Macroeconomic
Theory and Policy
Session-9
Biswa Swarup Misra
Session-9
Analyze the causes and types 1. Employment and Unemployment
of unemployment:
2. The Dynamics of the Labor Market
➢ Frictional unemployment
3. Understanding Unemployment
➢ Structural unemployment
4. The Cost of Unemployment
Macmillan Learning, ©2023
Recap:
Exercise
In each of the following, what happens to the u-rate? Does
the u-rate give an accurate impression of what’s happening in
the labor market?
A. Sue lost her job, and begins looking for a new one.
B. Jon, a steelworker who has been out of work since his mill
closed last year, becomes discouraged and gives up looking for
work.
C. Sam, the sole earner in his family of 5, just lost his $80,000 job
as a research scientist. Immediately, he takes a part-time job at
McDonald’s until he can find another job in his field.
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Recap:
Answers
A. Sue lost her job, and begins looking for a new one.
u-rate rises
A rising u-rate gives the impression that the labor market is
worsening, and it is.
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Recap 2:
Answers
B. Jon has been out of work since last year,
becomes discouraged, stops looking for work.
Discouraged workers
would like to work but have given up looking for jobs
classified as “not in the labor force” rather than “unemployed”
u-rate falls, because Jon is no longer counted as unemployed.
A falling u-rate gives the impression that the labor market is
improving, but it is not.
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Recap 2:
Answers
C. Sam lost his $80,000 job, and takes a part-time job at
McDonald’s until he finds a better one.
u-rate unchanged, because a person is “employed” whether they
work full or part time.
Things are worse, but the u-rate fails to show it.
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What Does the U-Rate Really Measure?
The u-rate is not a perfect indicator of joblessness or the health of the labor
market:
excludes discouraged workers
does not distinguish between full-time and
part-time work, or people working part time because full-time jobs are not
available.
Also, some people may misreport their work status in the BLS survey.
Despite these issues, the u-rate is still a very useful barometer of the labor
market & economy.
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Three Types of Unemployment
Frictional: Unemployment that is due to the time it takes for
employers to search for workers and for workers to search for
jobs.
Structural: Unemployment that occurs because wages don’t
fall to bring labor demand and supply into equilibrium.
Cyclical: Unemployment that is due to a temporary downturn
in the economy.
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Types of Unemployment
Can persist even when the economy is doing well.
1. Frictional unemployment: unemployment due to the time it takes for employers to
search for workers, and for workers to search for jobs.
➢ Lots of time spent going on interviews, and considering which job is the best fit.
2. Structural unemployment: unemployment that occurs because wages don’t fall to
bring labor demand and supply into equilibrium.
➢ Wages may remain high as a result of unions, government, or employer actions.
3. Cyclical unemployment: unemployment that is due to a temporary downturn in the
economy.
➢ During an economic downturn (2020 recession, 2008 recession), many resources,
including labor, go unused.
9 Macmillan Learning, ©2023
Frictional unemployment
There are enough jobs for everyone, but the
process of matching workers to jobs is not
instantaneous.
Three major factors determine how much
time it takes for workers and employers to
find each other:
1. The efficiency of the resources
employers and workers use to find each
other.
2. The alignment of the skills workers
have and the skills employers desire.
3. Unemployment insurance and other
income support during unemployment.
10 Frances Roberts/Alamy Macmillan Learning, ©2023
Frictional unemployment: factor #1
Frictional unemployment reflects an information problem.
➢ Employers and workers must find each other.
Anything that affects the information that’s available can affect the amount of frictional
unemployment:
➢ Word of mouth
➢ Online job postings
➢ Recruiting firms
➢ Career centers
The more efficient the resources available for workers and managers to find each other,
the lower the frictional unemployment will be.
➢ Spend less time searching!
11 Macmillan Learning, ©2023
Frictional unemployment: factor #2
If you have lots of different socks, then sorting them into
pairs can be frustrating.
➢ Workers all differ in skills and personalities, and
jobs differ in their attributes, so it can be difficult to
find a match.
There can also be a skills mismatch.
➢ The skills workers have aren’t the skills that
employers want.
The changing mix of occupations and industries can
increase frictional unemployment.
➢ Workers leaving declining sectors can have a hard
time finding a new job.
➢ They may need to seek retraining.
12 Malan/Stone/Getty Images
David Macmillan Learning, ©2023
Frictional unemployment: factor #3
When the government financially supports people during unemployment, unemployment is likely
to last longer.
➢ Government’s goal: Reduce hardship faced when unemployed.
