UNIVERSITY COLLEGE LONDON
DEPARTMENT OF ECONOMICS
Economics BSc (Econ)
First Year – Term 2
ECONOMICS
ECON0002
Rodrigo Antón García
rodrigo.garcia.20@ucl.ac.uk
London, 2021
, Contents
Topic 9 – The labour market: wages, profits and unemployment. 1
Topic 10 – Banks, money and the credit market. 29
Topic 13 – Economic fluctuations and unemployment. 60
Topic 14 – Unemployment and fiscal policy. 77
Topic 15 – Inflation, unemployment, and monetary policy. 101
Topic 16 – Technological progress, employment, and living standards in the long
run. 123
Topic 17 – Capstone: The Great Depression, Golden Age, and Global Financial
Crisis. 143
Topic 19 – Capstone: Economic Inequality. 171
,Economics – ECON0002 Rodrigo Antón García
ECON0002: ECONOMICS SUMMARY – TERM 2
Topic 9 – The Labour Market: wages, profits and unemployment.
How the economy-wide market for labour determines wages, employment and the
distribution of income.
• The labour market functions quite differently from the bread market described in
the previous unit because firms cannot purchase the work of employees directly but only
hire their time.
• As we saw in Unit 6, the principal–agent model is used to explain the conflict of
interest between the employer and the employee over how hard the worker - works, and
why this issue cannot be resolved by a contract.
• The outcome of the wage-setting process across all firms in the economy is the
wage-setting curve, which shows the wage associated with each unemployment rate.
• The prices that firms charge for their products are influenced by the demand for
their goods and the cost of labour, the wage.
• The outcome of the price-setting process across all firms is the price-setting curve,
which gives the value of the real wage that is consistent with a firm’s profit-maximizing
mark-up over production costs.
• Excess supply of labour (involuntary unemployment) is a feature of labour
markets, even in equilibrium.
• If economy-wide demand for goods and services is too low, unemployment will
be higher than its equilibrium level and may persist.
• Unions and public policies can affect labour market equilibrium.
In this unit, we describe how the labour market works and why even in equilibrium, the
supply of labour (number of people seeking jobs) exceeds the demand for labour
(number of jobs offered). Those without work in this situation are termed the involuntary
unemployed (to distinguish them from those who are unemployed by choice, but are
looking for a job).
Involuntary unemployment: the state of being out of work, but preferring to have a job at
the wages and working conditions that otherwise identical employed workers have.
o Topic 9.1 – The wage-setting curve, the price-setting curve, and the labour
market.
We consider the simple case in which the only input to production is labour, so that the
only cost is the wage, and profits are determined by just three things: the nominal wage
(the actual amount received in a particular currency), the price at which the firm sells its
goods, and the average output produced by a worker in an hour.
Nominal wage: the actual amount received in payment for work, in a particular currency.
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,Economics – ECON0002 Rodrigo Antón García
- The Labour Market.
The labour market brings together two earlier themes: the firm and its employees (Unit
6) and the firm and its customers (Unit 7).
- Firms and employees (wage-setting):
In order to motivate employees to work hard and well, firms must set the wage sufficiently
high so that the worker receives an employment rent.
- This means there is a cost of job loss: he is better off being employed than being
fired due to inadequate effort. As a result, if the worker is very likely to find alternative
work if he is fired, which will be the case if the employment level in the economy is high,
he will need a higher wage to work hard.
Think of wage-setting as the business of the human resources (HR) department of the
firm.
- Firms and customers (price-setting):
In setting the price of the good they sell, firms face a trade-off between selling more
goods and setting a higher price, due to the demand curve they face.
- To determine the price to set, the firm finds the mark-up over their production cost
that balances the gains from a higher price against the losses from lower sales so as to
maximize its profits. This profit-maximizing mark-up determines the division of the firm’s
revenues between profits and wages.
Think of price-setting as the business of the marketing department of the firm.
- Wages and Employment.
