when the real wage rate is w/p and the level of warks is N. We can think
of this overall level of work effort as corresponding to aggregate
employment or to total hours worked by all persons. Figure 6.2 allow us to
relate the market clearing values of the real wages rate and employment
(or total hours worked) to variables the shift eithr the labor demand
curve on the labor supply curve. These variables include the interest
rate,R, the form of the labor supply curve. These variables include the
interst rate,R, the forms of production function, and prospective changees
in the real wage rate. For example increase the interest rate shifts the
labor supply curve rightwward in figure 6,2. Hence employment,N, rises
while the real wage rate,w/p, declnes
Clearing of the commodity market
Using equation 6,5 and 6,7, we can write
commodity market as

the condition for clearing the

We want to show that this condition is essentially the same as the one
for clearing the commodity market in chapter 5. That is ,we want to
demonstrate that thr introduction of the labor market and firms leaves
intact our previous analysis of the commodity market. This finding is
important because it means that our result from chapter 5 carry througt to
the extended model that includes a labor market
Recall that the conditions for clearing the labor market in equation 6.8
(and figure 6.2) determine w/p.This conditions implies that an increase in
the interest rate ries,R, We can use this result to subtitute iur of the
real wage rate,w/p, in the conditions for the clearing the commodity
market, equation 6.9.In particular , we have show that w/p varies
inversely with R. Therefore, after subtituting for w/p in terms of R, we
get the simplified condition for clearing the commodity market .
As usal, the expression.. includes characteristics of the production
function Notice that w/p does not appear in equation 6.10 because we have
replaced it by the various elements, including R, that determine the real
wage rate, In particular,since Y depends on w/p in equation 6.9 abd since
w/p depends on R,Y depends indirectly on R. Therefore, when we solve out
for w/p,Y, depends directly on R in equation 6.10
Lets examine in detail how the interst rate enters into the condition for
clearing the commodiy market in equation 6.10. Recall that an increase in
R shifts the labor supply curve rightward in figure 6.2, which leads to
decline in w/p. This decline in w/p leads, as shown in equation 6.9 to an
expansion of goods supply, Y, Therefore, the positive effect of R on Y in
equation 6.10 picks up this channel of effect
On the demand side, the change in the interst rate has two effect. first,
from equation 6.9 an increase inR lowers consumer demand,C, for a given
value of w/p/ Second, because an increase in R leads to a lower value of
w/p, there is a further decline in consumer demand. Therefore, the negative
effect of R on c in equation 6.10 picks up both channels of effect.
The important point is that equation 6.10 looks just like the conditions
for clearing
the commodity market taht we used in chapter 5 . Since the

conditions for clearing the commodity market looks as it did before , we


can still use our previous analysis to determine the interest rate and
the qyuantutues of output and work efort for each period. To see how this
work, lets reconsider the example of a shift the production function
An improvement in the production functiom
Assume a permanent proportional upward shift of the production function.
This change means that the level of aggregate output and the marginal
product of labor increase any given amount of aggregate work effort
Figure 6.3 show the effect on the labor market. Since the disturbance raise
wealth,the supply of labor declines for given value of w.p. Because of the
upward shift to the schedule for labor marginal product, the demand for
labor rises for given value of w/p. Hence,figure 6.3 show that the real
wage increase, the change in the quantity of work is uncertain. As in some
previous cases, wealth effect suggest less work, but the impprovement in
productivity suggest more worl
Figure 6.4 show effect on the commoduty market. We use the market clearing
conditions from equations 6.10, which takes account of the determine of
the real wage rate from the labor market. Notice first the rigtward shift
consumer demand . This shift reflects partly the wealth effect from the
improvement in the prduction function and partly the subtituting effect
(toward consumption and away from leisure) from the rise in the real wage
rate
The supply of goods rises with the improvement in the production function
but falls because of the increase in the real wage rate. Recall, however ,
that the shift the production function and resulting change in w/p are
permanent in the example. Therefore, the aggregate of desired saving would
change little, if at all the initial interest rate . This result means that
goods suppky, y, shift rightward on net by roughly the same amount as c.
We conclude from figure 6.4 that output increase , but the interest rate
does no change
An important observation is that the resulting with those that we reached
earlier, when people worked on only their own production processes. A
permanent improvement in production opportunities raises aggregate output
but has an ambiguous effect on work effort. Further, because the shift
in the production functiion is permanent , there is not chane in interest
rate
The introduction pf the labor market does deliver an important result
about the behavior of the real wage rate. Economic development onvolves a
series of permanent improvements to the production function of the sort
that we considered in figure 6.3 and 6,4, Hence, our analysis shows that
economic development leads to continuing increase in the real wage. This
proposition accord with data for a large number of countris. For example,
in the united state , the average hourls real wage rate rose at an average
rate of 1,0% per years from 1948 to 1987
Nominal wages rate
To determine nominal wage rate and other nominal variables , we again
consider the condition for money to be wilingly held. This condition loos
as it did in chapter 5
The aggregate real demand for money, L(), now includes money held by firms
as well as households, however, the form of this function does not differ

gratly from that in our analysis. In particular, the amoubt of real money
demanded still falls with an increase in interest rate, R, and risse with
an increase in real transactions as measurred by real output,y,
The full market clearing model now consist of equation 6.11 plus the
conditios derived earlier for clearing the labor and commodity market:
We have already seen that equation 6.12 and 6.13 determine the real wage
raise w/p, the interest rate ,R, and the levels of output ,y, and
employment,n,
We showed in chapter 5 that an increase in the quantity of money,was
neutral. The price level ,p, rose in the same proportion, but all real
money balances m/p- we are unchanged. This property of monetary
neutrality still holds in the model that include a labor market. However,
we have to add the real wage rate,w/p, the list tof real variables that do
not change.Then we have to include the nominal wage rate,w, along with
the nominal variable that rise in the same proportion the quantity of
money
To verify thede result, remember that equation 6.12 and 6.13 determine R
and Y these variable then determine the real demand for money, L(). Given
the real demand, equation 6.11 implies that an increase in M raises P in
the same proportion. Therefor real money balances,M/p, Do not change when
there is once and for all shift in the nominal quantity of money
Recall that equation 6.12 and 6,13 determine w/p and N. In fact, the rea;
wage rate equals the marginal product of labor at this values of N. We can
find the nominal wage rate,w, by multiplying the real wage rate,w/p by the
pric level ,P, which we have already determine . Notice that an increase
in M raises P in the same proportion but does not change w/p, an increase
in M must raise the nominal wage rate w (As well as p) in the same
proportion
The labor market in the microeconomic model]
Consider how the introduction of labor market and firms affect our
analysis. We have shown that these new features do not change the way
that shift to the production function affect the interest rate and the
aggregate quantities of output and work effort. We also found that the
extensions did not change the interaction betwen money and prices. In other
word ,our earlier simplification- which neglected the labor market and the
existence of firm- allows us to get reasonable answer to many important
questions. Thereforr for most of the subsquent analysis. We shall find it
satisfactory to return to the simplier framework, which does not deal
explicittly with the labot market or firms. The main place we reintroduce
firms an the labor market in chapter 11. Where we study unemployment

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