➢ Modest pay — no more than half a worker’s previous wages (and typically less).
➢ Usually pay for up to six months.
Unemployment insurance can increase unemployment durations because it reduces the
opportunity cost of searching for a job.
➢ No financial support: You may take any job, even if it is not a good fit.
➢ With financial support: You are less desperate for cash and can spend more days searching for a
job that is a good fit.
➢ Income support during a job search can lead to better long-term outcomes.
13 Macmillan Learning, ©2023
What causes frictional unemployment?
1. It takes time to make an employer-
employee match.
2. Sectoral Shifts
3. Skills mismatch
4. People who are between the jobs
due to a change of location
5. Unemployment insurance and Students who look for a job
other income support after college are considered
frictionally unemployed.
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Job Search
Workers have different tastes & skills, and jobs have different requirements.
Job search is the process of matching workers with appropriate jobs.
Sectoral shifts are changes in the composition of demand across industries or regions of the
country.
Such shifts displace some workers, who must search for new jobs appropriate for their skills &
tastes.
The economy is always changing, so some frictional unemployment is inevitable.
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CASE STUDY:
Structural change over the long run
Agriculture
Manufacturing
1960 Other industry
2012
Services
77.7%
57.9%
4.2%
1.3%
9.9% 13.0%
28.0% 8.0% 16
More examples of sectoral shifts
• Industrial revolution (1800s):
agriculture declines, manufacturing soars
• Energy crisis (1970s):
demand shifts from larger cars to smaller ones
• Health care spending as % of GDP:
1960: 5.2 2000: 13.8
1980: 9.1 2010: 17.9
In a dynamic economy,
smaller sectoral shifts occur frequently,
contributing to frictional unemployment.
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Public Policy and Job Search
Govt employment agencies:
give out information about job vacancies to speed up the matching of workers with
jobs
Public training programs:
aim to equip workers displaced from declining industries with the skills needed in
growing industries
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Unemployment Insurance
Unemployment insurance (UI):
a govt program that partially protects workers’ incomes
when they become unemployed
UI increases frictional unemployment.
To see why, recall one of the
Ten Principles of Economics:
People respond to incentives.
UI benefits end when a worker takes a job,
so workers have less incentive to search or
take jobs while eligible to receive benefits.
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Unemployment Insurance
Benefits of UI:
• Reduces uncertainty over incomes
• Gives the unemployed more time to search, resulting in better job
matches and thus higher productivity
• In 2008 and 2009, as the U.S. economy experienced a deep
recession, the labor market demonstrated a new and striking
phenomenon: a large upward spike in the duration of
unemployment - It almost doubled to 25 weeks from 12 weeks
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UI-Contrasting Views
• Some economists believe that the increase in long-term
unemployment is a result of government policies.
• In particular, in February 2009, when the depth of the recession was
apparent, Congress extended the eligibility for unemployment
insurance from the normal 26 weeks to 99 weeks, and it did not allow
this program of extended benefits to expire until January 2014.
• Extending unemployment- insurance benefits is typical during
recessions, because jobs are harder to find, but the extension to nearly
two years was extraordinary.
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UI-Contrasting Views
• Barro(2010), “the dramatic expansion of unemployment insurance eligibility to 99
weeks is almost surely the culprit” responsible for the rise in long term
unemployment.
• Barro concludes that the “reckless expansion of unemployment-insurance
coverage to 99 weeks was unwise economically and politically.”
• Other economists, however, are skeptical that these government policies are to
blame.
• In their opinion, the extraordinary increase in eligibility for unemployment
insurance was a reasonable and compassionate response to a historically deep
economic downturn and weak labor market.
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UI-Contrasting Views
Krugman(2010) “Do unemployment benefits reduce the incentive to seek work?
Yes: workers receiving unemployment benefits aren’t quite as desperate as workers
without benefits, and are likely to be slightly more choosy about accepting new jobs.
The operative word here is “slightly”: recent economic research suggests that the
effect of unemployment benefits on worker behavior is much weaker than was
previously believed. Still, it’s a real effect when the economy is doing well.
But as you may have noticed, right now the economy isn’t booming-there are five
unemployed workers for every job opening. Cutting off benefits to the unemployed
will make them even more desperate for work-but they can’t take jobs that aren’t
there.
Wait: there’s more. One main reason there aren’t enough jobs right now is
weak consumer demand. Helping the unemployed, by putting money in the pockets
of people who badly need it, helps support consumer spending 23
What Determines Union Membership
• First, it appears that younger workers are considerably less likely to join trade unions than
their older counterparts.
