ECON 105 Principles of Macroeconomics

Unemployment and Its Natural Rate (Ch. 9)

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 Topics Covered

Measuring Unemployment
Frictional Unemployment
Structural Unemployment
Job Search Theory
Minimum-Wage Laws
Unions and Collective Bargaining
Theory of Efficiency Wages

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 A Scenario

Read the following news statement from the government: The

unemployment rate is 6.5%.
This statement would be viewed as good news in Canada, but bad
news in the US.
Whats going on here?

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 Why Do We Care about Unemployment?

Costs of unemployment:
Loss of income and output
Unemployed workers lose income.
Total output falls because fewer workers are productively employed.
Personal, psychological, and social costs
Workers suffering long spells of unemployment lose their skills and self-
esteem, and suffer from stress.
Unemployment and crime.

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 The Problem of Unemployment

The long-run problem (Ch. 9)

Natural rate of unemployment = the normal level of
unemployment that persists in an economy in the long run
The short-run problem (Ch. 16)
Cyclical rate of unemployment = the deviation of unemployment
from its natural rate

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 Measuring Unemployment

Every month Statistics Canada conducts a Labour Force Survey

which produces data on unemployment and on other aspects of
the labour market, such as types of employment, length of the
average work week, and the duration of unemployment.

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 Labour Force Survey

Statistics Canada places each adult (aged 15 and over) in each

surveyed household into one of three categories:
1) Employed: a person who spent most of the previous week working
at a paid job.
2) Unemployed: a person who is on temporary layoff or is looking for
a job.
3) Not in the labour force: a person who fits neither of the other two
categories, such as a full-time student, homemaker, or retiree.

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 The Breakdown of the Adult Population in 2014

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 Labour Market Statistics

Labour force: the total number of workers, including both the employed
and the unemployed.
Labour force = number of employed + number of unemployed
Unemployment rate: the percentage of the labour force that is
unemployed.
number of unemployed
Unemployment rate = 100%
labour force
Labour-force participation rate: the percentage of the adult population
that is in the labour force.
labour force
Labour force participation rate = 100%
adult population

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 Labour Market Statistics

Pitfalls: Unemployment rate vs. Employment rate

According to Statistics Canada, the employment rate is defined as the
ratio of the number of employed to the adult population.
number of employed
Employment rate = 100%
adult population

Employment rate is also called employment-population ratio.

Suppose you know that the unemployment rate is 6%, does that mean
that the employment rate is 100% - 6% = 94%?
No. Because some adults are not in the labour force.

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 Example

Adult Population by Group, 2014

# of employed 17.80 million
# of unemployed 1.32 million
not in labour force 9.86 million

Labour force = 17.80 + 1.32 = 19.12

1.32
Unemployment rate = 100% = 6.90%
19.12
Adult population = 19.12 + 9.86 = 28.98
17.80
Employment rate = 100% = 61.42%
28.98
19.12
Labour force participation rate = 100% = 65.98%
28.98
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 The Labour-Market Experiences of
Various Demographic Groups (2014)

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 Canadian Regional Unemployment Rates

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 Labour-Force Participation Rates for Men and Women

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 The Significance of the Unemployment Rate

In general, the unemployment rate is a good indicator of the labour

market conditions.
However, its not a literal measure of the percentage of people who
want a job but cannot find one.
In some ways, the unemployment rate overstates the joblessness
in the economy (i.e. true level of unemployment).
In other ways, the unemployment rate understates the joblessness
in the economy (i.e. true level of unemployment).

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 How the Unemployment Rate Can Overstate
the Amount of Joblessness
The unemployment rate overstates the amount of joblessness
because some of those who report being unemployed may not, in
fact, be trying hard to find a job.
Some people claim to be looking for job just to collect Employment
Insurance (EI) benefits. Actually they dont want to work.
Jobs are plentiful, but job search intensity is low.

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 How the Unemployment Rate Can Understate
the Amount of Joblessness
Discouraged searchers are individuals who would like to work but
have given up looking for a job.
Discouraged searchers are not counted as part of the labour force
because they are no looking for jobs actively, and as a result they do
not show up in the unemployment statistics.
Because of the discouraged searchers, the unemployment rate falls
but the labour market is not improving.

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 How the Unemployment Rate Can Understate
the Amount of Joblessness
An example:
Last year, the number of employed was 93, and the number of
7
unemployed was 7. The unemployment rate was 100% =
93+7
7%. After a long time of unsuccessful job searching, 2 of the 7
unemployed become discouraged and give up looking for jobs this
year. Other things stay the same, now the unemployment rate
5
becomes 100% = 5.1%.
93+5

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 Duration of Unemployment

Duration of unemployment measures how long the unemployed are

without work.
Community A: Community B:
100 workers 100 workers
5 workers are unemployed for a year 5 workers are unemployed for a month
Unemployment rate = 5% Unemployment rate = 5%
Duration of unemployment = 1 year Duration of unemployment = 1 month

Two communities have same unemployment rate, but the severity of

unemployment is very different.

