## Wage Curve Theory - Lesson Plan

A lesson plan that introduces the wage curve theory at AS and A2 level.

# Wage Curve Theory

### What Does This Resource Cover?

This is the first in a new series of articles aimed at students following courses in economics in the 16 - 19 age groups. The articles aim to highlight some recent thinking in economics that has relevance to the way in which key topics in Economics are viewed. The first of these articles looks at the Phillips Curve and the Wage Curve. It is relevant to those studying labour economics as well as macroeconomics.

## The Phillips Curve

The Phillips Curve has been much discussed in the years since it was first put forward by Professor A.W. Phillips in 1958. Briefly, Phillips spent time looking at the relationship between the rate of growth of wages and unemployment. He came to the conclusion that there was an inverse relationship between the two; in other words, a rise in the rate of growth of wages was associated with a fall in unemployment and vice versa.

This had implications for macroeconomic policy-makers. If the rate of growth of wages has a relationship with the level of unemployment, then as the rate of growth of wages slows down, we might expect the labour market to be looser; in other words, the demand for labour in relation to the supply of labour is falling. Under normal market conditions, we would expect the wage rate to start to fall. In reality, this translates to the slowing down in the rate of growth of wages.

Draw a diagram and offer a brief explanation to show how the rate of growth in the wage rate could be expected to slow down when the demand for labour falls.

The relationship of the wage rate to unemployment takes us a small step towards linking the level of inflation with unemployment. The rate of growth in wages is a factor that influences the overall level of prices in the economy. Wages represent a cost to employers; other things being equal, if they rise then employers might well seek to raise prices to cover the increased cost. If this happens throughout the economy on an aggregate level, wage growth leads to inflation.

Policies designed to boost the employment rate can be expected, according to the Phillips Curve, to lead to an increase in the level of inflation in an economy. There is thus a trade off between inflation and unemployment. If we try to graph the level of unemployment against the rate of inflation, there does not appear to be any sort of neat relationship between the two, as suggested by the textbook representation of the Phillips Curve.

Look at Biz/ed's Key Economic Data section. Select the variables 'Inflation (CPI) and unemployment'. Can you identify any sort of inverse relationship between the two?

## The Death of the Phillips Curve?

The 1970s saw economic conditions changing. The major cause was the massive rise in oil prices as a result of the Arab-Israeli conflict.

The eruption of conflict between Arab nations and Israel in the early 1970s sent shock waves throughout the whole world. With the West supporting Israel, the Arab states responded by reducing oil supplies to the West - the result, a doubling of oil prices! This supply side shock caused problems in major economies such as the US and the UK. Copyright: Luiz Baltar, from stock.xchng.

This massive supply side shock led to economies experiencing not only rising inflation but also rising unemployment. Was the Phillips Curve dead? Not necessarily. It could be shifting. This led to the development of the so-called expectations augmented Phillips Curve, which basically said that people come to build in their expectations of what inflation is going to do in their wage negotiations. If employers accede to these wage demands then the result could be a shift in the Phillips Curve, with higher levels of inflation being associated with higher levels of unemployment.

Analysis: use AS/AD analysis to comment on what might happen in the following scenario:

• The unemployment rate is currently at 8%, which the government thinks is too high. They decide to adopt some fiscal policy moves to try to reduce the level of unemployment by boosting the level of AD.

Comment on the possible short and long term effect of this policy. (Hint: think how both employees and employers will react to the situation).

As a result of the incorporation of expectations of inflation, the variation of the Phillips Curve can be expressed using a formula. Economists use these formulas to be able to clarify what depends on what. For example, look at the following formula:

Δpt = Et Δpt+1 + (NRt - RUt)

This simply says that the change in the inflation rate in a time period (Δpt
) is equal to expected inflation in a time period (Et Δpt+1
) and the natural rate of unemployment minus the national unemployment rate. Such formulas can look rather daunting but they help to make a seemingly complex relationship more straightforward. By adjusting the variables in the formula whilst holding other variables constant, economists can make certain observations, much as a scientist might do in a laboratory experiment.

