Economics: The Labor Market

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We have got an aggregate demand curve and we are trying to come up with an aggregate supply curve so we can put the two together and get an equilibrium price level and output for the economy. But we have run into this problem, which is that if the price level rises, the price of goods, raw materials, and labor are rising together. Since business opportunities are not changing when all prices rise together, why should businesses change their output?
This has led us to ask the question, what in the short run could be happening? That is during the price adjustment process, what could be happening that creates profit opportunity that leads business to change their output? We considered the possibility that there is confusion. It takes you a while to figure out weather the price of your good is changing relative to other goods or whether it is just general inflation.
And businesses will respond during this period of confusion to what they think may be a profit opportunity. We have considered the problem of "sticky prices," that is, it takes a while to adjust your prices because of the cost of printing a new menu or the fear of angering your customers. In that case, a profit opportunity is created in the short run as some businesses fall behind the price adjustment process and become uncompetitive.
Now we are going to consider a third thing that can happen in the short run that can create a profit opportunity when the aggregate price level changes. That third thing is fixed wages. Now the classical view of the market is that wages and prices all adjust very quickly to make supply and demand equal to each other. In the classical view, the bidding mechanism quickly establishes equilibrium any time something changes. So, there is no profit opportunity created. All prices go right up and you are left right where you were before.
In the view that we are going to discuss now, which is a Keynesian view, wages remain fixed in the short-run. When wages are fixed and the process of goods increase then there is a profit opportunity because the real wage that your factory is paying has shrunk. That is the wage as a percentage of your revenue is getting smaller, so it looks like your profits are getting bigger because, in fact, they are. In that event, businesses are going to produce more output when the general price level rises because the price of their goods and services, their revenue, is rising faster than their costs because the wages are fixed.
Now, before I go back the aggregate supply curve, you are probably going to ask me, "Why would wages be fixed in the short-run?" Why is it that there is a period of time during which wages do not rise during a period of general inflation? Usually, rising wages are going to occur during periods of collective bargaining if the workers are unionized. So inflation occurs, and the workers gather represented by their union, and their union negotiates a nominal higher wage so that the workers can keep up with inflation. Then that wage is locked in for a period of two or three years. If, during that two or three year period, there should be unexpectedly high inflation, prices increase faster than the workers expected, then the workers are going to find themselves at a disadvantage because they locked in a wage increase, but it was less than they would have needed to keep equal with inflation. So, if there is an unexpected price increase, then the fact that wages are fixed works to the workers' disadvantage. So, why would they put themselves in a position were that could happen?
Because, think about it, workers accept fixed wages, and many of us accept fixed salaries as a kind of risk sharing arrangement. I have an agreement with my employer that I get paid a fixed wage whether I am working harder during a period of high demand at my business or whether I have more time to play computer games because demand is slack. Along the way, my wage remains fixed. I get paid about the average of what I add to my company's bottom line. I like that. It is better that my company paying me better in boom times and less in bust times, and then I would have to go buy the insurance myself. So constant wages, or fixed wages, are kind of an insurance arrangement, and I like that even if it means that sometimes the price level is going to be rising faster than my wages because I bought insurance.
Another thing is the problem that as wages rise, sometimes workers actually want to work less. So, businesses find a wage that encourages workers to be willing to supply labor rather than using their newfound wealth to buy leisure by taking more time off. We have also discussed elsewhere the phenomenon of efficiency wages, that there are reasons why employers would not adjust wages over time because of the effect on workers' moral, workers' ability to buy healthcare and good nutrition, and the ability to attract high quality workers. There are a lot of factors in the labor market, including laws like minimum wage laws, union contracts, efficiency wages, and the desire for leisure that can cause wages to be less flexible than other prices.
If wages are, in fact, sticky during a period of time, then it is possible that goods prices will rise faster than wages. When they do, then you have got an opportunity for profit. That opportunity for profit can be seen in the short-run aggregate supply curve. Here is a general increase in the price level. When the price level increases generally and wages remain sticky, then the firm is now able to make more profit because revenue is rising faster than costs. Another way to put it, real wages are shrinking, wages as a percentage of the price of the company's product is shrinking. Therefore the business sees that there is a profit opportunity and it expands output. Now, if wages are generally fixed across the economy, that is, they're sticky, they are not adjusting especially rapidly because of these concerns, then a general increase in the price level creates a broad opportunity across the market for firms to make profits by increasing their output, and that is precisely what they will do.
In the long run what happens is that workers go back to the negotiating table and ask for a higher wage that helps them keep up with the increase in the price level. But in the short run, if wages are fixed, then the businesses take advantage of the situation. They increase their output and they make more profits. So now we have got three reasons why the short run aggregate supply curve slopes upwards, three reasons why a general increase in the price level leads businesses to produce more output. That is, confusion about relative prices, the cost of adjusting prices or sticky prices, and finally the problem of fixed wages.
In the classical view there should be no relationship between the price level and output. But in the view that we have talked about, the more sophisticated view that tries to adapt some of Keynes' ideas to a modern way of thinking about the economy, there is clear reasons why increases in the price level in the short run lead to increases in the overall level of output.
Aggregate Demand/Aggregate Supply Model
Aggregate Supply
The Labor Market Page [2 of 2]