CHAPTER

FOUR

LABOR MARKET
1
4.1. Labour Demand: (A) Individual Firm Labour Demand

 The demand for labour is a derived Demand.

 Firms will only demand labour if it is profitable to do so.

 It will be profitable to employ more labour if the marginal

revenue earned from the sale of extra output exceeds the
marginal cost of producing that output

 Hence, the demand for labour by an individual firm operating

in competitive markets is based on the notion of profit
maximization.

 Profit maximization implies that additional labour will be

demanded until MCL (real wage) just equals MRL obtained
from sale of extra output produced by marginal worker.
2
 MR and MC of a firm is determined by state of technology and
nature of production function.
 The following figure shows production function, which describes
real output (Y) is function of labour input and the capital stock.
Y

Y = f (N, K )

N
N N N
APN 1 2 3

MPN

APN = y / N

N
MPN 3
 With this information the firm’s labour(N) demand decision can
be examined.
 First, the employment of one more worker will lead output
to rise by the MPN.
 If the addition to total output is sold in a competitive market,
such that the price it sells for is the same as that for all previous
units, then Marginal revenue received by the firm is P.MPN.
 This is called the marginal revenue product of labour
(MRPN=VMPN).
 Thus, the profit maximization condition where by the MC of
extra worker is the money wage, W, equals MR product of
labour is given as in the following page:

4
 𝜋 = 𝑝. 𝑦 𝑁, 𝐾 − 𝑊. 𝑁 … … … … … … … … … … … … … .4.1
𝑑
𝜕𝜋
𝐿 = = 0 … … … … … … … … … … … … … … … … … . … .4.2
𝜕𝑁
𝜕𝑦(𝑁, 𝐾 )
𝑝. −𝑊 =0
𝜕𝑁
𝑝. 𝑀𝑃𝑁 = W … … … … … … … … … … … … … . … … … … … … … . . . . 4.3
𝑀𝑅𝑃𝑁 = 𝑊 … … … … … … … … … … … … … … … … … … … … . … .4.4
 This indicates that at equilibrium 𝑀𝑅𝑃𝑁 is equal to nominal
wage.
 Alternatively labour demand is also written in real term as
𝜕𝑦 𝑊
 𝑁𝑑 = = = 𝑤 … … … … … . . … .4.5
𝜕𝑁 𝑃

5
 B) Aggregate labour Demand
In the aggregate it is assumed that the demand for labour is the horizontal summation of individual
firm’s demand for labour, which gives the downward slopping curve as depicted in figure below. The
aggregate demand for labour function is therefore denoted as
W
L  w   f (N ) Or W  P. f (N ) --------------- (4.5)
d

Where f (N ) denotes the economy wide MPN schedule. Since the marginal product of labour schedule

falls as N increases f (N )  0 and the real wage is inversely related to the aggregate demand for labour.

6
W
P

W
0

P
f ( N)

N
N
w 0

w0

P.f(N)

N0 N 7
4.2. Labor Supply
 The individual supplier of labor is assumed to supply labor in
direct relation to the real (consumption) wage.
 In developing aggregate demand for labor, we do not make
any explicit assumption about price or wage expectation of
employers on demand side of labor market.
 This is because we assume that employer has good information
on or perhaps control of particular prices changed and wage
rate paid.
 The employer is thus in a position to know real wage at each
point in time.

8
 1. THE INDIVIDULAL WORKER-LEISURE DECISION
To develop the labour supply function we again borrow some basic ideas from microeconomics.
Assumptions:
a. A worker wants to allocate the total hours available (T) in a day into hours of work (n) thus

earning real income, ye , and leisure hours (including sleep)- s . Thus, T  s  n hour of
working hours,
b. Workers are uncertain about the current and future price level,
C. Since we assume the worker is uncertain about the price level to use to convert nominal income in to real income,
the expected price level, Pe enters the calculation of expected real wage- we and the expected income- ye .That is, the
budget constraint of a worker that maximize his/her utility is
W
ye  (T  s)  we (T  s)-------------------------- (4.7)
Pe
dye  wds . So that the slope of the budget line dye / ds  w .

9
 As expected real wage increases from initial low level, leisure can
be traded for income (decrease leisure hours by individual worker)
and hence the budget line would swing up to meet the y axis at the
new 𝒘𝒆 𝑻 and the equilibrium point would move to the right and
increase number of hours worked (T - s = n).
 The labour supply curve may tend to bend backwards (such as
beyond point B) , implying once the wage rate reach a certain
high level, increase in wages may cause some workers to begin to
increase leisure rather than working hours, as income effect
overcomes the substitution effect (when work becomes inferior).

