Economics Chapter 7 Homework A More General Theory of the Natural Rate of

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.