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CHAPTER 7
Unemployment
Notes to the Instructor
Chapter Summary
This is a relatively easy chapter that examines the determination of the natural rate of
unemployment. It discusses why all free-market economies have some unemployment and what
determines the unemployment rate in the long run. In keeping with the long-run focus of Part II
of the book, this chapter abstracts from cyclical unemployment completely.
The chapter has four primary goals:
1. To show that unemployment is the natural consequence of labor force dynamics and
2. To discuss how the process of job search leads to frictional unemployment and how
government policies such as unemployment insurance influence the amount of
frictional unemployment.
4. To teach some of the important facts about patterns of unemployment in the United
States and in Europe.
Comments
It should be possible to present the material in this chapter in one lecture. When presenting this
material, I stress the reasons why we care about unemployment; the lecture notes reflect this. I
also like to discuss efficiency-wage theories in more detail; there are a number of supplements
on this topic.
Use of the Dismal Scientist Web Site
Use the Dismal Scientist Web site to download annual data for the unemployment rate in the
United States, Germany, Japan, Canada, and the United Kingdom over the past 40 years. Assess
whether these rates have generally moved together or not.
Chapter Supplements
This chapter includes the following supplements:
7-1 Social Costs of Unemployment
7-3 A More General Theory of the Natural Rate of Unemployment
7-5 Robert Lucas and $500 Bills
7-7 Minimum Wages and Efficiency Wages (Case Study)
7-9 The Two Views of Unions
7-11 Efficiency Wages II: The Shapiro–Stiglitz Model
7-12 Efficiency Wages and Wage Differentials
7-14 More on the Duration of Unemployment (Case Study)
7-16 The Secrets to Happiness
7-17 Additional Readings
Lecture Notes | 147
Lecture Notes
Introduction
The long-run model of the economy has thus far assumed full employment. Our discussion of
the labor market in Chapter 3 ignored the reality that not everyone in the labor force has a job.
We now turn to one of the most closely watched macroeconomic variables—unemployment. We
In our analysis of the classical model, we took the supplies of capital and labor as given
and assumed that each was fully utilized. Here, we continue to assume a constant supply of fully
utilized capital but allow for the supply of labor to differ from the amount employed in the
production of goods and services. We also discuss how labor supply and population are related.
Why do economists care about unemployment? Perhaps the main reason that an economist
would give is not the one that would immediately spring to the mind of a noneconomist. Since
labor is an input into the production of goods and services that people want to consume,
unemployment may signal a waste of a scarce resource. Other reasons include the significant
human and social costs of unemployment and the fact that the prospect of unemployment
confronts individuals with undesirable uncertainty about future income. Finally, the burden of
the cost of unemployment is borne largely by those who are unemployed; it is not distributed
evenly across society.
Why do we expect any unemployment at all in the long run? It might seem that a well-
7-1 Job Loss, Job Finding, and the Natural Rate of Unemployment
To obtain insight into the workings of the labor market, consider a simple model of flows into
and out of employment. We assume that the labor force is fixed (= L); that is, we take as given
the population and the labor force participation rate. Recall from Chapter 2 that the labor force
equals the sum of employed and unemployed workers:
employed status to unemployed status. We look for a situation where the levels of employment
and unemployment (and hence also the employment and unemployment rates) are constant. For
this to be true, flows into employment must exactly match flows out of employment:
fU = sE.
!Supplement 7-1,
“Social Costs of
Unemployment”
!Figure 7-2
1=s+f
s
U/L
( )
⇒U/L
( )
=s
s+f
.
Similarly, we have
First, we want to know why we observe unemployment in society—or, in terms of this model,
why the separation rate is not very small or the job-finding rate is not very large. Second, we
might wonder whether or not policymakers would want to change the natural rate of
unemployment (and, related to this, we would like to know what sorts of policies will affect the
natural rate).
7-2 Job Search and Frictional Unemployment
Workers and firms spend time searching for each other. Our models so far have assumed that all
workers and all firms are identical but, obviously, there are many different types of jobs and
many different types of workers. An economy that is functioning well is one that matches up
jobs and skills; in a complex economy, we cannot expect such matches to occur instantaneously.
