The Labor Market, Wages, and Unemployment

Chapter 7: The Labor Market, Wages, and Unemployment

Unemployment

• Definition: Individuals willing and able to work but unable to find employment.

• Measurement: Percentage of the labor force actively seeking employment but unable to find it.

Causes of Unemployment

1. Economic Downturns:

   • Recessions or downturns decrease consumer demand for goods and services.

   • Businesses reduce production and lay off workers.

   • Companies implement cost-cutting measures to stay afloat.

2. Technological Changes:

   • Automation replaces human labor with machines or software.

   • Increases efficiency and productivity.

   • Results in job displacement for workers whose tasks can be automated.

3. Structural Shifts in Industries:

   • Changes in industry structure (globalization, shifts in consumer preferences).

   • Decline of certain sectors and growth of others.

   • Workers in declining industries face unemployment if they lack skills for emerging sectors.

4. Skill Mismatches:

   • Mismatches between workers' skills and employers' demands.

   • Industries evolve and require new skill sets.

   • Workers lacking necessary skills struggle to find employment.

   • Affects individuals with outdated or obsolete skills.

5. Geographic Location:

   • Unemployment rates vary based on geographic location.

   • Areas with limited economic opportunities or declining industries have higher unemployment.

   • Individuals in areas with limited job prospects face difficulty finding suitable employment.

6. Policy Factors:

   • Government policies and regulations influence unemployment rates.

   • Minimum wage laws, labor market regulations, and unemployment benefits impact labor supply and demand.

   • Fiscal and monetary policies aimed at stimulating or stabilizing the economy affect employment levels.

Types of Unemployment

1. Frictional Unemployment:

   • Occurs due to normal turnover in the labor market.

   • Time it takes for workers to find new jobs that match their skills and preferences.

   • Examples: Individuals transitioning between jobs, recent graduates entering workforce, workers relocating.

   • Often temporary and reflects the natural process of job search in a dynamic economy.

   • Inevitable in a healthy, growing economy as it reflects constant movement and adaptation.

2. Structural Unemployment:

   • Arises from fundamental changes in the structure of an economy.

   • Shifts in industries or technological advancements lead to mismatches between workers' skills and job requirements.

   • Examples: Workers losing jobs due to automation or outsourcing.

   • More persistent and long-term compared to frictional unemployment.

   • Results from changes in consumer preferences, globalization, or shifts in production methods.

   • Exacerbated in economies with rigid labor market regulations or high costs of hiring and firing.

3. Cyclical Unemployment:

   • Tied to fluctuations in the business cycle and arises during economic downturns or recessions.

   • Occurs when there is a decline in aggregate demand for goods and services, leading to reduced production and layoffs.

   • Workers losing jobs during downturns experience cyclical unemployment until economic conditions improve.

   • Tends to be temporary and decreases during economic expansion and growth.

   • Government fiscal and monetary policies are often employed to mitigate cyclical unemployment.

Sticky Wages

• Wages fall slowly even in times of high unemployment, hindering the adjustment process in the labor market.

• The sticky wage theory is an economic concept describing how wages adjust slowly to changes in labor market conditions.

• Unlike other markets where prices are dictated by supply and demand, wages tend to remain above equilibrium as employees resist wage cuts.

• Reasons for wage stickiness:

  • Human reaction to wage cuts: Employees react negatively to wage cuts, leading to potential dissatisfaction and reduced productivity.

  • Employer reluctance: Employers may hesitate to lower wages due to concerns about employee morale and potential disruptions in the workplace.

  • Minimum wages and union contracts: These impose limits on how low wages can go, affecting the rate of rehiring for unemployed workers.

  • Job preferences: Workers may be reluctant to accept lower-wage, lower-skill jobs than their previous positions, prolonging their job search.

Natural Rate of Unemployment

• Definition: The level of unemployment that would exist in the absence of cyclical unemployment.

• Significance:

  • Economic policy implications: Policymakers can potentially reduce cyclical unemployment through fiscal and monetary policies, but these policies have limited impact on frictional and structural unemployment.

  • Policy effectiveness: When the unemployment rate approaches the natural rate, the effectiveness of monetary and fiscal policies diminishes.

Wage Determination

• Determined by the marginal product of labour (MPL): This refers to the increase in a firm's revenues resulting from hiring additional labour.