10
w1e

e
S
w 2

y 2e

w0e
C
y e
U2  IC2
y 1
B e

T
Work n0 n n2 Leisure hrs
hrs 1

Fig 1.16: Individual worker labour supply curve

11
 THE AGGREGATE LABOUR SUPPLY CURVE
 This is obtained by summing all individual labour supply curves
for a given expected wage rate (𝑤 𝑒 ) to get the aggregate labour
supply curve for the entire economy; that is n*N.
 Therefore, the aggregate supply curve of labour in expected price
can be represented mathematically as:

𝑵 = 𝑵 𝒘𝒆
𝑊
In real value 𝐿𝑠 = 𝑤 𝑒 = 𝑒 = 𝑔 𝑁 ; 𝑔′ > 0--------- 4.8a
𝑃
 Alternatively, g(N ) = W/Pe in equation (4.8a) can be written in the
current actual real wage (w) and the level of employment, N ,
relationship by converting the expected real wage (we) in to the
actual real wage (w).
𝑊 𝑃𝑒 𝑾
 By definition:𝐿𝑠 = 𝑤 = 𝑒 . , by substituting 𝒆 by g(N) from
𝑃 𝑃 𝑷
𝑃 𝑒
equation (4.8a) 𝑠
𝐿 = 𝑤 = . g(N)………..(4.9a)
𝑃
12
 This is another version of equation (4.8a).
 However, the labour supply function in nominal wage derived
from equation (4.9a) is similar to that of (4.8b).
 That is 𝐿𝑠 = 𝑊 = 𝑃𝑒 . g(N)………..(4.9b), since g(N)=W/𝑃𝑒
 Aggregate labour supply (LS) derived in current actual real and
nominal wage rather than expected real wage (equation 4.9) are
depicted graphically as follows,

13
expected real wage (equation 1.4.10) are depicted graphically as follows,
e
P

w w = P .g(N)

w0

N
N0
W e
W = P .g(N )

W0

N
N0
Fig 3.4: Aggregate labour supply 14
 Since the aggregate labour supply function depends on the
relative price of consumer goods (or expected price) to the
price of domestic output, unless these price indices move in
the same proportion, labour supply condition will change.
 For example, a devaluation (or rise in E or Birr/1USD), which
increases a rise in Pe will result in an upward shift of the
aggregate labour supply since higher level of wage rate will be
required to maintain the purchasing power of money
(consumption) wage.

15
Frictionless Labour Market Equilibrium and the Aggregate Supply Curve
(A) Frictionless Labour Market Equilibrium (Classical equilibrium)
Dearhave
we students wethe
derived have deriveddemand
aggregate the aggregate demand
and supply and supply
of labour of labour
equations in the equations in the
labour market labour
both as a
market both
function as aand
of real function of real
nominal wageand
in nominal
equationwage
(3.5) in
4.5 andequation (3.5) and (3.10)
(3.10) respectively as respectively as
4.9
W
L d  w  (N ) Or W P. f (N ) ------------------------- (3.2..1)
4.5
P
Pe
L w  .g(N ) Or W P e .g(N ) ------------- (3.2.2)
s 4.9
d s P
Equating labour DD ( L ) to labour SS ( L ) gives the labour market equilibrium. That is,
4.10
Pe
 In real wage: f (N )  .g(N ) ------------------------------- (3.2.3)
P 4.11
 In nominal wage: P. f (N ) P e .g(N ) --------------------------- (3.2.4)

The graphic representation of labour market equilibrium is represented by the intersection of the two
4.10 4.11
curves indicated in equation 3 and 4 above. For a given value of actual price level, P0 and the
e e
expected price level, P equilibrium real and nominal wage are w0 and w , respectively while

equilibrium employment is N0 , and real income, y0 .