• Second, workers with left-leaning political views are more likely to be trade union members
than workers with centre or right-leaning political views.
• Finally, female workers are less likely to be unionized than their male counterparts.
• Individuals who regularly participate in civil society may be more inclined to join trade unions
than their less civically active counterparts.
• Another reason attitudinal changes brought about by rising affluence and social stability,
which supposedly lead younger generations to view socio-cultural and environmental
concerns, rather than economic issues, as society’s most pressing concerns
• Moreover, many workers don’t want to pay initiation fees, around $50, and union dues, which
are about 1% to 2% of each paycheck.
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What causes structural unemployment?
Structural unemployment occurs when wages are unable to fall to the market-clearing
wage. This creates a labor surplus.
In a well-functioning labor market, equilibrium occurs where labor supply equals labor
demand and no structural unemployment exists.
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Supply and demand in the labor market
In equilibrium, no one is unemployed.
Labor supply: Workers supply their labor for a price Wage
(their wage). Labor supply
➢ Upward sloping: Workers supply more labor
when wages are high.
Labor demand: employers are the buyers of labor.
➢ Downward sloping: Employers demand less labor Equilibrium
when the price of labor is high.
➢ Hire fewer people when wages are high.
Equilibrium: Where the quantity of labor demanded
is equal to the quantity of labor supplied. Labor demand
➢ Everyone who wants to work for the market
wage is hired. Quantity of workers
26 Macmillan Learning, ©2023
Structural unemployment There aren’t enough jobs at the prevailing market
wage because there are structural impediments
preventing wages from falling.
Structural
Wage unemployment When the wage is above the supply-equals-demand
Labor supply equilibrium point:
Prevailing ➢ Employers demand fewer workers.
market wage ➢ Quantity of labor supplied is higher.
Equilibrium The gap between the number of available jobs and
(no unemployment) the number of available workers is the structural
unemployment.
Some reasons for structural unemployment:
Labor demand 1. Efficiency wages
Quantity of workers 2. Institutional barriers
27 Macmillan Learning, ©2023
Institutions: Additional causes of structural unemployment (1 of 2)
Unions are organizations representing workers who
Institutional causes of band together to negotiate jointly with their employer.
structural unemployment:
➢ Earn 15% more than comparable non-union.
1. Unions
➢ Better benefits.
2. Job protection regulations
➢ Only 7% of private-sector workers are unionized.
3. Minimum wage laws
Union wages mean more workers want union jobs than
there are union jobs available.
Job protection regulations make it hard to fire workers.
➢ Succeed in reducing the number of people who lose their job.
➢ Reduces the labor demand.
28 Macmillan Learning, ©2023
1. Minimum-Wage Laws
The min. wage may exceed the eq’m wage
for the least skilled or experienced workers, causing structural unemployment.
But this group is a small part of the labor force, so the min. wage can’t explain most
unemployment.
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2. Unions
• Union: a worker association that bargains with employers over
wages, benefits, and working conditions
• Unions exert their market power to negotiate higher wages for
workers.
• The typical union worker earns 20% higher wages and gets more
benefits than a nonunion worker for the same type of work.
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2. Unions
When unions raise the wage above eq’m,
quantity of labor demanded falls and unemployment results.
“Insiders” – workers who remain employed,
they are better off
“Outsiders” – workers who lose their jobs,
they are worse off
Some outsiders go to non-unionized labor markets, which increases labor supply and
reduces wages in those markets.
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2. Unions
Are unions good or bad? Economists disagree.
Critics:
Unions are cartels. They raise wages above eq’m, which causes
unemployment and/or depresses wages in non-union labor
markets.
Advocates:
Unions counter the market power of large firms, make firms more
responsive to workers’ concerns.
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Effects of Unions
• The share of wage and salary workers belonging to unions declined from 20% in 1983 to 11% in
2014. The percent of private-sector union members is even lower, at 6.6%.
• Many plants become uncompetitive when they are unionized, and they go offshore. Rather
than getting a raise, union members end up unemployed. Consider the case of Pillowtex, a
textile firm in North Carolina. In 1999, after a long battle, the plant was unionized. In 2000
Pillowtex filed for bankruptcy, and the firm failed in 2003. Now textiles are primarily produced
offshore.
• Consider the example of Volkswagen. In 1987, Volkswagen closed what was then its only
assembly plant in America, which was located in New Stanton, Southwestern Pennsylvania.
During its 10 years of operation, workers went on strike several times, halting production lines
and forcing the company to pay higher wages. Volkswagen moved its production to Mexico
and Brazil to take advantage of lower wage rates.
