EC102 WEEK 7

(slides 137-146)

Labour-market status
 Employed: working at a paid job
 Unemployed: mot employed but looking for a job
 In the labour force/out of the labour force: employed or looking/ neither employed
nor looking
 Rate of unemployment: the % of the labour force that is employed

Graphs:
 Germany’s unemployment is on average 5-6%, Spain’s unemployment is almost
always around 10% - countries gravitate around different unemployment rates
 Some countries tend to gravitate around very low unemployment rates on average,
and some others around a much higher rate
 Distinction between the cyclical component and its more longer-term, normal level
 Unemployment rate is counter-cyclical, but the long-run average varies a lot from
country to country
 When Spain and Germany, for example are equally free from cyclical shocks, they
still have different levels of natural unemployment rates

Why do some countries have high natural rates of unemployment and some low?
What determines the natural rate of unemployment?

‘cyclical’ vs ‘natural’ unemployment

 Natural: the normal unemployment rate which the economy experiences when it is
neither in a recession nor a boom
 Cyclical: the difference between the actual and the natural rate
 Contractionary demand or supply shocks push economic activity down, and increase
unemployment; expansionary shocks cause firms to expand production and hence
decrease unemployment

A basic model of the natural rate

L= no of workers in labour force (fixed)
E= no of employed workers
U= no of unemployed people
U/L =unemployment rate

Labour market flows: separations

From employment to unemployment:
 firms may decide to separate themselves from workers: redundancies; workers
pushed out of employment by a firm’s decision or closure; some other workers
decide to quit firms and go from being employed to unemployed

s= rate of job separation

= Fraction of employed workers that become separated from their jobs in a given
period (e.g. 1% per month)
Labour market flows: matches
From unemployment to employment
 Search process: firms decide to employ extra people, and so they open vacancies to
search for workers; or workers search for firms
 There is a lot of friction of trial and error or effort and time that is required for the
two sides of this market to meet (worker and firm)
 The search and matching processes take time and effort
 at any point in time there are workers looking for a job, and firms looking for
workers, but the process of search is a such that, only a fraction of these workers will
find a match -> to capture this friction, the rate of job finding is introduced:

f= rate of job finding

= Fraction of unemployed workers who find jobs in a given period (e.g. 20% per
month)

o No of workers transitioning from unemployed to employed: no of unemployed

people x job finding rate (U x f)
o No of workers transitioning from employed to unemployed: separation rate x no of
employed people (s x E)
o Unemployment is roughly constant when these flows cancel each other out
(roughly), i.e. when flows in, roughly equal flows out; flows in both direction equal
each other when no fluctuations occur
o Assuming that f and s are constant

Solving for the natural rate:

 The natural rate of unemployment is larger if: s is larger, and/or f is smaller

  Unemployment increases if separation>hires. In principle, since separation
rate=separations/employment and job-finding rate=hires/unemployment, it would
be possible for the separation rate to exceed the job-finding rate but still separations
being less than hires

Labour market policies and institutions:

 Some separations and delays in job finding are inevitable, and so is some
unemployment
 But policies and institutions can affect f and s:
- Incentives to open vacancies (value of a job)/ does this policy increase or
decrease the value of the job? -> on the condition that one is unemployed, they
are more likely to find a job if there are more vacancies (what makes firms post
more vacancies? Value of a job for the firm: how much output the worker will
produce less how much does that workers/job cost (wages, regulation, the very
process of posting the vacancies, i.e. training and recruiting) to the firm?)
- Incentives to exert search effort -> search effort will be higher under a policy
improving the incentives to search, i.e. more matches
- Efficiency of search -> there may be unemployed workers spending the time to
search but lack information needed to be effective in their search, they don’t
know which jobs are in higher demand or that if they move, they could find more
jobs etc. -> more successful searches, more matches
- Cost of separation -> policies that affect the cost of separation, increasing this
cost will make it more costly for firms to separate from workers
- Outside options for quitters -> changes in the desire/ willingness of workers to
quit, affects the rate of separation

Active labour market policies

 Government employment agencies: Government intervenes, to disseminate
information about what opportunities are out there, among workers; facilitate a
better match between workers and firms
 Public job training programs: creating a better match between what the workers
know and what the firms are looking for; government helps workers displaced from
declining industries get skills needed for jobs in growing industries
 Conditional unemployment benefits: incentivising search effort by workers, by
making UI dependent on job search efforts
 All of these improve the job finding rate, which then translates to a lower natural
unemployment rate

Unemployment Insurance: pays part of a worker’s former wages for a limited time after the
worker loses his/her job
1. Reduces the hardship of unemployment
2. Efficiency in the allocation of workers to jobs: people just taking the first job they
encounter, which is not socially optimal, because people need to work in jobs for
which they have a better match: By allowing workers more time to search, UI may
lead to better matches between jobs and workers, and thus to greater productivity
and higher incomes; without unemployment insurance people may be motivated to
take any job even if it is not right for their skills
 3. May support AD in recessions by preserving the spending power of the unemployed;
a way of cushioning against a contractionary shock

But, problems with UI?

