What is the significance of agents becoming price setters as opposed to price takers? In product markers now firms are setting the price pegged to elasticity of demand which is dependant partly due to the extent of competition. Labour markets now are wage setters. Trade unions are setting wages through collective bargaining, this will be dependent on level of current employment when the economy has high employment trade unions powers diminish as workers bargaining power is weak. When assuming price setting as opposed to price taking behaviour changes. We analyse macroeconomic phenomena such as inflation and unemployment differently.
What is the WS PS curve? The WS curve is wage settings; they are set by collective bargaining. The aggregate nominal wages are set by prices, workers don’t really care about their nominal wage they care about their real wage. Wages are set before prices so workers make the decision about what wage to claim, this is why we use the term expected price level. Conditions of the labour market after WS since workers have to bargain for their wages, if there is low unemployment they will have a lot of bargaining powers since firms are away there is a large pool of unemployed to choose from. The characteristics of the labour market will also affect it minimum wage and employment law rigidity.
Wage-Setting Real Wage Curve (WS)
Source; University of Ulster
The wage setting relationship tells us how nominal wages are determined. I will look at the three main factors expected price level, unemployment rate and institutional factors. The expected price level is part of wage bargaining as labour isn’t interest in only nominal wage, it’s interested in real wage. Labour bargains nominal wage to increase real wage, when labour bargains for this they aren’t sure what the price level is so it’s the expected price level. Let’s assume nominal wage is 200 and price level is 100 you can purchase two goods or services. If it changes to 120 you can no longer purchase as much. Then labour would bargain for an increase, so we can expect price and wages to both increase the two are conversely linked.
Unemployment influences the bargaining position of labour. The higher the unemployment level the lower the bargaining power. This is because if you lose your job it will difficult to find another job, from a firm’s position it’s easier to replace workers. Now you can expect a decrease in nominal wage, the same is true if unemployment is low you would expect the opposite to occur. Here are some institutional factors which may affect wages, minimum wage, reservation wage, unemployment, benefits, labour laws & regulations and collective bargaining
What is PS curve? This is price settings; as the wages have been set from collective bargaining the firms looks at what prices will be. There are two prices the mark up and production cost price. If firms only used labour to produce output this would be the production. The amount of output that is produced from one worker, firms look at the nominal cost of hiring him and how many units of output he will produce this is the relative cost of hiring someone. Firms do a cost benefit analysis when the relative costs are factored they now know how much they have to pay their workers so they set a price. If it was a perfect market the price would be equal to the costs but firms seek to make profits, in an imperfect market there is an additional cost this is the mark up price.
WS & PS Curve
Source; Oxford Journals
If the WS curve shifts downwards: workers will bargain for a lower wage ceteris paribus and therefore the wage-setting curve shifts down, if PS curve shifts downwards, the mark up rises, if PS curve Shifts downwards; the tax wedge rises, reducing the real wage for workers and if WS curve shifts downwards and lowering bargaining power of unions.
Theoretical Work
Interpreting the WS & PS curve;
WS: wages are determined by expected level of prices, factoring in unemployment and market conditions.
PS: Prices are determined by wages & the mark up price rate.
To find the structural rate of unemployment is found by setting P=Pe. This gives us the expected rate of unemployment in the long run. This is illustrated diagrammatically in figure below.
In the short run it can’t always be assumed that P= P e. If there are any shocks for example unexpected inflation occurs, this change to P≠Pe
The short run is now denoted as;
We now have two WS-PS equations, by subtracting the Long Run equation from the Short Run equation we are getting a relation between deviations from the equilibrium.
This is the basis leading to the underpinning of the Philips Curve theory.
When looking at the rational of the WS PS Curve it appears that capital formation affects the equilibrium unemployment rate. Two notions of equilibrium unemployment can be distinguished. The short-run NAIRU, when capital stock is taken as given, the long-run NAIRU when capital stock is endogenous. To maintain a constant short-run NAIRU, capital must grow fast enough to offset growth in the labour supply and the labour- augmenting bias in technical progress. If capital formation is inadequate, the short- run NAIRU will increase and the scope for demand stimulation will be limited by scarcity of capital. (Graham Hacche, 1999)
Why is equilibrium employment lower when wages are set at industry rather than at firm level? How would you expect this relationship to be affected, if at all, if the economy in question is open to international trade?
What effect has union density on the equilibrium rate of unemployment? Union strength whether it be the amount percentage of employers whose wages are covered by union wage agreements or union members, the greater it is the greater wage push factor it can apply. It’s commonly accepted the stronger the union which increases WS curve therefore raises the ERU.
There are more factors to consider when analysing the effect of union activity in wage setting. In the 1980’s an influential article was published. It argued that the relationship between wage bargaining and unemployment performance may not be monotonic but hump shaped. Economies with highly centralized and de-centralized wage bargaining would perform well, and those in the middle with only moderately centralized bargaining would perform worst. As illustrated below (Calmfors & Driffill, 2005)
Relationship between real wage & centralization
Source; Lars Calmfors & John Driffill, 1988
A binding minimum wage represents a price floor below which wages cannot fall. As a result, actual wages cannot move toward equilibrium. So a minimum wage causes the quantity of labour supplied to exceed the quantity of labour demanded. Because this surplus of labour reflects unemployed workers, it affects the unemployment rate. Collective bargaining has a similar effect—unions are able to raise the wage above the equilibrium level. This will act like a minimum wage by causing the number of job seekers to be larger than the number of workers firms are willing to hire. Collective bargaining causes the unemployment rate to be higher than it otherwise would be.
