8.3What Causes Changes in Unemployment over the Short Run

method for society to provide support for the unemployed, rather than a sign of a healthy economy. LINK IT UP We hear about the Chinese economy in the news all the time. The value of the Chinese yuan in comparison to the U.S. dollar is likely to be part of the nightly business report, so why is the Chinese economy not included in this discussion of international unemployment? The lack of reliable statistics is the reason. This article (https://openstax.org/l/ChinaEmployment) explains why. Comparing unemployment rates in the United States and other high-income economies with unemployment rates in Latin America, Africa, Eastern Europe, and Asia is very difficult. One reason is that the statistical agencies in many poorer countries lack the resources and technical capabilities of the U.S. Bureau of the Census. However, a more difficult problem with international comparisons is that in many low-income countries, most workers are not involved in the labor market through an employer who pays them regularly. Instead, workers in these countries are engaged in short-term work, subsistence activities, and barter. Moreover, the effect of unemployment is very different in high-income and low-income countries. Unemployed workers in the developed economies have access to various government programs like unemployment insurance, welfare, and food stamps. Such programs may barely exist in poorer countries. Although unemployment is a serious problem in many low-income countries, it manifests itself in a different way than in high-income countries.

8.3 What Causes Changes in Unemployment over the Short Run

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Analyze cyclical unemployment
• Explain the relationship between sticky wages and employment using various economic arguments
• Apply supply and demand models to unemployment and wages

We have seen that unemployment varies across times and places. What causes changes in unemployment? There are different answers in the short run and in the long run. Let's look at the short run first.

Cyclical Unemployment

Let’s make the plausible assumption that in the short run, from a few months to a few years, the quantity of hours that the average person is willing to work for a given wage does not change much, so the labor supply curve does not shift much. In addition, make the standard ceteris paribus assumption that there is no substantial short-term change in the age structure of the labor force, institutions and laws affecting the labor market, or other possibly relevant factors. One primary determinant of the demand for labor from firms is how they perceive the state of the macro economy. If firms believe that business is expanding, then at any given wage they will desire to hire a greater quantity of labor, and the labor demand curve shifts to the right. Conversely, if firms perceive that the economy is slowing down or entering a recession, then they will wish to hire a lower quantity of labor at any given wage, and the labor demand curve will shift to the left. Economists call the variation in unemployment that the economy causes moving from expansion to recession or from recession to expansion (i.e. the business cycle) cyclical unemployment. From the standpoint of the supply-and-demand model of competitive and flexible labor markets, unemployment represents something of a puzzle. In a supply-and-demand model of a labor market, as Figure 8.5 illustrates, the labor market should move toward an equilibrium wage and quantity. At the equilibrium wage (We), the equilibrium quantity (Qe) of labor supplied by workers should be equal to the quantity of labor demanded by employers.

FIGURE 8.5The Unemployment and Equilibrium in the Labor Market In a labor market with flexible wages, the equilibrium will occur at wage We and quantity Qe, where the number of people who want jobs (shown by S) equals the number of jobs available (shown by D). One possibility for unemployment is that people who are unemployed are those who are not willing to work at the current equilibrium wage, say $10 an hour, but would be willing to work at a higher wage, like $20 per hour. The monthly Current Population Survey would count these people as unemployed, because they say they are ready and looking for work (at $20 per hour). However, from an economist’s perspective, these people are choosing to be unemployed. Probably a few people are unemployed because of unrealistic expectations about wages, but they do not represent the majority of the unemployed. Instead, unemployed people often have friends or acquaintances of similar skill levels who are employed, and the unemployed would be willing to work at the jobs and wages similar to what those people are receiving. However, the employers of their friends and acquaintances do not seem to be hiring. In other words, these people are involuntarily unemployed. What causes involuntary unemployment?

