Unemployment

The employment level in the economy is an

important input in the national production and
determinant of the rate of growth.
Where unemployment occurs an economy
will be operating below its production
possibility frontier implying a waste of
economic resources.
―Actual GDP is less than potential real GDP‖
 Production
Possibility
P
Curve

• Labour force could be fully employed and yet the

economy may fail to produce on its production possibility
curve. This occurs when the labour force is underutilised.
Workers may be employed but have too little work to do
or may ‗slack‘ due to poor management.
• Developing countries usually have fast population growth
but lack the education, training and capital to take into
account quantity and quality as reflected in educational
attainment, training and skills.
 Measurement
The Labour force is a sub set of an
economy‘s total population.
The potential workforce will be less than the
total population which includes:
• Children
• Sick
• Institutionalised
• Retired
 Women
• Also consider the number of women of
working age seeking work.
• In the last 50 years there has been a
gradual rise in the percentage of working
women in developed economies.
Increased educational and job
opportunities, and a slowing birth rate
• Women now make up over 50% of the
workforce in the USA.
 The actual workforce will be less
than the potential workforce when:
• Economic recession with fewer jobs on
offer.
• Fast rising potential labour force but
slower rate of growth in job opportunities.
• Potential workers choose not to make
themselves available for work. (choose
leisure time instead supported by state
welfare benefits as with the poverty trap)
Unemployment rate refers to the percentage of the
workforce unemployed at a given time.

Unemployment rate = number of people unemployed x 100

Workforce
 Official figures may simply calculate the workforce as the
number of people in work and the number registered as
unemployed (excluding those unemployed but not
registered)

Activity rate = workforce x 100

Working age population

Employment to population rates = Number employed =100

Working age population
 Population survey of
unemployment
Such as a Census – Office of National Statistics
carries out a Labour Force Survey.
Households are asked about the backgrounds of
members: age, gender, qualifications, ethnicity
and employment.
Provides a standardised rate for international
comparison, persons who are out of work and
are available to commence work within two
weeks, have actually sought work in the last four
weeks and are waiting to take up a job.
 Claimant count
Number registered unemployed with state
agencies, usually receiving state unemployment
benefits.
Further category ‗Economically active‘ or
‗Economically inactive‘
 Types of Unemployment
• Frictional unemployment – temporary as people
change jobs (transitional unemployment)
• Structural unemployment – due to rigidities in the
labour market (often associated with regional
unemployment). Due to market movements in particular
industries.
• Should eventually disappear as real wages adjust and
workers move to other industries or geographical areas.
• Effective policies would be retraining schemes,
incentives and rebates, investment and employment
subsidies.
• Classical unemployment – entirely voluntary, people
choosing not to accept available jobs.
 Unemployment in excess of the
natural rate (NAIRU)
NAIRU is the rate that produces a stable
inflation rate.
Policies should make the labour market
more flexible or adaptive to changes in
Demand and Supply.
• Demand deficient unemployment – entirely voluntary
and is often referred to as ‗Keynesian unemployment‘
• Cyclical unemployment – occurs when the economy
goes into recession as normal episodes of the business
cycle (5-7 Years since the industrial revolution).
• General unemployment – Used in the 1930s to
describe protracted unemployment resulting from a
deficiency in aggregate demand. This has been rare
since the 1940s.
• Maybe tackled using Keynesian management
techniques.
• Keynesian economists argue that wage reductions take
too long to take effect, leading to years of unemployment
and social deprivation, so look to stimulate demand.
• These policies may lead to lower ―real wage rates‖
through inflationary effects.
 Cost of unemployment
• Economic costs – loss of natural output (potential)
• ―Okun‘s Law‖ states that a 1% point of cyclical (demand
deficient) unemployment is associated with a loss that is
equal to 2.5% of full employment output.
• Also reflects the lower productivity levels, shorter
working week and other recessionary measures.
• Social Costs
• Long term unemployed lose job skills and self esteem as
time passes. The benefits of leisure activities weighed
against economic and social costs but are unlikely to
fully compensate most individuals.
• Recession 2009 severe effect on 18-24 year olds over
16%.
 Unemployment and hysteresis
(from the Greek to be behind)
• Due to prolonged periods of unemployment, some
people can become unemployable; they lose the
technical and social skills needed to work efficiently.
Countries suffering from this are likely to experience a
decline in capital formation and technological
development and lag behind others as a result.
• Hysteresis means that the natural rate of unemployment
depends on the actual rate of unemployment, rising if the
actual rate is above the current natural rate and falling if
the national rate is below the current natural rate.
• This can be reversed by boosting productivity growth.
Unemployment levels
 Wage determination
• Collective bargaining is bargaining between firms and
unions.

