Why do Real-World Markets Not Tend to Operate at the 'Full Employment' Level?

INTRODUCTION 

This post follows from my previous two posts:

1) Market Structure: Classical Vs. Keynesian Assumption where I talk about the difference in the Classical and Keynesian assumption regarding Market Structure. Classicals assume that markets (both output and factor markets) are Perfectly Competitive, which is a necessary condition for markets to operate at/move towards 'Full Employment'. Keynesians on the other hand, reject this assumption and assert that real-world markets are comprised of powerful monopolies and oligopolies, and that in such market structures there are no natural forces pushing the system towards Full Employment. 

and

2) Why do Perfectly Competitive Markets Tend to Operate at the 'Full Employment' Level? where I continue from my post on market structure, and go on to demonstrate using a fair amount of Microeconomics, how Perfectly Competitive markets tend to operate at the Full Employment level. 

In this current post, I will explain (using microeconomic concepts again) why real-world markets where monopolies and oligopolies (buyers exerting market power) as well as monopsonies (single seller) or a few sellers are common, do not tend to operate at the Full Employment level. With that preamble, let's move on to the business at hand. 

CURRENT POST

Keynesian theory asserts that the assumption of Perfect Competition is unrealistic. There are strong Monopolies and Oligopolies in the real world. Under such market structures, the labour market does NOT function at Full Employment levels. Let us explain how. 

How Price and Output are Determined in a Monopoly Output Market

Just like in perfect competition, a profit maximizing monopoly will produce upto the point where MR = MC. However, unlike a firm operating in a perfectly competitive market (faces a flat, perfectly elastic demand curve), the monopolist faces a downward sloping demand curve. This is because a monopolist has market power and can exert influence on the price of output by changing the quantity it produces. See chart 2 below.

Chart 2: Output and Price determination in a Monopoly vs. Perfect Competition

A monopolist will produce a quantity of output (QM) where MR = MC (see in chart above that the MR and MC curves interest at this level of output). He will then sell this quantity QM at a price PM that he gets off his demand curve.

Notice that at price PM, demand for output (i.e. QM) is not = supply. The monopolist chooses to sell at price PM because this maximizes his profit.

In perfect competition on the other hand, equilibrium price would be Pc and equilibrium quantity would be Qc, and demand for output would be = supply for output at this equilibrium level. 

Conclusion: Lower output is produced (at a higher price) in a monopoly vs. in a perfectly competitive market. As a result, employment of labour would be lower in a monopoly too. Since we know now, that a perfectly competitive output market functions at the “full employment” level, we can conclude that a monopoly output market operates below the full employment level of the economy. 

How Price and Output are Determined in a Monopsonist Labour Market 

1. How do we get the Labour Demand curve for a Monopsonist?

Let’s assume that the firm that we’ve talked about above, which a Monopolist (single seller) in its output market, is a Monopsonist (single buyer) in the labour market. I've done this to introduce another dimension of market power, even though we've shown above that  a firm being a monopolist in its output market is enough to ensure that the labour it employs is less than the 'full employment" level of labour employed by a perfectly competitive output market.

That said, let’s see how the wage rate and labour employed by a monopsony is determined in the labour market and compare it with the wage rate and labour employed by a perfectly competitive labour market. 

At any wage rate (w), the monopsonist will demand labour upto the point where the MR from an additional unit of labour - this is called the Marginal Revenue Product of labour (MRPL) - is equal to “w”. 

MRPL = MR * MPL 

Consequently, the MRPL curve of the monopsonist (MRPL at different levels of labour employment plotted against the wage rate) is the demand curve for labour in this market (since the monopsonist is the only buyer). See chart 3 below. 

Chart 3: Determination of Labour employed and Wage rate in a Monopsony vs. Perfect Competition

2. The Labour Supply curve in a Monopsony

The labour supply curve for a monopsony is upward sloping (see curve labeled “supply” in chart above). Since the monopsonist is the only buyer, he can hire more labour when he pays a higher wage, unlike a perfectly competitive firm that can hire any amount of labour at the prevailing wage rate. 

3. How much Labour does the Monopsonist employ and at what Wage?

The monopsonist will employ labour upto the point where the MRPL of the last unit of labour = the MC of this unit of labour. Note: the MC of an incremental unit of labour will be different from the existing wage because of the upward slope of the labour supply curve. This is why I’ve plotted the MC curve for labour separately in chart 3. 