Ignore the formula. What do you think the rate of inflation will be in one year's time? On what have you based your estimation?

What came out of all this research was a new explanation for the problems that many economies were experiencing in the 1970s and 1980s - the expectations augmented Phillips Curve. This posited that what was happening was that people were anticipating inflation in the future and basing their behaviour and decision-making on those expectations: therefore, the Phillips Curve was shifting. This helped to explain how higher inflation might also be experienced at the same time as higher unemployment - so-called 'stagflation'.

Unemployment is a problem to the economy as labour resources are wasted. There is an opportunity cost of labour not working - and in addition, the cost to the government and the taxpayer of supporting the unemployed contributes to the growth in social security payments, one of the biggest portions of government spending. Copyright: Alexander Radev, from stock.xchng.

In the mid 1970s, the view from the Government effectively confirmed this view of the economy. The then Prime Minister, James Callaghan, gave a speech at the 1976 Labour Party conference at which he said:

We used to think you could just spend your way out of recession, and increase employment, by cutting taxes and boosting government spending. I tell you in all candour, that that option no longer exists, and insofar as it ever did exist, it worked by injecting inflation into the economy. And each time that happened, the average level of unemployment has risen. Higher inflation followed by higher unemployment. That is the history of the last twenty years.

This really was economics at the very cutting edge. In these few words, Mr Callaghan effectively condemned a whole branch of economic thought to the waste bin and set up a new agenda for economic policy. Mrs Thatcher, who took much of the plaudits for reversing the fortunes of the British economy, had much to be thankful about Mr Callaghan and the Labour government. She continued to pursue policies that moved away from Keynesian demand-management to policies based more on supply side and monetary policy as the fundamental tools of managing the economy.

What was the basis of this shift? The theory can be expressed quite simply and logically using some basic understanding of AS and AD and linking it to the Phillips Curve. Please go through to the PowerPoint presentation. This presentation takes you through the principles step by step:

1. Assume that the economy is in equilibrium, with AS = AD at an inflation rate of 3% and an unemployment rate of 7%. The Government believes that unemployment is too high and takes steps to boost demand through an expansionary fiscal policy.
2. What happens? The level of aggregate demand rises shown by a shift in AD to the right and a movement along the Phillips Curve to the left. The short-run outcome is that unemployment has fallen to 5% but inflation has crept up to 4%.
3. The next step is where the effect of expectations comes into the analysis. Given that unemployment has fallen, workers feel less threatened in their jobs, which affects how they negotiate pay awards. They will also anticipate that if inflation has risen to 5%, it is entirely plausible that it could rise again next year. They then build this into pay claims. Part of the assumption now is that pay claims in excess of inflation will be met by employers. In the trade union-dominated world of the late seventies, this was entirely possible and was one of the arguments Mrs Thatcher put forward for restricting the power of trade unions.
4. Let us assume that workers put in for average pay increases of 7%: this represents a 'real' pay claim of 2% given current inflation levels (5%). If employers meet these pay demands (and in times of falling unemployment, they have no reason to think that that they cannot increase prices to the consumer) then they will experience additional costs. Any rise in the cost of production has the effect of pushing the AS curve to the left. For some businesses, the rising cost of labour will put pressure on their profit margins and some will be forced to shed labour in the process. What we now see, therefore, is a gradual rise in the number of unemployed people but a corresponding increase in the inflation rate as increased wage costs in the economy are passed onto the consumer.
5. The long-run situation, therefore, may well see the economy return to a situation of 7% unemployment but in the process, experiencing an inflation rate now standing at 6%. If the government perceived 7% unemployment as unacceptable at the start of the analysis, there is no reason to assume that they will not do so at this stage and so the whole process starts again.

