Unit 5 Unemployment

OVERVIEW

This unit provides the learners the knowledge and understanding of the working
adult population in the labor force and not in the labor and the computation of
labor force participation rate and unemployment. It also covers the types and
causes of unemployment and measures to address unemployment.

LEARNING OUTCOMES

By the end of Unit 5, you should be able to:

1. use data on the number of employed, unemployed, and not in the labor
force to calculate the unemployment rate and the labor force
participation rate.

2. distinguish between cyclical, frictional, and structural unemployment

and explain suitable remedies.

3. describe natural unemployment and full employment.

4. explain why some unemployment is inevitable.

5. illustrate in a diagram the impact of the minimum wage on high wage

and low wage sectors.

6. list the reasons why unions cause unemployment and, alternatively, why
unions might increase efficiency in some cases.
7. describe the four reasons why firms may choose to pay wages above the
competitive wage

5.1 Introduction

Unemployment is defined by the Bureau of Labor Statistics(BLS)) as people

who have actively looked for a job in the past four weeks but unable to get a
job. The unemployed also those who are temporarily laid off and are waiting to
be called back to do the job. Unemployment can be categorized into (i) natural
unemployment, and (ii) cyclical unemployment. The natural rate of
unemployment comprises structural and frictional unemployment.

5.2 Components of Working Adults Population

The components of the working adult population are required to compute the
unemployment rate and the labor force participation rate. Figure 5.1
summarizes the various components of the working adult population.

Figure 5.1: Components of the working adult population.

 Working Adult/age
Poplation

Labor Force Not in the Labor Force

Homemakers

Pensioners
Employed Unemployed
Labor Force Labor Force Students pursuing
tertiary education

Discourage Workers

5.2.1 Working Adults Population

The working-age/adults population of a nation is those who are 16 years and

above. It is used to estimate the total number of potential workers within an
economy. The working adults or age population can be divided into those who
are economically active and those who are economically inactive. Those people
who are economically active fall in the labor force category and those who are
economically inactive fall in the not of the labor force category.

5.2.2 Labor Force

The working adult population fall in the labor force category is economically
active. The labor force can be divided into two groups, those who are employed
and those who are unemployed groups.
 Labor Force(LF) = Number unemployed + Number employed

5.2.3 Not in the Labor Force

The working-age population who are not in the labor are economically inactive.
The not in the labor force category consists of retirees, homemakers, students,
discouraged workers, etc.

5.2.4 Unemployment

Unemployed labor forces are those who want to work, but could not find a job.
The unemployment rate is the proportion of the number of unemployed to the
total labor force. It describes the percentage of the labor force who are
unemployed.

𝐍𝐮𝐦𝐛𝐞𝐫 𝐮𝐧𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝
Unemployment rate = 𝐋𝐚𝐛𝐨𝐫 𝐅𝐨𝐫𝐜𝐞
𝐱 𝟏𝟎𝟎

Example 1

Suppose Nation A in 2019 has 10 million working adults/age population, 4

million of them are not in the labor force and the total number of employed is
5.4 million.

Labor Force(2019) = Working Age Population – Not if the Labor Force = 10

million – 4 million = 6 million
The number of unemployed(2019) = Labor Force – Number of employed = 6
million – 5.4 million = 0.6 million.

Therefore,

Number of unemployed 0.6million

Unemployment rate(2019) = Labor Force
x 100 = 6 million
x 100 =

10%

5.2.5 Labor Force Participation Rate

The labor force participation rate is defined describes the percentage of the
working adult population who is in the labor force.

𝐋𝐚𝐛𝐨𝐫 𝐅𝐨𝐫𝐜𝐞
Labor Force Participation Rate = 𝐱 𝟏𝟎𝟎
𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐀𝐠𝐞 𝐏𝐨𝐩𝐮𝐥𝐚𝐭𝐢𝐨𝐧

Example 2

Using the data given in Example 1, the labor force participation rate is
calculated as below.

Labor force 6 million

Labor force participation rate =Working Age Population x 100 = 10 million
x 100 =

60%
Interpretation: Sixty percent(60%) of the working adult population are actively
looking for work or economically active.

Table 5.1: Key Statistics of Labor Force in Malaysia, October 2016.