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 Alternative Measures of Labour Underutilization

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 Exercise

In each of the following cases, what happens to the unemployment

rate? Does the change in unemployment rate give an accurate
impression of whats happening in the labour market?
1) Sue lost her job, and begins looking for a new one.
2) Jon, a steelworker who has been out of work since his mill closed last
year, becomes discouraged and gives up looking for work.
3) Sam, the sole earner in his family, just lost his $80,000 job as a
research scientist. Immediately, he takes a job at McDonalds until he
can find another job in his field.

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 Answer

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 Example: Economics in the News

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 Why Are There Always Some People Unemployed?

There is always unemployment even when the economy is doing

well.
Some kinds of unemployment are unavoidable.
The unemployment rate is never zero, it fluctuates around the
natural rate.
Over the past half-century, the unemployment rate in Canada
has never dropped below 3.6%.

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 Natural Rate of Unemployment

The natural rate of unemployment is the rate of unemployment to

which the economy tends to return in the long run.
Full employment is defined as a situation in which the
unemployment rate equals the natural rate of unemployment.
The exact value of the natural unemployment rate is unknown, but
most economists estimate the rate in Canada to be 6 to 8 percent.
The natural unemployment includes frictional unemployment and
structural unemployment.

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 Natural Rate of Unemployment

1) Frictional unemployment is the unemployment that results from

the process of matching workers and jobs.
2) Structural unemployment is the unemployment that occurs when
the quantity of labour supplied exceeds the quantity demanded.

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 A Summary of Various Types of Unemployment

Natural unemployment = Frictional unemployment + Structural

unemployment.
Actual unemployment (or observed unemployment) = Natural
unemployment + Cyclical unemployment.

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 Observed and Natural Unemployment Rates

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 Explaining the Natural Unemployment

1) Job Search Theory

2) Minimum-Wage Laws
3) Unions and Collective Bargaining
4) Theory of Efficiency Wages

Job search theory explains frictional unemployment.

Minimum wages, union and collective bargaining, and efficiency
wages explain structural unemployment.

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 Job Search Theory

Job search is the process by which workers find appropriate jobs

given their tastes and skills.
Job search theory explains why some frictional unemployment is
inevitable.
A certain amount of frictional unemployment is inevitable due to the
constant process of economic changes.

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 Job Search Theory

Frictional unemployment is a permanent and healthy phenomenon

in a dynamic economy.
In a dynamic economy, with jobs continually being created in
growing industries and destroyed in declining industries, and
workers continually entering and exiting the labour force, there is
always some frictional unemployment.
Changes in the composition of demand among industries or regions
are called sectoral shifts. Because it takes time for workers to search
for jobs in the new sectors, sectoral shifts temporarily cause
unemployment.

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 Public Policy and Job Search

Government programs can help to reduce the amount of frictional

unemployment.
Government-run employment agencies give out information on
job vacancies to speed up the matching of workers with jobs.
Public training programs aim to equip workers displaced from
declining industries with the skills needed in growing industries.

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 Employment Insurance (EI)

EI = a government program that provides temporary financial

assistance for individuals between jobs.
Pros of EI:
EI reduces the hardship of unemployment
EI reduces uncertainty over incomes
EI gives the unemployed more time to search, resulting in better
job matches and thus higher productivity
Cons of EI:
EI increases the amount of unemployment that exists

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 Minimum-Wage Laws

A minimum wage is the lowest wage that a firm is legally allowed to

pay its workers.
When the government sets a minimum wage that exceeds the
market equilibrium wage in that market, the quantity of labour
supplied is greater than the quantity of labour demanded. The
resulting surplus of labour represents structural unemployment.

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 Minimum Wages and Its Effects

When the government sets a

minimum wage that exceeds
the market equilibrium wage in
that market, the quantity of
labour supplied is greater than
the quantity of labour
demanded. The resulting
surplus of labour represents
structural unemployment.

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 Unions and Collective Bargaining

A union is a worker association that bargains with employers over

wages, benefits, and working conditions.
The process by which unions and employers agree on the terms of
employment is called collective bargaining.
If unions and employers do not reach agreement, then
unions can exercise bargaining power by taking job actions, such as a
strike (a collective refusal to work).
employers can counter the bargaining power of unions by threatening
a lockout, in which union workers are locked out and rendered
unemployed.

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 Unions and Collective Bargaining

When unions have increased bargaining power, they tend to

demand and receive higher wages.
Union workers typically earn 10 to 20 percent more than similar
workers who dont belong to unions.

Some facts: As of 2013, 30% of all employed workers in Canada

belong to unions.

