Unit 2 Unemployment, wages, and inequality: Supply-side policies and institutions
2.4 Labour market policies to address structural unemployment and inequality
The objectives of labour market policies typically include reducing unemployment and raising wages (particularly of the least well off). Using a macroeconomic model helps identify effective policies and avoid the pitfalls of ignoring the unintended consequences of policies.
Education and training shift the PS curve up
Consider an improvement in the quality of education and training that future employees receive, which increases the productivity of labour (output per head). How will higher productivity affect real wages and equilibrium employment?
The markup chosen by the firm when it sets its price to maximize its profits is determined by the amount of competition it faces, and therefore is unaffected by the increase in productivity. This markup determines the distribution of the firm’s revenue between the employees and the owners. When output per head rises, but the profit and wage shares remain the same, the PS curve shifts up. At the new WS–PS equilibrium, workers benefit from a higher real wage. As we stressed in Unit 1, for workers to get the higher real wage, it must be the case that competition among firms pushes prices down (since their unit labour costs have fallen). The lower price level for the basket of goods they consume implies a higher real wage.
To show explicitly the implications for inequality, in Figure 2.9 we use the Lorenz curve diagram: the lower equilibrium unemployment level draws the kink in the Lorenz curve on the horizontal axis further to the left and the second kink remains unchanged (since the profit share is unaffected by the rise in productivity). The result is that the Lorenz curve is closer to the line of equal incomes and the Gini coefficient falls. Note that the Lorenz curve does not tell us anything about the level of real wages—for that, we need the WS–PS diagram.
Figure 2.9 The effect of education and training on labour market outcomes and inequality.
A change in \(\lambda\), holding the profit and wage shares fixed, decreases unemployment, reducing inequality.
- structural unemployment
- The level of unemployment where the supply side of the economy is in equilibrium. In the WS–PS model, it is the unemployment level at which the price-setting real wage equals the wage-setting real wage. See also: WS–PS model, Nash equilibrium, supply side.
The outcome of an improvement in education and training is a fall in structural unemployment, a rise in the real wage, a fall in inequality, and an unchanged profit share.
A wage subsidy shifts the PS curve up
A policy that has been advocated to increase employment is a subsidy paid to firms in proportion to the wages it pays its workers. For example, suppose that hiring a worker for an hour would cost the firm $40 in wages, but it would receive a 10% subsidy of that amount from the government, or $4. The net wage cost to the firm would then be $36.
How would this affect the price-setting curve? The costs of the firm have now fallen (due to the wage subsidy rather than as a result of higher productivity, as in the previous example). As above, the markup that the firm will use to set its price relative to its costs has not changed, so with lower costs it will set a lower price. When all firms do this, the prices of goods that the workers consume fall, and real wages rise. The effect, as above, is to shift the PS curve upwards.
- wage subsidy
- A government payment either to firms or employees, to raise the wage received by workers or lower the wage costs paid by firms, with the objective of increasing hiring and workers’ incomes.
The outcome of a wage subsidy policy is a fall in structural unemployment and a rise in the real wage.
Paying for labour market policies
Assessing the full effect of each of these policies should take account of how the education and training or wage subsidy are financed, but to allow a simple illustration of how the model works, we assume that the funds necessary for these programmes could be raised without affecting the labour or product markets. We return to how to model taxation in Section 2.7.
Unintended consequences of labour market policies: Introducing an unemployment benefit
- unemployment benefit
- A government transfer that is paid to an unemployed person while they are unemployed (or for part of the unemployment period). Also known as: unemployment insurance.
- Nash equilibrium
- An outcome is termed a Nash equilibrium if none of those involved, by individually choosing a different action, could bring about an outcome that they would prefer. In game theory, a Nash equilibrium is a set of strategies, one for each player in the game, such that each player’s strategy is a best response to the strategies chosen by everyone else. See also: game theory.
In the previous section, we assumed that the income of unemployed workers was zero. Now suppose that the government decides to introduce an unemployment benefit (unemployment insurance) with the aim of improving the standard of living of the unemployed. We assume that the government shifts its spending priorities in order to be able to finance the unemployment benefits.
We begin by identifying the Nash equilibrium in the initial situation before the policy is introduced. In Figure 2.10, the economy is at the point marked E, where the wage- and price-setting curves intersect. This is a Nash equilibrium because neither a worker (employed or unemployed) nor a firm could be better off by setting a different wage or price, offering to work at a different wage, or hiring a different number of workers.
First, we examine the short-run impact of the policy using Figure 2.10.
- reservation wage
- The reservation wage is the lowest wage a worker is willing to accept to take up a new job. It is the wage available in the worker’s next best job option (the reservation option). For workers whose next best option is unemployment, the reservation wage takes into account the wages they expect to receive when they find a new job as well as any income received while unemployed.
- Initial equilibrium with no unemployment benefit: With no unemployment benefits, the Nash equilibrium is at point E.
- Voters successfully demand an unemployment benefit: The workers—employed and unemployed—vote to elect a government that offers a new policy. Workers will receive an unemployment benefit when they are out of work.
- The benefit raises the reservation wage of employed workers: In the short run, this shifts the wage-setting curve upwards, so that employers now have to pay more to recruit workers and induce them to work hard and well. This is shown by point C.
