8.4.1A MODEL EXPLAINING THE NATURAL RATE OF UNEMPLOYMENT

Given the earlier definition of the natural rate of unemployment, several economic features help us to understand why some countries tend to have higher natural rates of unemployment (e.g. Spain, Italy, Greece) than others (USA, Austria, the Netherlands). Remember the natural rate is a long-run equilibrium rate. By appealing to analysis we have already conducted in the labour market and in terms of firms’ pricing behaviour we can develop a model to understand how the natural rate of unemployment comes about. (This section draws on the model presented in Miles and Scott, 2002, ch. 8).

We saw in Chapter 2 that real wages and the number of workers employed is determined as shown in the labour market model of labour demand and labour supply. We saw how firms’ demand for labour reflected the marginal revenue product of labour. We also saw in Chapters 4 and 6 that firms attempting to maximize profits, when facing downward sloping demand curves, can earn profits above the normal level once their cost curves lie below the demand curve. Wages represent a large portion of firms’ costs and we see that when supernormal profits are earned, firms earn more than required to pay for all their costs.

In thinking about how the natural rate of unemployment is determined, we assume here that firms over the long run set themselves rates of profit that they wish to earn expressed as mark-ups over their costs. The mark-up would depend on the line of business a firm is in, the mark-up targeted by competitors, the firm’s strategy (i.e. how it tries to compete in its chosen market, e.g. by offering lower prices or higher quality).

The profit margin, also called the price-cost margin, describes the mark-up over costs that a firm makes or wishes to make. Some firms will be happy to earn low mark-ups, other firms wish to earn high mark-ups.

In attempting to set prices for their output and generate a desired mark-up, when costs rise over time firms put pressure on the real wage rate to fall. Higher prices on average feed into lower real wages. Workers too can affect real wage rates. This happens most directly if we think about the role of labour unions in wage-setting negotiations if they try to use their bargaining power to increase wages for their members. Non-unionized workers can also exert an influence on real wage rates because employers generally wish to minimize the turnover rate of good staff because it is costly:

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•to have a post vacant since the post generates no revenue product of labour;

•to advertise, interview and train new staff.

The extent to which individual workers or unions try to negotiate higher nominal wages with their employers will vary with the unemployment level, as high rates of unemployment mean there is greater competition for available jobs and neither workers nor unions wish to price themselves out of a labour market which is characterized by high unemployment. This information is presented graphically in Figure 8.11.

The margin-setting curve (MSC) indicates the long-run real wage corresponding to firms’ average desired profit margins. This profit margin in the figure is assumed to be constant, hence the MSC is a horizontal line.

The real wage-setting (RWS) curve is downward sloping reflecting the tendency for workers and unions to link demands for real wage increases to the level of unemployment. The intersection of the MS and RWS curves determines the natural rate of unemployment.

The equilibrium position generated by this model indicates that there is one real wage rate that unions (and workers) are willing to accept that corresponds to what firms are willing to accept.

There is only one real wage rate and one level of unemployment where firms’ desired profit margins match the wages desired by unions and workers.

As we have seen earlier, the macroeconomy can be away from its long-run equilibrium position for certain periods. The model shown in Figure 8.11 can be used to consider what we can expect if the economy is out of its equilibrium position. We begin with an example where the natural rate of unemployment lies above the equilibrium level, as shown in Figure 8.12.

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With a rate of unemployment above the natural rate, demands for real wage levels by unions and workers are moderate at W1. With such moderate wage rates, firms can hire more workers so unemployment tends to move to its long-run natural rate. As the economy adjusts towards the natural rate, unions and workers wage demands will rise. Up until the natural rate, firms still have incentives to hire more workers to produce additional output (for which they perceive a demand). Although real wage rates rise from W1, as long as wage demands are below the equilibrium level, there is no pressure on the average price level so not only does unemployment fall in this case, but so too does inflation as the economy moves back to its equilibrium position.

Next we look to the opposite situation in Figure 8.13 where the economy begins in a disequilibrium situation initially with lower than natural unemployment and a higher than equilibrium real wage rate of W2. Workers and unions have high wage demands in this case as they are aware that firms have little choice in a limited

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labour market. With too high real wage demands, firms will start letting workers go because the costs are out of line with firms’ desired profit margins.

Firms might respond to the cost pressure by increasing their own output prices (in an attempt to cover high wage costs) to maintain their margins. Increasing unemployment will lead to lower wage demands and the wage rate declines from W2 towards equilibrium. Hence, in this case rising inflation and unemployment would be observed as the economy moved towards the long-run equilibrium position.

8.4.2CAUSES OF DIFFERENCES IN NATURAL RATES OF UNEMPLOYMENT

From the model shown in Figure 8.11, we can conclude that there are three determinants of the natural rate of unemployment. Each is considered below.

1.Firms’ desired margin – reflected in the height of the MS curve.

If firms set relatively high profit margins, this is associated with relatively high prices of goods implying lower real wages. The MS curve for firms setting high margins would, therefore, lie below those shown in Figures 8.12, 8.13 and 8.14 and would have the effects as shown in Figure 8.14.

