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CORE Econ’s New Approach to the �Labour Market

Margaret Stevens

27th March, 2023

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Teaching of the labour market can be incoherent�in introductory and intermediate courses

  • Introduced as an extension/application of standard micro theory
    • Labour supply as a more challenging extension of consumer choice
    • Theory of production and factor demand for the price-taking firm
    • Most micro texts say almost nothing about competitive labour market equilibrium (or just use it to show that minimum wages cause unemployment)
    • And/or add lots of caveats about why it’s not really like that.
  • Macro courses don’t make much use of competitive microfoundations
    • May use w=MPL for long-run analysis
    • But they need a labour market model that accounts satisfactorily for unemployment
    • May rely mainly on a descriptive flows approach that is hard to relate to static analysis and the micro approach
    • Or move straight to an imperfectly competitive wage and price setting model

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Treatment of the labour market in TE1.0

  • Unit 3: the individual labour supply decision – choice of consumption and hours of work (to explain LR trends)
  • Unit 6: employment relationships and contracts; the labour discipline model (incomplete contract, rent, effort e(w), wage-setting, implications for unemployment)
  • Unit 9: deriving the wage-setting curve (employers choose the wage given economy-wide employment/unemployment); combined with price-setting, determines aggregate employment and output
  • Unit 9: Implications: distribution of income, effect of change in labour supply (labour force), labour market policies; why the labour market is different
  • Unit 16: Flows: job creation and destruction; Beveridge curve (unemployment and vacancies); mismatch

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What’s missing?

  • Tools for analysis at the level of individual labour markets. We go straight from the labour discipline model (1 worker, 1 firm) to equilibrium aggregate employment.
  • Ability to explain: observed employment effects of the minimum wage; existence of vacancies; distribution of wages; discrimination, why employers invest in training …
  • A clear connection between employment determined by WS-PS, and the Unit 16 flow analysis.
  • An intuitive picture of how labour markets work. We’ve avoided the misleading spot-market LD-LS diagram, but we haven’t replaced it with anything.

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Objectives

  1. A tractable model that can explain important features of the labour market
    1. In TE1.0, firms have product market power but not labour market power. In the labour discipline model employment is determined competitively (w=MRPL)
    2. We want to integrate labour market power (“monopsony”) alongside unobserved effort, so that the model can also explain (e.g) min w, training, discrimination…
    3. and to extend and incorporate it easily into a macroeconomic model
  2. To embed the model in a plausible and persuasive picture of the labour market that accords with what students can observe for themselves

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Describe what the labour market is like, rather than what it is not like

  • Employment relationships are long term
  • Heterogeneous workers and jobs; mobility frictions
  • Finding a good match, and maintaining it, matters
  • A dynamic process in which workers search for jobs, move in and out of employment, and from job to job; firms create vacancies and search for suitable workers
  • Relationships are governed by long-term, but incomplete, contracts

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  • This is the natural setting for the labour discipline model
  • And frictions bestow monopsony power

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Unit title

Where the labour market comes in

VI Unit 3

Scarcity, work, and choice

Choice of consumption and working hours, to explain long run trends. As before, but for a worker with a fixed wage

VI Unit 6

The firm: Owners, managers, and workers

How labour markets work; the micro model of wage setting with employer power and unobserved effort

VII Unit 1

The supply side: unemployment, real wages, and inequality

Deriving the WS-curve from U6 model and PS from U7🡪 labour market equilibrium, policy analysis

VII Unit 3

Inflation, unemployment and the Phillips curve

Unemployment over the business cycle

VII Unit 8

Creative destruction and the future of work

Job creation, job destruction, flows and the Beveridge curve; WS-PS applications

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6.1

Exploding tyres: The mystery unravelled

Firestone tyres: within-firm relationships and worker motivation

6.2

The structure of the firm: Owners, managers, and workers

How firms coordinate work; information; contracts, long-term relationships

6.3

Other people’s money: The separation of ownership and control

Firm structure; owners (residual claimants), managers and employees, conflicts of interest