Industry level wage setting (in a model where the union sets the wage in a monopolistic way) can deliver a higher level of unemployment since the union can set higher wages because it believes that even if the prices for that industry’s products go up there is little substitutability between the industry’s products and other products and therefore the demand for that particular good will not be much affected. While a firm level union fears that the substitute between products with the same industry is high and too high wages/prices could drive the firm out of the market. These contrasting perceptions produce a higher WS curve in the case of industry level and wage setting than in firm level wage setting. Hence in equilibrium when wages and prices have been set, the level of employment consistent with constant inflation is higher in the case of firm level wage setting. In an open economy competition happens in the international arena, and therefore the above mentioned mechanism leading industry level unions to high wage claims will be weakened or eliminated. Hence the employment equilibria will be closer together in an open economy.
Wage setting in the insider outsider model is set on the assumption that wages are set with in regards with incumbent workers & little interest is given to the unemployed or non-union members. In non-union settings incumbent workers are likely to have bargaining power because of the fixed costs of hiring a new worker, and because of they can threaten to withhold effort. The differential importance of incumbent workers in wage setting decisions is exemplified by the reluctance of unions to accept two tier contracts. Their reluctance stems from fears that eventually wage decisions will come to be made not in the interests of current members but instead in the interests of new lower tier workers.(O.J Blanchard & L.H Summers, 1986)
Source; Oxford Journals
The WS PS curve above illustrates the converse relationship between price wage & price settings. The diagram shows cost push inflation as upward pressure on prices increases the costs of factors of production in turn increasing the real wage. A decrease in the level of competition leads to an increase in mark-up price. This would lead to an increase in the level of structural unemployment.
What effect has international trade on unions & the ERU?
International integration of economies would affect bargaining outcomes. They argued that openness of the economy would be likely to lower the hump. Greater international competition would reduce the ability of domestic industry unions to raise wages. At the same time the national price level would be less affected by the wage decisions of domestic unions.
Foreign competition tends generally to flatten the relationship between domestic bargaining coordination between and the real wage. There are two main reasons for this. Competition from abroad restricts the possibilities to raise output prices in response to domestic wage increases, which is particularly important for wage bargaining at industry level. Foreign trade weakens the incentive for wage restraints.
Collective Bargaining
Openness of the economy lowers the hump. Greater international competition would reduce the ability of domestic industry unions to raise wages.
Source; Calmfors, Lars, and John Driffill 1987
I: The effect of internalization of negative externalities
II: Hump- shaped relationship with small foreign trade
III: Hump-shaped relationship with large foreign trade
Conclusion
Let us suppose the W S-curve shifts up because union power is strengthen by a change in legislation. There is a new medium-run equilibrium at Z with higher employment and with inflation at the original rate: the supply-side shift lowers the ERU. The assumption that the P S-curve is flat means that the real wage in the new equilibrium is the same as it was originally. This is a rather striking result; higher union bargaining power means a higher ERU but unchanged real wage means unions are able to raise the wage above the equilibrium level. Thus this minimum wage causes the number of job seekers to be larger than the number of workers firms are willing to hire. Collective bargaining causes the unemployment rate to be higher than it otherwise would be.
The conclusion that an intermediate extent of centralisation (wage setting at the industry level) may produce worse macroeconomic outcomes than both very high and very low degrees of centralisation rests on the assumption that a substantial amount of competitive pressures for wage restraint is eliminated if domestic producers bargain together. The increase in market power will, however, be less; the more important is international competition, since foreign competitors are not encompassed by domestic wage increases. The hump will be lower the more international competition there is a flatter relationship between centralization & unemployment. Indeed, if domestic and foreign products are perfect substitutes, it would be impossible for domestic firms within a given sector in a small open economy to raise their relative price even if they co-operate In this case, the relationship between the extent of centralisation and the aggregate real wage degenerates into a horizontal line.
Bibliography
Graham Hacche , Unemployment, Capital-Labour Subsitution, and Economic Growth; IMF March 1999
Paul Krugman, Margaret Ray & Ray Anderson, Macroeconomics for AP, page 180-181 , University of Mary Washington, 2010
Ochel, Wolfgang, Decentralizing Wage Bargaining in Germany - A Way to Increase Employment?. Labour, Vol. 19, No. 1, pp. 91-121, March 2005
Olivier J.Blanchard & Lawrence H.Summers , Hysteresis in Unemployment, National Bearuea of Economic Research, October 1986
Lars Calmors & John Driffill , The Centralization of Wage Bargaining Revisited. What have we learned? University of London , November 2005
Calmfors, Lars, and John Driffill. "Centralization of wage bargaining and macroeconomic performance." (1987).