Two ways of analysing labour markets

The macroeconomics of labour markets

• Frictional unemployment — This reflects the fact that it takes time for people to find and settle into new jobs. If 12 individuals each take one month before they start a new job, the aggregate unemployment statistics will record this as a single unemployed worker. Technological change often reduces frictional unemployment, for example: the internet made job searches cheaper and more comprehensive.
• Structural unemployment — This reflects a mismatch between the skills and other attributes of the labour force and those demanded by employers. If 4 workers each take six months off to re-train before they start a new job, the aggregate unemployment statistics will record this as two unemployed workers. Technological change often increases structural unemployment, for example: technological change might require workers to re-train.
• Natural rate of unemployment — This is the summation of frictional and structural unemployment. It is the lowest rate of unemployment that a stable economy can expect to achieve, seeing as some frictional and structural unemployment is inevitable. Economists don't agree on the natural rate, with estimates ranging from 1% to 5%, or on its meaning — some associate it with "non-accelerating inflation". The estimated rate varies from country to country and from time to time.
• Demand deficient unemployment — In Keynesian economics, any level of unemployment beyond the natural rate is most likely due to insufficient demand in the overall economy. During a recession, aggregate expenditure is deficient causing the underutilisation of inputs (including labour). Aggregate expenditure (AE) can be increased, according to Keynes, by increasing consumption spending (C), increasing investment spending (I), increasing government spending (G), or increasing the net of exports minus imports (X−M).
  
  
  
  
  Effects of a wage increase
  If wages increase, this individual's constraint line pivots up from X,Y₁ to X,Y₂. He/she can now purchase more goods and services. His/her utility will increase from point A on IC₁ to point B on IC₂. To understand what effect this might have on the decision of how many hours to work, you must look at the income effect and substitution effect.
     The wage increase shown in the previous diagram can be decompiled into two separate effects. The pure income effect is shown as the movement from point A to point C in the next diagram. Consumption increases from Y_A to Y_C and — assuming leisure is a normal good — leisure time increases from X_A to X_C (employment time decreases by the same amount; X_A to X_C).
  
  The Income and Substitution effects of a wage increase
  But that's only part of the picture. As the wage rate rises, the worker will substitute work hours for leisure hours, that is, will work more hours to take advantage of the higher wage rate, or in other words substitute away from leisure because of its higher opportunity cost. This substitution effect is represented by the shift from point C to point B. The net impact of these two effects is shown by the shift from point A to point B. The relative magnitude of the two effects depends on the circumstances. In some cases the substitution effect is greater than the income effect (in which case more time will be allocated to working), but in other cases the income effect will be greater than the substitution effect (in which case less time is allocated to working). The intuition behind this latter case is that the worker has reached the point where his marginal utility of leisure outweighs his marginal utility of income. To put it in less formal (and less accurate) terms: there's no point in earning more money if you don't have the time to spend it.
  
  The Labour Supply curve
  If the substitution effect is greater than the income effect, the labour supply curve (diagram to the left) will slope upwards to the right, as it does at point E for example. This individual will continue to increase his supply of labour services as the wage rate increases up to point F where he's working H_F hours (each period of time). Beyond this point he'll start to reduce the amount of labour hours he supplies (for example at point G he's reduced his work hours to H_G). Where the supply curve is sloping upwards to the right (positive wage elasticity of labour supply), the substitution effect is greater than the income effect. Where it slopes upwards to the left (negative elasticity), the income effect is greater than the substitution effect. The direction of slope may change more than once for some individuals, and the labour supply curve is likely to be different for different individuals.
     Other variables that affect this decision include taxation, welfare, and work environment.

  Neoclassical microeconomic model — Demand

  This article has examined the labour supply curve which illustrates at every wage rate the maximum quantity of hours a worker will be willing to supply to the economy per period of time. Economists also need to know the maximum quantity of hours an employer will demand at every wage rate. To understand the quantity of hours demanded per period of time it's necessary to look at product production. That is, labour demand is a derived demand: it's derived from the output levels in the goods market.
     A firm's labour demand is based on its marginal physical product of labour (MPL). This is defined as the additional output (or physical product) that results from an increase of one unit of labour (or from an infinitesimally small increase in labour). If you're not familiar with these concepts, you might want to look at production theory basics before continuing with this article.
  