Indicator Number of people (in 000)

Employed 14,253.4
Unemployed 511.7
Labor Force 14,765.1
Not in the Labor Force 7,071.1
Source:https://www.statistics.gov.my

Table 1 shows the key statistics of the labor force in Malaysia as of October
2016.

Number of unemployed 511.7

Unemployment rate = x 100 = x 100 = 3.5%
Labor Force 14,765.1

Labor force 14,765.1

Labor force participation rate = x 100 = x 100 =
Working Age Population 21,836.2

67.6 %

ACTIVITY 5.1

Suppose some discourage workers resume looking for jobs. How

will this affect the labor force participation rate and unemployment
rate?
 5.3 Types of Unemployment

Unemployment is broadly categorized into cyclical unemployment and natural

unemployment.

5.3.1 Cyclical Unemployment

Cyclical unemployment happens when the economy goes downswing caused by

declining in the level of spending or aggregate demand. This phenomenon is
known as recession resulting in a fall in household spending, business
investment, and net export. The economic performance falls below its potential
level. Firms are compelled to reduce their production resulting in workers'
retrenchment The financial crisis in 2008 is a good example of an economic
meltdown in the US caused by the subprime mortgage resulting in cyclical
unemployment. The construction sector was badly affected by the crisis
resulting in the loss of construction jobs. The housing crisis causes the home
builders to stop constructing new homes. This resulted in 2 million
construction workers losing their jobs. (Source: CBS News, 2 Million
Construction Jobs Lost, June 16, 2011)

Figure 5.2:Underachieving Economy(Recession)

Expenditure(E)
Y=E
Deflationary gap
AE + C + I + G + NX
 Ye YF Real GDP(Y)

Figure 5.2 illustrates the economy is facing a deficiency in the level of

spending. The level of spending at the full employment real GDP (YF) is less
than the level of production resulting in a deflationary gap. Cyclical
unemployment occurs because the economic performance (Ye) is below its
potential level (YF). The level of spending in the economy must increase to raise
the level of economic activity and create more employment is to raise the level
of spending. The aggregate expenditure(AE) must increase and it has to
intersect the output line(Y) at the full employment/potential level.

Remedial measures for cyclical unemployment

An expansionary demand policy must be implemented. The demand policy

consists of the fiscal policy and monetary policy. A fiscal policy is used by the
government to directly raise the level of spending using its fiscal tools (taxes
and government spending). The government must implement an expansionary
fiscal policy to raise the level of spending. This is done by reducing taxes and
increasing government spending. A reduction in income tax will increase
household disposable income and household spending. The increase in
household spending depends on the household's marginal propensity to
consume. A reduction in the business tax will encourage firms to increase their
investment.
An expansionary monetary policy can also increase the level of spending. The
central bank will use the monetary tools( lowering reserve requirement ratio,
lowering the discount rate, and purchase government securities in the open
market operation) to raise the money supply to reduce the interest rate.

Figure 5.3: Impact of an expansionary monetary policy

r MS MS1

r0 e
f
r1
DM

Quantity of money

M0 M1

Figure 5.5 illustrates the effect of an expansionary monetary policy. An

expansionary monetary policy increases the money supply resulting in the
money supply curve shifting to the right to MS1. The increase in the money
supply reduces the interest rate from r o to r1. It is an incentive for households
and firms to borrow money as the borrowing cost fall due to a lower interest
rate. The lower interest rate makes loans and even credit card payments
cheaper. An effective expansionary monetary will have a positive impact on the
goods and services markets. The fall in the interest rate will encourage greater
consumption and investment and hence increasing the aggregate demand or
expenditure. The increase in the aggregate demand will encourage firms to
increase their production and employment of resources. The economy will start
to expand and unemployment will fall. The monetary policy is only effective in
the short run.

5.3.2 Natural Unemployment

Natural unemployment is defined as the normal rate of unemployment around

which the unemployment rate fluctuates and it continues to happen in the long
run. Natural unemployment represents the hypothetical unemployment rate
that is consistent with aggregate production being at a long-run level. It
consists of structural and frictional unemployment.

