# Wage setting and price relationship status

### What determines the natural rate of unemployment | mnmeconomics

wage equation - W = PeF(u,z) expected price level - Pe, determines nominal wage cost (equal to 0 in perfectly competitive markets); in this simplified situation. The wage-setting curve, the price-setting curve, and the labour market Given the position of the demand curve, which indicates the level of . unemployment rate: The ratio of the number of the unemployed to the total labour force. The natural rate of unemployment is defined as the unemployment rate such that the real wage determined in wage-setting and price-setting.

A cut in the unemployment benefit would shift the best response function to the left. However that would mean that the equilibrium wage falls for a given unemployment rate, and lower the wage-setting curve.

An extended expected unemployment period would shift the best response function to the left, lowering the wage-setting curve. This reduces the equilibrium wage for a given unemployment rate, resulting in a lower wage-setting curve. With the balance of job seekers and vacancies shifting in favour of the workers, their best response function would shift to the right, resulting in the wage-setting curve moving upwards.

The amount produced depends on the amount that the firm is able to sell, which in turn depends on the price that it charges. Recall in our model they are human resources HRthe marketing department, and the production department PD. Remember this firm has only one input—labour—so the wage is the only cost. So the wage the firm pays W is the cost of a unit of output in the relevant currency unit. Note that W is the nominal wage and w is the real wage. The process is summarized in the table in Figure 9.

### Price and wage-setting in advanced Economies: takeaways from the ECB’s Sintra Forum

Once HR has set the wage at a level sufficient to motivate the workforce, the marketing department proceeds in two steps. So first, as in Unit 7, the marketing department asks: These combinations are shown by the demand curve, which will depend on the amounts that other firms are producing, the prices they are setting, the wages they are paying, and other influences on the total level of demand for goods in the economy.

Step two is to pick a point on the demand curve, so the marketing department looks at Figure 9. Using the value of W chosen by HR, the marketing department constructs the isoprofit curves shown.

Recall that each curve is the collection of all combinations of price and quantity that will yield the firm the same level of profit, given the wage. Curves further out from the origin higher price and quantity indicate higher profits. As in Unit 7, maximum profits occur at point B, where the demand curve is tangent to an isoprofit curve.

Notice from the figure that once the firm has set a price, it has determined the division of the total revenue between profits and wages. As you have seen from Unit 7, this is greater when the demand curve is less elastic, indicating less intense competition.

It will help in the next section to think about how the model explains what the firm would do if it found itself at a point like A.

The marketing department would see that the firm was making lower profits because the isoprofit curve at A is lower than at point B. The marketing department would then raise the price and inform the PD that it should produce less.

Similarly, if the firm were at point C, the marketing department would lower its price and the PD would get the message to produce more, to meet the higher sales at the lower price. Based on this information, which of the following statements is correct? Between points A and C, the firm would prefer point A as the output is higher.

If the firm finds itself producing at point C, it can increase its profit by selling more units at a lower price. This is therefore the slope of the isoprofit curve. Points A and C are on the same isoprofit curve. Therefore the firm would be indifferent between the two. The marketing department determines the price after HR determines the wage level. The profit-maximizing point is B, in which the firm produces more and charges less than at point C.

Wages and profits in the whole economy We have seen in Figure 9. The value of the real wage consistent with the markup does not depend on the level of employment in the economy, so it is shown as in Figure 9. Point B in Figures 9. If the real wage is too high, it means the markup is too low. Point B The firm will raise its price so as to move towards higher profits at point B. The increased price will mean that fewer goods are sold, and as this is true of all firms, total employment falls.

Point C Below the price-setting curve, at a point like C, firms lower their prices and hire more people. Given economy-wide demand, total profits are lower at A and C for firms facing the demand curve in Figure 9. Now think about point A in Figure 9. Follow the steps in Figure 9. The rise in price and the reduction in employment are indicated by the arrow at point A in Figure 9. It points down because the rise in prices implies a fall in the real wage, that is, the nominal wage divided by the price.

It points left because a price increase implies a fall in output and employment. Below the price-setting curve, at a point like C, firms lower prices and hire more people. What will determine the height of the price-setting curve? There are many influences once we consider the impact of public policies as we will see later in this unitbut two things have an important influence on the price-setting curve, even in the absence of government intervention: The intensity of competition in the economy determines the extent to which firms can charge a price that exceeds their costs, that is, the markup.