Causes of Frictional Unemployment
The types of goods that households and firms purchase change over time. When spending shifts
from certain types of goods to others, the demand for labor that produces those goods also shifts.
This change in composition of demand among industries or regions is known as a sectoral shift.
In a dynamic economy, sectoral shifts are always occurring, and because it takes time for
Lecture Notes | 149
Public Policy and Frictional Unemployment
Recognizing that some frictional unemployment is desirable in a market economy is the easy
part. It is much harder to know whether the U.S. economy exhibits too much, too little, or the
right amount of frictional unemployment. To put this another way, it is unclear whether firms
and workers spend too much or too little effort in the business of searching for each other. The
main reason why this is unclear is that firms’ and workers’ search decisions generate
externalities. When a firm and a worker are successfully matched, they both derive some benefit.
A worker who chooses to search harder is more likely to get a good match. But a good match
benefits the firm as well; there is an external benefit to the firm. Since the worker does not get all
the benefit from his effort, he is likely to work too little from a social perspective. Exactly the
payments from the government while they are unemployed. This reduces the immediate
necessity for workers to accept the first job that comes along and so may increase the natural rate
of unemployment. The presence of unemployment insurance may also make firms more willing
to lay off workers.
Case Study: Unemployment Insurance and the Rate of Job
Finding
Another piece of evidence suggesting a link between unemployment insurance and the level of
unemployment is the fact that the probability of finding a job increases markedly when the
worker ceases to be eligible for unemployment insurance.
7-3 Real-Wage Rigidity and Structural Unemployment
Another reason why we may observe some unemployment even in the long run is real-wage
rigidity. The classical model assumed that the real wage adjusts to bring about equilibrium in the
labor market. This is in keeping with the standard economists’ approach to markets: Prices
adjust to bring about equality between supply and demand. Nevertheless, there are reasons why
supply of labor exceeds the demand for labor. Workers are waiting for jobs to become available
at the current wage.
!Supplement 7-4,
“Dutch Male
Unemployment and
Unemployment
Benefits”
150 | CHAPTER 7 Unemployment
Minimum-Wage Laws
Minimum-wage laws are an obvious reason why the real wage might not clear the market. If the
equilibrium wage is below the government-mandated wage, then we immediately have wage
rigidity. In practice, of course, minimum-wage laws are irrelevant for many workers since they
are paid much more than the minimum wage. But for some workers—primarily young and/or
unskilled workers—this constraint may be relevant.
Case Study: The Characteristics of Minimum-Wage Workers
The Current Population Survey, which is used to compute the unemployment rate and other
labor-force data, can also be used to study the characteristics of workers who earn the minimum
wage. In a report issued in 2014, the Bureau of Labor Statistics provided detailed information
about these workers. Roughly 1.5 million workers reported that they were paid the minimum
wage of $7.25 per hour during 2013, and an additional 1.8 million workers reported that they
Unions and Collective Bargaining
Unions provide another explanation of real-wage rigidity of differing importance in different
countries. Wage agreements between unions and firms usually set wages and let the firm choose
the level of employment. The bargaining process between the firm and its workers might well
lead to a wage above that consistent with supply equal to demand. In essence, this is because the
labor market loses the features of a competitive market; instead, workers have some monopoly
power, which allows them to set a wage above the market-clearing level.
Efficiency Wages
Another class of theories that has recently been developed to explain real-wage rigidity is
!Table 7-1
“Efficiency Wages
I: The Solow
Condition”
!Supplement 7-11,
Differentials”
Case Study: Henry Ford’s $5 Workday
7-4 Labor Market Experience: The United States
The Duration of Unemployment
Evidence on the duration of unemployment can help us ascertain the relative importance of
frictional and structural unemployment. While short unemployment spells may well be due to
Case Study: The Increase in U.S. Long-term Unemployment and
the Debate over Unemployment Insurance
During the severe recession of 2008–2009, the duration of unemployment rose significantly
more than in previous recessions. Some economists believe the sharp increase in duration
resulted from expanded unemployment insurance benefits that Congress passed in early 2009.