6.4

Finding jobs and filling vacancies

How labour markets work; day-labour vs good match+long-term contract; matching market; relationship-specific assets; labour market flows

6.5

Managing hiring and quitting: The reservation wage curve

Reservation wages of job-searchers; the wage that equalizes the firm’s flow of hires and quits at the desired steady state employment level

6.6

Getting the work done: Contracts, principals, and agents

Introduction to the PA model of work effort; unverifiable information and incomplete contracts

6.7

Employment rents: The cost of job loss

Why people work hard; employment rents; how they might be used by firms

6.8

Counting the cost of job loss: Rents and reservation wages

Calculating Maria’s rent when her next-best option is search for a new job; determination of her reservation wage. (Rent per hour=w-rw)

6.9

Getting employees to work hard: The labour discipline model

Labour discipline. Game between Maria and employer determines the no-shirking wage and corresponding rent.

6.10

Combining recruitment and labour discipline: The wage-setting model

The reservation wage curve and NS-condition determine the firm’s no-shirking wage curve, w=w(N) and hence the firm’s feasible set of (N,w). It sets w to maximise profit, with constant labour productivity y.

6.11

Putting the wage setting model to work: Wages, employment, and the rate of unemployment

Involuntary and search unemployment; comparative statics for w and N; aggregating: whole economy WS curve, full employment impossible

6.12

How employers exercise power

Power to control wages (monopsony); power to terminate employment

6.13

Application: The minimum wage

Application of model plus empirical evidence

6.14

Application: Another kind of business organization

Worker-owned cooperatives; John Lewis.

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6.5 Managing hiring and quitting (the first component of the model)

Underlying model

  • Firm meets A0 potential workers per period, with different idiosyncratic utilities α of being unemployed. Distribution function for reservation wages F(.).
  • A potential worker will accept a job offer with wage w if their reservation wage is less than w.
  • Max. number of hires per period: �H(w) = A0 F(w).
  • Employment N; Quitting = qN
  • Steady state: A0 F(w) = qN

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Hiring = Quitting

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How a Parisian language school recruits teachers

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6.5 Managing hiring and quitting: The reservation wage curve

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  • Steady state: A0 F(w) = qN
  • Determines wage required for steady-state employment N.
  • We call this the firm’s reservation wage curve. It tells us:
    • The wage required to employ N workers, and
    • …the reservation wages of the firm’s employees.

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The second component: The labour discipline model

(First discuss effort, motivation, incomplete labour contracts, and the role of employment rents)

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  • Maria is employed at a wage of $12
  • Effort is costly for her, so her net utility while working is $10
  • Her next best option is to enter unemployment, where her utility while searching for a new job will be $6
  • She expects to take 44 weeks to find a new job.
  • She expects that her net utility while working in another job will be $9

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How much rent is she getting? What is her reservation wage?

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6.8 Counting the cost of job loss: Rents and reservation wages

  • Maria’s planning horizon is h weeks.
  • Wage w and effort cost c
  • Weekly utility while unemployed = b + αM
  • Average net utility in other jobs (wage – effort cost ) is v per week.
  • She expects that it will take j weeks to find another job.

 

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6.9 Getting employees to work hard: The labour discipline model

  • If Maria shirks she will lose her job after an average of s weeks

 

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6.10 Combining recruitment and labour discipline: �The wage-setting model

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How a Parisian language school recruits and motivates teachers

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6.10 Combining recruitment and labour discipline: �The wage-setting model

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6.11 Putting the wage setting model to work: Wages, employment, and the rate of unemployment

  • Involuntary unemployment

as well as

  • Search unemployment

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6.11 Putting the wage setting model to work: Wages, employment, and the rate of unemployment

  • Look at what shifts it … e.g. …
  • A fall in morale within the firm
  • or improved monitoring
  • or productivity in other firms

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  • The firm’s no-shirking wage curve is:

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6.11 Putting the wage setting model to work: Wages, employment, and the rate of unemployment