What are some key definitions related to the labor market? - Chapter 1


The macro-labor literature has developed in between the mid-1990s and the Great Recession. Differences in labor market institutions were seen as the main reason for cross-country differences of unemployment changes resulting from changes in output. The literature focused on transatlantic comparisons of employment and unemployment.

The Organisation for Economic Co-operation and Development (OECD) report attempts to explain employment and unemployment performance of Europe versus the U.S. The main result of this report was that there are institutional rigidities in Europe, which are not in the U.S. Because of these rigidities the labor market does not create as many jobs in the private sector as it does in the U.S.

Especially strict employment protection is responsible for the different shocks in Europe and de U.S. To fully understand these differences one should look further than the cross-country analysis. One should get to know more about the national labor market institutions. Another thing to look at is the nature of the shocks that led to a fall in output in the Great Recession.

From the Great Recession we have learned that labor market institutions are very important. To understand their impact on the labor market one should understand how these institutions work.

Some key definitions

labor market: a market where a quantity of labor services, L, is offered in exchange for a price or remuneration, called wage w.

According to the OECD-International Labour Organization (ILO) definitions, the entire working population can be divided into three labor market states:

  1. An employed individual: someone in the armed forces or who has worked for pay for at least 1 hour during the reference period or has a formal attachment to a job but is currently not at work (because of for instance a holiday).

  2. An unemployed individual: someone who satisfies the following criteria:

  • Currently not working

  • Looked for work in 4 weeks before survey

  • Actively looking for a job

  • Willing to work

  • Immediately available for work

  1. An inactive individual: someone who is neither employed nor unemployed. This residual group consists of people who are voluntarily inactive and people who are disabled.

In the field of labour economics we use U for the number of unemployed workers, L for the number of employed workers and O for inactivity. With these variables we can measure several things:

  • Labor force (LF) = L + U

  • Working-age populations (N) = LF + O

  • Unemployment rate (u) = U/LF

  • Employment rate (e) = L/N

  • Participation rate (p) = LF/N

  • Together this leads to the following: e = p(1-u)

The steady state equilibrium is reached when inflows into and outflows from unemployment are equal; the labor force is fixed. This equilibrium can be defined as:

δL = μU

In this formula δ measures the rate at which workers lose their jobs and μ is the rate at which unemployed workers find jobs. From this we can derive that:

u = δ / (μ + δ)

The value of a job, y, is the value of the labor product obtained when a firm and a worker engage in production. It can be seen as the revenue from a job; the quantity and price of the output produced by the job. We often use the marginal product of labor. This is the price of the good multiplied by the increase in output made possible by hiring an additional worker.

The worker’s reservation wage, wr, is the lowest wage at which the worker is willing to accept a job offer. The worker’s surplus is the difference between the actual wage and the reservation wage. It is given by w – wr.

The firm’s surplus is the difference between the value of a job and it costs (the wages paid). It is given by y – w.

The total surplus from a job is the sum of the firm’s and worker’s surplus. It is given by:

(y – w) + (w – wr) = y - wr

We can distinct between a perfectly competitive market and an imperfect market:

  • perfect labor market is a market where there is no total surplus associated with the marginal job. In other words, in this market y = w and w = wr. This leads to the fact that y = wr. Employers and workers are indifferent between continuing or terminating a job relation. This market is a transparent market, both parties are perfectly informed. There are also no frictions or costs involved in matching labor supply and demand.

  • An imperfect labor market is a market where there are rents associated with every job. This means that the surplus is positive. These imperfect markets are characterized by labor market institutions. In such a market wage setting is very important. Job destruction is a big deal for at least for one of the parties involved. In this market there are frictions, informational asymmetries and market power.

labor market institution is a system of laws, norms or conventions resulting from a collective choice and providing constraints or incentives that alter individual choices over labor and pay. These institutions create a wedge between the value of the job for the firm and the worker’s reservation wage. In other words; they can create rents. If y < wr for all jobs in a market, then the labor market cannot operate.

The reservation wage

For individuals to participate in the labor market their reservation wage must be lower than the wage offered in the market. An individual’s utility function is defined by:

U (c,l) where c stands for consumption and l stands for leisure.

The budget constraint is given by:

m + wh

Where m stands for nonlabor income, w stands for the wage and h stands for working hours.

When m=0, the budget constraint is a straight line crossing the horizontal axis.

The utility function can graphically be seen as a set of indifference curves. Each curve represents a combination of leisure and consumption that yield the same utility level. The slope of the indifference curve is given by wr.

A wage lower than the reservation wage will not be accepted by the worker. When w > wr the worker is willing to work some hours and devotes the rest of its time to leisure.

