Unemployment Notes

Natural Rate of Unemployment

  • The natural rate of unemployment is the average level around which the unemployment rate fluctuates. It represents the unemployment rate that exists when the economy is operating at its potential output.

  • In a recession, the actual unemployment rate rises above the natural rate, indicating a slowdown in economic activity. Conversely, in a boom, it falls below, suggesting the economy is operating above its sustainable capacity.

Determinants of Natural Rate

  • Notation:

    • LL = # of workers in labor force

    • EE = # of employed workers

    • UU = # of unemployed

    • U/LU/L = unemployment rate (the percentage of the labor force that is unemployed)

    • L=E+UL = E + U (the labor force is the sum of employed and unemployed workers)

  • Assumptions:

    • LL is exogenously fixed (the size of the labor force is determined by factors outside the model).

    • ss = rate of job separations (fraction of employed workers who lose jobs)

    • ff = rate of job finding (fraction of unemployed workers who find jobs)

  • Steady State Condition: s×E=f×Us \times E = f \times U (in the steady state, the number of workers losing jobs equals the number of workers finding jobs)

  • Equilibrium Unemployment Rate: U/L=s/(f+s)U/L = s / (f + s); This equation shows that the unemployment rate depends on the rate of job separation and the rate of job finding.

  • Policy Implication: Lower the rate of job separation (e.g., by policies that encourage firms to retain workers) or increase the rate of job finding (e.g., by improving job search assistance) to lower the natural rate of unemployment.

Why is there Unemployment?

  • Two reasons why f < 1:

    1. Job search

    2. Wage rigidity

Job Search & Frictional Unemployment

  • Frictional unemployment: caused by the time it takes workers to search for a job. This type of unemployment is inevitable in a dynamic economy.

  • Sectoral shifts: Changes in the composition of demand among industries or regions lead to frictional unemployment. Workers need time to move between sectors.

Public Policy and Job Search

  • Government employment agencies and public job training programs can help reduce frictional unemployment by matching workers to jobs more quickly.

  • Employment Insurance (EI) increases frictional unemployment by reducing the urgency of finding work. It provides income support to unemployed workers, allowing them to search longer for a suitable job.

Real Wage Rigidity and Structural Unemployment

  • Wage rigidity: Wages fail to adjust to a level at which labor supply equals labor demand. This can lead to a surplus of labor, resulting in unemployment.

  • Structural unemployment: Unemployment resulting from real wage rigidity and job rationing. It occurs when there are not enough jobs for everyone who wants one.

  • Reasons for wage rigidity:

    1. Minimum-wage laws: Set a floor on wages, which can be above the equilibrium wage.

    2. The monopoly power of unions: Unions can bargain for higher wages than the equilibrium wage.

    3. Efficiency wages: Firms may pay wages above the equilibrium wage to increase worker productivity.

Minimum-Wage Laws

  • The minimum wage may exceed the equilibrium wage of unskilled workers, especially teenagers, leading to unemployment among these groups.

Labor Unions

  • Wages of unionized workers are determined by bargaining between union leaders and firm management, not by supply and demand. This can lead to wages that are above the equilibrium wage, resulting in unemployment for non-union workers.

  • Insiders: Employed union workers whose interest is to keep wages high. They benefit from higher wages, even if it means fewer jobs.

  • Outsiders: Unemployed non-union workers who prefer eq’m wages, so there would be enough jobs for them. They are willing to work for lower wages, but are unable to find jobs due to the higher union wages.

Efficiency Wages

  • High wages make workers more productive. Paying higher wages can lead to increased efficiency and reduced costs for firms.

  • Theories:

    • Wages influence nutrition (relevant for poorer countries). Higher wages allow workers to afford a better diet, leading to increased productivity.

    • High wages reduce labor turnover. Workers are less likely to quit their jobs if they are paid well, reducing the costs of hiring and training new employees.

    • The average quality of a firm’s workforce depends on the wage it pays. Higher wages attract more qualified workers.

    • A high wage improves worker effort (reduces moral hazard). Workers are more likely to work hard if they are paid well, reducing the need for monitoring.

Labor Market Experiences in Canada

  • Two components of unemployment rate:

    1. Incidence -- likelihood that an individual suffers an unemployment spell. This measures how common unemployment is.

    2. Duration --- average length of the spell. This measures how long people are unemployed for.

  • Trends in Unemployment:

    1. Demographics: Entry of baby boomers and increased participation of women. These demographic shifts have changed the composition of the labor force.

    2. Sectoral shifts: Increased pace of technological change. This requires workers to constantly update their skills.

    3. Productivity: Slowdown in productivity growth. This can lead to slower wage growth and increased unemployment.

    4. Transitions into and out of Labour Force: People moving in and out of the labor force can affect the unemployment rate.

Comparing Unemployment: U.S. and Canada

  • Gap can be decomposed in three components:

    1. Definition of unemployment: Differences in how unemployment is defined can lead to differences in unemployment rates.