So, the monopsonist will employ LM amount of labour because when labour = LM, MRPL = MC.

To determine the wage the monopsonist will pay, we look at the labour supply curve and read off the wage rate (wM) corresponding to LM amount of labour. The monopsonist will employ LM amount of labour at a wage = wM. 

4. How does this compare with Labour employed and Wage rate in a Perfectly competitive Labour market?

The labour demand curve in a perfectly competitive labour market = the summation of the MRPL curves of all the firms comprising the market. We assume that these individual firms sell output in a perfect competitive market as well. Therefore, the MRPL for each of these firm is = P0 * MPL (as we discussed in the Classical section) where P0 is the price of their output. 

In chart 3, we’ve denoted the labour market demand curve for a perfectly competitive labour market as P0 * MPL, even though technically it should be denoted as Σ P0 * MPL.

You’ll see that this curve lies above the demand curve for the monopsonist. The reason is simple. For the sake of comparison, if we assume that the price (P0) and the total quantity of output sold in the output market is the same for the monopsonist as well as the perfectly competitive firms, and that the MPL is also the same for both the monopsonist and the perfectly competitive firms in the labour market, then the P0 * MPL curve will always lie above the MR * MPL curve. This is because the market demand curve in the output market is usually always downward sloping, which means that P0 is always > MR. 

The labour market supply curve is the same in perfect competition as it is for the monopsonist. 

Now, the equilibrium wage in the perfectly competitive labour market will be wPC where the labour demand curve (P0 * MPL) intersects the labour supply curve. See chart 3 above. 

So, in a perfectly competitive labour market, LPC units of labour will be employed (higher than the LM units employed in a monopsony) at wage wPC (higher than wM - the wage paid out by the monopsonist). 

Conclusion: The amount of labour employed and the wage paid out in a monopsony are always LOWER than those in a perfectly competitive labour market. 

While in a perfectly competitive labour market, at the equilibrium wage (wPC), demand for labour = the supply of labour i.e. the labour market is at “full employment”, a monopsony (labour market) functions below the full employment level of the economy.

Finally, in both the scenarios examined above, we've shown that in real-world markets which are far from perfectly competitive and where individual firms can exert tremendous power on wage and output determination, the labour market tends to function below the full employment level of the economy.

Why do Perfectly Competitive Markets Tend to Operate at the 'Full Employment' Level?

This post is a continuation of my previous post Market Structure: Classical Vs. Keynesian Assumption (Give it a quick read to gain context). 

The Classical macroeconomic model assumes that markets (Output as well as Factor markets) are Perfectly Competitive. Perfectly competitive markets tend to operate at the 'Full Employment' level. In this post, we'll demonstrate why, by explaining how Price and Output are determined in Perfectly competitive markets.

How Price and Output are determined in a Perfectly Competitive Output Market

1. In a perfectly competitive Output market, the price (P0) of a product is determined at the intersection of the Market demand and Market supply curves (see chart 1: Output market). While market demand depends on consumer preferences, the market supply curve is simply an aggregation of the supply curves of the individual firms comprising the output market. 

Chart 1: Determination of Price and Output  (top panel), as well as Wage and Labour Employed (lower panel) in Perfectly Competitive Markets

2. How do we get the Supply curve for an individual firm? 
Since each individual firm wants to maximize profits, it will sell up to the point where its Marginal Revenue (MR) (revenue from the sale of an incremental unit of output) is = its Marginal Cost (MC) (cost of producing an incremental unit of output). The MR for a competitive firm = the Price of its output. Hence, the supply curve for this firm is simply its MC curve (See chart 1: Firm output).

3. How do we derive the Demand curve for an individual firm? 
The price of the firm’s output (P0) is determined by the intersection of the market demand and market supply curves, as we noted above. This price (P0) is taken as a ‘given’ by all the firms comprising the market because each of these firms is too small to impact P0 in any way. Hence, the demand curve for each of these firms is perfectly elastic (i.e. flat) at price P0, meaning that they can sell any amount of output that they produce at this market-determined price (See chart 1: Firm output). 

4. How much does each firm produce?

Each firm produces upto the point where the demand for its output = the supply of its output i.e. P0 = MC. You can see in the chart above (Firm output) that each firm will produce an output “x0” at price P0.