Natural unemployment = Frictional unemployment + Structural unemployment

Frictional Unemployment

Frictional unemployment happens when workers leave their jobs to find a

better job. It's usually thought of as a voluntary exit. The time, effort, and
expense to find new jobs occur because workers need to learn about possible
new employment opportunities. It's an unavoidable part of the job search
process that is usually short-term. Workers normally hold onto their existing
jobs until they find new ones. Often, the workers must move for some reason
before they can start searching for new jobs. They might have gotten married
or have to care for elderly relatives. Other times, they might have saved enough
money so they can quit unfulfilling jobs, and have the luxury to search until
they find just the right opportunities.

The frictional unemployment can occur due to:

• Job leavers (those that voluntarily quit their jobs) looking for jobs that
better suit their taste and skills.
• Reentry into the job market. Example mothers who are reentering or
rejoining the workforce after their children have grown up.
• New entrants. University graduates looking for jobs.

Remedial measures for frictional unemployment

The main cause of frictional unemployment is the lack of job market

information. Frictional unemployment is addressed by making job information
available to job seekers. This is accomplished by online job matching services
agencies, such as Simply Hired, Monster.com, Jobstreet, and CareerBuilder.
However, it still takes time to write a compelling resume, search for the right
job, apply, wait for a response and go through the interview process.
Furthermore, many job seekers still find the best source of new jobs is through
their professional network. Even this has been helped by online services such
as Facebook, Twitter, and LinkedIn.

Structural Unemployment

Structural unemployment is unemployment caused by factors other than the

business cycle. It occurs when economic transformation makes it difficult for
some to find jobs. Structural unemployment occurs because the quantity
supplied of labor is more than the quantity demanded labor.

The imbalance between the quantity demanded and supplied of labor can also
occur when (i) technological advancement, (ii) government intervention in the
labor market by enacting minimum wage, (iii) the formation of trade unions,
and (iv) firms offering efficient wages.

The employment of advanced technology by firms will reduce firms' demand

for labor. For example, in the manufacturing industry firms are using robotic
technology instead of unskilled workers for production.

As mentioned above, structural unemployment can happen because of a

nation's economic transformation. For example, the economic transition from
an agricultural economy to manufacturing, and then to a services economy
contributed to structural unemployment. Workers are required to be retrained
to be employed in the new sectors.

The existence of trade unions and the implementation of minimum wages will
see the wages are set above the equilibrium wage rate, causing an excess of
labor.

Minimum wage

A minimum wage is a minimum legal wage set by the government based on the
Minimum Wage Act. A binding minimum wage is a minimum wage set above
the equilibrium wage. It causes an imbalance between the quantity demanded
and quantity supplied of labor in a competitive labor market.

Figure 5.4: Minimum Wage

 30

25 S
Wage rate($ per hour)

20 Min. Wage

15

10

5 D

0
0 20 40 60 80 100 120
Quantity of labor(hours)

Figure 5.4 shows the demand and supply of labor in a competitive labor
market. The equilibrium wage rate is $15 per hour and the quantity of labor
employed is 60 hours. As the government sets a minimum wage rate at $20 per
hour the quantity demanded labor fall to 40 hours and the quantity supplied of
labor increases to 80 hours, causing a surplus of labor or unemployment of 40
labor hours.

Unionized and Non Unionized Labor Market

A trade union is an organization formed by workers to safe guide the interest of
the members. The main aims of trade unions are to negotiate with the
employers for better wages, incentives, working conditions, and to regulate the
relationship between their members and employers.
 30
Figure 5.5: Unionized Labor Market
25 S
Wage rate($ per hour)

20 Union wage

15

10

5 D

0
0 20 40 60 80 100 120
Quantity of labor(hours)

Figure 5.6: Nonunionized Labor Market

30

25 S S1
Wage rate($ per hour)

20

15

10

5 D

0
0 20 40 60 80 100 120 140 160
Quantity of labor(Hours)

Figure 5.5 illustrates a unionized labor market and Figure 5.6 represents a
nonunionized labor market. Suppose in the unionized labor market, the trade
union succeeds in getting a wage rate of $20 per hour above the equilibrium wage
rate of $15 per hour. This resulting in a declined in the quantity demanded labor
from 60 hours to 40 hours and the quantity supplied of labor increased from 40
hours to 80 hours. The unionized labor market will experience a surplus of labor
or unemployment of labor of 40 hours. The quantity of labor employed in this
market is inefficient since more workers would like to have jobs at the existing
wage. These unemployed workers in the unionized labor will seek employment
in the nonunionized market increasing the supply of labor in the nonunionized
labor market. The increase in the supply of labor in the nonunionized labor
market will shift the supply curve to the right from S1 to S2. The result is a decline
in the wage in the nonunionized sector from $15 per hour to $10 per hour and an
increase in employment in the nonunionized market from 60 hours to 80 hours.