Why Wages Might Be Sticky Downward

If a labor market model with flexible wages does not describe unemployment very well—because it predicts that anyone willing to work at the going wage can always find a job—then it may prove useful to consider economic models in which wages are not flexible or adjust only very slowly. In particular, even though wage increases may occur with relative ease, wage decreases are few and far between. One set of reasons why wages may be “sticky downward,” as economists put it, involves economic laws and institutions. For low-skilled workers receiving minimum wage, it is illegal to reduce their wages. For union workers operating under a multiyear contract with a company, wage cuts might violate the contract and create a labor dispute or a strike. However, minimum wages and union contracts are not a sufficient reason why wages would be sticky downward for the U.S. economy as a whole. After all, out of the 73.3 million or so employed workers in the U.S. economy who earn wages by the hour, only about 1.1 million—less than 2% of the total—do not receive compensation above the minimum wage. Similarly, labor unions represent only about 12% of American wage and salary workers. In other high-income countries, more workers may have their wages determined by unions or the minimum wage may be set at a level that applies to a larger share of workers. However, for the United States, these two factors combined affect only about 15% or less of the labor force. Economists looking for reasons why wages might be sticky downwards have focused on factors that may characterize most labor relationships in the economy, not just a few. Many have proposed a number of different theories, but they share a common tone. One argument is that even employees who are not union members often work under an implicit contract, which is that the employer will try to keep wages from falling when the economy is weak or the business is having trouble, and the employee will not expect huge salary increases when the economy or the business is strong. This wage-setting behavior acts like a form of insurance: the employee has some protection against wage declines in bad times, but pays for that protection with lower wages in good times. Clearly, this sort of implicit contract means that firms will be hesitant to cut wages, lest workers feel betrayed and work less hard or even leave the firm. Efficiency wage theory argues that workers' productivity depends on their pay, and so employers will often find it worthwhile to pay their employees somewhat more than market conditions might dictate. One reason is that employees who receive better pay than others will be more productive because they recognize that if they were to lose their current jobs, they would suffer a decline in salary. As a result, they are motivated to work harder and to stay with the current employer. In addition, employers know that it is costly and time-consuming to hire and train new employees, so they would prefer to pay workers a little extra now rather than to lose them and have to hire and train new workers. Thus, by avoiding wage cuts, the employer minimizes costs of training and hiring new workers, and reaps the benefits of well-motivated employees. The adverse selection of wage cuts argument points out that if an employer reacts to poor business conditions by reducing wages for all workers, then the best workers, those with the best employment alternatives at other firms, are the most likely to leave. The least attractive workers, with fewer employment alternatives, are more likely to stay. Consequently, firms are more likely to choose which workers should depart, through layoffs and firings, rather than trimming wages across the board. Sometimes companies that are experiencing difficult times can persuade workers to take a pay cut for the short term, and still retain most of the firm’s workers. However, it is far more typical for companies to lay off some workers, rather than to cut wages for everyone. The insider-outsider model of the labor force, in simple terms, argues that those already working for firms are “insiders,” while new employees, at least for a time, are “outsiders.” A firm depends on its insiders to keep the organization running smoothly, to be familiar with routine procedures, and to train new employees. However, cutting wages will alienate the insiders and damage the firm’s productivity and prospects. Finally, the relative wage coordination argument points out that even if most workers were hypothetically willing to see a decline in their own wages in bad economic times as long as everyone else also experiences such a decline, there is no obvious way for a decentralized economy to implement such a plan. Instead, workers confronted with the possibility of a wage cut will worry that other workers will not have such a wage cut, and so a wage cut means being worse off both in absolute terms and relative to others. As a result, workers fight hard against wage cuts. These theories of why wages tend not to move downward differ in their logic and their implications, and figuring out the strengths and weaknesses of each theory is an ongoing subject of research and controversy among economists. All tend to imply that wages will decline only very slowly, if at all, even when the economy or a business is having tough times. When wages are inflexible and unlikely to fall, then either short-run or long-run unemployment can result. Figure 8.6 illustrates this.

FIGURE 8.6Sticky Wages in the Labor Market Because the wage rate is stuck at W, above the equilibrium, the number of those who want jobs (Qs) is greater than the number of job openings (Qd). The result is unemployment, shown by the bracket in the figure. Figure 8.7 shows the interaction between shifts in labor demand and wages that are sticky downward. Figure 8.7 (a) illustrates the situation in which the demand for labor shifts to the right from D0 to D1. In this case, the equilibrium wage rises from W0 to W1 and the equilibrium quantity of labor hired increases from Q0 to Q1. It does not hurt employee morale at all for wages to rise. Figure 8.7 (b) shows the situation in which the demand for labor shifts to the left, from D0 to D1, as it would tend to do in a recession. Because wages are sticky downward, they do not adjust toward what would have been the new equilibrium wage (W1), at least not in the short run. Instead, after the shift in the labor demand curve, the same quantity of workers is willing to work at that wage as before; however, the quantity of workers demanded at that wage has declined from the original equilibrium (Q0) to Q2. The gap between the original equilibrium quantity (Q0) and the new quantity demanded of labor (Q2) represents workers who would be willing to work at the going wage but cannot find jobs. The gap represents the economic meaning of unemployment.

