Difficulty: Intermediate | Prerequisites: IS-LM model (Chapter 5), basic supply and demand concepts.
The labor market is the third market in the macroeconomic model, alongside the goods market and the financial market. Unlike the other two, the labor market is characterised by persistent disequilibrium: unemployment exists even when wages and prices are at their "equilibrium" values. This chapter introduces how wages are determined (through bargaining power, not simple supply and demand), how firms set prices (using a mark-up over costs), and how the intersection of wage-setting and price-setting produces a "natural" rate of unemployment. Understanding this market is essential for connecting the short-run IS-LM world to medium-run models like AS-AD.
Wages are set by bargaining between workers and firms, influenced by unemployment, unionisation, and expected prices. Firms set prices as a mark-up over wage costs. Where the wage-setting and price-setting relations intersect, you get the natural rate of unemployment, the equilibrium real wage, and natural output.
Labor force (work force)
All persons who either have a job or are actively seeking one. In simple terms, it is the pool of people available for work.
Participation rate
The share of the working-age population (typically ages 15/18 to 65) that belongs to the labor force. A higher participation rate means more people are working or looking for work.
Unemployment rate (u)
The number of unemployed persons divided by the labor force. Measured as u = (L - N) / L, where L is the labor force and N is employment.
Nominal wage (W)
The wage expressed in money terms (the number on the payslip). In simple terms, it is what you are paid in currency.
Real wage (W/P)
The nominal wage divided by the price level. This measures purchasing power: what the wage can buy in goods. Workers care about the real wage, not the nominal one.
Reservation wage
The lowest wage at which an unemployed person is willing to accept a job. Below this, the fixed costs of working (commuting, clothing, discipline) make employment unattractive.
Efficiency wages
Wages set above the reservation wage or minimum wage, paid by firms to retain workers, reduce turnover costs, benefit from firm-specific training, and discourage shirking (poor effort). The idea is that workers' productivity depends positively on their pay.
Bargaining power
The ability of workers (or their unions) to negotiate wages above the minimum. Weakened by high unemployment (more competition for jobs) and strengthened by unionisation and unemployment insurance.
Wage function, W = Pᵉ F(u, z)
The equation describing how wages are set. Pᵉ is the expected price level, u is the unemployment rate, z is a catchall for other labor-market variables (unionisation, unemployment insurance, job turnover). F is decreasing in u (more unemployment weakens bargaining power).
Production function, Y = AN
Output (Y) equals labor productivity (A) times employment (N). A = Y/N tells you how much one worker produces.
Labor productivity (A)
Output per worker. Has increased enormously over the past century. The simplified model often sets A = 1.
Mark-up (μ)
The amount by which firms set prices above their wage costs. Reflects market power, or compensation for non-labor inputs (capital, energy, land). Price-setting: P = (1 + μ) W/A.
Natural unemployment rate (uₙ)
The unemployment rate at which wage-setting and price-setting are consistent. Not a constant of nature: it depends on the mark-up μ, unionisation, unemployment insurance, and other structural factors captured in z.
Natural output (Yₙ)
The level of output corresponding to the natural unemployment rate. Determined implicitly by F(1 - Yₙ/L, z) = 1/(1 + μ) when A = 1.
The labor market differs from the goods and financial markets in a crucial way: the roles of households and firms are reversed.
In goods/financial markets: firms and the central bank supply, households demand.
In the labor market: households supply labor, firms (and government) demand it.
The labor market tends toward persistent disequilibrium. Unemployment exists even when the economy is functioning normally, unlike goods markets (where inventories adjust) and financial markets (which clear quickly).
Labor force = employed + unemployed (those actively seeking work).
Dependent labor force = total labor force minus self-employed workers.
Unemployment rate = unemployed / labor force.
Unemployment is a stock (a number at a point in time), but behind it sits a flow: people entering and leaving unemployment each month. In Austria, roughly 40,000 to 50,000 people flow in or out of unemployment monthly against a stock of around 200,000.
Wages are not set by a simple supply-demand intersection. They emerge from bargaining between workers and firms.
The wage function captures this:
W = Pᵉ · F(u, z)
Pᵉ = expected price level. Workers bargain over real purchasing power, not nominal amounts.
u = unemployment rate. Higher unemployment weakens workers' bargaining position, so F is decreasing in u.
z = catchall variable for everything else that affects bargaining: unionisation, unemployment insurance, labour-market fluctuation (high turnover reduces the fear of joblessness even at high u).
