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Chapter 6
Search and Unemployment

 Teaching Goals
Search is a key element in economic activity, and this chapter is devoted to two search models – a one-
sided model and a two-sided model – that capture different aspects (and some of the same ones, in
somewhat different ways) of search, and why it is important in macroeconomic models, and for giving
insight into how labor markets work.

The one-sided model is a partial equilibrium framework that explains how an unemployed worker
behaves, when facing an exogenous distribution of wage offers. This model tells us the determinants of the
unemployed worker’s reservation wage. If an offer is received at or above the reservation wage, the
unemployed worker accepts the offer; otherwise he or she declines and continues to search. The
reservation wage then determines a long-run unemployment rate, which is the steady state unemployment
rate if the wage offer distribution stays fixed and there is a constant separation rate.

The second model – the two-sided search model – is a static version of the widely used Diamond-
Mortensen-Pissarides model of search and unemployment. This model differs from the one-sided model in
that it is general equilibrium, and focuses on the decision by firms concerning how many job vacancies to
post. Students should not have difficulty understanding the model, but they may need some additional
help, as the approach is somewhat different than what we use in standard competitive equilibrium models,
for example in Chapter 5. However, it helps to think of the labor market in terms of demand and supply
sides. Then, it is possible to use what a student knows from Chapter 5 to teach them about the two-sided
search model. Workers and firms care about the wage in the same way they do in a competitive model, but
now the market “clears” in a different way. Workers care not only about the wage, but the unemployment
insurance benefit (because their job search may be unsuccessful) and labor market tightness (which
determines the chances of finding a job). Would-be employers care about labor market tightness and the
cost of posting a vacancy, as well as the market wage. The matching function, which determines the
number of successful matches as a function of matching efficiency and the numbers of firms and
consumers searching, is an important concept. In this case, appeal to what students know about the
production function, as the matching function has the same properties. Then, one can appeal by analogy to
production so that the student understands how the matching process takes place.

It is important first to understand the labor market data. The two-sided search model is very nice, as the
variables in the model match up almost exactly with the labor market data as measured. The unemployed
are those who chose to search but were unsuccessful, the labor force is the number of people who actively
searched and found a job (employed) plus the number who actively searched and were unsuccessful (the
unemployed), etc.

The experiments in the model – increase in the unemployment insurance benefit, increase in productivity,
decrease in matching efficiency – are all useful in understanding recent economic events and less-recent
ones.

Copyright ©2018 Pearson Education, Inc.

 Chapter 6 Search and Unemployment 55

 Classroom Discussion Topics

It should not be hard to get students talking about unemployment. Most of them should know someone
who has been unemployed, or they have read about unemployment as it relates to the recent recession.
However, students may not understand how unemployment is actually defined, or how economists think
about it. An important feature of the search models is that there will be unemployment under any
circumstances, and students should understand that we cannot make unemployment go away, nor should
we want it to.

It will be helpful if students understand why a search-model approach is necessary to understanding

unemployment. Get them thinking about what unemployed people are actually doing, and what is
motivating them. Unemployment is an economically measurable activity, and we want to take a scientific
approach to thinking about it.

Also, get the students to think about what motivates firms to search for workers to fill job openings. Why
is searching for workers costly? What difficulties does a firm face in hiring workers? How does matching
between firms and workers take place? Why is the market for labor similar to, and different from, the
market for a good or service?

Students should be encouraged to think about government intervention and how it matters for labor market
behavior. What will unemployment insurance do? How can the government speed up or slow down the
matching process in the labor market?

 Outline
1. The Behavior of the Unemployment Rate, the Participation Rate, and the Employment/Population
Ratio in the United States
A. Unemployment Rate, Participation Rate, and Employment/Population Ratio: Data
B. Key Determinants of the Unemployment Rate: Aggregate Economic Activity, Demographics,
Government Intervention, Mismatch

2. A One-Sided Search Model

A. Welfare of the Employed and Unemployed
B. Reservation Wage
C. Determining the Unemployment Rate
D. Unemployment Insurance Benefits
E. Job Offer Rate

3. The Two-Sided Model of Search and Unemployment

A. Consumers
B. Firms
C. Matching
D. Optimization by Consumers
E. Optimization by Firms
F. Equilibrium
G. An Increase in the Unemployment Insurance Benefit
H. An Increase in Productivity
I. A Decrease in Matching Efficiency
J. The Beveridge Curve

Copyright ©2018 Pearson Education, Inc.

