Chapter 7: Unemployment and the Labor Market

IN THIS CHAPTER, YOU WILL LEARN:

- About the natural rate of unemployment
- What it means
- What causes it
- Understanding its behaviour in the real world

- Rose as an aftermath of the financial crisis and recession of 2008-2009

- Rate of unemployment:​ % of the labor force unemployed
- Fluctuates from year to year; never gets close to zero
- Natural rate of unemployment:​ Average rate of unemployment around which the
economy fluctuates
- Average rate of unemployment toward which the economy gravitates in the
long run
- Recession = higher than natural rate
- Boom = lower than natural rate

JOB LOSS, JOB FINDING, AND THE NATURAL RATE OF UNEMPLOYMENT ​(7-1)

- L = labor force
- Every worker is either employed or unemployed
- Labor force:​ Sum of the employed and unemployed
- E = number of employed workers
- U = number of unemployed workers
- Rate of unemployment:​ U/L
To see what factors determine the unemployment rate...

- Assume that labor force (L) is fixed

- s = ​rate of job separation
- Fraction of employed individuals who lose or leave their jobs each month
- f = ​rate of job finding
- Fraction of unemployed individuals who find a job each month
- The rate of separation (s) and the rate of job finding (f) determine the rate of
unemployment
- Assumption that s and f are exogenous

Steady-state Condition

- Unemployment rate is neither rising nor falling = Labor market is in s

​ teady
state
- Unemployment rate is constant
- fU = number of people finding jobs
- sE = number of people losing jobs
- Use this to find the s
​ teady-state unemployment rate
- E = L - U (number of employed = labor force - number of unemployed);
substitute (L - U) for E in the steady-state condition

- Divide both sides by L

- Solve for the unemployment rate (U/L)

 - Equations shows that the steady-state of unemployment (U/L) depends
on the rates of job separation (s) and job finding (f)
- rate of job separation = unemployment rate
- rate of job finding = ➡ unemployment rate

- Model of the n
​ atural rate of unemployment​ has an important implication for public
policy
- Policy to ➡ lower natural rate of unemployment → either ➡ reduce the rate of
job separation or increase the rate of job finding
- Any policy that affects the rate of job separation or job finding also changes the
natural rate of unemployment
- Policy implication
- A policy will reduce the natural rate of unemployment only if it lowers s or
increases f

JOB SEARCH AND F ​ RICTIONAL UNEMPLOYMENT​ ​(7-2)

- Why is there unemployment?
- If job finding were instantaneous (f = 1) then all spells of unemployment would
be brief and the natural rate would be near zero
- 2 reasons why f<1
- Job search and wage rigidity
- One reason for unemployment: Takes time to match workers and jobs
- Flow of information about job candidates and job vacancies is imperfect
- Geographic mobility of workers is not instantaneous
- Frictional unemployment:​ Unemployment caused by the time it takes workers to
search for a job
- Unavoidable as long as the supply and demand for labor are changing
- Occurs even when wages are flexible and there are enough jobs to go around
I. CAUSES OF FRICTIONAL UNEMPLOYMENT
- Sectoral shift: ​Change in the composition of demand among industries or
regions
- Because sectoral shifts are always occurring and because it takes time
for workers to change sectors = frictional unemployment
 - Aside from this, other causes of job separation and frictional
unemployment include:
- firm failure
- unacceptable work performance
- particular skills not being needed anymore
- change of career or moving to another country
- Changing economy
- As demand for goods shift, so does the demand for the labor that
produces those goods (Ex. Invention of computer reduced the
demand for typewriters and their manufacturers)
- Different regions produce different goods, so demand for labor
may rise in one part and fall in another (Ex. price of oil =
demand for labor in oil-producing states)
- Ex. Technological change
- Ex. A new international trade agreement
- Labor demand increases in export sectors decreases in
import-competing sectors
- These scenarios result in frictional unemployment
- More examples of sectoral shift
- Industrial revolution
- Energy crisis
- Demand shifts from larger cars to smaller ones
- In a dynamic economy, smaller sectoral shifts occur frequently
contributing to frictional unemployment
II. PUBLIC POLICY AND FRICTIONAL UNEMPLOYMENT
- Public policy to decrease the natural rate of unemployment by reducing
frictional unemployment
- Government employment agencies
- Government to disseminate information about job vacancies
- Disseminate information to better match workers and jobs
- Publicly funded retraining programs
- Help workers displaced from declining industries get skills
needed for jobs in growing industries
- Unemployment insurance:​ One government program that increases the
amount of frictional unemployment
- Unemployed workers can collect a fraction of their wages for a certain
period after losing their jobs
- Pays a part of a worker’s former wages for a limited time after the
worker loses his/her job
- Increases frictional unemployment
- Reduces opportunity cost of being unemployed
- Urgency of finding work
- f (rate of finding) is lower
 - Softens economic hardship of unemployment and ➡ rate of job finding
- Less pressed to look for jobs
- Most likely to turn down unattractive job officers
- Less likely to seek jobs with stable employment prospects and
bargain for guarantees of job security
- frictional unemployment and natural rate
- Does not necessarily imply that the policy is ill advised
- Program has the benefit of reducing workers’ uncertainty about
their incomes
- Inducing workers to reject unattractive job offers may lead to
better matches between workers and jobs
- Studies: the longer a worker is eligible for UI, the longer the average
spell of unemployment
a. 100% experience rated
- Proposal that requires a firm to lay off a worker to bear the full
cost of that worker’s unemployment benefits
- Rate each firm pays to into the unemployment-insurance system
fully reflects the unemployment experience of its own workers
b. Partially experience rated
- Most current programs
- When a firm lays off a worker, it is charged for only part of the
worker’s unemployment benefits; the raminder comes from the
program’s general revenue
- Firm has an incentive to lay off workers when its demand for
labor is temporarily low (should reduce this incentive to reduce
temporary layoffs)
- Note: absence of benefits increases the search effort of unemployed workers
- Benefits of UI
- By allowing workers more time to search, UI may lead to better matches
between jobs and workers
- Which would lead to greater productivity and higher incomes