We want to know how the real wage and the level of employment in the economy as a
whole are determined. Keep in mind that the real wage is the nominal wage divided by
the price level of a standard bundle of consumer goods, so it is determined both by the
nominal wages paid by the firms and the prices they each set.
Real wage: the nominal wage, adjusted to take account of changes in prices between
different time periods (adjusted for inflation).
We can think about this in two stages:
- First, each firm decides what wage to pay, what price to charge for its products,
and how many people to hire.
- Then, adding up all of these decisions across all firms gives the total employment
in the economy and the real wage.
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Here is how the first stage (choosing the wage, price, and employment) takes place in
each firm:
- The human resources department determines the lowest wage it can pay: It must
not undermine the workers’ motivation to work, and its decision is based on the prices of
other firms’ products, the wages the other firms are paying, and the unemployment rate
in the economy. This is the nominal wage set by the firm. It communicates this
information to the marketing department.
- The marketing department sets the price: This is based on the firm’s nominal
wage and the shape and position of the demand curve facing the firm. For example, if
the demand curve is elastic, indicating a high level of competition from other firms, it will
set a lower price. Setting the price is the same thing as fixing the size of the mark-up
over the cost of hiring labour.
Given the position of the demand curve, which indicates the level of economy-
wide demand, the marketing department then determines the amount of output the firm
will sell. It communicates this information to the production department (PD).
- The production department calculates the number of employees required: The
production department then calculates how many employees have to be hired to produce
the output determined by the marketing department, based on the firm’s production
function.
The second stage, considering the outcome of all the firms’ decisions added together, is
more complicated. But the key idea is simple.
Once all firms in the economy have made their wage and price (mark-up) decisions, the
output per worker in the economy is divided into the real wage that a worker receives,
and the real profits that the owner receives. If all firms are charging the same price and
setting the same nominal wage, then a higher real wage (!/#) means a lower markup
(1 − (!/#)).
To understand how the real wage and employment are jointly determined in the labour
market, we need two basic concepts:
- The wage-setting curve: this gives the real wage necessary at each level of
economy-wide employment to provide workers with incentives to work hard and well.
- The price-setting curve: this gives the real wage paid when firms choose their
profit-maximizing price.
Wage-setting curve: the curve that gives the real wage necessary at each level of
economy-wide employment to provide workers with incentives to work hard and well.
Price-setting curve: the curve that gives the real wage paid when firms choose their
profit-maximizing price.
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o Topic 9.2 – Measuring the economy: employment and unemployment.
According to the standardized definition of the International Labour Organization (ILO),
the unemployed are the people who (willing and able but can’t find a job):
- were without work during a reference period (usually four weeks), which means
they were not in paid employment or self-employment.
- were available for work.
- were seeking work, which means they had taken specific steps in that period to
seek paid employment or self-employment.
The following figure provides an overview of the labour market and shows how these
components fit together.
Population of working age: a statistical convention, which in many countries is all people
aged between 15 and 64 years. It is divided into two parts: the labour force and those
out of the labour force (known as inactive).
Labour force: the number of people in the population of working age who are, or wish to
be, in work outside the household. They are either employed (including self-employed)
or unemployed. Only members of the labour force can be considered as employed or
unemployed.
People out of the labour force are not employed or actively looking for work, for example,
people unable to work due to sickness or disability, or parents who stay at home to raise
children.
There are a number of statistics that are useful for evaluating labour market performance
in a country and for comparing labour markets across countries. The statistics depend
on the relative sizes of the boxes shown in the figure above.
Participation rate: the ratio of the number of people in the labour force to the population
of working age. This shows the proportion of the working age population that is in the
labour force. It is calculated as follows:
3*4/5+ 6/+.1 1:)3/;1< + 501:)3/;1<
)*+,-.-)*,-/0 +*,1 = =
)/)53*,-/0 /6 7/+8-09 *91 )/)53*,-/0 /6 7/+8-09 *91
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,Economics – ECON0002 Rodrigo Antón García
Unemployment rate: the ratio of the number of the unemployed to the total labour force.