The policy has its intended effect—the unemployed receive a higher income. Moreover, employed workers’ wages have risen too, seemingly an unexpected benefit of a policy oriented towards reducing inequality. However, this unintended effect—raising wages—takes the economy away from its initial Nash equilibrium. We will analyse how the long-run effects can differ from the short-run effects.
Using the analysis in Figure 2.10, follow the logic of the model as the actors respond to the policy.
Figure 2.10 Short- and long-run effects of introducing an unemployment benefit.
The status quo
The intended consequence
A new, lower Gini coefficient
The result for employment
The result for inequality
We can summarize the impact of the policy:
- The short-run impact shifts the wage-setting curve upwards: The unemployed receive higher benefits and the employed receive higher wages (point C).
- The long-run impact is higher structural unemployment and a higher standard of living of the unemployed: There is a new Nash equilibrium in the long run. The economy is at point E′. As intended, the unemployed now receive higher income when out of work. But fewer workers are employed, which was not intended.
Whether this is a desirable policy depends on the importance of the intended consequence (the unemployed are better off) as compared with the unintended one (there are more unemployed).
Unemployment benefits in the model and in the data
Surprisingly, the data shows that countries with more generous unemployment benefits do not, on average, have higher unemployment rates. In Figure 2.11, for example, Denmark has very generous unemployment benefits and a low rate of unemployment. This is also the case for Norway, Sweden, and the Netherlands.
Figure 2.11 Unemployment benefit generosity and unemployment rates across the OECD (2001–2020). The gross unemployment benefit replacement rate is an average for the economy of how much of a person’s pre-tax earnings is replaced by unemployment benefits.
OECD. 2021. OECD Statistics.
Unemployment benefits and wage setting in Sweden
This suggests that these countries were able to achieve a Nash equilibrium outcome different from either E or E′ in Figure 2.10. To understand how an economy with generous unemployment benefits could avoid the unintended consequence of higher unemployment, we examine the example of Sweden.
The Swedish approach had its origins in the ‘solidarity wage policy’, devised in 1951 by Gösta Rehn and Rudolph Meidner, two economists who worked at the research institute of the Trade Union Confederation in Sweden.
They reasoned that workers and employers have a common interest in rapid productivity growth, and that workers could enjoy higher wages without the profits of firms being reduced if more of the economy’s output was produced by high-productivity firms rather than by firms with low productivity.
In our ‘Economist in action’ video, John Van Reenen reports on the wide variation in productivity across firms in the economy, and how best practices in technology and management can be promoted.
Question 2.4 Choose the correct answer(s)
Watch our ‘Economist in action’ video featuring John Van Reenen about the determinants of the productivity of firms. Based on the video, read the following statements and choose the correct option(s).
- Different management practices are part of the explanation, but do not entirely explain the huge variation. Technology and the rate of innovation diffusion is another important determinant.
- While a country’s openness to FDI is an important factor for improving productivity, the video did not suggest that it is more important than creative destruction.
- Driving up average productivity through new entry and innovation (the ‘creative’ part) takes time and the effects can usually only be experienced in the long run.
- Openness to imports affects the flow of new ideas into the economy, which can promote technological advances and innovation.
The solidarity wage policy in Sweden was actually three linked policies:
- Equal wages for equal work: This means that the wage for each job was set at the national level by negotiations between the representatives of employers and workers. This had the effect of reducing wage differences among workers doing similar jobs. The lowest-productivity firms had survived by paying lower wages than other firms paid to equivalent workers. Under the new policy, these firms could not pay the negotiated wage for the job and still remain profitable, so they had to exit the industry. Higher-productivity firms survived and took over the market share of the failed firms.
- Unemployment benefits: These were generous but were only available for a relatively short time, creating strong incentives for job search.
- Active labour market policy: Retraining and mobility allowances helped displaced workers find new jobs.
The solidarity wage policy forced low-productivity firms out of the market. The remaining firms had higher productivity and could, therefore, maintain their profit margins at lower prices, pushing the price-setting curve upwards. Retraining and mobility allowances ensured that these high-productivity firms had access to a well-trained workforce, allowing them to cut costs and prices even further.
Figure 2.12 shows how this combination of policies results in a new equilibrium at E″ with higher real wages and with less unemployment than at E′. This is a third Nash equilibrium, where a new, higher price-setting curve intersects the wage-setting curve with unemployment benefits.
Figure 2.12 Combining the introduction of an unemployment benefit with a solidarity wage policy to raise productivity in the economy.
Exercise 2.3 Unemployment rates and labour market policies
Pick two countries from Figure 2.11 that have different unemployment rates and/or different unemployment benefit replacement rates.
- Research the labour market policies in your chosen countries and use this information to suggest some reasons for the differences in Figure 2.11.
- Use a WS–PS diagram like Figure 2.12 to illustrate the labour market outcomes in your chosen countries. (You can either draw these countries on the same diagram or separate diagrams.)
Question 2.5 Choose the correct answer(s)
Referring to Figure 2.12, read the following statements and choose the correct option(s).
- Real wages would remain at the level they were before the policy was introduced and employment would decrease.
- The price-setting curve is horizontal; therefore, unless the price-setting curve moves up or down, any equilibrium will have real wages at the same level.
- Imposing a standard wage for the job through national wage negotiations led to firms with productivity levels below the new negotiated wage exiting the industry.
- Unemployment benefits offer valuable insurance to workers who could lose their jobs. While workers are clearly made worse off by the decrease in employment, they may still benefit overall from the policy.
