Friday began with the familiar beep-beep-beep of the alarm, a steamy shower, and the aroma of brewing coffee. Commuting was, as usual, a hassle. Morning meetings seemed standard fare, mixed with day-dreaming about possible weekend activities. The plant manager dropped the bomb at 2 P.M—loss of a major contract. Layoffs would affect not only assembly line workers this time, but executives as well. Two months' severance pay and accrued vacation were in a final check. Firm handshakes accompanied sincere wishes for "Best of luck." Then, out the door, lugging a box full of personal items. Driving home was a nightmare. "My skills are strong; some competitors have expressed interest in my expertise. But are they hiring now? Recession has been in the news. Can we afford health insurance? How will the mortgage be paid? Do I need to move to find work?" The happily anticipated weekend has dissolved into pure gloom—a reaction typical for workers cut adrift without a job.
See Cost of Unemployment
See Benefites of Unemployment
Unemployment during the Great Depression cut a wide swathe across American society and ultimately led to the Employment Act of 1946, which specified "maintaining maximum employment" as one government goal. Assessing how well this goal has been met usually begins with the overall unemployment rate—a statistic heard regularly in the news. But this single measure is only a crude guide to policy because unemployment occurs for multiple reasons. Before examining various types of unemployment, we must discover who the unemployed are.
Half of the 270 million people in the United States are in the labor force, but this does not mean the rest are unemployed. (Any notion that homemakers are not working is quickly cured by a short stint managing a household and a couple of kids.) Adults can elect to be, or not to be, members of the labor force. Economists classify people as "employed" or "unemployed" only if they choose to be in the labor force.
Conceptually, unemployment occurs when people are able to work and would willingly accept the prevailing wage paid to someone with their skills, but either cannot find or have not yet secured suitable employment.
Figure 4 illustrates unemployment as a labor market surplus. At prevailing average hourly wages of $12, Americans want to "sell" 260 billion hours of labor, but firms will hire only 240 billion hours. Thus, 20 billion hours are unemployed—almost 8 percent of total hours available.
Standard theories of markets identify cuts in prices (or wages) as a cure for any surplus. Although markets for most goods remedy surpluses rapidly through price cuts, similar remedies do not seem to work as quickly in labor markets when there are gluts of workers. In Figure 4, there would be full employment if wages dropped to an average of $10 hourly. But wages are seldom perfectly flexible—they tend to be downwardly "sticky," which prolongs unemployment. Economists and the public at large differ about whether wage stickiness is a matter under the control of individual workers, or whether certain institutional factors cause this stickiness.
Voluntary vs. Involuntary Unemployment
Unemployment can be viewed as either voluntary or involuntary.
Voluntary unemployment occurs when people could find work quickly, but choose to search for what they view as better jobs in terms of pay or working conditions.
You or some of your friends may be working part or full time during college. When you graduate do you expect to earn more than you do now? If you turn down one job because you feel that your education warrants your receiving better pay, you would be considered voluntarily unemployed. The same would be true, if you turned down a night job that required a 50-mile commute, looking instead for 9-to-5 work closer to your home.
Some people view all unemployment as voluntary: If you really want a job and are willing to work for "what you're worth," you can find work almost immediately. I am willing to hire you to paint my home, mow my lawn, or babysit as long as you accept a wage equal to what these activities are worth to me. My neighbor would do the same. Thus, if you are unemployed for more than a few hours, it must be voluntary.
The counterargument is that people should not be forced to accept just any job.
Involuntary unemployment occurs when people lack jobs, but they are willing, able, and even eager to work at wages commensurate with their skills.
According to this point of view, work should neither underemploy people's skills nor insult their human worth, but wretched business conditions and corporate restructuring may yield times and places in which job openings are almost nonexistent.
There are times and circumstances when individual workers have little or no discretion about accepting a lower wage, despite arguments from those who maintain that all unemployment is voluntary for anyone who is (a) productive, and (b) willing to accept a sufficiently low wage.
Even workers who overcome a widespread psychological aversion to accept wage cuts may be unable to agree to a lower wage. Minimum wage laws are one example of restrictions that make some wages downwardly sticky—less than perfectly flexible.
Sticky wages and prices occur whenever wages or prices fail to instantaneously adjust to clear a market at the point where the quantities demanded and supplied are equal.
Wages are also sticky because individual workers cannot negotiate their own wages with unionized employers. Union wage contracts typically govern wage structures from 2 to 3 years. It would be futile for any individual facing a lay-off to try to offer to work for a lower wage in hopes that the firm would might lay off someone unwilling to accept a wage cut. Unionized firms lack this discretion, and such a strategy would aggravate other workers. Most union workers are hostile to "scabs"—workers willing to accept pay cuts while union members get bumped.
Seniority rules are another barrier to wage cuts as ways to keep your job at the expense of another employee. Even the personnel manuals of non-unionized firms often specify something on the order of "last hired, first fired." Seniority rules are attempts on the part of management to appear fair when allocating pay hikes, promotions, or even work itself. Productivity partly depends on morale. Almost any partial lay-off by a firm, whether unionized or not, is governed by rules intended to maintain employee morale—especially that of career employees. Consequently, firms under pressure because of weak demands for their products will be reluctant to hire job applicants merely because the applicants are willing to accept lower wages. However, even if wages are sticky in the short run, they ultimately fall if business is depressed for a sufficient period. In 1993, United Airlines sold roughly 40 percent of the company to its unions for cash plus wage and benefit concessions to obtain a more competitive wage structure.
