Unemployment

Gavin Cameron
University of Oxford
OUBEP 2006
introduction
• “When in any country the demand
for those who live by wages… is
continually increasing; when every
year furnishes employment for a
greater number than had been
employed the year before, the
workmen have no occasion to
combine to raise their wages. The
scarcity of hands occasions
competition among masters, who bid
against one another, in order to get
workmen…” Adam Smith (1776)

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job separation and job finding
• The workforce= employed + unemployed
• L=E+U
• When unemployment is stable, the number of job separations must
equal the number of jobs found.
• sE=fU
• but since E=L-U
• s(L-U)=fU, divide both sides by L to obtain
• s(1-U/L)=fU/L and solve for U/L to find
• (U/L)*= s/(s+f)
• The steady-state unemployment rate is an increasing function of the
job separation rate and a decreasing function of the job finding rate.

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 labour supply

When real wages rise, the budget line rotates around point A (the endowment of time remains unchanged) and
becomes steeper. This allows both consumption and leisure to increase at the same time (income effect).
Because leisure is more expensive, however, some is given up (substitution effect). In the case depicted here,
the substitution effect dominates at first, but not in the extreme.

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the supply of labour
Individual
real wage

Aggregate

The aggregate curve is less steep

than for an individual since new
workers enter the workforce as
wages rise.

employment

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the demand for labour
real wage

A competitive firm demands labour up until the point

where MC=MR, that is W=MPL*P, which is the same as
W/P=MPL

As more workers are added into the

workforce, for a given level of capital
and technology, the marginal product of labour demand, Ld
labour, and hence the demand for
labour, falls.

employment

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the natural rate of unemployment
real wage
labour supply, Ls workforce

equilibrium wage

labour demand, Ld

natural rate

equilibrium employment employment

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the natural rate and the NAIRU
• The natural rate model assumes that markets clear and that there is
competition in all markets.
• In fact, the labour market may be dominated by unions.
• If so, there is bargaining between unions and firms.
• Other things being equal, this will raise the level of unemployment
for any given real wage.
• Also, goods markets may be dominated by a few large sellers
(imperfect competition) in which case the labour demand curve may
be less steep, possibly even horizontal.

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wage bargaining
• Unemployment is the means by which the competing claims of
employers and unions are reconciled.
• Unions bargain over wages relative to prices (the wage-setting curve)
and reduce their demands when unemployment is high.
• Unions care about the employed (insiders) without caring too much
about the unemployed (outsiders).
• Employers set prices relative to wages: this leads to a relatively flat
labour demand schedule (the price-setting curve).

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wage-setting and price-setting
real wage wage-setting, WS labour supply, Ls
workforce

price-setting: firms set a

constant mark-up of
prices over costs, PS

employment

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two views of the labour market
• The natural rate model suggests that most equilibrium
unemployment is voluntary in the sense that workers could find jobs
at the current real wage, but choose not to.
• The NAIRU model suggests that some equilibrium unemployment is
involuntary in the sense that workers would like to work at the
current real wage but cannot find jobs.

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the NRU and the NAIRU
real wage labour supply, Ls
wage-setting, WS
workforce

labour demand, Ld

price-setting: firms set a

constant mark-up of
prices over costs, PS

involuntary voluntary

employment
NAIRU

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unemployment equilibrium
• Unions claim real wages that rise with employment:
target wage = base + aggression (employment)
• Firms offer real wages as a proportion of labour productivity:
feasible wage = productivity * (100%-markup)
• In equilibrium, the target wage equals the feasible wage when:
employment= productivity * (100%-markup) – base
aggression
• If productivity and the markup don’t vary with employment, then
we have the horizontal price-setting curve from the NAIRU diagram.

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 minimum wages in a secondary labour market
real wage workforce
labour supply, Ls

The secondary labour market

minimum wage
(typically for unskilled, young
workers) is potentially
equilibrium wage vulnerable to the effect of a
minimum wage.

labour demand, Ld

equilibrium employment employment

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 a monopsony labour market
A monopsonist who pays all
real wage workers the same equates its marginal cost of labour
demand for labour with its
marginal cost, Wm, when
setting employment at Em.

labour supply Ls

competitive wage

equilibrium wage

labour demand Ld

Em Ec employment

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why pay above the going rate?
• In 1914, the Ford Motor Company paid
its workers $5 per day when the going
rate was between $2 and $3. Why?
• “A low wage business is always
insecure… The payment of five dollars a
day for an eight hour day was one of the
finest cost-cutting moves we ever
made”, Henry Ford
• Why would this policy reduce costs?
• Workers might work harder and staff
turnover might be reduced because
workers don’t want to run the risk of a
big cut in wages (moral hazard). The
firm may also attract better quality
workers.
• If many firms pay efficiency wages, it will
be harder for the unemployed to find
jobs, and so unemployment will be
higher.

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how to reduce unemployment
• Active Labour Market Policies: training and work experience
schemes for long-term unemployed, unskilled, youths, women, older
workers;
• Reform of the benefit system, especially duration;
• Limitations on union power – no closed shops, no secondary
picketing, secret ballots;
• Changes to wage bargaining, especially increased employer
coordination;
• Tax reform (lower payroll taxes for the unskilled etc);
• Increased labour mobility.
• Flexicurity: Cuts to employment protection, coupled with active
labour market policies;

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how not to reduce unemployment
• Cunning demand-side policies (unlikely to have much effect in the
long-run, plus very expensive);
• Job-sharing or cuts in working hours;
• Increased investment by firms (although this will raise wages);
• Protectionism (any benefit to workers massively outweighed by costs
to consumers).

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 unemployment around the world

Source: Faggio and Nickell (2006)

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Source: BIS (2006)
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Source: O’Mahony and Van Ark (2003), table I.1.

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Source: OECD (2005)
summary
• “When large numbers of
people are out of work….
unemployment invariably
follows”, Calvin Coolidge (US
President, 1923-1929).

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syndicate topics
• What is the effect on unemployment of (a) a fall in union strength or
(b) a fall in real benefits?
• Would unemployment fall if working hours were cut?
• Do firms pay workers their marginal product?
• Is competition from the South a cause of unemployment in the
North?
• Why has the relative pay of the unskilled fallen since 1980?
• What are the current trends in unemployment around the world?

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