Wage Setting Curve
The wage setting curve describes the relationship between the real wage that workers and firms negotiate and the level of employment or unemployment. It is a central element of models of the labour market that incorporate bargaining, efficiency wages, or other frictions, and it complements the price setting behaviour of firms in the determination of equilibrium unemployment.
The Relationship
The wage setting curve typically relates the real wage to the unemployment rate. At lower unemployment, workers have more bargaining power, and the real wage is higher. At higher unemployment, the threat of job loss disciplines wage demands, and the real wage is lower. The curve therefore slopes downward in unemployment.
The position of the curve depends on factors that affect bargaining power and wage-setting behaviour, including the generosity of unemployment benefits, the strength of unions, the level of minimum wages, and the characteristics of the labour market. Changes in these factors shift the curve.
Price Setting and Equilibrium
The price setting curve describes the real wage that firms are willing to pay at a given level of employment, determined by their pricing behaviour and the markup they apply. The intersection of the wage setting and price setting curves determines the equilibrium level of unemployment, sometimes called the natural rate.
The framework, associated with the analysis of the labour market in New Keynesian and structural models, clarifies the determinants of equilibrium unemployment. Unemployment in this framework reflects the interaction of wage-setting behaviour and pricing behaviour, and it depends on the institutional features of the labour market.
Shifts and Policy
Shifts in the wage setting curve affect equilibrium unemployment. Policies that reduce the bargaining power of workers, such as reductions in unemployment benefits or in union power, shift the curve downward, reducing the real wage for a given level of unemployment and lowering equilibrium unemployment. Policies that strengthen workers' power have the opposite effect.
The framework informs the analysis of labour market policy and of structural reform. It clarifies the channels through which institutions affect unemployment and the trade-offs involved in reform, and it provides a basis for assessing the effects of policies on wages and employment.
Applications
The wage setting and price setting framework is used to analyse a range of questions, including the effects of labour market institutions on unemployment, the determinants of the natural rate, and the response of wages to changes in economic conditions.
The framework also informs the analysis of inflation dynamics, since wage and price setting determine the relationship between inflation and unemployment and the persistence of inflation. It is a central element of the analysis of the labour market and of the macroeconomy, and it links the microeconomics of wage and price determination to the macroeconomic outcomes of employment and inflation.
Bargaining Models
Wage setting can be analysed through bargaining models, in which wages are the outcome of negotiation between workers and firms. The bargaining power of each party depends on the alternatives available and on the institutional environment, and the resulting wage reflects the relative strength of the parties.
The wage setting curve can be derived from bargaining models, with the real wage depending on the unemployment rate and on the factors that affect bargaining power. The framework clarifies the channels through which institutions and policies affect wages and employment.
Efficiency Wage Considerations
Efficiency wage theories provide an alternative foundation for the wage setting curve. Firms may pay above-market wages to motivate workers, to reduce turnover, or to attract better applicants. The resulting wages depend on the firm's productivity and on the cost of turnover, and they may be insensitive to the level of unemployment.
The combination of bargaining and efficiency wage considerations determines the wage setting curve and the equilibrium level of unemployment. The framework helps explain why wages do not fall to clear the labour market and why unemployment can persist.
Inflation Dynamics
The wage setting and price setting framework underpins the analysis of inflation dynamics. The relationship between inflation and unemployment, the Phillips curve, can be derived from wage and price setting behaviour, with the slope and position of the curve depending on the institutions and on the behaviour of expectations.
The framework clarifies the sources of inflation, including the role of expectations, of supply shocks, and of the labour market. It informs the analysis of monetary policy and the assessment of the trade-offs involved in the pursuit of price stability and full employment.
Policy and Institutions
The wage setting curve is affected by labour market institutions, including the structure of collective bargaining, the level of minimum wages, and the generosity of unemployment benefits. Reforms to these institutions shift the curve and alter the equilibrium level of unemployment.
The analysis informs the assessment of structural reform in the labour market. It clarifies the effects of reform on wages and employment and the trade-offs involved, and it provides a framework for evaluating the consequences of institutional change for the labour market and for the macroeconomy.