• The demand for labour: Firms will hire labour as long as the wage is less than the marginal product of labour (MPL). The demand curve for labour is derived from MPL.

• Wage and MPL relationship: As the market wage falls, the MPL also decreases, influencing firms' hiring decisions.

Labor Supply and Demand

• Labor demand refers to the quantity of labour that firms are willing to hire at different wage rates, while labour supply represents the quantity of labour that individuals are willing to offer at varying wage rates.

• The interaction between these two forces, depicted in a basic supply-and-demand diagram, determines the equilibrium level of employment and the prevailing wage rate in the labour market.

Basic Diagram of Supply and Demand

• In the basic supply-and-demand diagram for the labour market, employment (quantity of labour, denoted as L) is represented on the horizontal axis, while the wage (price of labour) is depicted on the vertical axis.

• The labour demand curve slopes downward, indicating that as the wage rate increases, firms are willing to hire fewer workers due to diminishing marginal productivity.

• Conversely, the labour supply curve slopes upward, reflecting the willingness of individuals to supply more labour at higher wage rates, as the opportunity cost of leisure increases.

• The equilibrium, where labour supply equals labour demand, determines the wage rate and the level of employment. Any shift in either curve affects this equilibrium and has significant implications for the labour market.

Effects of Changes in Labor Supply

1. Taxation Impact:

   • A labour income tax reduces workers' take-home pay for a given wage.

   • The supply of labour decreases, leading to a leftward shift in the labour supply curve.

2. Wage Adjustment:

   • With reduced labour supply, the equilibrium wage rate increases from w to w', while employment decreases from L to L'.

   • Some workers may opt out of the labour force due to higher taxes, potentially impacting the unemployment rate in the short run.

3. Unemployment Dynamics:

   • The immediate impact of a tax-induced reduction in labour supply might not change the unemployment rate.

   • Over time, some workers may become discouraged and drop out of the labour force, thus affecting the unemployment rate indirectly.

Factors Affecting Labour Supply

• Factors influencing labour supply include demographics, education levels, immigration policies, and societal attitudes towards work.

Effects of Changes in Labor Demand

1. Regulatory Impact:

   • Government regulations hindering firing practices can reduce labour demand.

   • Depicted by a leftward shift of the labour demand curve.

2. Decrease in Employment:

   • The equilibrium wage decreases (from w to w'), leading to reduced employment (from L to L') and a decline in the employment-population ratio.

   • A reduction in labour demand causes both the equilibrium wage and the level of employment to decline.

3. Initial Rise in Unemployment:

   • Initially, the unemployment rate may rise due to fewer job opportunities.

   • Over time, discouraged workers may exit the labour force, potentially reducing the unemployment rate.

Factors Affecting Labour Demand

• Changes in technology, government policies, business cycles, and global economic conditions can all influence labour demand.

Wage Rigidity

• Wage rigidity refers to the phenomenon where wages do not adjust to clear the labour market, potentially leading to inefficiencies in resource allocation.

1. Persistent Wage Levels:

   • If wages remain rigid despite changes in labour demand, it can lead to significant employment adjustments.

2. Employment Disparities:

   • With wages unchanged, firms demand less labour at the same high wage level, resulting in excess labour supply.

   • If wages are rigid for some reason and don’t fall to clear the labour market, the result is an even larger reduction in employment (compare points B and C). Also notice that at the original wage 𝑊̅, labour supply exceeds labour demand: more people would like to work than are able to find jobs.

3. Substantial Employment Decline:

   • Employment falls significantly (from L' to L''), well below the market-clearing level, exacerbating unemployment issues.

Factors Affecting Wage Rigidity

• Factors contributing to wage rigidity include labour market regulations, minimum wage laws, collective bargaining agreements, and social norms.

The Bathtub Model of Unemployment

• The bathtub model of unemployment offers a simplistic yet insightful framework for understanding the dynamics of employment and unemployment rates in an economy.

• It draws an analogy between the unemployment rate and the water level in a bathtub, where inflows and outflows determine the equilibrium level.

Equation 1: Total Labour Force

Et + Ut = \bar{L}

• This equation states that the total labour force (\bar{L}) is composed of employed individuals (Et) and unemployed individuals (Ut).

• It assumes a constant labour force size (\bar{L}).

Equation 2: Unemployment Changes Over Time

\Delta Ut+1 = \bar{s}Et - \bar{f}Ut

• The core of the bathtub model, this equation describes how unemployment changes over time.