FIGURE 8.7Rising Wage and Low Unemployment: Where Is the Unemployment in Supply and Demand? (a) In a labor market where wages are able to rise, an increase in the demand for labor from D0 to D1 leads to an increase in equilibrium quantity of labor hired from Q0 to Q1 and a rise in the equilibrium wage from W0 to W1. (b) In a labor market where wages do not decline, a fall in the demand for labor from D0 to D1 leads to a decline in the quantity of labor demanded at the original wage (W0) from Q0 to Q2. These workers will want to work at the prevailing wage (W0), but will not be able to find jobs. This analysis helps to explain the connection that we noted earlier: that unemployment tends to rise in recessions and to decline during expansions. The overall state of the economy shifts the labor demand curve and, combined with wages that are sticky downwards, unemployment changes. The rise in unemployment that occurs because of a recession is cyclical unemployment. LINK IT UP The St. Louis Federal Reserve Bank is the best resource for macroeconomic time series data, known as the Federal Reserve Economic Data (FRED). FRED (https://openstax.org/l/FRED_employment) provides complete data sets on various measures of the unemployment rate as well as the monthly Bureau of Labor Statistics report on the results of the household and employment surveys.

8.4 What Causes Changes in Unemployment over the Long Run

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Explain frictional and structural unemployment
• Assess relationships between the natural rate of employment and potential real GDP, productivity, and public policy
• Identify recent patterns in the natural rate of employment
• Propose ways to combat unemployment

Cyclical unemployment explains why unemployment rises during a recession and falls during an economic expansion, but what explains the remaining level of unemployment even in good economic times? Why is the unemployment rate never zero? Even when the U.S. economy is growing strongly, the unemployment rate only rarely dips as low as 4%. Moreover, the discussion earlier in this chapter pointed out that unemployment rates in many European countries like Italy, France, and Germany have often been remarkably high at various times in the last few decades. Why does some level of unemployment persist even when economies are growing strongly? Why are unemployment rates continually higher in certain economies, through good economic years and bad? Economists have a term to describe the remaining level of unemployment that occurs even when the economy is healthy: they call it the natural rate of unemployment.

The Long Run: The Natural Rate of Unemployment

The natural rate of unemployment is not “natural” in the sense that water freezes at 32 degrees Fahrenheit or boils at 212 degrees Fahrenheit. It is not a physical and unchanging law of nature. Instead, it is only the “natural” rate because it is the unemployment rate that would result from the combination of economic, social, and political factors that exist at a time—assuming the economy was neither booming nor in recession. These forces include the usual pattern of companies expanding and contracting their workforces in a dynamic economy, social and economic forces that affect the labor market, or public policies that affect either the eagerness of people to work or the willingness of businesses to hire. Let’s discuss these factors in more detail.

Frictional Unemployment

In a market economy, some companies are always going broke for a variety of reasons: old technology; poor management; good management that happened to make bad decisions; shifts in tastes of consumers so that less of the firm’s product is desired; a large customer who went broke; or tough domestic or foreign competitors. Conversely, other companies will be doing very well for just the opposite reasons and looking to hire more employees. In a perfect world, all of those who lost jobs would immediately find new ones. However, in the real world, even if the number of job seekers is equal to the number of job vacancies, it takes time to find out about new jobs, to interview and figure out if the new job is a good match, or perhaps to sell a house and

Simpler explanation — Cambridge AS & A Level Economics

Unemployment can be divided into three main types: frictional, structural and cyclical, as shown in Figure 19.6. Each of these types has different causes. Frictional unemployment Frictional unemployment is unemployment that arises when workers are between jobs. One form of frictional unemployment is voluntary unemployment. This occurs when workers are not willing to accept jobs at the current wage rate and working conditions.

This form of frictional unemployment may be influenced by how the level of unemployment benefits compares to low wages. If the amount workers can earn in employment is less than they can receive in benefits, some workers may decide to stay unemployed. In most countries, the amount of unemployment benefit workers receives falls after a period of time. Another related form of frictional unemployment is search unemployment. This arises when workers do not accept the first job or jobs on offer, but spend some time looking for a better-paid job.

The provision of more and better-quality information may reduce search unemployment, There are two other forms of frictional employment. Casual unemployment refers to workers who are out of work between periods of employment including, for example, actors, supply teachers and construction workers. In the case of seasonal unemployment, demand for workers fluctuates according to the time of the year. During periods of the year, people working in, for example, the tourism, hospitality, building and farming industries may be out of work. In a group, discuss:

• whether workers who are voluntarily unemployed should be counted as unemployed
• how you would assess whether unemployment is voluntary or involuntary