Efficiency Wage Theory

An efficiency wage rate is a wage rate offer by firms above the equilibrium
wage rate. The purpose of offering an efficient wage rate is to increase
workers' productivity and performance. It is profitable to the firms for the
following reasons.

a) Reduced worker Turnover

The opportunity cost for the workers to leave the job is high as they may not be
able to get the efficient wage rate in other firms. The ability of the firms to
retain workers is beneficial to the firms as they can avoid the cost associated
with high labor turnover costs such as recruiting, hiring, and training cost.

b) Increased Worker Quality

Firms offering high wages will attract quality workers to the firms. The high
wages increase the overall quality and ability level of the pool of applicants for
the job and help to win the most talented workers away from competitors.
Quality workers will provide quality ideas and work giving the firm an edge in
the market.

c) Improved Worker Health

Better paid workers can take care of themselves better in terms of better
nutrition, sleep, stress, and so on. The benefits of a better quality of life are
often shared with employers since healthier employees are usually more
productive than unhealthy employees.

d) Improved Worker Effort

Money is a key motivator for workers earning low wages. Firms offering
efficient wages will motivate the workers to exert more effort (and are hence
more productive). The performance of workers depends on the worker's ability,
motivation, and opportunities. The worker’s performance can improve by
improving worker ability through training, job opportunities through job
redesigning, and motivation by offering high wages.

Remedial measures for structural unemployment.

Remedies for structural unemployment vary from other types of

unemployment. Structural unemployment cannot be eliminated by one-time
stimulus measures because this type of unemployment doesn't involve a
shortage of jobs. Some have suggested that government programs to retrain
workers can reduce unemployment. Additionally, tax incentives could be
provided to companies that locate jobs in areas with surplus labor. Despite
these responsive measures, it is doubtful this type of unemployment can be
eliminated.
ACTIVITY 5.2

Suggest suitable measures to address cyclical unemployment.

SUMMARY OF UNIT 5

• The working adult population is those who are 16 years and above. It has
two broad components – labor force and not in the labor force.
• The labor force consists of the working adult who is economically active. It
consists of those who are employed and unemployed.
• The not in the labor force consists of the working adult who is not
economically active.
• Labor force participation is the percentage of the working adult population
in the labor force.
• The unemployment rate is the percentage of the labor force who are
unemployed.
• Unemployment can be broadly categorized into cyclical and natural
unemployment.
• Cyclical unemployment occurs during a recession caused by a deficiency in
the level of spending in the economy. The expansionary fiscal and monetary
policy can reduce cyclical unemployment.
• Natural unemployment consists of frictional and structural unemployment.
• Frictional unemployment happens of workers regularly changing jobs.
• Structural unemployment is caused by the quantity supplied of labor
exceeding the quantity demanded labor. This can happen due to
technological advancement, economic transformation, enactment of
minimum wages, formation of trade unions, and firms offering efficient
wages.
• Firms offering wages beneficial to the firms because it improved workers’
motivation and effort, attracts quality workers, lower the workers’ turnover
 and improved workers’ health.

GLOSSARY

Working-adult Those who are aged 16 years and above.

population
Labor force Economically active who are employed and unemployed.
Not in the labor Economically inactive.
force
Labor force The percentage of the working adult population in the
participation rate labor force.
Unemployment rate The percentage of the labor force who are unemployed.
Cyclical Unemployed is caused by inadequate spending in an
unemployment economy.
Natural The normal rate of unemployment around which the
unemployment unemployment rate fluctuates and continues to happen
in the long run.
Trade union An association or organization representing the
members to safe guide their interest.
Efficiency wage Wages are paid above the equilibrium wage rate as an
incentive for better workers’ productivity and
performance.