  The Marginal Physical Product of Labour
  In most industries, and over the relevant range of outputs, the marginal physical product of labour is declining. That is, as more and more units of labour are employed, their additional output begins to decline. This is reflected by the slope of the MPP_L curve in the diagram to the right. If the marginal physical product of labour is multiplied by the value of the output that it produces, we obtain the Value of marginal physical product of labour: » MPP_L * P_Q = VMPP_L
  
  The value of marginal physical product of labour (VMPP_L) is the value of the additional output produced by an additional unit of labour. This is illustrated in the diagram by the VMPP_L curve that's above the MPP_L.
     In competitive industries, the VMPP_L is in identity with the marginal revenue product of labour (MRP_L). This is because in competitive markets price is equal to marginal revenue, and marginal revenue product is defined as the marginal physical product times the marginal revenue from the output (MRP = MPP * MR).
  
  A Firm's Labour Demand in the Short Run
  The marginal revenue product of labour can be used as the demand for labour curve for this firm in the short run. In competitive markets, a firm faces a perfectly elastic supply of labour which corresponds with the wage rate and the marginal resource cost of labour (W = S_L = MFC_L). In imperfect markets, the diagram would have to be adjusted because MFC_L would then be equal to the wage rate divided by marginal costs. Because optimum resource allocation requires that marginal factor costs equal marginal revenue product, this firm would demand L units of labour as shown in the diagram.

  Neoclassical microeconomic model — Equilibrium

  The demand for labour of this firm can be summed with the demand for labour of all other firms in the economy to obtain the aggregate demand for labour. Likewise, the supply curves of all the individual workers (mentioned above) can be summed to obtain the aggregate supply of labour. These supply and demand curves can be analysed in the same way as any other industry demand and supply curves to determine equilibrium wage and employment levels.

  Information Approaches

  Since the 1970s some attention has shifted to the information characteristics of the labour market.
     In the classical model it's assumed that both sides know how much work effort and marginal product the employee contributes.
     In many real-life situations this is far from the case. The firm doesn't necessarily know how hard a worker is working or how productive they are. This provides an incentive for workers to shirk from providing their full effort — since it's difficult for the employer to identify the hard-working and the shirking employees, there's no incentive to work hard and productivity falls overall.
     The methods used to overcome this type of problem have been studied by modern labour economists.
     One solution used recently (stock options) grants employees the chance to benefit directly from the firm's success. However, this solution has attracted criticism as executives with large stock option packages have been suspected of acting to over-inflate share values to the detriment of the long-run welfare of the firm.
     Another aspect of uncertainty results from the firm's imperfect knowledge about worker ability. If a firm is unsure about a worker's ability, it pays a wage assuming that the worker's ability is the average of similar workers. This wage undercompenstates high ability workers and may drive them away from the labour market. Such phenomenon is called adverse selection and can sometimes lead to market collapse.
     There are many ways to overcome adverse selection in labour market. One important mechanism is called signalling, pioneered by Michael Spence. In his classical paper on job signalling, Spence showed that even if education doesn't increase productivity, high ability workers may still acquire it just to signal their abilities. Employers can then use education as a signal to infer worker ability and pay higher wages to better educated workers.

  Search models

  One of the major research achievements of the last 20 years has been the development of a framework with dynamic search, matching, and bargaining. Work started in the early 1980s with contributions from Peter A. Diamond, Dale T. Mortensen and others which characterised equilibrium in such model economies. Later, this framework was tailored to the labour market. More recently, Mortensen and Christopher A. Pissarides have extended the framework to include labour market institutions such as unemployment insurance and employment protection.

  Criticisms of labour economics and recent research

  One critique of standard economic analysis of labour markets is that it doesn't account for the importance of social networks in the employment process. This view holds that personal connections are key for both workers and employees. Hence, employees are more likely to apply for jobs where they've a personal connection, and are more likely to be hired if they apply. In response to this issue, a large literature has recently evolved that attempts to identify statistical discrimination in hiring, looking at whether group membership, most notably race, influences firms' hiring decisions.
     More generally, sociologists and political economists claim that labour economics tends to lose sight of the complexity of individual employment decisions. These decisions, particularly on the supply side, are often loaded with considerable emotional baggage and a purely numerical analysis can miss important dimensions of the process.
     Also missing from most labour market analyses is the role of unpaid labour. Even though this type of labour is unpaid it can nevertheless play an important part in society. The most dramatic example is child raising. However, over the past 25 years an increasing literature, usually designated as the Economics of the Family, has sought to study within household decision making, including joint labour supply, fertility, child raising, as well as other areas of what is generally referred to as home production.
  

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