Variation in the Unemployment Rate Across Demographic
Groups
The unemployment rate varies across demographic groups. Younger workers have notably
Transitions Into and Out of the Labor Force
The simple model presented at the start of this chapter considered only flows into employment
and unemployment and held the labor force fixed. Many of the unemployed at any time are new
or recent entrants into the labor force and perhaps are not searching actively for a job. By
contrast, unemployed workers often withdraw from the labor force, perhaps because they cannot
!Supplement 7-14,
!Figure 7-4
!Table 7-2
!Table 7-3
152 | CHAPTER 7 Unemployment
several alternative measures of labor underutilization—some broader and some narrower than
the official unemployment rate—to help gauge the relative importance of these issues (see
Supplement 2-11, “Alternative Measures of Unemployment”).
Case Study: The Decline in Labor Force Participation: 2007–
2014
The labor-force participation rate fell from 66.1 percent in 2007 to 63.0 percent in 2014. This
decline followed a nearly two-decade period during which the rate had fluctuated narrowly
between about 66 percent and 67 percent. A recent study at the Federal Reserve Bank of
Philadelphia looks at individuals not in the labor force to assess why they are not working or
looking for work. About half of the increase in nonparticipation is accounted for by an increase
7-5 Labor Market Experience: Europe
Europe’s experience of unemployment has been rather different from that of the United States.
In most European countries, unemployment rose substantially in the early 1980s and has since
remained stubbornly high. The two main reasons that have been advanced to explain this
unemployment are generous unemployment benefits and a decrease in demand for unskilled
Unemployment Variation in Europe
Labor market conditions vary significantly across European countries. The unemployment rate,
which for Europe as a whole has averaged well above the unemployment rate in the United
States, has actually been below the U.S. rate in nations representing roughly one-third of the
The Rise of European Leisure
In the early 1970s, Americans and Europeans worked roughly the same number of hours. Since
then, hours worked have declined for Europeans, while hours worked have remained about the
same for Americans. Today, Americans work on average about 30 percent more hours than do
!Table 7-4
!Figure 7-6
!Supplement 7-16,
“The Secrets to
Happiness”
Lecture Notes | 153
7-6 Conclusion
While our models give us some insight into the causes of unemployment, they do not tell us
154
ADDITIONAL CASE STUDY
7-1 Social Costs of Unemployment
Analysts have identified a number of costs of unemployment not discussed in the textbook. First, there is
some evidence that unemployment adversely affects productivity. A survey of unemployed professional
workers indicated that feelings of loyalty and commitment to the job that existed prior to unemployment
were replaced by cynicism and low commitment during unemployment; moreover, these feelings persisted
after the workers were reemployed.1 If such responses to unemployment are widespread, then even short-
term unemployment might have long-term consequences.2
1 S. Fineman, White Collar Unemployment: Impact and Stress (New York: John Wiley, 1983). This survey is discussed in John Naylor and Barbara
Senior, Incompressible Unemployment (Aldershot, England: Avebury Press, 1988). The survey found that workers’ attitudes toward their job
changed after unemployment, but it did not attempt any direct measures of productivity effects.
2 The idea that short-run unemployment might imply reduced productivity and hence have long-run effects on the unemployment rate lies behind
theories of hysteresis, which are discussed in Chapter 13 of the textbook.
ADDITIONAL CASE STUDY
7-2 Job Finding and Job Separation
News sources frequently report information on changes in employment and unemployment. But as is
evident from the model presented in Chapter 7, these are the net result of flows from employment to
unemployment, from unemployment to employment, and in and out of the labor force. A month in which
no one changes employment status and a month in which 1 million people are hired and 1 million people
Source: Figures 1, 2, and 3 from J. Ritter, “Measuring Labor Market Dynamics: Gross Flows of Workers and Jobs,” Federal
Reserve Bank of St. Louis Review (November/December 1993): 39–57.
Figures 2 and 3 reveal that substantial labor market activity is normal in the U.S. labor market. Figure
2 shows job-finding and -separation rates based on Bureau of Labor Statistics data. Figure 3 shows the
creation and destruction of manufacturing jobs as documented by Steve Davis and John Haltiwanger.22
Both indicate that there is always substantial movement of workers in and out of jobs in the U.S. economy.