Overall, the Output market will produce X0 quantity of output (summation of the output of all the individual firms or Σx0) at price P0. 

How Wage and Labour Employed are determined in a Perfectly Competitive Labour Market (i.e. the market where the firms operating in our Perfectly Competitive Output market buy their labour)

So far, we’ve discussed how price and output quantity are determined in a Perfectly competitive Output market. Where do the firms operating in this Output market buy their labour? Per Classical economic theory, from a perfectly competitive labour market. Let's now demonstrate how Wage and Labour Employed are determined in this labour market.

1. How is Wage determined in the Labour market? 
The Classical model assumes that all markets are perfectly competitive including the labour market. Consequently, equilibrium wage (w0) is determined at the intersection of labour market demand and labour market supply curves (See chart 1: Labour market). The labour market demand curve is nothing but the aggregation of the labour demand curves of individual firms in the output market. 

2. How do we derive the Labour Demand curve for an individual firm? 

As discussed above, each profit maximizing, competitive firm produces output upto to the point where P0 = MC. From this condition, I’m going to derive the labour demand curve of this firm. Here goes: 

MC = ΔFC/ΔQ + ΔVC/ΔQ          where FC = fixed cost, VC = variable cost

What this means is that MC = increase in FC due to the production of an incremental unit of output + increase in VC due to the production of an incremental unit of output. 

Since FC is constant and does not change with the number of units of output, ΔFC/ΔQ = 0; MC is simply = ΔVC/ΔQ. We further assume that the only VC of production is the labour cost. 

Hence, MC = w * ΔL/ΔQ          (1) 

where w = wage, ΔL = change in amount of labour employed, ΔQ = change in output 

Let us now define a new term, the Marginal Product of labour (MPL). It is = the units of output produced by employing an additional unit of labour, keeping everything else constant. 

So, MPL = ΔQ/ΔL                     (2)

Substituting (2) in (1) 

MC = w/MPL                             (3)

But remember, the firm produces output till MC = P0. 

Substituting this in (3) gives us the firm’s labour demand curve:

P0 = w/MPL or

w = P0 * MPL

At any wage (w), the firm demands labour upto the point where the price of its output (P0) multiplied by the Marginal Product of the last unit of labour employed (MPL) is = w (see chart 1: Firm labour demand). 

3. How do we get the Labour Supply curve for an individual firm? 

To hire labour, the firm will have to pay the equilibrium wage = w0, determined by the market demand and market supply for labour. Each firm will take this wage (w0) as given since it’s too small to affect the wage rate. Hence, the labour supply curve for each firm will be perfectly elastic (flat) at wage = w0. The firm can employ any amount of labour by paying a wage of w0. See chart (Firm labour demand). 

4. How much labour does each firm employ?

Each firm will employ labour upto the point where its demand for labour is = the supply of labour available to it i.e. till w0 = P0 * MPL.

You can see in the chart above (Firm labour demand) that each firm will demand “l0” quantity of labour at wage w0. Overall, L0 units of labour (summation of the labour employed by all individual firms or Σl0) will be employed in the labour market at wage w0. 

Conclusion: when Output and Labour markets are Perfectly Competitive (as assumed in the Classical model), they tend to operate at the 'Full Employment' level 

To appreciate what this means, let’s remind ourselves of the meaning of “full employment”. Full employment refers to the situation in the labour market, where at the existing wage, everyone who wants to work is able to find work i.e. market demand for labour is = market supply for labour. This is the case in Chart 1 (Labour market) where at w0, the demand for labour (DL) is = the supply for labour (SL).

This is always the case for perfectly competitive markets. As we’ve explained above, the existing wage in a perfectly competitive labour market is always determined at a point where labour demand = labour supply. Further, this demand for labour is derived from firms operating in a perfectly competitive output market where price and quantity are again determined at a point where market demand for the output = market supply. 

Bottom-line, general equilibrium (when all interacting markets in an economy are in equilibrium) in perfectly competitive markets is always at the 'full employment' level - else prices adjust (rise/fall) to make it so.

This is what the Classical model of economic theory assumes. The Keynesian model on the other hand, rejects this assertion. To understand what the Keynesian model says about market structure and Full employment, read my next post Why do Real-World Markets Not Tend to Operate at the 'Full Employment' Level?. 

