Discuss the rationale behind the WS and PS curves (12 marks)
Keynesian macroeconomics assumes that markets are imperfect and this as the result of lack of competition. The implication of imperfect market is that agents are no longer price takers as in perfect markets, but become price setters. In product markets the firms are price setters considering the elasticity of demand which is partly dependant on competition. In the labour market, workers are the wage setters. Through collective bargaining Trade Unions set wage rates, considering the elasticity for demand for labour and the level of local unemployment. “A worker who is employed in an area of high unemployment earns less than an identical individual who works in a region with low joblessness”. ( www.njfac.org/us19.htm last accessed on the 19th March 2014). When price taking behaviour is accepted, it changes how macroeconomics is analysed as inflation, unemployment, monitory policy, fiscal policy etc.
The wage equation (WS) sets a relationship between the wage (WP) and the level of unemployment (E) in the economy, and is considered from the worker’s point of view. WS shows the rates of real wages that would fulfil the level of expectations of workers at different levels of unemployment. The Price Setting equation (PS) also sets up a relationship between the wage (WP) and the level of unemployment (E) but is viewed from the prospective of the firm. PS shows the rate of real wages that would fulfil the expectations of the firm at different levels of unemployment. When the two curves meet, the real wage at the point of intersection will meet the expectation of both the firm and the worker; thus equilibrium is established by the intersection of the PS and WS.
When Trade Unions / workers bargain with employers regarding the money wage (W) consideration must be given to the state of employment and the expected selling price level of the product in the future. With employment, the higher the level of employment (E), there is a lower level of unemployment (U) this then provides an opportunity for greater bargaining power in relation to the wage rate. With regards to the expected product price, if it is anticipated that product price will rise during the next period, trade unions will seek a higher wage rate to compensate for the higher prices.
Wage setting Real Wage Curve (WS)
The wage setting curve is upward slopping, similar to the labour supply curve, but lies above the latter. For any level of employment (E), the real wage implied by the wage setting equation is higher than the wage rate that would prevail at (E) if labour markets were competitive. The gap between the two curves represents the mark up (in real wage) per worker because of market imperfections. Reasons which can explain the mark-up in wage can include the monopoly power of the trade unions and the efficiency wage which is offered by employers.
In considering Price- setting, firms will maximise profit when MR (marginal rate) = MC (marginal cost). This is true irrespective of the degree of competition within the market. With an imperfect product market the real wage that will maximise profit is less than the marginal productivity of labour, how much lower will depend upon the degree of imperfection due to the lack of competition.
Price setting Wage Curve
In the diagram above, the PS curve is depicted by a horizontal line rather than a downward slopping PS curve. This can be justified by making the assumptions f a constant MPL and constant mark-up, Є/(1-Є). The constant MPL also means that there is a constant output per worker (APL). The fixed output per worker is divided between profit and real wage. However if the mark-up is also constant, this means profits per worker is constant. Therefore, the real implied wage per worker is also constant, thus the flat PS curve.
The labour market is in equilibrium when the WS and PS curves intersect: Wws = Wps At this point the real