16
w s e
L w= P .g(N )
P
0

w0 E

Ld w = f (N )

N
N0 NF

e
W W = P .g(N )

E
W0
Ld = w =P. f (N )

N
NF
N0
Fig 3.5: Equilibrium in the labour market
17
 At point E the labor market clears.
 But this does not imply that there is zero unemployment.
 Note that if all the workers are in employment the labor supply
curve would become vertical since no matter how high real
wages were pushed up, there could be no increase in
employment because all workers are employed.
 In figure 3.5 the level of full employment is given at NF.
 The distance between NF and N0 therefore denotes the level of
voluntary unemployment.
 The level of voluntary unemployment expressed as a percentage
of total labour force in an economy is usually referred to as the
natural rate of unemployment.
 The voluntary unemployment due to the labour market frictions is
frequently believed to consist of two specific kinds of
unemployment, namely frictional unemployment and
structural employment.
18
 If we assume workers and all jobs are the same and therefore
that each worker equally well-suited to each job, then frictional
unemployment would be zero.
 In other word the labour market is said to be frictionless.
 In reality however, workers have different preference and
abilities and jobs have different characteristics and the
geographical mobility of workers is often low.
 Hence, searching job takes time and effort and because different
jobs require different skills and pay different wage rates,
unemployed workers may not accept the first job offer they
receive.
 As structural change occur in the economy, some industries
of the country may decline and some labour skill categories
become redundant as others expand.
 This can lead to structural unemployment.

19
 Thus the natural rate of unemployment or the level of
employment consistent with the labour market clearing is
voluntary in the sense that the number of job vacancies is equal
to the number of workers seeking job.
 In other words, the natural rate of unemployment means
frictionless labour market equilibrium.
 It corresponds to the classical labour market equilibrium.
 Because classical assume that workers have perfect foresight of
current and expected price levels and hence price and wage
rates are flexible- conclude that labour market always clears both
in short and long run along aggregate supply (AS) curve.
 Thus any changes in unemployment are entirely voluntary.
(B) The Aggregate Supply (AS) Curve in a closed economy
 AS curve is derived from the aggregate labour mrkt and prdn fun
to give direct r/nship b/n output and price level for a given state
of technology and work-leisure preference of workers.
20
The derivation of the AS curve is based on the labour market equilibrium expressed in real and
d s
nominal wages as L =L . That is
e
P
(1) w  f (N)  .g(N)
P
Real product wage or MPL = Real consumption (money) wage

(2) W P.f (N) Pe .g(N)

Actual money wage = Expected nominal wage
e
The degree to which the expectation of workers about P adjust to the movement of P is given
by
P e  (P);0   1 ------------------------ (3.2.5)
e
Where,𝛼 is the slope of the price function (or P /P ) and its value lies between 0 and 1
d

21
 Now let us see first what will happen to labour market
equilibrium, level of employment, income, and wage (real and
nominal) rates of the classical and extreme Keynesians as price
level changes and then derive their aggregate supply (AS) curves.
 To do so, we assume for simplicity the following two assumptions:
1) Initially both actual and expected prices are equal or P0e = P0
2) The price level rises from P0 to P1.
 With these assumptions we can then derive the classical AS curve of
the frictionless (classical) and extreme Keynesians school of
thoughts by examining what happens to the equilibrium level of
employment, income and wage rates for a closed economy (an
economy without international trade) as price level increases
exogenously?

22
 a) The extreme classical case:
 The basic assumption of the classical regarding the labour market
is that there is complete and correct adjustment or perfect
foresight of Pe to P.
 That is ∆Pe = ∆P and hence 𝛼 =1 in equation (3.2.5) above.
 This assumption stems from its two core assumptions about the
aggregate economy: price and wage flexibility and economic
agents are rational.
 When 𝑃𝑒 moves by the same proportion as P rises from P0 to P1
or a =1, the ratio of Pe/P remains unchanged.
 This is evident from figure 3.6(a) below that when expected price
Pe fully adjusts to change in actual price labour market
equilibrium remains at point A leaving initial labour market
equilibrium value, w0 and N0 space undisturbed.
 This is known as classical result, in which movements of price
level don’t affect equilibrium level of employment and real wage.
23
 P
=
e
s . g (
W = N )
P
0

A
(a)
w0
Ld
= f (N )

N
N0
W P1.g(N )

B P0.g(N )
W1 (b)
A

W0 P1. f (N )
P0. f (N )
N
N0
Y
Y Y (N )
(c)
Y0

450
N0 N
P Y AS Y (g(N ), f (N ), EP* )

P B'
1
(d)
P0 A

Y
Y0
Fig 3.6: The Classical aggregate supply (AS) curve 24
b) The extreme Keynesians Case:
 This is the opposite of the extreme classical case.
 It assumes zero (no) adjustment of the expected price level (Pe) as
the actual price level changes from P0 to P1 .
 Hence, when P0e = P1e or 0, implying imperfect foresight (myopia or
shortsightedness) or complete money illusion.
 This is because of the assumption of price and wage rigidity and
static expectation of economic agents about price level.
 With Pe constant as the price level changes labour supply depends on
only the money (nominal) wage rate-W.
 When there is no adjustment of Pe to P, only the demand for
labour curve shifts to the right along the unchanged labour
supply curve from P0.f (N ) to the higher P1. f (N ) in figure 3.6.(b)
due to the decline in real wage.
 Since increase in price level has shifted only labour demand curve,
but not labour supply curve, employment raises from N0 to N1 and
the nominal wage from W0 toW1.
25
by less than the rise in the price level for expected price ( P ) is fixed due to myopia.
Pw
Ls0  0 .g(N )
P0 Pe
L1  0 .g(N )
s
w
P1

w1 A

B
(a)
w0
L0d  f (N )