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 Two Effects

1) Unions push the wages that workers receive above the equilibrium
wage, resulting in unemployment.
2) The supply of workers in nonunionized labour market will increase,
pushing wages in non-union firms down.

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 Effects of Unions on Two Labour Markets

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 Are Unions Good or Bad for the Economy?

Economists disagree.
Critics:
Unions are cartels. They raise wages above the equilibrium level,
which causes unemployment and depresses wages in nonunionized
labour markets.
Advocates:
Unions counter the market power of large firms, make firms more
responsive to workers concerns.

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 The Theory of Efficiency Wages

Efficiency wages are above-equilibrium wages set by employers as

an incentive for their workers to perform better.
Example: Henry Ford and $5-a-day wage (about twice the going
rate)
Henry Ford: The payment of five dollars a day for an eight-hour day
was one of the finest cost-cutting moves we ever made

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 The Theory of Efficiency Wages

The unemployment that arises from efficiency wages is similar to

the unemployment that arises from minimum-wage laws and
unions. In all three cases, unemployment is the result of wages
above the level that balances the quantity of labour supplied and
the quantity of labour demanded.

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 The Theory of Efficiency Wages

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 Why Firms Pay Efficiency Wages?

1) Worker health: In less developed countries, poor nutrition is a

common problem. Paying higher wages allows workers to eat a better
diet, making them healthier and more productive.
2) Worker turnover: Recruiting and training new workers are costly.
Paying high wages reduces worker turnover by giving them more
incentives to stay.

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 Why Firms Pay Efficiency Wages?

3) Worker effort: In many jobs, monitoring workers is costly and

imperfect. High wages give workers an incentive to put forth more
effort.
4) Worker quality: Offering high wages attracts better job applicants and
thereby increases the quality of the firms work force.

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 Differentiate between Theories?

Minimum-wage theory, unions,

and efficiency-wage theory have
same graph.
For all three theories, the wage in
the labour market is above the
equilibrium level. As a result,
unemployment arises.
The reasons for the above-
equilibrium wages are different.

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 Exercise

In Sylvania, based on concepts similar to those used to compute

Canadian labour market statistics, the unemployment rate is 6 percent,
the labour force participation rate is 65 percent, and the adult
population is 150 million. How many people are employed?

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 Answer

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 Exercise

Between 2010 and 2015, total employment in Hykania increased by 7

million workers, and the number of unemployed workers decreased
by 2 million. What happened to the labour force?

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 Answer

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 Exercise

Using a diagram of the labour market, show the effect of an increase in

the minimum wage on the wage paid to workers, the number of
workers supplied, the number of workers demanded, and the amount
of unemployment.

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 Answer

At the initial minimum wage (m1), the

quantity of labour supplied L1S is
greater than the quantity of labour
demanded L1D, and unemployment is
equal to L1S L1D. An increase in the
minimum wage to m2 leads to an
increase in the quantity of labour
supplied to L2S and a decrease in the
quantity of labour demanded to L2D.
As a result, unemployment increases
as the minimum wage rises.

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 Exercise

Which of the following would be most likely to reduce frictional

unemployment?
1) The government eliminates the minimum wage.
2) The government increases employment insurance (EI) benefits.
3) A new law bans labour unions.
4) More workers post their resumes at Job.com, and more employers
use Job.com to find suitable workers to hire.
5) Sectoral shifts become more frequent.

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 Answer

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 Summary

The unemployment rate is the percentage of those who would like

to work but do not have jobs. Statistics Canada calculates this
statistic monthly based on a survey of thousands of households.
The unemployment rate is an imperfect measure of joblessness.
Some people who call themselves unemployed may actually not
want to work, and some people who would like to work have left the
labour force after an unsuccessful search.

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 Summary

In the Canadian economy, most people who become unemployed

find work within a fairly short period of time. The fraction of those
who find themselves unemployed for periods longer than six months
is relatively small. Public policy solutions to the unemployment
problem should be directed toward providing help to those
experiencing long bouts of unemployment.
One reason for unemployment is the time it takes for workers to
search for jobs that best suit their tastes and skills. Employment
Insurance is a government policy that, while protecting workers
incomes, increases the amount of frictional unemployment.

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 Summary

The second reason why our economy always has some

unemployment is minimum-wage laws. By raising the wage of
unskilled and inexperienced workers above the equilibrium level,
minimum-wage laws raise the quantity of labour supplied and
reduce the quantity demanded. The resulting surplus of labour
represents unemployment.
The third reason for unemployment is the market power of unions.
When unions push the wages in unionized industries above the
equilibrium level, they create a surplus of labour.

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 Summary

The fourth reason for unemployment is suggested by the theory of

efficiency wages. According to this theory, firms find it profitable to
pay wages above the equilibrium level. High wages can improve
worker health, lower worker turnover, increase worker effort, and
raise worker quality.

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