We see from Figure 8.14 that higher desired margins by firms are associated with a lower real wage and a higher natural rate of unemployment. Higher margins imply higher prices of goods and we know from the law of demand that higher-priced output is demanded in relatively lower quantities by consumers. Lower quantities of output demanded by consumers require fewer workers to produce the output, so the end result is higher equilibrium unemployment.

2.The responsiveness of unions and workers wage demands to the level of unemployment – reflected in the position and slope of the RWS curve.

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3.The strength/negotiating power of labour unions – reflected in the share of unionized workers.

The strength and responsiveness of unions and workers wage demands to unemployment can be seen from the comparison presented in Figure 8.15.

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When unions and workers have a lot of bargaining power the real wage-setting curve lies above the curve for lower bargaining power. A relatively flatter real wagesetting curve (such as curve 2 in Figure 8.15) indicates a greater responsiveness of wage-setting behaviour to unemployment. The bargaining power of workers and unions is usually high when:

•The share of workers affected by unions’ negotiations is high. Many non-union members are still affected by the wage negotiations agreed by unions with other decision-makers.

•Unemployment benefits are high and long-term. This affects some individuals’ incentives to find new jobs. This explains a general tendency by countries to offer sliding scales of unemployment benefits that decline over time. Reasonable levels of benefits also increases the likelihood that workers will search out jobs best suited to their skills – maximizing their potential productivity. If the cost of becoming unemployed is low in the sense that the benefits are high, this can lead to high demands for wages by those in employment.

•The share of long-term unemployed is high. A high proportion of long-term unemployed signals that those individuals are not competitive in the job market – their skills may be out of date and this problem is exacerbated the longer an individual remains long-term unemployed and is outside the active labour force.

•There is substantial mismatch between labour demand in various locations within a region or between skills available and skills in demand.

•The tax wedge is high. When the tax wedge is high, unions and workers demand relatively higher real wage rates to compensate for higher taxes that must be paid.

Tax wedge: the difference between the real wage paid by an employee and the real wage received by an employee. Differences are accounted for by payroll taxes (usually related to social insurance/security contributions), income taxes, consumer price taxes.

8 . 5 C R O S S - C O U N T R Y D I F F E R E N C E S – I N F L A T I O N A N D U N E M P L O Y M E N T

The general pattern evident in international prices (Figure 8.9) is that consumer prices tend to move similarly internationally. This is largely explained by the substantial economic linkages between industrialized countries due to the size and nature of flows of traded goods and services, financial capital and people. Firms competing internationally are under pressure to keep abreast of ‘best practice’. Manufacturing firms attempt to source inputs from their most cost-effective location (as with outsourcing – see Chapter 5) and so similar pressures are extended on firms operating out of different locations. Consumers become aware of international availability of products through their own travel patterns and through the information increasingly available via the national and international media facilitated by information technology developments.

Greater disparity exists in terms of international unemployment rates, which is evident from publications such as the OECD Employment Outlook, the source of the data in Table 8.1. From the discussion of the determinants of the natural rate of unemployment, it is possible to identify ways of addressing a rate of natural unemployment, which is higher than desired by identifying its cause and by focusing policies, where possible, on

•reducing firms’ desired profit margins;

•reducing the strength/power of labour unions and workers in negotiating wage increases.

Governments do not generally enact laws governing the profit margins that firms are permitted to set because this goes against all economic arguments regarding the ability of the market system to bring about the most appropriate resource allocation by allowing most prices to be set freely within the functioning of markets. However, governments do keep a watchful eye on the conduct of firms in terms of whether firms follow pro-competitive or anti-competitive practices. If firms are setting high desired profit margins, this could only occur in practice on a sustained basis if there are some barriers to competition, as considered in Chapter 6.

A low-cost competitor producing a similar good to an incumbent can take over a market if they set a lower price for consumers. The extent to which goods are differentiated from each other in terms of the attributes of the goods or the levels of quality may create ‘switching costs’ for consumers to buy from one supplier than another. As long as entry to a market is easy, however, we would expect firms who identify profitable opportunities, as reflected in high profit levels, to have incentives to enter and compete in such markets. Competition would generally mean that more low-cost competitors would exist in markets and pass on benefits to consumers in the form of lower prices. Hence, governments focusing on addressing high profit margins in some sectors of the economy could focus on supporting increased competition in those markets by removing any obstacles to new entrants, where they exist. This might involve increasing licences where they are required to compete, as in the taxi market cited in Chapter 3.

To address the power of labour and workers in wage negotiations the process by which wages are negotiated appears important since collective wage-bargaining, as mentioned earlier, increases the likelihood that adverse unemployment effects of strong unions will be low. A set of policies known as active labour market policies (ALPS) is the term given to the various measures governments use to focus on increasing employment and reducing unemployment. Examples of ALPS include:

•increasing information on available vacancies via employment agencies, providing retraining and reskilling programmes;

•providing courses on filling application forms, presenting CVs and interview techniques;

•providing subsidies to firms that hire unemployed workers;

•providing financial and other supports to people wishing to start their own business.

Furthermore, given the reference to the tax wedge earlier, government policies that try to reduce the taxes that create large differences between wages paid and received would change incentives regarding the demand for and supply of labour.