The comparison between the market for bread and for baristas at the end of section 9.12 gives a quick overview of the reasoning.

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UNIT 6 TEACHING GUIDE Introduction This is th final unit that focuss on conomic rlationships and intractions.

Th intraction in this unit is btwn th mployr and th mploy, whr th first principal-agnt problm is studid.

Traditional txts introduc labour dmand for a firm using th marginal rvnu product curv and th supply curv of labour (which may, or may not, b horizontal dpnding on th comptitiv conditions assumd).

1 UNIT 6 TEACHING GUIDE Introduction This is th final unit that focuss on conomic rlationships and intractions. Employrs and mploys From Unit 2 onwards th cours has xamind aspcts of th dcision-making procss, and from Unit 4 onwards ths dcisions hav involvd intractions among conomic actors. Th intraction in this unit is btwn th mployr and th mploy, whr th first principal-agnt problm is studid. Labour markts ar a stapl of most introductory conomics txts, but hr th approach to this markt using an fficincy wag modl is quit diffrnt from what is usual at this lvl of study. Traditional txts introduc labour dmand for a firm using th marginal rvnu product curv and th supply curv of labour (which may, or may not, b horizontal dpnding on th comptitiv conditions assumd). Non-claring labour markts Ths traditional modls ar not usd in CORE bcaus markts clar, which is not a fatur of labour markts in capitalist conomis. Taching markt-claring labour modls has a fundamntal problm: thy do not match th livd rality of studnts, who will b familiar with involuntary unmploymnt, vn whn inflation is low and stabl. In th past w hav mad th assumption that th markt clars in microconomics, and thn gnrat unmploymnt ithr through pric controls (such as a minimum wag) or assum som kind of friction lik sticky wags in macro modls. Alvin Birdi UNIVERSITY OF BRISTOL Parama Chaudhury UNIVERSITY COLLEGE LONDON Nithr of ths analytical solutions is satisfactory. In th cas of th microconomic modl in which unmploymnt rsults from a pric floor, th analysis dos not match th vidnc from th UK and US, which show ngativ mploymnt ffcts, if any, ar small. Nor dos it xplain th xistnc of unmploymnt in situations whr thr is no minimum wag. In th macro modl, th sticky wag assumption oftn fls arbitrary to studnts, and is not insightful about th conomy thy xprinc. In any cas, studnts ar confusd whn th labour markt is traditionally modlld onc for microconomics and thn diffrntly for macroconomics. Ths modls fail to produc a usful dpiction of labour markts bcaus thy fail to addrss th fact that markts for labour cannot b charactrisd by complt information, lik many product markts. Th comparison btwn th markt for brad and for baristas at th nd of sction 9.2 givs a quick ovrviw of th rasoning. Incomplt wag contracts CORE uss a mor ralistic dpiction of th labour markt by charactrising th natur of th wag contract as incomplt, bcaus all rlvant information is not forthcoming. Spcifically: firms cannot prfctly monitor on-th-job ffort

2 th tasks rquird of workrs cannot b fully spcifid in any contract. Th rsulting modl thrfor has th usual faturs of a principal-agnt modl in which th pric must b incrasd in ordr to licit bhaviour that cannot b spcifid in th contract. Ths ralistic faturs of th wag contract will appar rasonabl and ralistic to studnts, and thy provid a modl in which th (Nash) quilibrium is charactrisd by th xistnc of (involuntary) unmploymnt. Micro, mt macro A furthr bnfit of this modl is that thr is no nd to introduc a diffrnt labour modl whn moving from th singl firm to th aggrgat conomy and hnc, th labour markt in Unit 9. Unit 6 and Unit 9 hav a clos rlationship, and instructors may wish to nsur thy ar familiar with Unit 9 bfor taching Unit 6. Economic rnts Unit 6 also continus th discussion of conomic rnts in 6.4 and 6.5. In this cas th rlvant rnts ar mploymnt rnts for workrs which provid th incntivs for workrs to supply ffort in rspons to th firm s wag offr. Th modl which is vntually dvlopd in sction 6.7 is anothr manifstation of th structur of an iso-wlfar locus that is bing maximisd in rlation to a fasibl st. It is worth noting that th diagram of this rlationship looks somwhat diffrnt to th cass of: Unit 3, whr th labour-lisur choic is modlld Unit 5, whr th bargaining modl of Angla and Bruno is dvlopd bcaus th indiffrnc curvs hr ar straight lins rprsnting th firm s profits and th fasibl st is a convx st rprsnting th workr s willingnss to supply ffort. Dspit th shap of ths functions (and th fact that th incras in wlfar occurs in a north-wstrly dirction on th diagram) th modl conforms to th gnral constraind optimisation framwork that is sn rpatdly in CORE, and whos optimal position is charactrisd by th MRS = MRT quality. Rminding studnts of th prvious tims that thy hav sn this (in Unit 3 and Unit 5) is a good way of familiarising thm with th common structur of th problm which has diffrnt spcific contnt. Th formal charactrisation of th labour contract as a principal-agnt problm (with hiddn action) is mad in 6.0 but it may b usful for instructors to us this trminology bfor raching this sction. What this unit contributs to th main thms Politics and Policy Th unit opns by charactrizing th firm as a st of powr rlationships btwn ownrs, managrs and mploys. Sction 6.4 contains a box which xplains how Coas and Marx agring on th rol of powr in th firm. This is a way to hlp studnts s that conomists from diffrnt traditions can agr on important aspcts of how th conomy works. Sctions 6.5, 6.6 and 6.8 continu th policy thm. Employmnt rnts ar shown to b dpndnt on policy dcisions such as th lvl of unmploymnt bnfit and mploymnt laws. Sction 6.9 discusss diffrnt typs of firm ownrship, such as cooprativs. 2

