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I'm currently working through the textbook Macroeconomics: European Perspective. I'm on chapter 7: the labour market. I'm a little confused by one of the sections. Let's jump in.

We can define the wage setting relation as given by:

$W=P\times F(u,z)$, where $W$ is the nominal wage, $P$ is the price level (discarding impacts of expected prices for now), $u$ it the unemployment rate, $z$ is a catch-all variable that covers anything other than employment that impacts wages, and $F()$ is the function that relates them.

The real wage is then given by: $\frac{W}{P}=F(u,z)$

To simplify the example lets assume that the only input into the production process is labour, and labour productivity is $1$, so that the marginal cost of production is just $W$, then we can then define the price setting equation as given by:

$P = (1+m)\times W$, where $m$ is the mark-up of price over cost. Where $m > 0$ we are not in a perfectly competitive market.

It then follows that: $\frac{W}{P} = \frac{1}{1+m}$

The equilibrium is then given when the wage set through wage setting and price setting are equal, that is:

$F(u,z)=\frac{1}{1+m}$

We can see that shifts in the wage setting curve will impact the level of unemployment, but not the real wage given by $\frac{1}{1+m}$

What I'm slightly lost with is why, at equilibrium, the price setting, and the level of mark-up, is independent of the level of unemployment. Intuitively, I would have thought that high levels of unemployment would lead to lower aggregate demand. Lower demand would depress prices and could lead to a lower level of mark-up. However, this dynamic appears to be completely missing from the model.

Have I interpreted this incorrectly?

Thanks for any help,

Hmmm16

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This is because mark up is caused by market power on goods market. This could be for example because there is some imperfect competition structure on goods market (eg oligopolies, monopolies etc).

High or low demand usually does not change the level of competition per se. An industry dominated by natural monopoly typically won’t become perfectly competitive market just because demand increased. Unless structure of the industry changes the markup stays constant.

In real life there could be some complex dynamics going on in some cases where changes in demand could change competition structure. However, this is for sure not common occurrence otherwise you would see rapid shifts in industrial structure during every recession and expansion across whole economy.

However, from your question I think you are getting confused by the fact that prices rise typically in the period of high demand and drop in periods of low demand. Higher demand will of course lead to higher prices (ceteris paribus) and vice versa, but markup is the firm ability to raise prices above the competitive price that is still subject to supply and demand.

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  • $\begingroup$ Thanks for this, super helpful. I think you are right - I'm making an inference that that the level of demand will impact the mark-up. But of course, higher prices don't mean higher mark-up, as you say. That's dictated by market structure. $\endgroup$
    – hmmmm
    Nov 13, 2022 at 14:04

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