CHAPTER 28: UNEMPLOYMENT
Introduction
Like GDP, unemployment ranks high as an indicator of economic well-‐being. This chapter starts
by describing how unemployment is measured and, related to this measurement issue, why
unemployment can sometimes be a misleading indicator of the true health of the economy.
Note, for instance, that there is unemployment even during normal or good economic times.
Partly for this reason, economists distinguish between two types of unemployment:
1. The natural rate of unemployment is the rate of unemployment that the economy
experiences even during normal times, that is, even when the economy is not in a
recession.
2. Cyclical unemployment refers to the additional unemployment that occurs during
recessions.
Alternatively, we can think about the natural rate of unemployment as the economy’s long-‐run
rate of unemployment and cyclical unemployment as the shorter-‐run fluctuations around the
natural rate.
This chapter focuses mainly on the determinants of the natural rate of unemployment,
leaving an analysis of cyclical unemployment for later. In particular, the chapter continues by
describing four types of theories or sets of considerations that economists use to explain the
economy’s natural rate of unemployment: job search, minimum-‐wage laws, unions, and
efficiency wages.
I. Identifying Unemployment
Data on unemployment in the US economy are assembled monthly by the Bureau of Labor
Statistics (BLS), which is part of the Department of Labor.
Each month, the BLS compiles these data from a survey of about 60,000 households called
the Current Population Survey.
Based on responses to survey questions, the BLS puts each adult aged 16 and over into one of
three categories:
- Employed. This category includes paid employees, both full-‐time and part-‐time, people who
worked in their own business, and those who were temporarily absent from work because
of illness or vacation.
- Unemployed. This category includes people who were not employed, were available for
work, and had tried to find a job within the previous four weeks, as well as those who were
temporarily laid off and waiting to be recalled.
- Not in the Labor Force. This category includes everyone else: students, homemakers,
retired people.
Figure 1 shows the breakdown of the US population in 2009 into these three categories.
The BLS then defines the labor force as the total number of workers, both employed and
unemployed:
Labor Force = Number of Employed + Number of Unemployed
the unemployment rate as the percentage of the labor force that is employed,
and the labor force participation rate as the percentage of the total adult population that is in
the labor force,
Let’s use the numbers from Figure 1 to compute these statistics for 2009:
-‐ Number of employed = 139.9 million.
-‐ Number of unemployed = 14.3 million.
-‐ Not in the labor force = 81.7 million.
-‐ Labor force = 139.9 + 14.3 = 154.2 million.
-‐ Unemployment rate = 14.3/154.2 x 100 = 9.3 percent.
-‐ Labor force participation rate = (139.9+14.3)/(139.9+14.3+81.7) = 154.2/235.9 = 65.4
percent.
Table 1 shows how the unemployment and labor force participation rates varied across
demographic groups in 2009. Figure 3 shows how labor force participation rates have varied
over time for men and women.
What factors might explain women’s rising labor force participation? What factors might
explain men’s falling labor force participation?
Figure 2 shows how the unemployment rate fluctuates about a long-‐run average, or natural, rate,
of around 5 percent.
Updating the data shown in Figure 2, the Congressional Budget Office now estimates the
natural rate of unemployment to be 5.2 percent.
Even during good economic times, there is some unemployment in the US economy. It is this
natural rate of unemployment that the theories described in this chapter seek to explain.
The most difficult part of measuring the unemployment rate entails determining who is
unemployed versus who is out of the labor force:
Suppose an employed worked loses his or her job, and starts looking for a new one. What
happens to the unemployment rate? It rises, since the number of unemployed workers goes
up while the labor force stays the same.
But suppose that after awhile, that same person becomes a discouraged worker: someone
who would like to work but has given up looking for a job. Maybe that person decides to go
back to school or maybe he or she just stays at home and doesn’t bother looking for a job.
Either way, the number of unemployment workers goes down, and while the labor force goes
down as well, the net effect is to decrease the rate of unemployment.
Symmetrically, what happens if the economy starts to look better, so that a discouraged
worked starts to look for a job? Now the number of unemployed workers rises, and while the
labor force also gets bigger, the net effect is to increase the unemployment rate.
So changes in the unemployment rate don’t always accurately reflect whether economic
conditions are improving or deteriorating.
Another set of facts pertains to the duration of unemployment spells: most spells of
unemployment are short, even though most unemployment observed at any given point in
time is long term.
How can both of these facts hold true? A simple example shows how:
-‐ Suppose that 55 people each year are unemployed.
-‐ Each week, one person loses his or her job, but finds a new job at the end of that week.
-‐ But three workers lose their jobs at the beginning of the year and stay
unemployment for the full year.
-‐ Then 52 out of 55 unemployment spells last only one week.
-‐ But, at any given point in time, three out of the four unemployed workers have
spells that last for one full year.
What explains the natural rate of unemployment? In other words, why are their unemployed
workers even during good times?