3 Inquality Ownrs, managrs and workrs will rciv vry diffrnt rwards in th principalagnt rlationship bcaus of thir rlativ powr in that rlationship. Sctions 6.4 and 6.7 discuss th natur of this powr rlationship and its rsult on th outcoms for th diffrnt actors. Sction 6.8 considrs how this rlationship changs if th structural rlationships in th firm ar diffrnt, for xampl, undr cooprativ ownrship. Links from prvious units Unit 2 W hav introducd th concpt of tchnology as a rlationship btwn inputs (including labour) and outputs, and so this unit focuss on th labour input and th dtrmination of wag costs. Unit 4 W introducd th concpt of stratgic intractions, and so discussing th important stratgic intraction btwn mployr and mploy is a natural nxt stp. Unit 5 W discussd th stratgic intractions btwn Angla and Bruno. Angla was a farmr-ownr and Bruno, who was not a farmr, claimd incrasing amounts of Angla s production. W xtnd this by considring Bruno as an mployr and Angla as th mploy. Links to futur units Units 7 and 8 Ths units considr th firm's optimisation problm and will rvisit th MRS = MRT condition in anothr contxt. This unit bgins th discussion of how firms as actors mak optimal choics. Unit 9 Unit 9 is a dvlopmnt of this unit into th aggrgat conomy. It is whr th wag-stting and pric-stting curvs ar introducd, and is thrfor a bridg btwn th micro-foundations of wag- (Unit 6) and pric- (Unit 7) stting and th macro modls. Unit 6 is a natural introduction to this discussion as it dscribs th incomplt contracts which imply that mploymnt rnts xist. In turn, th associatd cost of job loss mans that thr is involuntary unmploymnt in quilibrium in th conomy as a whol. Unit 5 Unit 5 uss th wag-stting curv/pric-stting curv modl to driv th Phillips curv for th analysis of inflation. 3

4 What's important or difficult? Employmnt rnts Th concpt of conomic rnts was introducd in Unit 2 (sction 2.3) with th application to innovation rnts. Employmnt rnts ar a form of conomic rnt. Th ky ida is that th mploymnt rnt is what an mploy gts from mploymnt ovr and abov his or hr rsrvation option, taking account of th disutility of work. It is this rnt that th mploy loss if h or sh loss a job, and it is what nsurs that th mploy xrts ffort on th job. Figurs 6.2 and 6.3 ar usful in introducing th ida of mploymnt rnts. Th bst way to hlp studnts undrstand this concpt is to work through diffrnt scnarios, for xampl: changs in unmploymnt bnfit improvmnts in th work atmosphr that lowr th disutility of ffort MCQ 6.5 and xrcis 6.3 ar good starting points for this. Isocost curv This modl rlis on undrstanding th isocost (of ffort) curv which looks diffrnt to th isocost curv introducd in unit 2, whr th choic of tchnology was bing studid. In sction 6.7, th firm s isocost curv is juxtaposd with th mploy s bst rspons function to complt th labour ffort modl. Th intractiv figurs ar particularly usful to undrstand th labour disciplin modl. On mthod of nsuring studnts undrstand th modl would b to ask thm to idntify xampls of policy or othr changs thy hav hard of (in th nws, in family convrsations, in anothr class) and s how ths would chang mploymnt rnts and thrfor choics about accpting a job. Using taching rsourcs Libnizs L6.6. Workr s bst rspons function: xplains th undrlying mathmatics for th bst rspons function usd in th labour disciplin modl. L6.7. Wags, ffort, and profits: xplains how th firm dcids on its optimal wag by maximising profits subjct to th ffort curv. It shows how th modl is solvd mathmatically. S th nd of this guid for a not on th rsrvation wag and th bst rspons function: Th background not is not intndd for taching. It is providd to nabl instructors to xplor th modl in mor tchnical dpth. Exrcis Qustions Exrciss 6. and 6.2 lnd thmslvs mor to an opn-ndd discussion and thrfor could b usd ithr bfor or aftr gtting into th mchanics of th modl. Exrcis 6.2 in particular is a good way to gt studnts thinking about what constraints mployrs can and cannot put on thir mploys, and how mploys rspond to ths constraints bcaus thy may hav had jobs thmslvs which will hlp thm to undrstand incomplt contracts and thir consquncs. 4

