Unemployment, job creation
and job destruction
Chapter 3
Chapter topics
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Measuring unemployment
Labor market dynamics
The natural rate of unemployment
US and European experience
Unemployment over the business cycle
Applying supply and demand to the labor
market
Measuring unemployment
• Labor force is the number of people aged
16 and over who are either working or
unemployed
• Unemployed: those looking for employment
during the week but who did not work
• Labor force participation rate: ratio of labor
force to population
• Natural rate of unemployment is the rate of
unemployment when the economy is in
equilibrium
Unemployment in the Long Run
• Natural rate of unemployment:
the average rate of unemployment around
which the economy fluctuates.
• In a recession, the actual unemployment rate
rises above the natural rate.
• In a boom, the actual unemployment rate falls
below the natural rate.
Unemployment in the U.S.
11
Percent of labor force
10
9
8
7
6
5
4
3
2
1955
1960
1965
1970
1975
Unemployment rate
1980
1985
1990
1995
2000
Natural rate of unemployment
Dynamics of the labor market
• Economy is characterized by large flows in
and out of employment. Flows are about
equal at three million or about 3% every
month.
• Population over 16:
– In the labor force, employed or unemployed
– Out of the labor force
The natural rate
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L = labor force
U = unemployed
l = job losing rate = losses/L
f =job-finding rate = finds/U
u =unemployment rate = U/L
In equilibrium, losses=finds or l=uf
That is u=l/f, the unemployment rate is the
ratio of the loss rate to the find rate.
Flows into unemployment
• Job destruction
• Job loss without distraction
• Personal transitions
Flows out of unemployment
• Two thirds success in finding a job
• One third leave the labor force
• Finding rate is a crucial factor and is
affected by
– Efficiency wages
– Union wage premiums
– Minimum wages
– Unemployment insurance
Minimum Wage
• The minimum wage is well below the eq’m
wage for most workers, so it cannot explain
the majority of natural rate unemployment.
• However, the minimum wage may exceed
the eq’m wage of unskilled workers,
especially teenagers.
• If so, then we would expect that increases
in the minimum wage would increase
unemployment among these groups.
Labor Unions
• Unions exercise monopoly power to
secure higher wages for their members.
• When the union wage exceeds the eq’m
wage, unemployment results.
• Employed union workers are insiders
whose interest is to keep wages high.
• Unemployed non-union workers are
outsiders and would prefer wages to be
lower (so that labor demand would be high
enough for them to get jobs).
Efficiency Wages
• Theories in which high wages increase
worker productivity:
– attract higher quality job applicants
– increase worker effort and reduce “shirking”
– reduce turnover, which is costly
• The increased productivity justifies the
cost of paying above-equilibrium wages.
• The result: unemployment
Example
• One percent of the employed lose jobs
every month while 20% of the
unemployed find jobs.
• Then, the unemployment rate is
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U/L = .01/(.01+.2) = .0476.
Or about 5%
• Why is the equilibrium unemployment
rate positive? Why is f not equal to 1?
Frictional Unemployment
• Workers are not interchangeable parts.
Skills and preferences vary as do job
requirements. Takes time to match the
individual and the job.
• Changes in the composition of demand
(sectoral shift), firm failure, poor job
performance, desire for career change all
contribute to frictional unemployment.
Policy Issues
• Reduce duration of job search through
– provision of information to workers and firms
– job training programs
• Unemployment insurance helps improve
the working of the labor market by
facilitating better job search but it does
increase the duration of job.
Structural Unemployment
• Structural unemployment results from
wage rigidity and job rationing.
• Sources of wage rigidity:
– Minimum wage laws
– Unions and collective bargaining
– Efficiency wages
• Market does not clear because wage is
above the equilibrium level
Okun’s Law
• An empirical relationship between
departures of GDP from its potential and
the unemployment from its natural rate.
S-D and Unemployment