Of course, the process described might take many years to go full circle. It is important to remember also that we are talking about the macro-economy and therefore about the behaviour of workers and producers in the aggregate - as a whole - rather than small groups or individuals. The above analysis effectively drove the changes in economic policy throughout the latter part of the 1970s and the 1980s.

In order to reduce both the level of unemployment and inflation, what strategies might policy makers have to adopt? Try to use the AD/AS framework and the Phillips Curve diagram as highlighted in the PowerPoint slide show to illustrate your analysis.

There have, however, been a number of economists who have questioned the existence of the Phillips Curve. Remember that the assumption of the Phillips Curve is that there is a relationship between the rate of growth of wages and unemployment. When unemployment rises, the rate of growth of wages falls and vice versa. This makes intuitive sense since if there is a large pool of unemployed workers, employed workers will be hesitant to push for higher wage claims for fear of joining the rank of unemployed.

Like many things in economics, however, this intuitive understanding can be questioned. We mentioned earlier that we are talking about the economy as a whole. We might ask the question, is this sort of behaviour expected of the majority of the population in the economy?

## The Wage Curve

David Blanchflower - one of the members of the Monetary Policy Committee of the Bank of England. Renowned for his work on the labour market and on the economics of 'happiness'. Source: Reproduced by kind permission of Newscast.

One economist did pose that very question. David Blanchflower worked at a number of institutions, including the University of Surrey and Warwick University. He now divides his time between working at Dartmouth College in New Hampshire in the US and being on the Bank of England's Monetary Policy Committee.

Blanchflower has been quoted as suggesting that as a result of his work, "the Phillips Curve is wrong, it's as fundamental as that". You will see reference to the Phillips Curve in every major A' level textbook and on most exam board syllabuses in the UK and elsewhere in the world. If what Blanchflower is saying is correct, however, then should we be revising these textbooks and questioning whether we should be teaching and learning something that is 'fundamentally wrong'? Let us have a look at what Blanchflower said on the subject.

## Rates of Growth in Wages and Levels of Wages

The traditional Phillips curve relates the rate of growth of wages with the level of unemployment. Within this relationship, a higher level of unemployment is associated with a lower level of the rate of growth of wages. Conversely, if unemployment rates were low, the rate of growth of wages would be higher. Such a relationship is given as a macroeconomic one rather than microeconomic, i.e. it holds for the economy as a whole. If the level of unemployment increases, therefore, it suggests there will be excess supply in the labour market. In such cases, the labour market will adjust and the rate of growth of wages will fall to eliminate the excess supply.

Blanchflower and his colleague, Andrew Oswald, spent time researching links between unemployment and wage rates at a microeconomic level and found that the relationship between unemployment and wages might be different depending on the region that was being investigated. Their research looked at the level of pay rather than the rate of growth of wages. They argued that the level of pay rather than the rate of growth in pay was what was negatively related to the level of unemployment.

According to this argument, a worker in region A, which has a high level of unemployment, would earn lower wages than an equivalent worker in region B with lower levels of unemployment. Blanchard and Oswald's research casts doubt upon the standard explanation, in both regional economics and labour economics, that the wage rate in an area is positively linked to the level of unemployment in an area. In other words, the higher the level of unemployment, the higher the wage level needed to persuade someone to work in that area and vice versa.

Their work would tend to call into question some of the basic 'laws' of economics, particularly those related to something like the minimum wage. The conventional wisdom might be that if the minimum wage was introduced into an economy, the higher wage levels would be associated with a rise in unemployment. Blanchflower and Oswald's analysis suggests that this may not be the case and that in some areas, there might even be a rise in the level of unemployment associated with a rise in wage levels.

The diagram above highlights the traditional view of the effect of the imposition of a minimum wage set above the market wage level (W1) on the level of unemployment. The minimum wage causes a fall in the quantity of labour demanded and an increase in the quantity supplied of labour (a movement along the D and S curves for labour). The result is an increase in the amount of unemployment, shown by the distance Q3 - Q2.

