The Labour Market
The labour force is the sum of those either working or looking for work. Those who are neither in the labour force nor looking for a job are known to be out of the labour force. The participation rate is defined as the ratio of the labour force to the population in working age. The unemployment rate is calculated by dividing the unemployed with the labour force (unemployed and employed). The average unemployment rate also hides large differences among different groups of workers within the same country. The most notable one is the higher incidence of unemployment among young workers.
To get a sense of what a given unemployment rate implies for individual workers, consider the following analogy. Take an airport full of passengers. It may be crowded because many planes are coming and going, and many passengers are quickly moving in and out of the airport. Or it may be crowded because of bad weather delaying the flights and passengers are stuck, waiting for the weather to improve. The number of passengers in the airport will be high in both cases, but their plights are quite different. Passengers in the second scenario are likely to be much less happy.
In the same way, a given unemployment rate may reflect two very different realities. It may reflect an active labour market, with many separations and many hires, and so with many workers entering and exiting unemployment; or it may reflect a sclerotic labour market, with few separations, few hires and a stagnant unemployment pool. Data of the movement in the labour force is collected by used the Labour Force Survey (LFS).
The flows of workers in and out of employment are in some countries large. Separations consist of: Quits, or workers leaving their jobs for a better alternative, and layoffs, which come from changes in employment levels across firms. The flows in and out of unemployment are large, especially in the US, in relation to the number of unemployed. The average duration of unemployment in the EU is 1 year. In the US it is about three months. There are large flows in and out of the labour force, much of them directly to and from employment. Discouraged workers are classified as “out of the labour force” but they may take a job if they find it. Wage Determination
Wages are set in many ways. Sometimes they are through collective bargaining – that is, bargaining between firms and unions. Common forces at work in the determination of wages include: Workers are typically paid a wage that exceeds their reservation wage, the wage that would make them indifferent between working or being unemployed. Wages typically depend on labour market conditions. The lower the unemployment rate, the higher the wages.
Even in the absence of collective bargaining, workers have some bargaining power, which they can and do use to obtain wages above their reservation wages. Also, firms themselves may, for a number of reasons, want to pay wages higher than the reservation wage.
Bargaining: How much bargaining power a worker has depends on two factors; how costly it would be for the firm to replace him—the nature of the job and how hard it would be for him to find another job—labour market conditions. The more costly it is for the firm to replace the worker, and the easier it is for him or her to find another job, the more bargaining power he or she will have.
Efficiency Wages: Giving a higher wages to your employees promotes good work, which leads to higher productivity. Economists call the theories that link the productivity or the efficiency of workers to the wage they are paid efficiency wage theories. These theories also suggest that wages depend on both the nature of the job and on labour-market conditions; firms that see employee morale and commitment as essential to the quality of their work, will pay more than firms in sectors where workers’ activities are more routine and labour market conditions will affect the wage.
We capture our discussion of wage determination by using the following equation:
The aggregate nominal wage, W, depends on three factors: * The expected price level, Pe * The unemployment rate, u * A catchall variable, z, that stands for all other variables that may affect the outcome of wage setting.
The Expected Price Level - Both workers and firms care about real wages (W/P), not nominal wages (W). Workers do not care about how many Euros they receive but about how many goods they can buy with those Euros. They care about W/P. Firms do not care about the nominal wages they pay but about the nominal wages, W, they pay relative to the price of the goods they sell, P. They also care about W/P. Wages depend on the expected price level, Pe, rather than the actual price level, P, because wages are set in nominal terms, and when they are set, the relevant price level is not yet known.
The Unemployment Rate - Also affecting the aggregate wage is the unemployment rate, u. If we think of wages as being determined by bargaining, then higher unemployment weakens workers’ bargaining power, forcing them to accept lower wages. Higher unemployment allows firms to pay lower wages and still keep workers willing to work.
The Other Factors - The third variable, z, is a catchall variable that stands for all the factors that affect wages, given the expected price level and the unemployment rate. Certain countries offer unemployment insurance is the payment of unemployment benefits to workers who lose their jobs. In some countries, unemployment benefits can be quite high depending on the country.
A further factor that is likely to affect wages, given the expected price level and unemployment, is the presence of a minimum wage set by law. The presence of a minimum wage can cause wage rigidity, as it prevents wages from falling below the legal minimum to restore equilibrium in the labour market. Economist believe that increasing the minimum wage would lead to an increase in the average wage, W, at a given unemployment rate.