Market Structure: Classical Vs. Keynesian Assumption

As part of a series where I contrast key Classical and Keynesian assumptions (read my introductory post Classical Vs. Keynesian Assumptions: An Introduction), today, I will talk about the Classical vs. Keynesian take on market structure. 

The Classical model assumes that output and factor markets are perfectly competitive. What is Perfect Competition you ask? Follow this Link to Wikipedia and give it a quick read. In a nutshell, Perfect Competition refers to a market structure where there are a large number of buyers and sellers, and each participant is a price taker. No one buyer/seller has the power to impact price. The price is determined at the point where market demand is = market supply. Whenever market demand is not = market supply, the price adjusts in order to equilibrate demand and supply yet again. 

As we’ve discussed before, the Classical model asserts that the economy naturally moves towards/is usually at 'Full Employment'. Full employment refers to the situation in the labour market where the demand for labour is = the supply of labour. To learn more about Full Employment, read my post What is Full Employment and Why it is Tricky to Estimate.

In order for full employment to prevail, the assumption of perfect competition is critical. Else, the economy will not move towards/remain at full employment.

The Keynesian model on the other hand, rejects the assumption of perfect competition. Keynesians believe that real-life markets are not very competitive. There are powerful monopolies (read about the characteristics of a monopoly here) and oligopolies in the real world that exert power over price in output and factor markets. The output produced in these monopoly markets lies below the full employment level of the economy. This is one reason (amongst others) why Keynesians reject the Classical assertion that markets naturally move towards full employment.

I am going to discuss and contrast Output and Price determination under Perfectly competitive and Monopoly markets in my following two posts. I’m doing this in order to explain how theoretically, perfectly competitive markets do infact tend to operate at full employment, while monopolies/monopsonies don’t.

Go ahead and read these posts (links provided below) in chronological order for this exposition:

1) Why do Perfectly Competitive Markets Tend to Operate at the 'Full Employment' Level?

2) Why do Real-World Markets Not Tend to Operate at the 'Full Employment' Level?

Note: I've used a lot of microeconomics in these posts.

What is Full Employment and why it is tricky to Estimate

What exactly is “Full Employment”? There’s no perfect answer. This is a controversial subject amongst economists; even Janet Yellen isn’t totally sure about the answer. 

Simply put, Full Employment refers to the situation where everyone who is willing to work at the prevailing wage rate, is able to find a job. In chart 1 below, the labour market is at Full Employment at equilibrium E3 where at the prevailing wage (wo), everyone in the labour force who is willing to work at this wage (L0), is able to find employment. 

Chart 1: The labour market is at Full Employment at E3

It follows that at Full Employment, the economy’s output is at full capacity as well. This makes sense because when everyone who’s willing to work is employed, output would be maximized too. 

Full Employment doesn’t mean 0% Unemployment

Does this mean then, that at the Full Employment level, unemployment is 0%? No. In reality, there is never a situation where everyone who’s looking for a job is able to find one. Even at the Full Employment level, there is always some amount of what of we call 1) Frictional Unemployment, and 2) Structural Unemployment.

Frictional Unemployment is the unemployment caused to due to the fact that it takes time for job seekers to find the kind of positions they desire. So when you’re in-between jobs - sending out resumes, interviewing and turning down jobs that you’re not interested in (until you find one that you do accept), you are counted amongst the frictionally unemployed. 

Frictional unemployment is not an undesirable phenomenon. If a job seeker jumps at the first job that comes her way, she may make a sub-optimal decision and end up feeling professionally dissatisfied. It’s better for her to take the time to find a suitable profile so that she can experience longevity and optimal productivity in this new position. Frequent displacement and dissatisfaction is not desirable for the individual worker or the workforce as a whole. 

Structural Unemployment occurs when there is a gap/ mismatch/ incompatibility between the skills required for the available jobs and the skill set of the unemployed. Read my previous post What is Structural Unemployment? for a quick yet deep understanding of this concept with relevant, real-world examples. 

While some Structural unemployment is unavoidable, unlike Frictional unemployment, it’s not a desirable phenomenon because what it essentially represents is the reality that while there are jobs out there, the unemployed lack the skills needed to do these jobs. 