To understand this, it is important to refer back to the basic model of the labour market shown below. In the diagram, if the demand for labour, for example, rose as indicated by a shift in the demand for labour curve to the right (DL - DL1), then there would be an excess demand for labour shown by the distance Q2 - Q1. Wage rates would rise in response to this shortage of labour and as the shortage is competed away, more people would end up being employed (Q3) at higher wage rates (W2). A rise in wage rates, therefore, is positively correlated with a fall in unemployment and vice versa.

Using traditional labour market analysis, explain how a fall in the demand for labour in one region of the country might affect the market wage rates in that region and also in neighbouring regions.

Blanchflower and Oswald's research was based around millions of observations. They identified the existence of wage curves in 16 countries and since the publication of their research in 1994, a number of other researchers have confirmed their findings. Blanchflower and Oswald suggested that their wage curve would have an elasticity of -0.1. What this refers to is the responsiveness of rates of pay to changes in unemployment.

 Wage Curve Elasticity = % change in pay % change in unemployment

An elasticity of -0.1, therefore, would suggest that if we took two regions within an economy, region A and region B, and if unemployment was 2% in region B but 4% in region A, we would expect wages to be around 10% lower in region A than B. This suggests some sort of causal relationship stemming from the level of unemployment in an area feeding through to the level of wages in that area, rather than the other way round.

## Implications of the Research

The suggestion that there is a relationship between the rate of growth of wages (and by implication, inflation) and unemployment has, as we saw in the early part of this article, implications for policy makers. This is based in part on the idea that controlling the rate of growth in wages (and hence inflation) is an important step in controlling unemployment.

The implications of Blanchard and Oswald's research could be far reaching - it turns the whole nature of the causal link between unemployment and wages on its head! Copyright: Silvia Cosimini, from stock.xchng.

If, however, Blanchard and Oswald's research on wage curves is correct, it changes the emphasis of policy-making both at a macro and at a micro level. Let us assume that the government are looking at an unemployment rate that they consider too high, and so want to reduce that rate. If they refer to traditional macroeconomic models of the labour market, they might look at wages as being one way of reducing unemployment in that area - in other words, a fall in wages would help to bring about a reduction in unemployment.

If a wage curve does exist, then attempts to reduce unemployment in this way could backfire, since falling wages would be associated with higher unemployment! In addition, it might be believed that high unemployment in an area might be affected most dramatically by focussing on high unemployment groups in that area - those with low levels of education, for example. It might be expected that these groups of people will be most likely to take on jobs that are created at lower wages and as such, policies to reduce unemployment could be achieved without a major impact on inflation. Again, the existence of a wage curve would tend to provide an argument against doing this. This is partly because it is the level of wages that are important rather than the rate of growth of wages.

Blanchflower and Oswald's research is far more complex than the simplified version we have presented here. One of the factors that they explore in their research is how labour reacts to differences in levels of pay between regions of a country (or even between states, as in the US, or countries tied by economic agreements such as the EU). There are a number of factors that might influence the movement of labour in finding new jobs. Consider the following factors in influencing the ability of workers to move to different areas and access new jobs in different regions:

1. Housing
2. Family ties
3. Risk (i.e. whether workers are risk averse or risk seeking)
4. Non-monetary (non-pecuniary) benefits of living in different regions of the country
5. The psychological impacts of being unemployed - the individual's 'happiness' or well being

In the light of the research by Blanchard and Oswald, consider how you might approach a question in an exam such as the following:

In recent years, the UK economy has maintained low inflation while unemployment has fallen. Evaluate the reasons for such an occurrence.

(Source: AQA Unit 6, Section B, January 2004)

Use supply and demand analysis to explain why it could be argued 'minimumwages priced unskilled workers out of jobs'.

Source: OCR Unit 2884, Economics of Work and Leisure, Specimen Assessment Materials).

Evaluate how UK labour market policies might affect wage differentials between men and women in the UK.

(Source: Edexcel Unit 5 Sample Assessment Material).