5 Gam Exrciss 6.3 to 6.6 ar good assignmnts to work through th modls and may b usd in conjunction with MCQ 5-8 mntiond abov to consolidat undrstanding of th modls. Exrcis 6.6 in particular conncts mpirical data with th modl. Exrcis 6.7 xtnds th discussion of th modl furthr to analys th contmporary issu of outsourcing. Exrciss 6.8 and 6.9 provid an opportunity to think mor about cooprativ firms. Exrcis 6.0 rturns to th thm of Exrcis 6.2 aftr th concpt of th principal-agnt problm has bn introducd, and gts studnts to considr two spcific cass of principal-agnt rlationships and to xplain which aspcts of th contract btwn thm ar ncssarily incomplt. Th incomplt contract gam in th Unit 6 taching rsourcs may b a good nxt stp aftr using Exrcis 6.2 to show how such contracts ar consistnt with quilibrium unmploymnt (discussd in mor dtail in Units 9 and 3). MCQs Ask studnts to complt qustions 5 to 9 to gt a thorough workout of th concpt of mploymnt rnts and th labour disciplin modl. Additional (tachr only) MCQs T6. looks at th dfinition of a firm (and distinguishs it from th dfinition of a markt). T6.2, looks at th natur of th gam playd in th labour disciplin modl. T6.3 tsts whthr studnts undrstand th natur of involuntary unmploymnt that ariss in th labour markt. T6.4 looks at th rspons of th markt to a chang in unmploymnt bnfits. Looking forward Macro units: For instructors taching a mor macro-focusd cours and thrfor using only th latr units, it is ssntial to covr sctions in this unit. Wag-stting curv: You can look ahad to Unit 9, in which th wag-stting curv is first dvlopd. Unmploymnt: You can also rfrnc this Unit 3, in which quilibrium unmploymnt in th macro conomy is discussd. Evn if th lcturr dos not plan to tach ths latr units, this is a good way to undrlin th motivation bhind th labour disciplin modl and show th link btwn th micro-foundations and th study of th macroconomy (showing th dirct connction for th modl hr of wagstting, to th conomy wid wag-stting curv, and to th Phillips curv). Prsonal taching xprinc Parama As somon who tachs labour conomics as an uppr lvl cours (using a diffrnt txt), I start this lctur in our introductory cours by discussing nw kinds of mploymnt rlationships, for xampl Googl s prks packag and rputation as a good mployr, as wll as zro-hours contracts, and companis lik Ubr. This hlps studnts to think about firms and workrs in a ralistic way, by looking at th rlationships around thm (and prhaps ons that thy may ntr into thmslvs). o o Frank s opportunity cost qustion, and its importanc in conomics: Tabarrok, Alx Opportunity Cost. Marginal Rvolution, 2 Sptmbr. Blanchflowr, David and Andrw Oswald An Introduction to th Wag Curv. Working papr. 5