This shows the proportion of the labour force that is unemployed. It is calculated as
follows:
501:)3/;1<
501:)3/;:10, +*,1 =
3*4/5+ 6/+.1
Employment rate: the ratio of the number of employed to the population of working age.
This which shows the proportion of the population of working age that are in paid work
or self-employed. It is calculated as follows:
1:)3/;1<
1:)3/;:10, +*,1 =
)/)53*,-/0 /6 7/+8-09 *91
Note that the employment rate and unemployment rate do not sum to 100%, as they
have different denominators. Hence, two countries with the same unemployment rate
can differ in their employment rates if one has a high participation rate and the other has
a low one.
- Low-unemployment, high-employment economy ! Scandinavian countries:
Norway, Sweden, Denmark, and Finland.
- High-unemployment, low-employment economy ! Southern European countries:
Spain, Portugal, Italy, Greece, etc.
- Low-unemployment, Low-employment economy ! South Korea.
o Topic 9.3 – The wage-setting curve: employment and real wages.
We now build a model of the labour market that can help to explain differences in
unemployment rates across countries, and changes over time within a country. To do
this, we broaden the perspective from the single firm in Unit 6 to the whole economy,
and we ask how changes in the unemployment rate affect the wage set by employers.
In the next figure, the horizontal axis represents the proportion of the working-age
population, and goes up to a value of 1. The vertical axis is the economy-wide wage.
- The labour force is the vertical line furthest to the right: it has a value less than 1,
depending on the participation rate.
- Inactive workers are to the right of the labour force line.
- The employment rate is the vertical
line to the left of the labour force, indicating the
share of the population who are actually
working.
- The unemployment rate is the
proportion of those in the labour force who are
not employed: that is, those workers in
between the employment rate line and the
labour force line.
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, Economics – ECON0002 Rodrigo Antón García
- The profit-maximizing wage is low when unemployment is high – At 12%
unemployment in the economy, the employee’s reservation wage is low and the worker
will put in a high level of effort for a relatively low wage. The firm’s profit-maximizing wage
is therefore low.
- The profit-maximizing wage is high when unemployment is low – At 5%
unemployment in the economy, the employee’s reservation wage is high and they will
not put in much effort unless the wage is high. The firm’s profit-maximizing wage is
therefore higher.
The upward-sloping line is called the wage-setting curve. At the employment rate x, the
wage w is the result of both employers and employees doing the best they can in setting
wages and responding to the wage with a given amount of effort, respectively.
This statement is true because the wage-setting curve for the whole economy is based
directly on the employer’s wage-setting decision and the employee’s effort decision in
an economy that is composed of many firms like the one we modelled in Unit 6.
- We show how to do this in the next figure by bringing together the figure above
(the economy-wide wage-setting curve) and the figure in 6.6 (how the firm sets the wage).
The top panel of this figure shows the
employee’s best response curve at the two
unemployment rates of 12% and 5%. As
we saw in Unit 6, a higher unemployment
rate reduces the reservation wage,
because a worker faces a longer expected
period of unemployment if he or she loses
a job. This weakens the employees’
bargaining power and shifts the best
response curve to the left. With an
unemployment rate of 12%, the
reservation wage is shown by point F. The
employer’s profit-maximizing choice is
point A with the low wage (wL).
In the lower panel, we plot point A in the
wage-setting curve. The dashed line from
unemployment of 12% indicates that the
wage is set at wL. We now assume a fixed
size for the labour force and the horizontal
axis gives the number of workers
employed, N. As employment increases to
the right, the unemployment rate falls.
Using exactly the same reasoning, we find the profit-maximizing wage set when
unemployment is much lower at 5%. Both the reservation wage and the wage set by the
employer are higher, as shown by point B. This gives the second point on the wage-
setting curve in the lower panel.
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