56 Williamson • Macroeconomics, Sixth Edition

 Learning Objectives
1. List the key labor market facts concerning the unemployment rate, the participation rate, and the
employment/population ratio.
2. Describe the Beveridge curve, and explain its importance.
3. In the one-sided search model, explain how the reservation wage is determined.
4. Show how the one-sided search model determines the unemployment rate.
5. Use the one-sided search model to determine the effects of changes in the labor market on the
efficiency wage and the unemployment rate.
6. Construct an equilibrium in the two-sided search model.
7. Use the two-sided search model to explain how shocks to the labor market change labor force
participation, unemployment, vacancies, aggregate output, and labor market tightness

Copyright ©2018 Pearson Education, Inc.

 Chapter 6 Search and Unemployment 57

 Solutions to End-of-Chapter Problems

1. If the separation rate s increases, this has two effects. In Figure 6.14, this shifts down the curve
Ve(w), as a job is now worth less – a worker has a greater chance of being separated from the job
at any wage. As a result, the reservation wage w* will increase, as the consumer becomes more
picky about the jobs he or she will take. That is, unemployment is more attractive relative to
working. So, H(w*), which is the chances of receiving a job offer that is acceptable, falls. So in the
second panel of Figure 6.14, UpH(w*) shifts down, and s(1-U) shifts up. Therefore, on net, the
long-term unemployment rate must rise. That is, workers are being separated from jobs at a higher
rate, causing a higher flow from employment to unemployment, and the unemployed are accepting
jobs at a lower rate, creating a lower flow from unemployment to employment. These two effects
both work to increase the unemployment rate.

2. If TFP increases, so that wages increase for all jobs, this has no effect on the reservation wage, as
neither Ve(w) nor Vu changes. But H(w) increases for each w, as the chances of receiving a job
offer higher than w increases for any w. Thus, in the second panel of Figure 6.14, the curve
UpH(w*) shifts up, and the long-term unemployment rate falls. As wages are higher, workers have
a better chance of finding an acceptable job, which acts to increase the flow from unemployment
to employment, which reduces the unemployment rate.

3. If it is harder to qualify for unemployment insurance, this works in the same way as a reduction in
the unemployment insurance benefit b. From Figure 6.15, the reservation wage falls, and the long-
term unemployment rate falls.

4. More labor-saving devices has the effect of reducing the payoff to working at home for all
consumers, which reduces v(Q) for each value of Q. As a result, the curve in panel (a) of Figure
6.1 shifts up. In equilibrium, Q increases, but j remains unchanged. The unemployment rate and
the vacancy rate are unaffected, but the labor force Q increases. Since j = A/Q, therefore the
number of firms A increases. Aggregate output Y = Qem(1,j), so Y increases, as Q has risen and j
is unchanged. Labor saving devices make searching for work more attractive relative to working at
home for consumers. With more consumers in the market, labor market tightness tends to go
down, which attracts more firms into the labor market. Ultimately, the number of active firms
increases proportionally to the number of consumers searching for work, and there is no change in
labor market tightness in equilibrium. Output goes up because there are more successful matches
in the labor market.

Copyright ©2018 Pearson Education, Inc.

58 Williamson • Macroeconomics, Sixth Edition

Figure 6.1

5. (i) With a subsidy s to hiring a worker, for a successful match, the surplus of the firm is z+s-w, the
surplus of the worker is w-b, total surplus is z+s-b, and the wage (from Nash bargaining) is
w=a(z+s)+(1-a)b. Then, on the supply side of the labor market, the equation determining the curve in
panel (a) of Figure 6.2 is given by

v(Q)=b+em(1,j)a(z+s-b),

and on the demand side of the market, the equation determining j is

(k/((1-a)(z+s-b)))=em((1/j),1)

Then, in Figure 6.2, comparing the equilibrium when s=0 to one with s>0, the subsidy acts to increase
labor market tightness, j, and to increase the labor force, Q. The subsidy acts to induce more firms to
enter the labor market to search for workers, which makes j=(A/Q) higher. This in turn acts to make

Copyright ©2018 Pearson Education, Inc.