REAL-​WAGE RIGIDITY​ AND STRUCTURAL UNEMPLOYMENT (​ 7-3)

- Second reason for unemployment: W ​ age rigidity
- Failure of wages to adjust to a level at which labor supply equals labor demand
- Wages are not always flexible
Real wage above equilibrium

- Quantity of labor supplied > quantity demand

- Workers are waiting for jobs to open up
- Firms must ration scarce jobs among workers
- Real-wage rigidity = ➡ rate of job finding = level of unemployment
- Structural unemployment:​ Unemployment resulting from wage rigidity and job
rationing
- Due to mismatch between number of people who want to work and
number of jobs available
- Arises because firms fail to reduce wage despite excess supply of labor
- If a real wage is stuck above its equilibrium level, there aren’t enough jobs to go
around
- Firms must ration the scarce jobs among worker
3 Causes of Wage Rigidity
1. Minimum-wage laws
- Sets a legal minimum on the wages that firms pay their employees
- Wage rigidity occurs when government prevents wages from falling to
equilibrium levels
- May exceed the equilibrium wage
- Ex. a 10% increase in minimum wage reduces teen employment
by 1-3%
- The minimum wage cannot explain the majority of the natural rate of
unemployment as most workers wages are well above the minimum
wage
a. Unskilled and inexperienced
- Minimum wage raises their wage above equilibrium level = ➡
quantity of their labor that firms demand
b. Teenagers
- Minimum wage has the greatest impact of increasing teenage
unemployment
- Equilibrium wage tend to be low because
- Least skilled and experienced = low marginal productivity
 - “Compensation” in the form of internships/trainings rather
than direct pay
PROS CONS

1. A way to raise the income of the working 1. Causes unemployment for some workers
poor 2. Minimum wage is poorly targeted
- Only a meager standard of living - Targets teenagers rather than heads
- Raises others out of poverty of households