1. UI may increase search unemployment, because it reduces the opportunity cost of
being unemployed; UI is often couched in extremely pejorative and simplistic way;
there is a stigma around receiving UI (being lazy); in practice it doesn’t finance a
pleasant lifestyle at all
2. If unemployment insurance was too generous it would discourage search for
employment
 Govt has to choose the level and duration of UI so as to find the right balance
between costs and benefits
 UI has the potential to affect the job finding rate

Employment protection legislation (EPL)

 In the US, there is a ‘fire at will’ model
 There are many countries where they have policies making firing workers more
costly such as; high mandatory severance pay, and spelling out of conditions for
severance: grave firm distress, grave misconduct (worker underperforming in a
provable unethical or disruptive way); very expensive to prove in court you want to
fire a worker
 In such countries, workers are protected from excessive insecurity and arbitrary
decisions; but there is also the possibility that the effect of this on unemployment
would be potentially to increase unemployment, since the separation rate will go
down (making separation more expensive by a stronger EPL, there will be fewer
separations)
 It may make some firms more reluctant to hire to begin with; reduces willingness to
post vacancies
 Reduces the value of the job for the firm; with EPL, firms have to factor in the
potential cost of the EPL process, which reduces the value of the job; therefore,
number of vacancies are reduced, and hence job finding rate is reduced
 Yes, lower separation rate, but it can also reduce the search rate
 Casual observation is that countries with high EPL tend to have higher
unemployment rates; but we cannot deduct a correlation, it is possibly suggestive
but it is not a causal relationship (theoretical ambiguity about its effect)
 Creates conflict among workers: an ‘insider’, someone who already has a job would
support a stronger EPL, but an outsider may worry that making EPL more tougher,
will actually deter employers from making more vacancies- in some countries there
is division between unions because of the tensions between the conflicting views on
EPL (political aspect- insiders are more politically powerful)

The wage setting process

 We tend to describe the process in which wages are set as a negotiation between
workers and employers; descriptive of what happens in the US, but in other
countries there is no individual one-on-one negotiation, but sectoral negotiation:
 representatives of both ends meet and decide on national contracts that apply to all
the workers in the sector
 In one-on-one interaction, the employer has disproportionate power; so, there is a
rationale for a union representing workers, to rebalance the disproportionate power
 But there are risks to unions: in practice unions tend to disproportionately represent
employed people (most of the members are employed); when negotiating, priority is
placed on people who are already employed, so unions push quite hard on the wage;
 But if wages are pushed really high, the value of the job (the output of the workers-
cost of workers employed) increases for the firms, which may consequently lower
the job finding rate (a trade-off) -> an employer who is now paying higher wages,
may open fewer new vacancies because the new high wage settlement has reduced
the value of the job -> so there is a conflict of interest, where the outsider might
have wished for a different outcome of the negotiation, one perhaps which puts less
emphasis on the wage and more on employment; conflict of interest as to who does
the union represent?
 The trade-off is particularly severe in countries with higher EPL: the more secure the
current insiders are (more unlikely to get fired, as it is more costly to fire workers)
the more they know they can push for higher wages, without worrying about losing
their jobs; if EPL is not very high we may limit higher wage demands in fear of losing
jobs

Dual labour markets

Evidence shows that some of the countries with high natural rates of unemployment, with a
combination of generous EPL and national sectoral wages, suggest that vacancy creation is
deterred
 Temporary jobs without EPL: a new category of jobs, where after a few months the
employer must either end this job or pump it up to a good job with EPL
 Advantage is that these poor unemployed people, at least get these gigs
 Disadvantage is that the firm has no incentive to invest in the skills or knowledge of
the worker, and similarly workers have no incentive to build their knowledge: dead-
end jobs (jobs with no future, no learning or growth)
 Result is that there are middle aged workers who are secure in permanent jobs, and
young workers in unemployment punctuated by brief spells in temporary jobs which
don’t build their skills (i.e. duality of the market)
 Recent reforms: in the last few years, there has been creation of more of a nuanced
path to full EPL; a system whereby you start in a job with zero EPL, and after a few
months you get a little bit of employment protection -> a smoother path to full EPL;
idea here is that firms may be more willing to cautiously move workers up the EPL
ladder -> eliminating this dual nature of the market; labour economies looking at
countries with these reforms (Spain, Italy)