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EC201 Intermediate Macroeconomics
EC201 Intermediate Macroeconomics

Lecture 27-28: Unemployment
Lecture Outline:
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The natural rate of unemployment;
Job search
Wage rigidity and efficiency wages;
Duration of unemployment;

Essential reading:
Mankiw: Ch
...
When unemployment
increases there are potential efficiency losses for the economy since production goes
down, moreover there are potential social losses associated with unemployment (loss
of income, increased inequality, etc
...
At any time in any economy many
individuals are unemployed
...
In particular we are interested to know if
unemployment represents a failure of the labour market (we know that if the labour
market works well as in the RBC world unemployment is only voluntary and we
know that this is not the case in reality)
...
For example in the AD-AS model, when aggregate demand increased we
said that output increased and after a while also prices increased
...
The
firms increased production by hiring more workers and so unemployment decreased
...
etc
...
In particular we will discuss the main causes of unemployment (and so
employment) and the main stylised facts about it
...

u=

U
L

where u is the unemployment rate, U is the number of people unemployed in a given
period of time and L is the labour force in that period of time
...

pr =

L
NILF + L

where NILF means the number of people not in the labour force that are in the
working age (they are between 14 and 65 years old) but are not working and are not
looking for a job
...

Excluding those who were either under working age (under 14), or above the
retirement age (65), the number of people potentially available for employment, the
population in working age, was 330 million
...
The other 92 million
people were not in the labour force (NILF), neither working in the marketplace nor
looking for work
...
Conversely, the nonparticipation rate, defined as the number of people out of the labour force divided by
the population in working age, was 92/330, or 28%
...

Therefore the unemployment rate in 2008 in EU27 was 16/238 or 6
...
In the
following graph the average unemployment rate for the year 2008 in Europe is
depicted:

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12
10
8
6
4
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A Model of the Natural Rate of Unemployment
First we introduce the determinants of the equilibrium unemployment rate in the longrun
...
In that lecture note we defined the Natural Rate of Unemployment as
the rate associated with the natural level of output
...
In a recession, the actual unemployment rate rises above the
natural rate
...
In
the graph below we plot the unemployment rate and the natural unemployment rate
for the US between 1967 and 2007
...


3

One thing the graph tells us is that until mid 80s the natural rate was increasing over
time and then the trend reversed
...
This means that L is given, say 10 million and it
remains 10 million always
...
Fraction of employed workers that become
separated from their jobs
...
Fraction of unemployed workers that find jobs
...

So in any period an amount s × E of workers lose their job and become unemployed
...
This transition between the two states (employed and unemployed) in the
market in any given period is depicted in the following figure
...

Definition: the labour market is at the long run equilibrium (or in steady state1), if
the unemployment rate is constant
...

The steady state condition for the labour market is therefore:
s × E = f ×U

What is the unemployment rate U / L implied by the steady state condition?
First we need to notice that the labour force is given by L = E + U
...
Therefore we can use

interchangeably the expressions “steady state” and long-run equilibrium
...

Consider the following examples:
1) Each month, 1% of employed workers lose their jobs (s = 0
...
19)
Then the equilibrium unemployment rate is

U
0
...
05 or 5%
...
19 + 0
...
04) and 76% of
unemployed workers find jobs (f = 0
...
04
=
= 0
...

L 0
...
04

In both case the outcome of the labour market is the same but the two examples look
very different
...
The second one appears a very active labour market where many
unemployed workers can find a job within a month
...

The main properties of the Natural Rate of Unemployment:
a)

∂ (U / L) s + f − s
f
=
=
≥0
2
∂s
( f + s)
( f + s) 2

b)

∂ (U / L)
−s
=
≤0
∂f
( f + s) 2

c) Since 0 ≤ s ≤ 1 , 0 ≤ f ≤ 1 and given the steady state condition the natural rate of
unemployment is normally different from zero
...
Then also f = 0 (unless U = 0, in which case the
natural rate is zero), otherwise the steady state condition will not hold
...
The steady state condition can be written as ( f + s )

U
= s
...

d) For a small value of s different from zero, the natural unemployment rate is low if
f = 1
...

Property a) tells you that the natural rate increases with the separation rate
...


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Those two properties give us a clear policy implication: any policy aiming to reduce
the natural rate of unemployment can do it only if it lowers s or increases f
...
All unemployed in a given month find a job in the same month
...
For example suppose that
s = 0
...
9%
...

There two main reasons for why f < 1 :
1) Job search and matching theory;
2) Wage rigidity;
Below is the graph of the job separation and job finding probabilities for the US
economy
...

Even if the labour market is competitive, the wages are flexible and there are many
jobs available we may have in each period unemployed people simply because it
requires time for those people to find a job and match with a firm
...

Different workers can have different abilities and different jobs may require different
skills
...
Assume that the labour market is competitive; however there is a
friction in the market
...
The workers and the firms need
to spend time (costly) to look for the best match
...
etc
...
Similarly a worker must search for job vacancies and
this takes time and it is costly
...
etc
...
Workers are
rational (as firms) and in deciding to accept a job or not they compare the costs and
benefits of searching activity
...
The worker has
to decide whether to accept it or not
...
However, by searching again he can obtain a better offer (and
this will be a benefit)
...
The cost of searching again is the sum of the foregone current offer and
the cost of searching (the time spent in searching) minus the unemployment benefit,
since by rejecting the job offer and start searching again the worker will become
unemployed for a while
...

Search and matching models offer a straightforward explanation for average
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unemployment: it may be the result of continually matching workers and jobs in a
complex market where there is imperfect information
...
Frictional unemployment is also
called Search Unemployment
...
Frictional unemployment is inevitable since the economy is always
changing
...
This explains
why the natural rate of unemployment is above zero even in good times
...

