Introduction

Most analyses throughout the book are based on the assumption of a wage setting or labour supply function which implies a relationship between the real wage and employment. A positive relationship between the real wage and employment can arise from one of the following possibilities: (i) the nominal wage is set by a trade union which optimises preferences with respect to employment and the real wage, (ii) the nominal wage is set by an individual wage earner who is in a short-term monopoly position with respect to setting the nominal wage, for example, due to specialised skills, (iii) a representative household determines the labour supply to optimise lifetime utility with respect to consumption and leisure, and (iv) the nominal wage is set by firms which incur costs associated with turnover in staff. The production and unemployment levels which follow from wage setters' and firms' optimisation, are termed respectively natural production and natural unemployment.

This chapter analyses the main assumptions that are made with respect to wage formation throughout the book. It is demonstrated that all of the four above-mentioned wage formation processes cause a relationship between the real wage and employment. To simplify, we have chosen to base subsequent analyses throughout the book on a wage setting where the nominal wage is set by a trade union which includes all employees in an industrial sector comprising a large number of firms and which optimises preferences involving the real wage and employment.