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In macroeconomic equilibrium, wages adjust to balance supply and demand, with unemployment at its natural rate. However, bargaining power, efficiency wages, and insider-outsider effects mean wages don't clear markets instantly. Higher unemployment increases firms' bargaining power and reduces wage growth; lower unemployment strengthens workers' bargaining power. Wage-setting behavior is central to understanding both inflation and unemployment dynamics.
From your study of the NAIRU, you know there exists a rate of unemployment at which inflation is stable — neither accelerating nor decelerating. But why does such a natural rate exist at all? The answer lies in how wages are actually set. In a frictionless textbook labor market, wages would instantly jump to clear the market and unemployment would be zero except for job search. Real labor markets don't work this way. Wages are set through bargaining — between firms and workers, unions and management, or implicitly through HR policy — and the outcome depends on the relative power of each side.
The unemployment rate is the key variable governing this bargaining power. When unemployment is low, workers have attractive outside options — they can leave and find another job quickly. This strengthens their wage-setting power. When unemployment is high, workers are desperate to keep their jobs and accept lower wages; firms face a large pool of applicants and can be selective. This is the core mechanism linking labor market slack to wage dynamics, which you already saw in the Phillips curve: low unemployment → rising wages → inflationary pressure.
Efficiency wages complicate this picture. A firm might choose to pay *above* the market-clearing wage, not because workers can demand it, but because higher wages raise worker productivity — by reducing shirking (workers fear losing their above-market wage), reducing turnover, and attracting better candidates. Efficiency wage theory predicts persistent unemployment in equilibrium: firms don't lower wages to clear the market because doing so would harm productivity. Unemployment serves a disciplinary function — the threat of job loss keeps employed workers productive.
The insider-outsider dynamic creates another source of wage rigidity. Current employees (insiders) have bargaining power because firms need their specific skills and cooperation during new worker training. Insiders may bargain for wages that keep outsiders (unemployed workers) permanently excluded, since insiders don't bear the unemployment cost themselves. This segmentation can keep wages above market-clearing levels even when unemployment is high, slowing the wage adjustment that would normally restore equilibrium.
Together, these mechanisms explain why wages don't clear labor markets the way prices clear goods markets. The wage-setting curve — showing the real wage consistent with worker bargaining power at each unemployment rate — slopes downward in unemployment/wage space. The price-setting curve — showing the real wage firms can afford given their markups — is roughly flat. Labor market equilibrium occurs where these two curves intersect, determining both the real wage and the NAIRU simultaneously. Inflation accelerates when actual unemployment falls below this intersection, because workers successfully push wages above what firms can sustain without raising prices — the precise link back to the Phillips curve dynamics you know.