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3. Efficiency Wages
The theory of efficiency wages:
firms voluntarily pay above-equilibrium wages to boost
worker productivity.
Different versions of efficiency wage theory suggest different
reasons why firms pay high wages.
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3. Efficiency Wages
Four reasons why firms might pay efficiency wages:
1. Worker health
In less developed countries, poor nutrition is a common problem. Paying higher
wages allows workers to eat better, makes them healthier, more productive.
Nobel winner Robert Fogel:
30% of Great Britain’s growth from 1890-1980 was due to improved
nutrition
2. Worker turnover
Hiring & training new workers is costly.
Paying high wages gives workers more incentive to stay, reduces turnover.
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3. Efficiency Wages
Four reasons why firms might pay efficiency wages:
3. Worker quality
Offering higher wages attracts better job applicants, increases quality of the
firm’s workforce.
4. Worker effort
Workers can work hard or shirk. Shirkers are fired
if caught. Is being fired a good deterrent?
Depends on how hard it is to find another job.
If market wage is above eq’m wage, there aren’t enough jobs to go around, so
workers have more incentive to work not shirk.
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Efficiency Wages:
One cause of structural unemployment
In 1913, Henry Ford pioneered the assembly line.
➢ Doubled production!
➢ But led to high turnover rate, as workers quit constantly
due to the dull work of focusing on a single simple task.
In 1914, Henry Ford made history again by doubling wages.
Hulton Archive/Getty Images
From the Collections of The Henry Ford
➢ $5 per day to reduce turnover (prevailing wage was $2.25).
➢ Efficiency wage: a higher wage paid to encourage
greater work productivity.
Efficiency wages create structural unemployment.
➢ Applicants flooded his gates looking for work.
➢ Rather stand in line at the gate hoping for a job, than take a
job elsewhere for $2.25.
38 Macmillan Learning, ©2023
Case Study-Efficiency Wage
In 1914 the Ford Motor Company started paying its workers $5 per day.
• The prevailing wage at the time was between $2 and $3 per day, so Ford’s wage was well above
the equilibrium level. Not surprisingly, long lines of job seekers waited outside the Ford plant
gates hoping for a chance to earn this high wage.
What was Ford’s motive?
• Henry Ford later wrote, “We wanted to pay these wages so that the business would be on a
lasting foundation. We were building for the future. 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.”
• From the standpoint of traditional economic theory, Ford’s explanation seems peculiar. He was
suggesting that high wages imply low costs. But perhaps Ford had discovered efficiency-wage
theory. Perhaps he was using the high wage to increase worker productivity.
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Case Study-Efficiency Wage
• Evidence suggests that paying such a high wage did benefit the company.
• According to an engineering report written at the time, “The Ford high wage does away with all
the inertia and living force resistance. . . .
“The workingmen are absolutely docile, and it is safe to say that since the last day of
1913, every single day has seen major reductions in Ford shops’ labor costs.”
Absenteeism fell by 75 percent, suggesting a large increase in worker effort.
• Alan Nevins, a historian who studied the early Ford Motor Company, wrote, “Ford and his
associates freely declared on many occasions that the high wage policy had turned out to be
good business. By this they meant that it had improved the discipline of the workers, given them
a more loyal interest in the institution, and raised their personal efficiency.”
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Explaining the Natural Rate: An Overview
Even when the economy is doing well, there is always some
unemployment, including:
Frictional unemployment
Occurs when workers spend time searching for
the jobs that best suit their skills and tastes
short-term for most workers
Structural unemployment
occurs when there are fewer jobs than workers
usually longer-term
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Cyclical Unemployment vs. the Natural Rate
There’s always some unemployment, though the u-rate fluctuates
from year to year.
The natural rate of unemployment
the normal rate of unemployment around which the actual unemployment rate
fluctuates
cyclical unemployment
the deviation of unemployment from its
natural rate associated with business cycles
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U.S. Unemployment Since 1950
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Explaining the Natural Rate of Unemployment: A Summary
The natural rate of unemployment consists of
frictional unemployment
it takes time to search for the right jobs
occurs even if there are enough jobs to go around
structural unemployment
when wage is above eqbm, not enough jobs
due to min. wages, labor unions, efficiency wages
In later sessions, we will learn about cyclical unemployment, the short-term
fluctuations in unemployment associated with business cycles.
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Why Sectoral Shifts related Unemployment are not classified as Structural
but Frictional
• Many books commonly define structural unemployment as arising
from a mismatch between the skills or locations of workers and the
skill requirements or locations of jobs. Such textbooks assert that
such unemployment results from sectoral shifts.
