University of California-Davis
Economics 1B-Intro to Macro
Handout 6
TA: Jason Lee
Email: jawlee@ucdavis.edu
I. Measuring Unemployment
A. Definitions
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Employed (E): Individuals are employed if they currently have jobs.
Unemployed (U): Individuals are unemployed if they currently do not
have jobs but are actively seeking employment (within the past month).
Labor Force (LF): The number of employed plus unemployed
LF = E + U
Not in the Labor Force: Individuals who are neither employed or
unemployed. This group would be composed of individuals who are not
working and are not looking for employment (i.e. full time students, stayat home parents, retirees, discouraged workers, etc…)
Unemployment Rate (u): The number of unemployed divided by the
labor force.
Unemployed
u=
Labor Force
Labor Force Participation Rate: The fraction of the adult population
(over the age of 16) that is in the labor force.
Labor Force Participation Rate =
Labor Force
Population over the age of 16
Example #1
Suppose that the Bureau of Labor Statistics announced that of all adult Americans,
145,993,000 were employed, 7,381,000 were unemployed and 79,436,000 were not in the
labor force. Use this information to calculate:
a) the labor force
b) the adult population
c) the labor-force participation rate
d) the unemployment rate
a) Labor Force = employed + unemployed =145,993,000 + 7,381,000 = 153,374,000
b) Adult population = Population in labor force + Population not in labor force
= (145,993,000 + 7,381,000) + 79,436,000 = 232,810,000
c) The labor-force participation rate = 153,374,000/232,810,000 = 65.88%
d) unemployment rate = 7,381,000/153,374,000 = 4.8%
B. Limitations of Employment Measures
The current measures of employment and unemployment by the Bureau of Labor
Statistics (BLS) does have some issues in terms of how they classify certain groups. In
particular there are three groups which the BLS does not fully count in the official
unemployment statistic which leads to an underestimate of the “true” level of
unemployment. Specifically:
1. The official unemployment rate does not include discouraged workers.
These are workers who tried to seek employment in the past but have given up hope of
finding a job.
2. The official unemployment rate does not included marginally attached
workers. These are workers who are prevented from working due to some obstacle, but
who otherwise would be willing to work. Individuals who lack a car to get to work, or
have to stay at home to watch their children are examples of marginally attached workers.
3. The official unemployment rate does not include part time workers who
would like to work full time. There are people who are willing to work 40 hours a week
but who can only find part time work. These part time workers are considered employed
even though they clearly would work more hours if they could.
The absence of these groups from the official unemployment statistic means the true
value of unemployment is higher than is officially reported.
C. Reasons for Unemployment
We see nowadays how unemployment is high during tough economic times, but even
during boom periods such as the late 1990s, unemployment was at 4%. Why does
unemployment exist even when the economy is doing well? There are three main
explanations for the existence of unemployment.
1. Cyclical Unemployment: This is the most straightforward reason.
Unemployment goes in the opposite direction of the business cycle. When the economy
is in a recession, firms are laying off workers and the unemployment rate goes up.
Conversely, when the economy is going well, firms are hiring workers and the
unemployment rate goes down. The cyclical unemployment rationale argues that
unemployment is a direct result of economic fluctuations.
2. Frictional Unemployment: Unemployment that results from the workings of
a normal economy. Workers in the United States are not tied to an employer for a
lifetime. One of the features of the U.S. labor market is the mobility of workers. At any
given time, workers are leaving firms for various reasons and thus there will always be
some level of unemployment, even when the economy is booming. Because our
economy is dynamic and always changing, there will always be some industries and
regions that are growing while other industries and regions are contracting. These
changes in industry and regions are called sectoral shifts. The key point is that it takes
time to match the right worker with the right job.
3. Structural Unemployment: While frictional unemployment is more of a
short-term problem, structural unemployment is more long-term. This is the
unemployment that sometimes results from some fundamental restructuring of an
economy. In cases with structural unemployment the quantity of labor supplied is
greater than the quantity of labor demanded at the current wage, there is an excess
supply of workers. As we know with supply and demand of any good, excess supply
occurs when the current price is greater than equilibrium price. Structural unemployment
occurs because the price of labor (wage rate) is set at a higher level than the market
clearing wage. We will discuss the potential causes of structural unemployment shortly.
Some examples of structural unemployment include an industry becoming obsolete, or a
foreign country that is able to produce the same good with cheaper labor. Individuals
who worked with typewriters found themselves unemployed in the 1980s with the advent
of the personal computer with no hopes of getting jobs in the old industry. Similarly low
wage textile workers in the South have been hard hit by low wage competition from
abroad. Many U.S. firms could not compete and were forced to shut down leaving their
workers unemployed. Structural unemployment requires more long-term solutions such
as job-retraining or increased education in order to make the structurally unemployed
work again.
Natural Rate of Unemployment (Full Employment): This term refers to the situation
in which there is no cyclical unemployment. The unemployment comes from just
frictional and structural unemployment. Be clear that this term does not imply that the
unemployment rate is 0.
D. Explaining Frictional Unemployment
Although frictional unemployment is part of the natural workings of the economy and
will thus always exist, there are factors and government policies that could affect the
number of people who are frictionally unemployed. Recall that frictional unemployment
exists because it takes time to match individuals with specific skills to the right job
opportunities. Anything that reduces the time to match individuals with jobs will lower
frictional unemployment.
1. Access to Information: One major problem in matching individuals with jobs is that
oftentimes potential workers are unaware of job openings that exist. The internet has
been instrumental in making it much easier for workers to be aware of job opportunities
that open up. Additionally, employment agencies (both public and private) can help
reduce the time it takes for the unemployed to find work by letting them know of
opportunities.