N0 N1 P0e .g(N ) N
W

B
W1 (b)
W0 A P1. f (N )

P0. f (N )
N
N0 N1
Y Y
Y (N )
Y1
B (
Y0 A

450
N0 N1 N
Y  AS

P1 B

P0 A
(d)
26
 If the money illusion assumption or 0 holds the labour SS curve is
constant, generating an increase in employment and output and
upward sloping AS curve.
 The extreme Keynesians are criticized on the ground that the
assumption of 0 is appropriate to examine the impact of the
movements of price level on equilibrium level of employment and
output during the market period (i.e., very short period of time
where supply cannot respond to demand) when the labour force
has not had time to absorb new price information on price level
and adjust Pe to P.
 This criticism gave rise to the new (general) Keynesian theory of
labour market, which postulate though: the degree of adjustment
of workers expected price to actual price improves with the
availability of information in the long run, the shape of the
aggregate supply curve is always upward sloping and the
equilibrium level of employment and output higher than the
classical but lower than the extreme Keynesians.
27
 c. The New Keynesian view of the labour market ( 0<α<1)
 In this model workers expectation adjust to changes in the actual
price level, but not fully.
 It implies the case in which adjustment of Pe in the labour market
equilibrium to an exogenous increase in the price level from P0
to P1 by less than the exogenous increase in P.
 It is somehow in between the two extreme (polar) assumptions-
the extreme classical and the Keynesian
 With less than perfect adjustment expectation (a<1), the increase in
P reduces the ratio of the expected to actual price level from
P0e/P0 to P0e/P1, like that of the extreme Keynesians.

28
 On the supply side of the labour supply curve, the higher price
of domestic output translates into a higher consumer price index
(CPI), so workers will perceive a fall in their real wages and so
reduce/contract their labour supply to the market.
 Crucially, however, in a closed economy context the aggregate
labour supply curve does not shift up as far as the demand curve
because the expected price level increases by less than that of,
which gives Pe1/P1 ratio strictly less than unity.
 Therefore, the aggregate labour supply curve only shifts up to the
left to P1.g(N ).
 The reason behind this upward sloping AS curve is that the real
product price (Pe/P.g(N)] has fallen, which encourage employers
to demand more labour and to increase production as MR has
increased by more than MC.

29
  In fact the AS curve may be vertical in the open economy case
if import prices measured in domestic currency change
exactly the same proportion as domestic prices.
 This is clear since if both elements of Pc rise by the same
amount then Pc must also rise by the same amount.
 In the long run, however, empirical evidence support for PPP
is stronger, albeit if not entirely convincing.
 If this is assumed to be the case that the real exchange rate will
be constant and the classical AS curve will be vertical at the
level of output corresponding to the natural rate of
unemployment.
 For short-run policy purpose, however, it is more appropriate
to consider the AS curve positively sloped

30
 P1e.g(N )
W
P01.g(N )
B
C
W1
D

W0 A 𝑃1 . 𝑓(𝑁)
P0. f (N )

N
Y N0 N1
Y

Y (N )
Y1

Y0

450
N0 N1 N

Y  AS  Y (g(N ), f (N ), EP*)