For example in the US labour market 3% of workers leave their jobs in a typical
month
...
Moreover in the US
manufacturing sector 10% of existing jobs disappear each year
...
etc
...
Many workers that are unemployed remain in that state for quite a long
time (especially in Europe, see the last section of this lecture note) and it seems
unlikely that the searching activity may be the source of such a long-term
unemployment
...

Policies that increase the information level in the market: this is done by the
government employment agencies with the aim of disseminating information about
job openings to better match workers and jobs
...
A very important implication from search and matching models is related
to the role of Unemployment Benefits (also called Unemployment Insurance) in the
labour market
...
This should
help the workers to have a sort of income flow while he is searching for a new job
...
We saw that unemployment benefits reduce the marginal
cost of searching, meaning that they provide an incentive for workers to continue to
search and so to remain more in the unemployment state
...
A decrease in the job finding rate will increase the natural rate of
unemployment
...
In order to have unemployment that is not
voluntary we must have a labour market in which the market wage is above the
competitive wage
...

If the market wage is above the competitive wage why it does not decrease?
We need to explain why the market wage is above the competitive wage and why it
may be rigid (it does not decrease towards the competitive wage)
...

Structural unemployment arises because wages are set artificially high above the
market clearing wage
...
93 per hour) and the minimum wage is above the
competitive wage especially for unskilled workers we have involuntary
unemployment and wage is rigid because there is a lower limit and the wage
cannot go below that limit
...

b) Labour Unions: if the market wage is the result of the bargaining between
firms and unions and unions are powerful, they may obtain higher wages,
above the competitive wage, and it may be difficult to decrease that wage

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since unions will normally dislike wage cuts
...

c) Efficiency Wages: it may be optimal for a firm to pay higher wages than the
competitive wage in order to motivate (increase the productivity) and keep its
workers
...


Efficiency Wage Theory
This theory tries to explain why it may be optimal for a firm to pay a wage that is
higher than the competitive wage
...
However, there costs and
benefits in paying higher wages
...
Efficiency wage theory assumes that higher
wages can increase workers productivity and since workers are going to be more
productive the firm may gain in terms of profits
...

Basic idea: a firm cannot monitor perfectly its workers (for example monitor can be
costly)
...
Then a high wage represents
an incentive given by the firm to the workers for them to exert effort and being
productive
...
If a worker is unproductive and it is caught while
“shirking” by the firm, he will be fired and so it will lose a high wage
...
Consider the following simple model
...
With probability 0 ≤ p < 1 a worker not exerting effort is caught “shirking”
(not exerting effort) and is fired
...
Therefore with probability (1-p) a worker not
exerting effort is not caught and so he keeps the job
...
He will be better off by not exerting effort and
getting the wage
...
Assume that c(e) > 0 if e > 0 and c(0) = 0 ,
meaning that when the worker does not exert effort the cost of exerting effort is zero
...
The firm pays a wage w
...

a) If a worker is not exerting effort then we have the following: with probability

p he is caught and fired
...
Moreover with
probability 1 − p he retains his job and his wage w and his cost of effort is

c(0) = 0
...
Solving that condition for the wage we have:

w≥

c ( e)
b
+
p (1 − f ) 1 − f

The wage is higher:
i)

Higher is the cost of exerting effort c(e)
...
Higher is the unemployment
benefit and lower is the cost of losing the job since the worker by getting
fired and being unemployed can still get a substantial payment;

iii)

Lower is the probability of monitoring p
...
Again, if
it is easy to find another job, then being fired is not very costly for a
worker and so the firm must pay a high wage to provide incentives to the
worker to exert effort:

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You should notice that the wage must be higher than c(e)
...
Therefore the wage defined above is higher
than the competitive wage
...


Main implication: since the wage is higher than the competitive wage the outcome of
the labour market is not Pareto optimal
...


Efficiency Wages and Cyclical Unemployment
Cyclical unemployment is the unemployment caused by the recession phase in the
business cycle (like in the recent credit crunch)
...
However this is
true if the wage is some how sticky
...
Efficiency wages theory can help explaining why in a recession the
wage does not fall enough and can remain above the market clearing wage and so
involuntary unemployment can arise
...
However in the case of efficiency wages, the wage
will not decrease enough to reach the competitive wage
...

Workers then will become less productive
...
This can be found in data and it is an important measure to
evaluate a particular labour market
...
In a country where the average duration is low being unemployed is more a
quick transition than a long wait between jobs
...

From the graph we see that the average duration is quite stable over time and more
importantly there is a big difference between the US labour market and the European
labour market
...

25
Czech Republic

m onths

20

Finland
France

15

Hungary
Slovak Republic

10

Spain
United States

5

Europe

0
2000

2001

2002

2003

2004

2005

2006

2007

2008

From the data we see that most of the average time spent unemployed is attributable
to the long term unemployed, so workers that are looking for jobs for a long time
...
Knowing this is important because it can help us craft policies that are more
likely to work
...

Moreover, after the 70s the average duration of unemployment became higher
in Europe than in US
...

c) Government employment protection (rules and regulations for firing and
layoffs, firing taxes) is stronger in Europe than in US
...
This is shown in the following Table where we put the
percentage of workers covered by collective bargaining in selected countries

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in 2004
...

This is shown in the following pictures
...


On the other hand in US during the same period the real wage increased by less than

15

50% but employment increased by 70%
...
However it would be misleading just to look at
those two pictures to point out the main differences between Europe and US
...


Finally it should be noticed that because of the credit crunch the difference became
zero in 2009 as shown in the following graph

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