2. Training Programs: Because the economy is constantly changing, there will always
be some sectors that are rising and other sectors are falling. One useful governmental
policy could include providing public training programs which would help workers in
declining industries gain new skills which would make them employable in the rising
sectors of the economy. Workers who have the right skill set will take less time finding a
new job in the ever changing economy.
3. Unemployment Insurance: Unemployment insurance is a governmental program
that pays part (usually ½) of the workers income if they become unemployed through no
fault of their own. Workers who get fired, quit or have just entered the work force are not
eligible for unemployment insurance.
How can unemployment insurance affect frictional unemployment? Consider the
following hypothetical example. Suppose you lived in a state with a generous
unemployment insurance program. In this program if you lose your job you’re are
eligible for 100% of your former wages for up to 4 years. Under such a generous
program, you would not have much incentive to look for a job right away. You get paid
your old full salary without having to work. You will take your time finding any new job
and can be very selective over what type of job you will take. A generous
unemployment insurance program will increase frictional unemployment. On the
other hand, suppose you lived in a state that offers a very miserly unemployment
insurance. In this state, once you lose your job you are entitled to only 25% of your
former wages for only 3 months. You would have a very strong incentive to find work as
soon as possible, even if it’s a job that does not suit your skills very well. A less
generous unemployment insurance program will decrease frictional unemployment.
Keep in mind, however, that although a less generous unemployment insurance program
might keep frictional unemployment low it will have the negative effect of forcing
workers to take the first job offer that comes their way. That job might not be the best
job suited for their tastes and skill sets and thus the economy would have many workers
not matched to the right job.
The differences in unemployment insurance between the United States and countries in
the European Union help to explain why European countries have much higher
unemployment rates than the United States.
E. Explaining Structural Unemployment
We saw that structural unemployment occurs because at the current wage, wages are set
artificially high, and as a result there is an excess supply of labor. What we must now ask
is what are some of the reasons why industries might set wages at a higher level than the
market clearing equilibrium wage.
1. Minimum wage laws: One obvious explanation on why wages are higher than
equilibrium is that the government has set the wages artificially higher. Almost always
the minimum wage is set at a wage above the market equilibrium wage. At this higher
wage, the number of workers demanded by firms will be lower than the number of
workers supplied and thus we have unemployment. Minimum wage laws could explain
why certain groups (teenagers or low skilled workers) have high rates of unemployment.
For these groups, the minimum wage is set above market equilibrium and thus
unemployment will occur. Minimum wage laws however, cannot explain most of the
structural unemployment that occurs in our economy. Minimum wage laws do not apply
to most workers. Most workers earn wages well above the minimum wage and thus most
industries have labor clearing markets.
2. Unions and Collective Bargaining: Unions are a group of workers that bargain with
employers over issues such as wages, working conditions and benefits. Whereas most
workers bargain individually with employers, unions engage in collective bargaining
where terms of employment are settled. Unions create artificially high wages, because
they usually ask for higher wages for their union members than what is the market
clearing wages. Unions are able to threaten firms with a strike if these wage demands are
not met. As a result union members (insiders) are better off because of the unions, they
are able to get a higher wage than they otherwise would have. Non-union members
(outsiders) are worse off because the higher wages have created more labor supply than
labor demand and unemployment is the result. Outsiders will either have to wait and stay
unemployed until they can become insiders or they will have to take non-union jobs and
experience lower wages.
3. Efficiency Wages: A third possible explanation for higher wages is the idea that
firms themselves offer high wages to their workforce in order to increase the productivity
of workers. There are several theories on how high wages will lead to higher worker
productivity.
a) Increase worker health: This theory mainly applies to low-income,
developing countries rather than to countries such as the United States. In developing
countries, it could be the case that the market clearing wage is insufficient to provide an
adequate diet to the workers. Workers who do not eat properly will be more prone to
sickness and will be less productive. By offering a higher wage, firms allow workers to
eat a healthy diet insuring good health and thus increasing productivity.
b) Worker Turnover: A major cost for firms is the hiring and training of new
workers. Each new worker that must be hired must be trained and will not be as
productive initially as a worker who has been with the firm a number of years. If a firm
can keep its workforce, it will not have to spend resources training and hiring new
workers and it will have a very productive labor pool. By offering high wages, the firm
is providing significant incentives to its current workers not to leave the firm and thus
reducing the odds of significant worker turnover.
c) Worker Effort: It is difficult for most firms to monitor their workers
constantly all the time. As a result, this could lead to the problem of shirking (not putting
in effort in your job) by workers. One way firms could avoid this shirking problem is to
offer a higher wage that makes it very costly for an individual to shirk. If the firm
manages to catch a worker shirking it can fire that individual and that fired worker will
soon find he/she will have trouble finding another job that paid that high of a wage. This
gives workers strong incentives to not shirk and risk losing the high wage.
d) Worker Quality: A final theory is that firms have a hard time distinguishing
between good workers and bad workers when filling an open position. Suppose a firm
knows that there are two types of workers in the labor pool, highly productive workers
and low productive workers. The highly productive workers are worth $80,000 a year
while the lowly productive workers are worth only $20,000 a year. If the firm offers a
low wage (such as $30,000) which type of workers will it attract? The highly productive
workers will scoff at such low wages and not apply for the job, while the not so
productive workers will view these wages as much higher than they deserve and will
apply eagerly. The firm will find itself with only low quality workers. By offering a
high wage, the firm can ensure they attract at least some high quality workers.