Price Determination
The prices set by firms depend on the costs they face. These costs depend, in turn, on the nature of the production function – the relation between the inputs used in production function – the relation between the inputs used in production and the quantity of output produced and on the prices of these inputs. Assuming that firms produce goods using only labour, this is a simplified version because normally capital is used in addition to labour, the production function can be written as: Y = AN
Y = output
N = employment
A = labour productivity, or output per worker
Further, assuming that one worker produces one unit of output—so that A = 1, then, the production function becomes: Y = N. This function implies that the cost of producing one more unit of output is the cost of employing one more worker, at wage W.
Firms set their price according to: P= (1 + µ)W.
The term is the markup of the price over the cost of production. If all markets were perfectly competitive, = 0, and P = W. The higher the degree of competition leads to lower mark-up and vice-versa. Moreover, the mark up also depends on the degree of regulation of the product market. The higher the degree of product market regulation, the lower the degree of competition. We can express this by writing the mark-up as a positive function of product market regulation (PMR): µ = f(PMR). This equation tells us that the mark-up µ depends positively on product market regulations, thus it depends negatively on the level of competition in the market.
The Natural Rate of Unemployment: In this section we will look at the implications of wage and price determination for unemployment. Let’s assume that nominal wages depend on the actual price level, P, rather than on the expected price level, Pe. Wage determination implies a negative relation between the real wage, W/P, and the unemployment rate, u: the higher the unemployment rate, the lower the real wage chosen by wage setters. The higher the unemployment rate, the weaker the position of workers in bargaining and the lower the real wage rate will be. Wage setting and price setting determine the equilibrium rate of unemployment.

The real wage is measured on the vertical axis. The unemployment rate is measured on the horizontal axis. The wage setting relation is drawn as the downward-sloping curve WS: the higher the unemployment rate, the lower the real wage.

The price-setting relation is drawn as the horizontal line PS (for price setting). The real wage implied by price setting is: 1/(1 + µ); it does not depend on the unemployment rate.
Equilibrium in the labour market requires that the real wage chosen in wage setting be equal to the real wage implied by price setting. Eliminating W/P from the wage-setting and the price-setting relations, we can obtain the equilibrium unemployment rate, or natural rate of unemployment, un:
The equilibrium unemployment rate (un) is called the natural rate of unemployment. The positions of the wage-setting and price-setting curves, and thus the equilibrium unemployment rate, depend on both z and μ. At a given unemployment rate, higher unemployment benefits lead to a higher real wage. A higher unemployment rate is needed to bring the real wage back to what firms are willing to pay.
An increase in unemployment benefits shifts the wage-setting curve up. The economy moves along the price-setting curve. Equilibrium unemployment increases. An increase in the mark-up shifts the price-setting line down. The economy moves along the wage-setting curve. Equilibrium unemployment increases. Because the equilibrium rate of unemployment reflects the structure of the economy, a better name for the natural rate of unemployment is the structural rate of unemployment.

From Unemployment to Employment: Associated with the natural rate of unemployment is a natural level of employment, the level of employment that prevails when unemployment is equal to its natural rate.

Let’s summarise: assume that the expected price level is equal to the actual price level. Then:
● The real wage chosen in wage setting is a decreasing function of the unemployment rate.
● The real wage implied by price setting is constant.
● Equilibrium in the labour market requires that the real wage chosen in wage setting be equal to the real wage implied by price setting.
● This determines the equilibrium unemployment rate.
● This equilibrium unemployment rate is known as the natural rate of unemployment.
● Associated with the natural rate of unemployment are a natural level of employment and a natural level of output.