When there are no constraints on the choice of hours then the reservation wage is given by:

wr = (Ul / Uc)

Where Uand Uc stand for the marginal utility of leisure and consumption respectively. When an individual is free to choose how many hours to work then the following holds:

U (m + wrft hft, I0 – hft) = U (m, l0)

The worker has no choice how many hours to work and can only choose to work hft corresponding to the hours of a full-time job. The individual is indifferent between working exactly hft hours and not working at all. The reservation wage of an individual with a constraint is higher than for an individual with no constraint. In other words wrft > wr.

When the wage increases more people will enter the labor market and thus labor supply will increase. The effect of an increase in the wage is ambiguous, it has two opposite effects:

  1. The income effect: if the wage goes up then income goes up. With leisure as a normal good, individuals will buy more leisure and thus the amount of working hours will be reduced.

  2. The Substitution effect: if the wage goes up, the price of leisure increases. Consumption of leisure will decrease and the amount of working hours will increase.

The substitution effect dominates for people with a low wage and the income effect dominates for people with a high wage. If leisure is an inferior good then the two effects will reinforce each other.

The reservation wage differs across individual workers. Some may need a higher reservation wage because of their private situation. We use G (w) to denote the fraction of individuals or working age with a reservation wage equal to or lower than w. If we multiply G by the number of persons of working age we obtain the aggregate labor supply schedule. G will increase when the wage w increases.

Suppose that capital is fixed in the short run so there is no possibility to substitute labor with capital. From the point of the firm there is only one type of worker. This means that labor is homogeneous. The firm will hire people up to the point where the value of the marginal job is equal to the marginal cost; y = w.

At the equilibrium, all firms will have the same y. The aggregate demand denotes the sum of all jobs at the equilibrium y. We can say that y shows the marginal willingness to pay or the inverse labor demand schedule y (L). We set y (L) = w and then solve for L. This will give us Ld (w). The labor demand declines when the wage increases.

In a perfect labor market the equilibrium is found where demand equals supply. This leads to the wage level w* and to the labor level L*. Workers with a reservation wage below w* will enjoy a positive surplus from participating in the labor market. The sum of all these individual surpluses is the area Ws.

Firms will also benefit. Their profits are reflected in the surplus equal to the area Fs. Workers with a reservation wage above w* will decide not to work. We can say that L* = G (w*) will be the employment rate. The equilibrium nonemployment rate will be equal to 1 – G (w*).

There can also be a labor market with a flat segment. This means that there are workers with wr = w* that are not willing to work. These workers are unemployed and are shown by the segment U. One can see this in the graph below. All other nonemployed individuals are inactive.

Labor market institutions

Labor market institutions create a wedge between labor supply and labor demand. An example of such an institution is a minimum wage. A minimum wage changes the slope of the labor supply curve. This prevents the firm from hiring workers at a wage below the minimum wage. The labor supply curve will make an upward shift.

The difference between the labor supply and the labor demand reflects unemployed individuals. Thus the minimum wage creates a wedge between supply and demand.

Another institution is a tax on labor. A tax on labor reduces both supply and demand of labor. This means that there is less employment and participation. The revenues of labor taxes are often used to finance retirement plans, family allowances and UBs. All the nonemployment benefits shift the supply curve up resulting in a reduction of the size of the labor market.

Most institutions like minimum wages, taxes and trade unions operate especially on the price of labor. Others operate on the quantity of labor. Such institutions create wedge indirectly because the effective labor supply faced by employers differs from the cumulative distribution of individuals’ reservation wages.

Examples of institutions operating on quantity are working hour regulations and immigration restrictions. They cut away a segment of labor supply to the left of w*. Such restrictions shift the supply curve up. This leads to a new equilibrium with higher wages and with lower employment. This is the same effect as we saw with institutions that act on prices.

Another quantity restriction is employment protection legislation (EPL). This legalization makes it costly for a firm to adjust its number of workers to shocks. It involves taxes and transfers to workers that are only paid in case of dismissal. An EPL reduces firms’ incentives to shed labor. It indirectly affects employment by giving more power to trade unions in wage bargaining. This leads to higher wage and lower aggregate employment. Thus EPL negatively affects employment.

In all OECD countries there are clusters of institutions. Each different cluster involves different labor market outcomes.

Three arguments for the existence of labor market institutions:

  1. Efficiency

There are market imperfections that prevent the market from reaching the competitive equilibrium outcome. Labor market institutions may remedy these failures of the market.

  1. Equity

In the absence of nondistortionary taxes and transfers, these institutions are best suited to achieve some redistribution that is supported by voters.

  1. Policy failures

There are failures in politics that make it possible for a powerful minority to impose institutions on a majority of citizens. Groups organized as a lobby may succeed in influencing political decisions disproportionately.

We consider four indicators of institutions:

  1. The index of strictness of EPL.

  2. The summary generosity measure of UBs.

  3. The ratio of active labor market policy (ALMP).

  4. The total tax wedge on low wages.

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