While Frictional unemployment goes away with time (for current job seekers anyway, even though a new set of unemployed workers who are in-between jobs takes their place), Structural unemployment can become chronic and long-lasting because the structurally unemployed are unable to find employment unless they retrain themselves in new disciplines. 

At the Full Employment level, there is no Cyclical Unemployment...

The type of unemployment that is not present at the Full Employment level is Cyclical or Demand-deficient Unemployment, which is caused by a lack of Aggregate Demand in the economy (happens when the economy is slowing down, in a recession or recovering from one). 

It’s important to note here that both frictional and structural unemployment are types of “supply-side” unemployment. They occur due to factors on the supply side (or labour force side), and not the demand side of the economy. Frictional unemployment occurs because workers need time to find the right job, and not because of a lack of demand for their skills. Similarly, structural unemployment occurs due to inflexibilities in the labour market i.e. unemployed workers not possessing the specific skills needed to fill the available positions, and not due to a general lack of demand for labour.

....Which means that stimulating Aggregate Demand will not increase Output/lower Unemployment, but rather lead to Inflation 

Since the unemployment that persists at the Full Employment level is not caused by a deficiency in demand, it cannot be reduced by stimulating Aggregate Demand (AD). All an increase in AD will do is cause inflation. 

Let’s understand this using Chart 2 below. Y0 is the Full Employment level of output, which is why the Aggregate Supply (AS) curve is vertical at this level. The economy is initially at equilibrium at E1 (price=P1 and output=Y0). 

If the government now decides to increase spending or reduce taxes in order to stimulate AD (from AD1 to AD2), the equilibrium will move to E2. Output will not rise (since at Y0 output is already at capacity), but prices/inflation will (from P1 to P2). 

Chart 2: An Increase in AD once the Full Employment level has been reached, leads to excessive Inflation

Infact, this is how most economists tend to identity the Full Employment level - it is that level of employment where the work force is as fully employed as possible and output is as high as possible, yet inflation hasn’t started rising excessively. 

Let’s explain further. Let’s assume the economy has reached full employment (Y0) once it is at equilibrium at E1. This means that that everyone willing and able to work is employed. Unemployment is as low as possible and output (Y0) is as high as possible. Trying to push unemployment below this point would be counter-productive. For example, if the Central Bank believes that we still haven’t reached full employment, it may cut interest rates or continue to keep them low which will tend to stimulate AD. To keep up with this demand, employers will want to hire more workers. However, since unemployment is as low as it can get, in order to hire more workers, employers will have to lure them away from other employers by offering higher wages. This will cause wages to rise. With wages rising, employers will have to raise prices of their final products/services in order to protect their margins. This will lead to a general rise in the price level i.e. inflation, above and beyond what is consistent with the existing trend. 

What I’ve described in detail above is the mechanism through which a delay in recognizing Full Employment can lead to unnecessary inflation. Since Central Banks are wary of Inflation, they do not like to be late in calling Full Employment. 

Why Full Employment is Hard to Estimate

(Note: I added this section in Nov 2017. It is especially relevant given all the discussion in 2017 around whether the US economy was at full employment or not.) 

With this background, one can begin to appreciate why the Full Employment level is so hard to estimate. 

First of all, no one knows what the exact level unemployment (frictional and structural) should be at the full employment level. Let’s take the example of the US. Economists tend to believe that when unemployment falls below 5%, the US economy is at Full Employment. This estimate is based on historical data. It’s not clear however, if historical patterns are the way to go as far as estimating Full Employment is concerned. For one, the level of structural unemployment keeps changing over time depending on changes in technology and barriers to trade. So does the level of frictional employment. Mobility between jobs, geographies and industries does not remain constant. How then can one use historical data to represent the present?

Second, the Full Employment level derives its significance for economists from the fact that an attempt to tighten the job market beyond this level, leads to excessive inflation. There is no reason to believe that in the case of the US, this level is 5%. Infact, the US Unemployment rate for October 2017 was 4.1%, even though economists have been saying that the economy is close to full employment since late 2015, when the unemployment rate hit 5% and the Fed first raised rates after 9 years. Even today, at 4.1% unemployment, wage growth remains sluggish, which technically means that this condition for full employment (wages rising threatening to cause excessive inflation) is still not fulfilled. 

No one can say for sure even today, if the US economy is at Full Employment and if not, when it will get there.