• The first term represents the number of employed individuals who lose their jobs (\bar{s}Et), where \bar{s} is the job separation rate.

• The second term represents the number of unemployed individuals who find jobs (\bar{f}Ut), where \bar{f} is the job finding rate.

Equation 3:

1. To determine equation 3, we first set the change in unemployment (\Delta Ut+1) equal to zero, 0 = \bar{s}Et - \bar{f}Ut representing the steady state where unemployment remains constant.

2. By substituting equation 1 into equation 2, we eliminate Et and solve for Ut in terms of the given parameters 0= \bar{s}(\bar{L} - Ut) - \bar{f}Ut 0= \bar{s}\bar{L} - (\bar{f} + \bar{s})Ut resulting in the equation 3:

3. U^* = \frac{\bar{s}\bar{L}}{\bar{f}+\bar{s}}

4. Equation 3: u^* \equiv \frac{U^}{\bar{L}} = \frac{\bar{s}}{\bar{f}+\bar{s}} defines the natural rate of unemployment (u^), representing the fraction of the labour force that is unemployed in the long run.

Illustration:

• For instance, with a job finding rate (\bar{f}) of 0.20 and a job separation rate (\bar{s}) of 0.01, the natural rate of unemployment (u^*) is calculated to be approximately 0.048 or 4.8%.

• u^* = \frac{0.01}{0.20 + 0.01} = 0.048

• This demonstrates that even small changes in job finding, and separation rates can have significant implications for the equilibrium unemployment rate, highlighting the sensitivity of the economy to these parameters.

Importance of the Bathtub Model

1. Steady State Analysis: The model helps in understanding the long-term equilibrium in employment and unemployment levels, akin to the steady state in growth models.

2. Intuitive Interpretation: The analogy with a bathtub provides an intuitive way to comprehend the dynamics of unemployment inflows and outflows.

3. Policy Implications: It highlights the importance of job finding and separation rates in determining the natural rate of unemployment, guiding policymakers in designing effective labour market policies.

4. Parameter Sensitivity: By analysing the effects of changes in job finding and separation rates on the natural rate of unemployment, the model underscores the sensitivity of unemployment to these factors.

5. Unintended Consequences: The model warns against potential unintended consequences of policies targeting job finding or separation rates, emphasizing the need for a holistic approach to labour market interventions.

The Rising Return to Education

• Panel A: Market for High School Workers:

  1. Stable Demand and Supply: In Panel A, the market for workers with a high school education is depicted. It assumes no significant shifts in either the demand or supply curves.

  2. Steady Wage Dynamics: With stable demand and supply, the wage for high school-educated workers remains relatively unchanged over time.

• Panel B: Market for College-Educated Workers:

  1. Rising Supply of College Graduates: Panel B illustrates the market for workers with a college education. The labour supply curve for college graduates has shifted outward over time, indicating a significant increase in the supply of college-educated workers.

  2. Demand Shift Out: Despite the increase in supply, the relative wage of college graduates has also increased, suggesting a simultaneous shift in the demand curve for college-educated workers.

  3. Explanation for Rising Wages: To explain the rising wage despite increased supply, it's posited that the demand for highly educated workers has shifted out even more significantly, surpassing the rise in supply.

• Explanations for Increased Demand for Highly Educated Workers:

  1. Skill-Biased Technical Change: New technologies like computers and the internet disproportionately benefit highly skilled workers, leading to a shift in demand in favor of these workers.

1. Globalization: Trade opens up the U.S. economy to a world where highly educated workers are scarcer, driving up their wages. Conversely, it exposes low-skilled workers to global competition, putting downward pressure on their wages.

• Magnitude of Effects:

  1. Skill-Biased Technical Change: Widely regarded as a contributor to rising wage inequality, this phenomenon favors highly skilled workers and may lead to significant changes in income distribution.

  2. Globalization: Initially considered to have modest effects on wages, recent research suggests that globalization, particularly trade with countries like China, has had a substantial impact on income inequality, especially for low-skilled workers.

• Continued Research:

  1. Complex Dynamics: Both skill-biased technical change and globalization likely play a role in rising wage inequality, but their relative importance remains a subject of ongoing research.

  2. Policy Implications: Understanding the drivers of rising return to education is crucial for policymakers to formulate effective strategies to address income inequality and ensure equitable access to opportunities in the labour market.