31
 Types and Causes of Unemployment
1) Frictional Unemployment: Occurs when individuals are
temporarily between jobs or are searching for their first job.
Common among recent graduates or people transitioning to new
careers. Reflects the natural turnover in the labor market.
2) Structural Unemployment: Results from a mismatch between
workers' skills and the demands of the labor market. Often caused
by technological advancements, globalization, or shifts in
industries. Can lead to long-term unemployment if workers need
retraining.
3) Cyclical Unemployment: Linked to the business cycle and
economic fluctuations. Rises during economic downturns or
recessions when demand for goods and services falls. Typically
decreases during periods of economic growth.
4) Seasonal Unemployment: Happens when demand for certain jobs
varies with the season. Examples include agricultural workers,
holiday retail jobs, or tourism-based employment.
32
 Review of The Classical and Neoclassical microeconomic
models of the labor market
1) Classical Microeconomic Model of the Labor Market:
 The Classical model assumes that the labor market operates under
conditions of perfect competition.
 Key features include:
a) Supply and Demand Mechanism: Labor supply is determined by
individuals' preferences for leisure versus work, depending on the
real wage rate. Labor demand comes from firms seeking to
maximize profits, with the demand for labor being derived from the
marginal productivity of labor.
b) Real Wage Adjustment: Real wages are flexible and adjust to
ensure equilibrium in the labor market. Unemployment is typically
seen as voluntary or frictional, as anyone willing to work at the
prevailing wage rate can find a job.
33
c) Full Employment Assumption: The economy is assumed to
operate at or near full employment. Any deviations from full
employment are temporary and self-correcting due to wage
flexibility.
d) Policy Implications: Government intervention in the labor market
(e.g., minimum wages or unemployment benefits) is viewed as
distorting the natural equilibrium and causing inefficiencies.

34
2) Neoclassical Microeconomic Model of the Labor Market
 The Neoclassical model builds upon the Classical framework but
incorporates additional elements, including individual decision-
making and market imperfections. Key aspects include:
a) Marginal Productivity Theory: Wages are determined by the
marginal productivity of labor, meaning workers are paid according
to their contribution to output.
b) Utility Maximization: Workers aim to maximize utility by
balancing income (earned through work) and leisure. The labor
supply curve reflects how individuals respond to changes in real
wages, with the substitution effect and income effect influencing
their decision-making.
c) Imperfect Information and Frictions: The Neoclassical model
acknowledges that the labor market is not perfectly competitive.
Search frictions, skill mismatches, and information asymmetries can
lead to unemployment or wage dispersion.
35
d) Role of Technology and Human Capital: Technological
advancements and investments in human capital (e.g., education and
training) are critical in shaping labor market outcomes.
e) Policy Implications: Neoclassical economists are more open to
selective government interventions, such as education subsidies or
job training programs, to address inefficiencies or improve market
outcomes.
 In summary, while both models emphasize the role of supply and
demand in determining wages and employment, the Neoclassical
model introduces greater complexity by considering real-world
imperfections.

36
3) The New Keynesian: view of the labor market incorporates insights
from Keynesian economics while addressing some of its limitations
with modern microeconomic foundations. It emphasizes the role of
market imperfections, wage rigidities, and other frictions that affect
labor market dynamics.
 Key Features of New Keynesian Labor Market Theory
a) Wage and Price Stickiness: New Keynesians argue that wages and
prices do not adjust instantly to changes in economic conditions.
Contracts, norms, and institutions lead to wage rigidity, which can
prevent the labor market from reaching equilibrium quickly. This
stickiness contributes to unemployment during economic
downturns.

37
b) Imperfect Competition: Firms operate in imperfectly competitive
markets, where they have some power to set wages and prices.
Instead of the labor market clearing automatically, firms may keep
wages above the equilibrium level to maintain morale and
productivity (efficiency wages).
c) Imperfect Information and Frictions: like Neoclassical model
acknowledges that the labor market is not perfectly competitive.
Search frictions, skill mismatches, and information asymmetries
can lead to unemployment or wage dispersion.
d) Unemployment as an Involuntary Phenomenon: Unlike Classical
models, New Keynesian theories recognize that unemployment can
be involuntary due to rigidities and frictions. Workers may be
willing to work at the current wage rate, but they cannot find jobs
because firms are not hiring.

38
e) Role of Aggregate Demand: Aggregate demand plays a significant
role in determining employment levels. Low demand during
recessions can lead to cyclical unemployment, which persists due to
wage and price rigidities.
f) Search Frictions: Similar to Neoclassical models, New Keynesian
theories account for the time and effort required for workers to find
jobs and for firms to fill vacancies. These frictions exacerbate
unemployment.
g) Importance of Policy Intervention: New Keynesians advocate for
government intervention to address unemployment and stimulate
demand. Policies like fiscal stimulus, unemployment benefits, and
training programs can help reduce frictions and increase
employment.

39
 Implications for the Labor Market
 The New Keynesian perspective suggests that markets are not
always self-correcting and that unemployment may persist without
policy intervention.
 It provides a theoretical basis for active labor market policies and
macroeconomic strategies aimed at stabilizing the economy.
 This view combines elements of Keynesian economics with modern
microeconomic foundations, making it highly relevant to
contemporary labor market analysis.

40
THANK
U
41