Unemployment
Large Variations in Labor per
Person (www.ggdc.net)
Hours per Worker 2001
Taiwan
South Korea
Singapore
Hong Kong
Japan
USA
EU
0
500
1,000
1,500
2,000
2,500
3,000
Variation in Labor Force
Participaton
Employment as a share of Population
52.00%
50.00%
48.00%
46.00%
44.00%
42.00%
40.00%
38.00%
Europe
U.S.A
Japan
Hong Kong
Singapore South Korea
Taiwan
Labor Demand given by marginal
product of labor
W
W
P
= W (L) = MPL(L)
P
P
LD
L
Labor Supply

Wages affect willingness to work.
 Substitution
effect: Each hour of leisure time costs
more in terms of goods when wages go up. This has
the effect of increasing willingness to work.
 Income/Wealth effect: Higher wages increase the size
of your paycheck. Working hard may be less
attractive when your wallet is full.

In theory, the effect of wages on labor supply
could run either way. Most empirical findings find
that labor supply is a weakly positive function of
real wages.
Increasing Hours per Population in
East Asia (http://www.ggdc.net)
Hours per Population
1000
800
600
400
Hong Kong
Singapore
S. Korea
Taiwan
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
200
0
1960
Hours
1400
1200
Decreasing in Europe,
Increasing in USA
Hours per Person
1200
1000
800
600
400
200
France
West
Italy
U.K.
U.S.A
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1973
1971
1969
1967
1965
1963
1961
1959
0
Labor Demand given by marginal
product of labor L
S
W
P
w*
LD
L
L*
Labor Market

If labor market is competitive, then labor
supply equals labor demand.
 Equilibrium
wages and labor are given at the
point where two curves meet.

Increases in technology or capital increase
average and marginal product of labor so
they shift labor demand curve up.
 Increase
in Q or K, will increase
equilibrium
W
P
or L in
Labor Demand given by marginal
product of labor L
S
W
Q↑ or K↑
P
w**
w*
LD
LD
L
L*
L**
Unemployment
Labor markets are characterized by sellers
(workers) who would be willing to work at
given wages but are not able to find work.
 Unemployment rate is the ratio of
unemployed to the labor force.
 Unemployment varies across countries.

Differences in Unemployment
Rates (http://www.oecd.org)
Standardized Unemployment Rates
Japan
Italy
Germany
France
USA
0
1
2
3
4
5
6
7
8
9
10
Oct-04
Oct-03
Oct-02
Oct-01
Oct-00
Oct-99
Oct-98
Oct-97
Oct-96
Oct-95
Oct-94
Oct-93
Oct-92
Oct-91
Oct-90
Oct-89
Oct-88
Oct-87
Oct-86
Oct-85
Oct-84
Oct-83
Oct-82
Oct-81
Rising Level of Unemployment in HK
Hong Kong Unemployment Rate
10
9
8
7
6
5
4
3
2
1
0
Efficiency Wages
In standard model, we think of the cost of
hiring workers as only the wage costs.
 Efficiency wage theory assumes that costs
are a function of turnover costs and costs
of monitoring workers.
 Real costs of hiring workers includes, ct,
representing management costs.

W
LABOR COSTt   t  Lt  ct Lt
 Pt 
Efficiency Wages
At the wage offered by firms, there is
greater labor supply than demand.
 Labor market competition does not bid
down the wages to clear the market
because firms know that if wages fall, their
management costs will rise

Wage Bar
LS
W
Unemployment
P
Efficiency Wage
w*
LD
L
L*
Labor Management Costs as a
function of wages

Management costs are a function of the
wage paid to workers.
 If
real wages are high, there will be relatively
little turnover.
 If real wages are high, workers will avoid
shirking their jobs so as to keep their jobs.