• However, if all wages were flexible, then they would adjust after
structural changes so that all workers with any given skill set in any
given location would be employed.
• The cause of “structural unemployment” therefore cannot be
changes in the structure of demand and production; the cause must
be wages that fail to adjust following these changes.
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Why Sectoral Shifts related Unemployment are not classified as Structural
but Frictional
• Millions of workers change occupations each month, but it can take time for
people to realize that their skills are not in as much demand and to seek
retraining.
• As a result, shifts in the skills needed by employers can lead to increases in
frictional unemployment as workers take longer to find jobs.
• In reality throughout your lifetime you’ll likely need to adapt your skills to the
changing needs of the labor market-you’ll probably change occupation (most
people do!) and you’ll need to learn to use new technology.
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Test your Understanding
Boris just finished an economics degree and wants to live in
Washington, D.C., where there are many job openings
matching his skills and education. He moves to D.C. without a
job and crashes on a friend’s couch while looking for one.
Boris is considered
A. frictionally unemployed. - Correct Answer
B. structurally unemployed.
C. cyclically unemployed.
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Test your Understanding
Netanya owns a consulting business. During a severe downturn
in the economy, she has to fire several of her analysts.
Netanya’s analysts are considered
A. frictionally unemployed.
B. structurally unemployed.
C. cyclically unemployed. - Correct Answer
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Test your Understanding
Indeed.com improves its algorithms so that job seekers can
more easily find jobs that match their skills.
This will likely reduce
A. frictional unemployment. - Correct Answer
B. structural unemployment.
C. cyclical unemployment.
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A C T I V E L E A R N I N G 3:
Exercise
Which of the following would be most likely to reduce frictional
unemployment?
A. The govt eliminates the minimum wage.
B. The govt increases unemployment insurance benefits.
C. A new law bans labor unions.
D. More workers post their resumes at Monster.com, and more
employers use Monster.com to find suitable workers to hire.
E. Sectoral shifts become more frequent.
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A C T I V E L E A R N I N G 3:
Answers
Which of the following would be most likely to reduce frictional
unemployment?
A. The govt eliminates the minimum wage.
C. A new law bans labor unions.
These are likely to reduce
structural unemployment,
not frictional unemployment.
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A C T I V E L E A R N I N G 3:
Answers
Which of the following would be most likely to reduce frictional
unemployment?
B. The govt increases unemployment insurance benefits.
E. Sectoral shifts become more frequent.
These are likely to increase
frictional unemployment, not reduce it.
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A C T I V E L E A R N I N G 3:
Answers
Which of the following would be most likely to reduce frictional
unemployment?
D. More workers post their resumes at Monster.com, and more
employers use Monster.com to find suitable workers to hire.
Likely to speed up the process of matching
workers & jobs, which would
reduce frictional unemployment.
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The economic costs of unemployment
Lower wages and worse career opportunities:
➢ When they find work again, they often receive lower pay for decades.
➢ Men laid off as part of mass layoff lose an average of 1.4 years of earnings (2.8 years when unemployment
rate is high).
➢ Loss of skills and hope, and discrimination against long-term unemployed contribute to lower lifetime
earning.
Hysteresis: when a period of high unemployment leads to higher equilibrium unemployment rate.
➢ Rise in frictional unemployment (2020 recession).
Government receives lower tax revenues, but spends more.
54 Macmillan Learning, ©2023
The social costs of unemployment
Unemployment is isolating and painful:
Less structured day, more stressed and isolated, and unable to afford things that used to be
a part of your everyday life.
➢ Surveys show more likely to experience depression, anxiety, divorce, and poverty.
➢ Higher risk of death, including suicide.
Associated with worse outcomes:
Greater permanent earnings losses, and more likely to have health problems.
Children of laid-off workers:
Worse academic outcomes, worse mental health outcomes, and worse employment
outcomes, making less money as adults.
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Protecting yourself from the harmful effects of unemployment
Do more job searching than you really want to do.
➢ Consider the marginal benefits and marginal costs of filling out an additional application.
Build up a nest egg.
➢ Save three to six months of expenses.
Build new skills.
Keep an eye out for better opportunities when you’re employed.
➢ Begin searching long before you think your current position ends.
Build a strong professional network and tap into it if you become unemployed.
➢ More likely to get hired if you have a referral.
Avoid long-term unemployment.
➢ Settle for Mr. Not-So-Right Job, and then keep searching for a better job.
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Key take-aways: Understanding unemployment
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