Because wages are fixed in negotiations for extended periods (not continuously renegotiated), W/Pᵉ is the expected real wage that matters.
Even with a homogeneous workforce, firms often pay more than the reservation wage or the legal minimum. Reasons include:
Retaining workers and avoiding search costs.
Benefiting from firm-specific training (losing a trained worker is costly).
Preventing shirking (poor effort, low morale).
These above-minimum wages are called efficiency wages. The core idea is that productivity depends positively on the wage paid.
The simple production function used here is Y = AN, where A is labor productivity and N is employment.
A = Y/N measures how much output one worker produces. Over the past century, A has risen dramatically.
For simplicity, the model often sets A = 1, meaning one worker produces one unit of output.
Under perfect competition, wages equal the marginal product of labor: W = AP, or equivalently W/P = A (the real wage equals productivity).
In practice, firms have market power and set prices above marginal cost by adding a mark-up μ:
P = (1 + μ) · W/A
With A = 1: P = (1 + μ) · W
The mark-up μ reflects market power, or can be seen as compensation for non-labor inputs (capital, energy, land).
Rearranging the price equation gives the real wage implied by price-setting:
W/P = A / (1 + μ)
With A = 1: W/P = 1 / (1 + μ)
This is a horizontal line in a (u, W/P) diagram. It does not depend on the unemployment rate (because the simple production function has constant returns to scale).
In principle, this is a labor demand function, but it appears flat due to the simple production function.
Setting P = Pᵉ (price expectations are correct, which holds in the medium run), the wage equation becomes:
W/P = F(u, z)
This is a downward-sloping curve in the (u, W/P) diagram: higher unemployment weakens bargaining power and lowers the real wage workers can negotiate.
In essence, this is a labor supply function drawn with u on the x-axis (so it appears negatively sloped instead of positively sloped).
The intersection of the wage-setting curve and the price-setting line determines:
The equilibrium real wage (W/P).
The natural unemployment rate (uₙ).
uₙ is called "natural" but is not a constant of nature. It depends on μ (market power), z (unions, insurance), and the technology.
Even at equilibrium, unemployment exists. The labor market does not "clear" in the traditional sense.
Natural employment: Nₙ = L(1 - uₙ)
Natural output: Yₙ = A · Nₙ. With A = 1, Yₙ is determined implicitly by F(1 - Yₙ/L, z) = 1/(1 + μ).
Higher A raises the real wage firms are willing to pay (the price-setting line shifts up).
If the wage-setting function F(u, z) stays fixed, unemployment would fall and the real wage would rise.
However, workers are likely to demand a share of the productivity gains, shifting F upward as well. In that case, uₙ may return to its original level.
The model does not force a particular answer here, because F is introduced as bargaining power rather than a standard labor supply function.
Wage-setting relation:
W = P^e \cdot F(u,\, z)Production function:
Y = ANPrice-setting relation (general):
P = (1 + \mu)\, \frac{W}{A}Price-setting relation (A = 1):
P = (1 + \mu)\, WEquilibrium real wage from price-setting:
\frac{W}{P} = \frac{A}{1 + \mu}Equilibrium real wage from wage-setting (P = Pᵉ):
\frac{W}{P} = F(u,\, z)Natural employment:
N_n = L(1 - u_n)Natural output (A = 1):
F\!\left(1 - \frac{Y_n}{L},\, z\right) = \frac{1}{1 + \mu}The efficiency wage concept explains a puzzle visible in most labour markets: workers in some industries are paid more than workers with comparable qualifications in other industries. If productivity depends on wages, firms have a rational reason to pay above the market-clearing rate.
The natural rate of unemployment framework underpins much of modern central banking. When policymakers talk about "full employment" or the economy being "at potential," they are referring to output and unemployment at (or near) the natural rate. Structural reforms (changes to unemployment insurance, union regulation, competition policy) work through z and μ to shift the natural rate itself.
Students often think the natural rate of unemployment means "the right" or "optimal" level of unemployment. It does not. It is simply the rate consistent with stable wages and prices, and it can be inefficiently high.
A common error is to treat the wage-setting curve as a standard labor supply curve. It represents bargaining power, not workers' preferences over leisure and income. The distinction matters when analysing how productivity changes affect uₙ.
Students sometimes confuse nominal and real wages. Workers bargain based on expected real wages (W/Pᵉ), not the nominal number. Inflation can erode gains in W without any change in bargaining.