Management costs relative to wage costs
are highest when wages are low.
W
ct  c( t

Pt
)
What determines wages




Firms don’t take market wages as given but
select market wages to minimize labor costs
including turnover costs.
Marginal cost of increasing wages is Lt.
Marginal benefit of increasing wages is marginal
reduction of management costs
c

Lt
W

P
Wages minimize labor costs when marginal
benefit equals marginal costs
c

1
W
P
Efficiency Wage
1
MC
MB
W
wE
P
Example
E2
c
W
)

  E 2  ( t )2
Pt Wt
Pt
W
 t
Pt
Pt

Cost function

Per Worker Marginal Benefit of Reducing
Wages
E 2  (wE )2  1  wE  E

Efficiency wages that minimize total costs.

W
c( t

c
Wt
W
 E2  ( t
Pt
Pt
) 2
Efficiency Wage
Wages offered by firms are set to minimize
the per unit labor costs.
 Principal determinant of the wage level are
those things, E, which determine how
sensitive management costs are to real
wages.
 Wages are not determined by intersection
of labor demand.

What determines the demand for labor?
Once firms decide how much to pay their
workforce to minimize labor costs, they decide
their demand for workers based on the
marginal product of labor.
 Marginal cost of hiring workers includes both
wages and management costs. Taking wages
as given, marginal cost of hiring one more
worker is W P  c(W P)
 Marginal benefit of hiring one more worker,
MPL. Firm maximizes profits by hiring workers
until
MPL  W  c(W )

P
P
At a given wage w, a firm chooses a labor demand which
sets MPL = w +c(w)
W
c
P
c(wB)
wB
c
c(wA)
c(wA)
wA
MPL
LD
LB
LA
Labor Demand at Efficiency Wages




Labor demand is demand for labor at given
wage once management costs are factored in.
Gap between labor demand and MPL curve is
larger at lower wages because management
costs are larger relative to wage costs.
Wage offer is decided at Labor solves
we + c(we) = MPL
Labor supply does not affect equilibrium labor
market so there may be positive unemployment.
Labor demand determined by efficiency ways
W
.
c
P
c
we
MPL
LD
L*
Young workers most likely to be unemploymed because they are least
skilled and management costs are high, so efficiency wages may not
drop down to their level.
HK: Unem ploym ent Rate
%
40
35
30
25
20
15
10
5
0
Nov-1994
Nov-1996
Total
Nov-1998
Nov-2000
Nov-2002
Age 15 to 19
Age 20 to 29
Age 30 to 39
Age 40 to 49
Age 50 to 59
Age Abov e 60
Nov-2004
Unemployment is an increasing function of efficiency wage.
LD
W
LS
P
U(eW’)
we’
U(eW)
we
L*
Equilibrium Unemployment Rate
eW
LD
ur
What determines the sensitivity of
management costs to wages.

Workers are most likely to increase their work
effort when they are afraid of losing their job.
This effect will be highest when
 Unemployment

is high.
Efficiency wages are a negative function of the
unemployment rate.
 Labor
market regulations and unions allow firms to
fire workers easily.
 Social benefits are low relative to workers.
Equilibrium Unemployment Rate
eW
LD
w e*
LS
ur
ur*
Why does unemployment vary
across countries.


In Europe, labor market regulations make it
difficult for firms to fire workers. This increases
management costs and allows workers to
demand high wages to avoid shirking.
In Hong Kong, some argue that deflation has
pushed up real value of social welfare payments
which increases efficiency wage levels.
Increase in Firing Regulation or
relative social welfare.
eW
LD
we**
LS’
w e*
LS
ur
ur*
ur**
Unemployment may also be a
function of economic conditions.
JP: Unem ploym ent Rate: Region: Whole Japan
%
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
Sep-1983
Sep-1986
Sep-1989
Sep-1992
Sep-1995
Sep-1998
Sep-2001
Sep-2004
Unemployment is a negative function of labor demand
curve.
LD
W
LS
P
U(eW)
we
U(eW’)
L*
Positive Productivity Shock
LD’
eW
LD
we**
w e*
LS
ur
ur**
ur*