 Chapter 6 Search and Unemployment 59

search more attractive for workers, as it is now easier to find a job. As well, the subsidy increases the
wage, which further increases the incentive to search for work. The unemployment rate is 1-em(1,j),
which falls when j increases, so the subsidy reduces the unemployment rate.
(ii) If the government pays would-be workers to stay out of the labor market, this has no effect on
the demand side (firms' behavior). However, the supply side of the labor market is now characterized
by the equation

q+v(Q)=b+em(1,j)a(z+s-b),

Therefore, when q>0, this shifts the curve in the upper panel of Figure 6.2 to the right. There is no
effect on labor market tightness, j, and therefore no effect on the unemployment rate. However, Q
falls. Since j does not change, this implies that A falls as well, since j=(A/Q). Therefore, this policy has
the effect not only of reducing the number of would-be workers looking for work, but it reduces the
number of firms searching for workers. The policy has an unintended side effect and has no effect on
the unemployment rate.

Figure 6.2

Copyright ©2018 Pearson Education, Inc.

60 Williamson • Macroeconomics, Sixth Edition

6. The lower recruiting cost, k, affects only the demand side of the labor market. In Figure 6.3, labor
market tightness increases from j₁ to j₂, and the labor force increases from Q₁ to Q₂. The
unemployment rate is 1-em(1,j), which decreases because of the increase in j, and the vacancy rate is
1-em((1/j),1), which increases. Since j=(A/Q), and since Q and j increase, A also increases. Aggregate
output is Qem(1,j)z, which increases, as Q and j both increase. Thus, the lower cost of recruiting
induces more firms to enter the labor market, which increases labor market tightness, inducing more
workers to enter the labor market to search for work, as the chances are now better of finding a job.

Figure 6.3

7. For this question, re-define labor market tightness as j = (A+G)/Q. Then, the diagram we work with
looks identical to Figure 6.10 in Chapter 6, and Q and j are determined as in Figure 6.10. Note in
particular that G is irrelevant for determining Q and j, so government activity is irrelevant for the size
of the labor force and labor market tightness. Further, government activity will not matter for the
unemployment rate, the vacancy rate, or aggregate output. However, since j and Q do not change when
G changes, A+G = jQ does not change either. But then an increase in G must reduce A by the same
amount. Therefore, government activity simply reduces the number of private firms by an equal
amount, and there is otherwise no effect on economic activity. The key to this result is that the

Copyright ©2018 Pearson Education, Inc.

 Chapter 6 Search and Unemployment 61

government was assumed to be no better or worse at producing output than private sector firms.
Therefore, the scale of government activity could not matter for aggregate variables.

8. If all social welfare programs simultaneously become more generous, suppose that we represent this as
a payment p to each person not in the labor force, and an increase by p in the employment insurance
benefit. Then, the equation that summarizes behavior on the supply side of the labor market becomes

v(Q) + p = b + p + em(1,j)a(z-b-p),

or, simplifying,

v(Q) = b + em(1,j)a(z-b-p).

As well, the equation summarizing demand-side behavior in the labor market can be written as

em(1/j,1) = k/(1-a)(z-b-p)

Therefore, in Figure 6.4, labor market tightness falls from j1 to j2, and the labor force falls from Q1 to
Q2. As a result, the unemployment rate increases and the vacancy rate decreases. The number of firms
is A=jQ, so A decreases. As well, output is Y=zQem(1,j), so output also falls. Consumers are affected
by two social programs – one that pays a benefit to people not in the labor force, and one that pays an
employment insurance benefit to the unemployed. Since the consumer receives the employment
insurance benefit only in the event that search for work is unsuccessful, the increase in generosity of
all social programs will on net discourage consumers from searching for work. Further, more generous
social programs reduce the total surplus from a successful match, and this discourages firms from
posting vacancies. On net, labor market tightness goes down, the labor force contracts, and aggregate
output decreases, with the unemployment rate increasing and the vacancy rate decreasing.

Copyright ©2018 Pearson Education, Inc.

62 Williamson • Macroeconomics, Sixth Edition

Figure 6.4

Copyright ©2018 Pearson Education, Inc.

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