Chapter 6. The Labor Market

I. Motivating Question How Is the Unemployment Rate Determined in the Medium Run?

In the medium run, the unemployment rate tends to return to the so-called natural rate, determined by equilibrium in the labor market when the expected price level equals the actual price level. Conditional on price level expectations, equilibrium in the labor market occurs when the real wage implied by wage-setting behavior (influenced by the relative bargaining power of workers and firms) equals the real wage implied by price-setting behavior (influenced by the degree of competition in the goods market).

II. Why the Answer Matters

The analytical framework in the text is built around equilibrium in three markets: goods, financial, and labor. Following the approach of Chapters 3 and 4, this chapter begins the discussion of the labor market by considering it in isolation. The assumption that isolates the labor market from the other markets is that the expected price level equals the actual price level. In these circumstances, the framework presented in the book produces an equilibrium rate of unemployment and an equilibrium real wage, independent of the goods and financial markets. Unlike the other markets, however, the labor market considered in isolation is relevant not to the short run but to the medium run, a time frame over which it is reasonable to assume that price expectations are correct. The task of Chapter 7, which discusses aggregate demand and aggregate supply, is to unite all three markets in general equilibrium, in both the short and medium run, and to consider the transition from the short run to the medium run.

III. Key Tools, Concepts, and Assumptions

1. Tools and Concepts

i. The chapter reviews the definition of key labor market terms introduced in Chapter 2 and introduces several new ones, including the nonemployment rate, discouraged workers, separations, layoffs, and quits.

ii. The chapter makes use of a production function.

iii. The chapter introduces wage-setting and price-setting relations.

iv. The chapter defines analytically the natural rate of unemployment and the natural level of output.

v. The chapter introduces the concept of an expected price level, the first expectation seen in the book.

2. Assumptions

i. The chapter assumes that labor is the only factor of production. The text maintains this assumption until Chapter 10, which introduces growth.

ii. The chapter assumes a constant returns to scale production function. This implies that, given fixed technology, the real wage is constant.

IV. Summary of the Material

1. A Tour of the Labor Market

The chapter begins by describing the U.S. labor market. The most important point is the discussion of flows in the labor market between the three states of labor market activity: employed, unemployed, and out of the labor force. The chapter notes that flows from out of the labor force into employment suggest that some individuals classified as out of the labor force may be discouraged workers, i.e., people who have given up looking for work, but who would take work if they were offered it. If this is the case, the unemployment rate underestimates the number of people available for work. Some economists prefer to use the nonemployment rate as a measure of the state of the labor market.