• Common forces at work in the determination of wages

include:
 Workers are typically paid a wage that exceeds their
reservation wage, the wage that would make them
indifferent between working or being unemployed.
 Wages typically depend on labor market conditions.
The lower the unemployment rate, the higher the
wages.
 Bargaining

• How much bargaining power a worker has

depends on two factors.

 How costly it would be for the firm to replace

him—the nature of the job.

 How hard it would be for him to find another

job—labor market conditions.
 Efficiency Wages
• Economists call the theories that link the productivity or
the efficiency of workers to the wage they are paid
efficiency wage theories.

• These theories also suggest that wages depend on both

the nature of the job and on labor-market conditions:
 Firms that see employee morale and commitment as
essential to the quality of their work, will pay more than
firms in sectors where workers‘ activities are more
routine.
 Labor market conditions will affect the wage.
Wages, Prices, and
Unemployment
W  P F(u, z) e

The aggregate nominal wage, W, depends

on three factors:
 The expected price level, Pe
 The unemployment rate, u
 A catchall variable, z, that stands for
all other variables that may affect the
outcome of wage setting.
 The Expected Price Level
• Both workers and firms care about real wages (W/P), not
nominal wages (W).

 Workers do not care about how many dollars they

receive but about how many goods they can buy with
those dollars. They care about W/P.

 Firms do not care about the nominal wages they pay

but about the nominal wages, W, they pay relative to
the price of the goods they sell, P. They also care
about W/P.
 The Unemployment Rate
• Also affecting the aggregate wage is the unemployment
rate, u.

• If we think of wages as being determined by bargaining,

then higher unemployment weakens workers‘ bargaining
power, forcing them to accept lower wages. Higher
unemployment allows firms to pay lower wages and still
keep workers willing to work.

• The third variable, z, is a catchall variable that stands for

all the factors that affect wages, given the expected price
level and the unemployment rate.
Equilibrium Real Wages and
Unemployment

1
F(un , z) 
1 

The equilibrium unemployment rate (un) is

called the natural rate of unemployment.
 Equilibrium Real Wages and
Unemployment
•The positions of the wage-setting and price-setting curves, and thus
the equilibrium unemployment rate, depend on both z and μ.

– At a given unemployment rate, higher unemployment benefits lead

to a higher real wage. A higher unemployment rate is needed to
bring the real wage back to what firms are willing to pay.

– By letting firms increase their prices given the wage, less stringent
enforcement of antitrust legislation leads to a decrease in the real
wage.
– Because the equilibrium rate of unemployment reflects the
structure of the economy, a better name for the natural rate of
unemployment is the structural rate of unemployment.
     (  z)   u
e

•According to this equation:

– An increase in the expected inflation, e, leads to an increase in

inflation, .

– Given expected inflation e, an increase in the markup, , or an

increase in the factors that affect wage determination, z, lead to an
increase in inflation .

– Given expected inflation, e, an increase in the unemployment rate,

u, leads to a decrease in inflation, .
Inflation, Expected Inflation,
and Unemployment
    (  z)   u
e

When referring to inflation, expected

inflation, or unemployment in a specific
year, the equation above needs to include
time indexes, as follows:

 t   t     z   ut
e

The variables , et, and ut refer to inflation,

expected inflation and unemployment in
year t.  and z are assumed constant and
don‘t have time indexes.
 The Early Incarnation
• If we set et = 0, then:

 t  (  z)   ut

This is the negative relation between

unemployment and inflation that Phillips
found for the United Kingdom, and Solow
and Samuelson found for the United States
(or the original Phillips curve).
The Phillips Curve
 The wage-price spiral:

Given Pet =Pt-1:

 Low unemployment leads to a higher nominal wage.

 In response to the higher nominal wage, firms increase
their prices and the price level increases.
 In response, workers ask for a higher wage.
 Higher nominal wage leads firms to further increase
prices. As a result, the price level increases further.
 This further increases wages asked for by workers.

And so the race between prices and wages

results in steady wage and price inflation.
 Back to the Natural Rate of
Unemployment
 t   t 1   (ut  un )
The equation above is an important relation for two reasons:

It gives us another way of thinking about the Phillips curve: as a relation

between the actual unemployment rate ut, the natural unemployment
rate un, and the change in the inflation rate .

It also gives us another way of thinking about the natural rate of

unemployment. The non-accelerating-inflation rate of unemployment,
(or NAIRU), is the rate of unemployment required to keep the inflation
rate constant.
 Milton Friedman and Edmund Phelps
Theory ahead of facts!

• Economists are usually not very good at predicting major

changes before they happen. Here is an exception.
• In the late 1960s—precisely as the original Phillips curve
relation was working like a charm—two economists,
Milton Friedman and Edmund Phelps, argued that the
appearance of a trade-off between inflation and
unemployment was an illusion.
• Friedman could not have been more right. A few years
later, the original Phillips curve started to disappear, in
exactly the way Friedman had predicted.