6 I also ask thm som clickr qustions about what kinds of wag/prks/hours combinations thy would b willing to accpt, which ncourags thm to think about how workrs mak thir dcisions and th trad-offs involvd. To introduc th ida of mploymnt rnts, I ask thm a qustion about opportunity costs, using Robrt Frank s xampl of a choic of which concrt to attnd. Th trickist thing for my studnts is th isocost curv, so I go through th firm s optimisation problm in th lctur, borrowing from th Libniz. Finally, I show thm som data from Blanchflowr and Oswald s 994 work on th wag curv so that thy can rlat th thory to th ral world, and ar st up to discuss unmploymnt starting in Unit 9, using this modl. Othr usful rsourcs Taching not on th rsrvation wag and bst rspons function o o "How w car for Googlrs" Hall, Jonathan and Alan Krugr An Analysis of th Labor Markt for Ubr s Drivr-Partnrs in th Unitd Stats. Working papr. This not is far too complx to us with studnts in a first lvl cours but is providd hr to giv instructors mor dtails about th drivation of th first ordr condition in th labour disciplin modl. Th not also xplains som comparativ statics rlatd to th optimum in th contxt of a spcific utility function for workrs. This should hlp instructors undrstand at a dpr lvl som of th ffcts in th labour disciplin diagram which ar discussd mor intuitivly in th CORE txt, for xampl, th ffct of incrasd duration of unmploymnt or bnfits on th ffort curv. Hr w xplor th rlationship btwn work ffort xpndd by th mploy () and th hourly wag (w), th xpctd unmploymnt duration xprssd in lost work hours (u) and th unmploymnt bnfit which is a lump sum paymnt qual to B Th rsrvation wag ( w ) is avrag incom that th unmployd will xprinc during a spll of unmploymnt or w= B u which is as xpctd incrasing in th unmploymnt bnfit and dcrasing in th xpctd duration of unmploymnt Th xpctd incom lost du to a spll of unmploymnt is th diffrnc btwn th (hourly) wag on th job and th (hourly) rsrvation wag or ( w- w) multiplid tims th hours of xpctd of unmploymnt D= ( w- B u) u= wu- B Th gratr th xpctd cost of job loss th gratr th ffort xpndd by th workr, so th mploy s bst rspons function is = ( D) for D³ 0 with (0) = 0, > 0 and < 0 Th bst rspons function is concav bcaus additional ffort is incrasingly onrous to th workr as som maximum possibl work ffort is approachd. Th firm varis w to maximiz /w, th first ordr condition for which is: u = w dd u = dw d u ' = dw Now bcaus so that this first-ordr condition can b rwrittn in a way rcognizabl as th Solow condition: 6

7 d dw = w rquiring that th slop of th bst rspons function b quatd to th slop of a ray from th origin (or MRT = MRS). This first ordr condition can also b sn to rquir that th marginal bnfit of raising th wag b qual to th marginal cost of raising th wag. To do this, writ th condition as marginal bnfit = % chang in = d dw % chang in w - marginal cost = w = Using this first ordr condition (diffrntiating it with rspct to u and stting th rsult qual to zro) w can show that whn th duration of unmploymnt incrass th profit maximizing wag falls: dw w =- < 0 du u Furthr, rarranging th first ordr condition as a profit maximizing wag quation w = u w s why th limination of unmploymnt (u = 0) is impossibl in this modl, as it would imply that th profit maximizing wag is infinit. W can illustrat th modl with an xplicit utility function of th mploy: which has th following proprtis: u = y-a( -) - abstracting from on s incom y, th utility associatd with going to work and doing nothing is -a (so just bing thr is a disutility); and u =-a æ ç - ö 2 è( - ) ø. so that u (0) 0 = and for positiv ffort th marginal - u disutility of ffort (that is ) is incrasing and convx. Th incom of th mploy is ithr y or y-d th lattr occurring with probability t (probability of job trmination) whr t = (- ) and th formr othrwis. So th mploy varis to maximis a a a u= ( -t) y + t( y-d) -( - ) = y +( -)( y-d) -( - ) = y-( -) D-( -) with th first ordr condition rquiring that th marginal disutility of ffort b quatd to th marginal ffct of working hardr on not gtting fird multiplid by th incom lost if fird: u = t D or using th abov quation: 7

8 -a æ ç - ö ( wu B) 2 =- - è( - ) ø Notic that Th lft-hand sid of this quation can also b intrprtd as th marginal u y = rat of substitution of ffort and goods (rcalling that whil th right-hand sid of th quation is th marginal rat of transformation of ffort into xpctd incom. W now solv this quation for to gt th mploys bst rspons function or: showing, as it should, that: /2 /2 æ a ö æ a ö = - ç = -ç èwu - B + a ø èd+ a ø whn th total incom lost in a spll of unmploymnt is zro (Δ = 0) th workr dos not work incrasd wags rais th ffort lvl incrasd duration of unmploymnt rais th ffort lvl and incrasd unmploymnt bnfits rduc th ffort lvl Furthr, noting that w and u ntr th bst rspons function multiplicativly whil wu and -B appar in it additivly w s that highr wags and longr unmploymnt ar complmnts in maintaining labor disciplin and gratr lost incom from a spll of unmploymnt (wu) and lssr unmploymnt bnfits ar substituts in maintaining labor disciplin. 8

Chapter 13 Aggregate Supply

Chapter 13 Aggregate Supply Chaptr 13 Aggrgat Supply 0 1 Larning Objctivs thr modls of aggrgat supply in which output dpnds positivly on th pric lvl in th short run th short-run tradoff btwn inflation and unmploymnt known as th Phillips