-‐ One explanation is that it takes time for workers to find jobs that are best-‐suited for
them. This type of unemployment is often called frictional unemployment.
-‐ A second set of explanations focus on why there might not be enough jobs to employ
everyone who wants one. This type of unemployment is often called structural
unemployment.
-‐ So the essence of frictional unemployment is that there are jobs out there, it just takes
time and effort for workers to find them. The essence of structural unemployment is
that there are just not enough jobs out there for everyone who wants one.
II. Job Search
Job search is the process by which workers find appropriate jobs given their tastes and skills.
The process of job search can explain why there is always some frictional unemployment:
-‐ Suppose that in the market for laptop computers and PCs, Dell takes market share
away from Hewlett-‐Packard. HP lays off workers; Dell hires new ones. In the interim
there is a period of unemployment in the industry.
-‐ Similarly, if the price of oil rises, energy exploration companies hire more workers,
while auto manufacturers and airlines lay off workers. Because of these sectoral
shifts, unemployment arises.
A certain amount of frictional unemployment is inevitable, simply because the economy is
always changing.
A century ago, the four industries with the largest employment in the US were cotton goods,
woolen goods, men’s clothing, and lumber. Today the largest industries by employment are
autos, aircraft, communications, and electrical components. The overall US economy has
grown enormously, but along the way some industries have declined or even disappeared
altogether, causing workers to have to find new jobs.
However, government training and re-‐training programs can help reduce the amount of frictional
unemployment.
Through unemployment insurance programs, the government partially protects workers’
incomes when they become unemployed.
Just like automobile and homeowners insurance, unemployment insurance makes risk-‐averse
workers better off.
But it can also lead to higher levels of frictional unemployment, by making it possible for
unemployed workers to search longer for the right job.
III. Minimum Wage Laws
Figure 4 illustrates how unemployment results from minimum wage laws.
This type of unemployment is structural as opposed to frictional, in that there are workers
who want to work at the minimum wage, but who will not be able to find those jobs even
after extensive search.
This type of unemployment affects low-‐wage workers, particularly teenagers.
But the same line of reasoning illustrated in Figure 4 implies that any factor or set of factors
that raises the actual wage above the equilibrium wage that would equate supply and demand
will cause structural unemployment.
IV. Unions and Collective Bargaining
A labor union is an association of workers that bargains with employers over wages,
benefits, and working conditions through a process of collective bargaining. If the two
sides can’t agree, the union can organize a strike, the organized withdrawal of labor from
the firm.
In the 1940s and 1950s, about one third of US workers were unionized. Now, that number is
only about 12 percent.
Studies show that through collective bargaining, unions can increase the wages that their
members receive by 10 to 20 percent.
The overall effects of unions on wages and unemployment therefore resemble the effects of
minimum wage laws:
-‐ Insiders, or union members, benefit from the higher wages.
-‐ But outsiders are hurt because at higher wages, fewer workers are hired.
V. The Theory of Efficiency Wages
Like minimum wage laws and union collective bargaining, the theory of efficiency wages
explains structural unemployment by appealing to wages that are above the level that
equates supply and demand.
But whereas the “above equilibrium” wage resulting from minimum wage laws comes from
government actions, and the above market equilibrium resulting from unions comes from
workers’ collective action, efficiency wage theory stresses that employers themselves might
want to pay their workers above equilibrium wages to raise worker productivity?
Why might an employer voluntarily want to pay above equilibrium wages? Why might higher
wages raise worker productivity?
- Worker Health. Better-‐paid workers will be healthier and therefore more productive. This
factor is probably not relevant in the United States, but certainly could be in developing
countries.
- Worker Turnover. It’s costly for the firm to hire and train new workers; hence it’s in a
firm’s interest to try to retain its existing workers. It can do this by paying them wages that
are higher than they can get elsewhere.
- Worker Quality. Suppose that a firm wants to fill an open job and advertises a lower wage.
Since the only people who will apply are those who can’t earn a higher wage elsewhere, it
runs the risk of having to hire someone with less experience or lower skills. Conversely, by
offering a higher wage, the firm can attract even the very best applicants.
- Worker Effort. If a firm’s workers are happy because they feel that they are well treated,
they will be willing to work harder. Also, if they know that they won’t be able to find as
good a job elsewhere, they will work harder to keep their existing job.
In 1914, Henry Ford offered his workers $5 per day, about twice what they could get at
other jobs. Worker turnover and absenteeism fell. Ford called the decision to raise wages “one
of the finest cost cutting moves we ever made.”
VI. Conclusion
After discussing how the unemployment rate is actually measured, this chapter goes on to
identify a number of explanations for the natural rate of unemployment, that is, the long-‐run
rate of unemployment that prevails even outside of recessions.
These explanations fall under two broad headings: theories that explain frictional
unemployment and theories that explain structural unemployment.