Figures 2 and 3 also reveal a puzzle. According to Figure 2, there has been a pronounced downward
156
Figure 2
Figure 3
157
LECTURE SUPPLEMENT
7-3 A More General Theory of the Natural Rate of Unemployment
The textbook considers flows between employment and unemployment and shows that the unemployment
rate can be written as
U/L = s/(s + f ),
where s is the separation rate and f is the job-finding rate. This analysis is evidently incomplete, since it
ignores movements in and out of the labor force. We present here a more general model.3
Since the unemployment rate equals U/L, it follows that the unemployment rate will be constant when
Changes in the number of unemployed workers arise, as before, because of job findings and job
separations. Thus, we have a flow into unemployment equal to sE and a flow out of unemployment equal
to fU. We assume that new entrants to the labor force are unemployed at first, and we suppose that a
fraction of unemployed workers retires each period. If we assume retirement is independent of whether or
not a worker is employed, then the retirement rate for the unemployed equals r. We then have
∆U = sE – fU + bL – rU
This differs from the result in the textbook only in that the birthrate is added to the numerator and to the
denominator: Both unemployment and the labor force increase as a result of new entrants into the labor
force. An increase in the birthrate, like an increase in the separation rate, increases the unemployment rate.
Notice that (because of the assumption that the retirement rate is the same for the employed and the
unemployed) the retirement rate does not affect the equilibrium unemployment rate.
CASE STUDY EXTENSION
7-4 Dutch Male Unemployment and Unemployment Benefits
A study by Gerard van den Berg on Dutch male unemployment in the mid-1980s does not find strong
evidence of a link between unemployment benefits and unemployment duration.1 He found that a 10
percent decrease in unemployment benefits reduced average duration of unemployment by about 3
percent. The less educated the worker, moreover, the weaker was the effect: A 10 percent decrease in
benefits decreased duration by 10 percent for university-educated workers, by only 5 percent for those
159
LECTURE SUPPLEMENT
7-5 Robert Lucas and $500 Bills
Economists are often not very specific about how markets get into equilibrium. They do generally believe,
however, in the existence of economic forces that make prices adjust to the point where supply equals
demand. Consider, for example, the labor market discussed in Chapter 7 of the textbook, and suppose that
the real wage is above the level consistent with equilibrium. Then, there are more workers available than
jobs, so jobs will be rationed in some way (since, presumably, firms cannot be forced to employ more
workers than they want). As a consequence, some workers will be unemployed, but they would like to
work at the going wage.
The story we might then tell is the following. An unemployed worker would go to a factory and offer
to work for a little bit less than the going wage. The firm would have every incentive to hire that worker
and fire one of its existing workers because that would increase its profits. If all unemployed workers did
160
LECTURE SUPPLEMENT
7-6 More on the Minimum Wage
The overall impact of the minimum wage depends both on the level of the minimum relative to wages
elsewhere and the number of workers who are potentially covered by the legislation. The percentage of
workers covered by minimum wages rose during the 1960s and 1970s from less than 40 percent at the end
of the 1950s to more than 80 percent by the beginning of the 1980s. Minimum-wage legislation thus has
Charles Brown, in a review of the evidence on minimum wages, concludes that both their harmful and
beneficial effects tend to be exaggerated.1 For example, summarizing research on the effects of the
minimum wage on teenage unemployment, Brown notes that a 10 percent increase in the minimum wage
probably raises the teenage unemployment rate somewhere between 0 and 3 percentage points, with the
lower end more likely. He concludes, “my reading of the time series estimates is that they are not
negligible … but one should look elsewhere (and I am not sure where) for the primary causes of high
unemployment rates in the youth market, particularly for black youth.”2 But if the effects on employment
are exaggerated, so too are the effects on income distribution because of “the surprisingly weak
relationship between being a worker whose hourly wage is low and being a member of a family whose
annual income is low.”3
1 C. Brown, “Minimum Wage Laws: Are They Overrated?” Journal of Economic Perspectives 2, no. 3 (Summer 1988): 133–45.
161
Brown also exposes a common fallacy in discussions of the minimum wage: that minimum wages do
not have a big effect on employment because we do not observe large-scale discharges of workers
following an increase in the minimum wage. This is a fallacy because turnover in minimum-wage jobs is
very high (over 10 percent per month), so employers do not need to fire workers to reduce employment;
attrition will serve.