The mark-up μ is sometimes treated as pure profit. It also covers compensation for non-labor inputs like capital, energy, and land.
⚠️ Be able to draw and explain the (u, W/P) diagram with the wage-setting curve (downward-sloping) and the price-setting line (horizontal with A = 1). Know what determines each and where they intersect.
⚠️ Know how to derive the price-setting real wage W/P = A/(1 + μ) from the production function and the mark-up.
⚠️ Understand what shifts the wage-setting curve (changes in z: unionisation, unemployment insurance, labour-market turnover) and what shifts the price-setting line (changes in μ or A).
⚠️ The question of whether productivity growth (higher A) reduces the natural unemployment rate is a classic exam discussion question. You need to explain both sides: the price-setting line rises, but the wage-setting curve may also shift if workers demand a share of productivity gains.
⚠️ Be clear on the difference between short-run disequilibrium (unemployment can be above or below uₙ) and medium-run equilibrium (the economy tends toward uₙ).
True or false: in the labor market, firms supply and households demand.
Fill in the blank: the wage function W = Pᵉ F(u, z) is decreasing in ____ because higher values weaken workers' bargaining power.
True or false: the natural unemployment rate is zero.
Fill in the blank: the mark-up μ is the amount by which firms set prices ____ their wage costs.
True or false: efficiency wages are wages set below the reservation wage to minimise costs.
Answers: 1. False (households supply labor, firms demand it). 2. u (the unemployment rate). 3. False (it is positive, even at equilibrium). 4. Above. 5. False (efficiency wages are set above the reservation wage to boost productivity and retention).
Q: What are the three reasons firms pay efficiency wages, and what problem does each address?
A: Firms pay above-minimum wages to (1) retain workers and avoid search/hiring costs, (2) benefit from firm-specific training that would be lost if the worker left, and (3) prevent shirking (poor effort and low morale). Each reason ties the wage to a productivity gain the firm captures.
Q: In a (u, W/P) diagram, explain why the wage-setting curve slopes downward while the price-setting line is horizontal.
A: The wage-setting curve slopes downward because higher unemployment (u) weakens workers' bargaining power, so the real wage they can negotiate (W/P = F(u, z)) falls as u rises. The price-setting line is horizontal because the simple production function Y = N (with A = 1) has constant returns to scale, making the real wage implied by price-setting (W/P = 1/(1 + μ)) independent of u.
Q: Explain how an increase in the mark-up μ affects the natural unemployment rate.
A: A higher μ lowers the price-setting real wage: W/P = 1/(1 + μ) falls, shifting the horizontal price-setting line downward. The wage-setting curve does not move. The new intersection occurs at a higher unemployment rate uₙ. In short, greater market power by firms compresses the real wage, and equilibrium requires higher unemployment to weaken bargaining enough for workers to accept the lower real wage.
Q: Why do workers care about the expected price level Pᵉ rather than the current price level P when bargaining over wages?
A: Wages are set in negotiations that cover a future period (months or years). Workers want to protect their purchasing power over that period, so they base their demands on what they expect prices to be, not what prices are at the moment of negotiation. If Pᵉ turns out to be wrong, the actual real wage W/P will differ from what workers bargained for.
Q: Could an increase in labor productivity (A) reduce the natural rate of unemployment? Under what conditions?
A: Higher A raises the real wage firms are willing to pay (the price-setting line shifts up). If the wage-setting function F(u, z) does not change, the intersection moves to a lower uₙ. However, if workers adjust their wage demands upward to claim a share of the productivity gain (shifting the wage-setting curve up), uₙ may not fall, or may return to its previous level. The outcome depends on whether productivity gains feed into bargaining expectations.
The labor market completes the three-market macro model. Combined with the IS-LM framework (Chapter 5), it provides the supply side needed for the AS-AD (Aggregate Supply, Aggregate Demand) model covered in later chapters. The natural rate of unemployment maps to a natural level of output, which becomes the anchor for the medium-run AS curve.
The wage-setting and price-setting framework also connects to inflation theory: when actual unemployment deviates from the natural rate, price expectations are not met, and inflation accelerates or decelerates.
Labor market, unemployment rate, natural rate of unemployment, natural output, NAIRU, wage setting, price setting, mark-up pricing, production function, labor productivity, efficiency wages, reservation wage, bargaining power, unionisation, participation rate, labor force, real wage, nominal wage, Blanchard macroeconomics, AS-AD model, medium run, wage function, catchall variable z