The less the competition, the greater the markup. Since this leads to higher prices across the whole economy, it implies lower real wages, pushing down the price-setting curve. For any given markup, the level of labour productivity—how much a worker produces in an hour—determines the real wage.

To understand more about the price-setting curve, read the Einstein at the end of this section. At point A, the markup is too high, and therefore the firm will raise its price. This leads to lower demand for the good and hence lower employment towards B. At point C, the real wage is too low and the markup is too high.

### Wage Rates and the Supply and Demand for Labour

Therefore the firm is able to increase profit by lowering prices and hiring more workers. Higher competition implies a lower price-setting curve. For any given markup, higher labour productivity implies a lower price-setting curve, which means a lower real wage.

At point A, the real wage is too high, which means that the markup is too low. The rest of the statement is correct. Point B is the profit-maximizing point. Therefore the firm is able to increase its profit by moving from C to B, by lowering its price which reduces the markup and increases the real wage and hiring more workers. Higher competition implies lower markup. This reduces the profit per worker. Since this leads to lower prices across the whole economy, it implies higher real wages, pushing up the price-setting curve.

Higher labour productivity means a higher average product of labour curve. For any given markup this means a higher price-setting curve, which means a higher real wage.

Einstein The price-setting curve There are several steps to show how the price-setting curve for the economy as a whole results from the decisions of individual firms.

## Wage-Setting, Price-Setting Relations

The firm pays the worker a wage W in dollars. Both labour productivity and wages can be measured per hour, per day or per year. The wealth effect of higher wages on leisure offsets the substitution effect. This explains why the enormous growth of per capita income in western countries during the last century has been accompanied by substantial declines in hours worked per week.

Figure 3 shows clearly the effect of an institutionally fixed minimum wage, whether imposed by the government or by union power, on aggregate employment in the economy. Unlike the case where wages are fixed in some sector of the economy, the labour displaced here by the minimum wage has nowhere to go to bid down wages to obtain employment.

Industrialized economies like those of Canada and the United States are less than one-third unionized. Minimum wages are in force but they are quite low and would displace only the most unskilled workers from employment.

Why then do we observe substantial unemployment in these economies from time to time? What is it that is keeping wages too high, and preventing workers from bidding them down?

This is the subject of our next three Topics. Before addressing it, however, there are two preliminary issues that must be dealt with.

First, we must recognize that even under the best conditions there will always be some amount of unemployment. Some people will be in the process of moving between jobs. Technological change inevitably leads to job losses in some areas of the economy and new jobs in other areas. It takes time for those displaced to relocate. Some degree of unemployment in the economy is thus inevitable and is not a signal that people who want jobs at current wages cannot find them. The normal level of this frictional unemployment is termed the natural rate of unemployment.

Frictional unemployment does not appear in Figure 3. Workers in the process of becoming informed are not part of the analysis.

The fact that frictional unemployment does not appear in Figure 3 and play a role in the determination of the equilibrium wage rate in the economy highlights the second issue that we must address. In other words, individual buyers and sellers have no influence on the market price.

Market prices are determined by all buyers and sellers together. But this raises a fundamental question. What is the process by which prices change? If every buyer and seller takes the price as given, there is no one in the market that performs the act of actually changing the price!

The supply and demand diagram assumes that prices get bid up and down while every market participant takes them as given. Indeed, it is as though there were an auctioneer in the background calling out prices to which suppliers and demanders respond. Such an auction mechanism can, in fact, be invoked to provide a rigorous basis for the analysis. But there are very few actual marketsmostly markets for stocks and bonds and commodities like wheat, gold, cattle and pork belliesin which auction mechanisms for setting prices exist.

These are markets for commodities whose quantities can be precisely defined and measured. Labour is not such a commodity. For most supply and demand analysis, including labour market analysis, the precise mechanism through which price changes occur is unimportantall that is required is that prices somehow adjust to equalize demand and supply.

When it comes to understanding the process by which workers find or fail to find jobs, however, the institutional details of wage adjustment become important. Essentially, the assumption that labour is a homogeneous commodity for which a unique market price exists must be abandoned and workers must be viewed as imperfect competitors, each selling a unique product to firms who are also imperfect competitors in labour markets, each offering a variety of unique jobs.