- Earned income tax credit:​ Amount that poor working families are allowed to subtract
from the taxes they owe
- Many believe that this is a better way to increase the income of the working
poor
- Pro: Does not reduce the quantity of labor that firms demand
- Con: Reduces the government’s tax revenue
- Note: C
​ urrent Population Survey​ can be used to see who earns the minimum wage
- More likely women than men
- Tend to be young, less educated, working part time, etc.
2. Unions and Collective Bargaining
- Monopoly power of unions
- Exercise monopoly power to secure higher wages for their
members
- Bargaining power of labor on issues
- Wages of unionized workers are determined not by the equilibrium of
supply and demand, but by bargaining between union leaders and firm
management
- When the union wage exceeds the equilibrium wage, unemployment
results
- Final agreement usually raises the wage above the equilibrium level =
allows the firm to decide how many workers to employ = ➡ number of
workers hired = ➡ rate of job finding = structural unemployment
- Most firms dislike unions
- Conflict between different groups of workers:
- Insiders​: workers employed in the firm who want to keep their
wages high
- Outsiders​: unemployed who bear part of the cost of higher
wages because at a lower wage they might be hired
- Unemployed non-union workers who prefer equilibrium
wages so there would be enough jobs for them
- Sweden:​ Wage bargaining takes place at a national level
- Centralization of bargaining and the role of government in the
process give more influence to outsiders = no high
unemployment rate since wage is closer to equilibrium
3. Efficiency Wages
- High wages make workers more productive
- Increase worker productivity
- Even though a wage reduction would lower a firm’s wage bill, it will also
lower worker productivity and the firm’s profits
a. Wages influence nutrition in poorer countries
- Better-paid workers can afford a more nutritious diet = healthier
= productive
- Improving health of workers
b. High wages reduce labor turnover in developed countries
- wage = incentive to stay with the firm = ➡ time and money
spent hiring and training new workers
- Turnover is costly to firms
c. Average quality of a firm’s workforce depends on the wage it pays
its employees
- Risk of worker taking another job and leaving the firm with
inferior employees
- Adverse selection:​ Tendency of people with more information
(workers who know their outside opportunities) to self-select in a
way that disadvantages people with less information (firm)
- Pay wage above equilibrium = ➡ adverse selection = quality
and productivity of workers
- Attracting higher quality job applicants
d. High wage improves worker effort
- Moral hazard: Tendency of people to behave inappropriately
when their behavior is imperfectly monitored
- Reduced by paying wage = cost of getting fired =
induces employees not to shirk = productivity
- Increases effort and reduces “shirking”
- Conclusion:​ Firm operates more efficiently if it pays its workers a high
wage (profitable to keep wage above equilibrium) = unemployment
LABOR-MARKET EXPERIENCE: THE UNITED STATES ​(7-4)
- Steady-state unemployment rate: D ​ epends on the​ rates of job separation ​and j​ ob
finding
- 2 reasons why job finding is not instantaneous
- Process of job search (leads to f​ rictional unemployment​)
- Wage rigidity (leads to s​ tructural unemployment​)
- Arises from m ​ inimum-wage laws, unionization, and efficiency
wages
I. THE DURATION OF UNEMPLOYMENT
- Most unemployment can be
a. Short-term unemployment = frictional
b. Long-term unemployment - structural
- Goal to ➡ natural rate of unemployment = make policies that
aim at the long-term unemployed
II. VARIATION IN THE UNEMPLOYMENT RATE ACROSS DEMOGRAPHIC GROUPS
- Rate of unemployment varies across different groups
- Examples of unemployment per group:
- Younger workers > older workers because they are uncertain about their
plans
- Blacks > whites
- Explaining the trend: demographics
- 1970s: the baby boomers were young
- Young workers change jobs more frequently
- High value of s
- Late 1980s through today: baby boomers aged
- Middle aged workers change jobs less often
- Low s
III. TRANSITIONS INTO AND OUT OF THE LABOR FORCE
- Discouraged workers: I​ ndividuals who want jobs, but gave up looking after
unsuccessful searches

LABOR-MARKET EXPERIENCE: EUROPE (​ 7-5)

I. THE RISE IN EUROPEAN UNEMPLOYMENT

-Cause?
- Long-standing policy: Generous benefits for unemployed workers
- Recent shock: Technologically driven fall in the demand for unskilled
workers relative to skilled workers
II. UNEMPLOYMENT VARIATION WITHIN EUROPE
- Europe:​ Not a single labor market, but a collection of national labor markets
- Unemployment rates vary from country to country
- Variation is attributable to the long-term unemployed
- Higher in nations with more generous unemployment insurance as
measured by the r​ eplacement rate​ (% of previous wages that is
replaced when a worker loses a job) + longer period of benefits
- Spending on “​ active” labor-market policies​ decrease unemployment
- Job training, assistance with job search, subsidized employment
- Unions vary
 - Why unemployment rose in Europe but not in the US
a. Shock
- Technological progress has shifted labor demand from unskilled
to skilled workers in the recent decades
b. Effect in United States
- An increase in the “skill premium” - the wage gap between skilled
and unskilled workers
c. Effect in Europe
- Higher unemployment, due to generous government benefits for
unemployed workers and strong union presence
III. RISE OF EUROPEAN LEISURE

- Europeans work shorter hours and have more frequent holidays

- More potential workers are employed in the US (​employment-to-population
ratio ​is higher)
- Earlier retirement in Europe = lower labor-force participation among older
workers
- Cause of differences in work patterns?
- Edward Prescott, 2004 winner of the Nobel Prize in economics
- Due to differences in tax system
- Europeans face higher and increasing tax rates than Americans
- Underground economy
- High tax rates = more incentives to work “off the books” to evade
taxes
- Role of unions
- Collective bargaining is more important in Europe
- Often push for shorter workweeks and more official holidays
- Different preferences
- Choose between increased consumption of goods and services
or increased leisure
 - Europeans have more taste for leisure than the Americans

CONCLUSION ​(7-6)
- Unemployment​ represents wasted resources (potential to contribute to national
income)
- Zero unemployment is not a plausible goal for free-market economies