In the interim, recognize its importance for determining whether unemployment can be involuntary, or if it is always voluntary. Neither position is unambiguously correct. Willingness to work at prevailing wages is not objectively ascertainable, so estimates of involuntary unemployment tend to be crude. In any event, published unemployment data rely on government surveys that use criteria only loosely related to our conceptual definition of unemployment.
The major source of U.S. unemployment statistics is a monthly Department of Labor survey of about 60,000 households—a sample sufficiently large that it ensures that the statistics collected are reasonably representative. This survey (broadly outlined in Figure 5) by the Bureau of Labor Statistics (BLS) is intended to determine the labor force status of each adult family member.
Figure 5 Determining Who Is Unemployed
Employed persons include (a) anyone who worked for pay any time during the week that includes the 12th day of the month, or unpaid for 15 hours or more in a family-operated firm, and (b) those temporarily absent from regular jobs because of illness, vacation, strikes, or similar reasons. Armed Forces personnel stationed in the United States are also counted as employed.
Unemployed persons are those who did not work during the survey week but were available for work, except for temporary illness, and who looked for jobs within the preceding 4 weeks. Persons who did not look for work because they were on layoff or waiting to start new jobs within the next 30 days are also counted as unemployed.
Refined survey questions and computerized technology introduced by the BLS in 1994 reduced the ambiguity of questions and the subjectivity of the interviewing process. Follow-up questions on the survey are now directed by computers, standardizing interview processes.
Accounting for Joblessness
More than one type of unemployment may account for some joblessness. For example, a golf pro in Michigan who lacked other skills might find a job easily each May, but be both seasonally and structurally unemployed in the dead of winter. Simple frictional unemployment and seasonal unemployment are normal by-products of economic activity. These two types of unemployment pose relatively mild social problems when compared with structural, cyclical, or induced unemployment. Nevertheless, different government programs are broadly aimed at different types of unemployment:
1. State employment offices match job applicants with vacancies to reduce transaction costs that boost frictional and seasonal unemployment.
2. Government retraining programs are intended to provide marketable skills to the structurally unemployed, and firms that hire the "hard-core" unemployed receive tax subsidies.
3. Occasional reforms to unemployment compensation systems (e.g., tighter monitoring to prevent cheating) are aimed at reducing induced unemployment. A lower minimum wage rate that applies to trainees is aimed at reducing unemployment among teenagers.
4. Policymakers attempt to reduce cyclical unemployment by trying to dampen the frequency, intensity, and duration of economic downturns.
Curing cyclical unemployment is a primary focus of macroeconomic policy, but broad prosperity tends to ease unemployment of all types, as echoed in the adage, "A rising tide lifts all boats."
Limitations of Unemployment Statistics
Most economic statistics reflect attempts to summarize, but keep in mind that a lot of detail can be lost in any summary. (You may have discovered this for yourself if, when studying for a test, you have ever relied too heavily on Cliff Notes or similar summaries.) One possibility is that published statistics may understate true unemployment. One reason is that some workers who are truly unemployed are uncounted if they have given up looking for jobs. Those individuals who have given up looking for work are no longer classified as "actively seeking work," so they are not counted as in the labor force.
Discouraged workers are so pessimistic about their prospects that they do not look for jobs, although they would like to work.
The discouraged worker syndrome is probably most pronounced during recessions, when job openings are perceived as few and far between.
Earlier BLS estimates of discouraged workers were widely criticized as too subjective— whether or not a worker was "discouraged" was inferred from answers to other questions. The refined survey introduced in 1994 asks questions that more carefully identify discouraged workers. Preliminary tests of the new questionnaire revealed that many of those previously classified as discouraged actually "had looked for work in the last year, found a job, lost or left the job, and had not looked for a job since." The new BLS survey explicitly asks individuals for the main reason they are not looking for work, and to prioritize their reasons. As a result, the discouraged worker category will probably be cut in half relative to previous estimates.
Another major reason unemployment rates may be understated is that all part-time employees are considered employed—the BLS unemployment rate does not weigh the problem of part-time unemployment. For example, if you want a full-time job but only work half time, ideally, the official unemployment rate should weight you as 1/2 of an unemployed worker. But it does not.
On the other hand, unemployment statistics may be overstated because of our unemployment compensation system. (Have you known people who drew unemployment checks even though they did not want a job?)
Dishonest nonworkers claim to be available for work so they can draw unemployment benefits, even though they do not intend to work.
Failure to include discouraged workers and the part-time unemployed in unemployment statistics biases official unemployment statistics downward—unemployment is understated. Dishonest nonworkers, on the other hand, bias unemployment data upwards. Which sets of effects are stronger, on balance, is a matter of continuing debate.
Some workers who enter a period of joblessness are entitled to unemployment compensation. Payment of unemployment compensation in the U.S. is usually limited to 26 weeks. After 26 weeks of payments, those unemployed Americans are largely on their own. However, in the depths of most recent recessions, Congress has extended eligibility for payment of unemployment compensation to 52 weeks—or even longer. Some jobless workers do not receive unemployment compensation - for example individuals who are self employed who may lose a contract position, or those who have been fired for cause from their place of employment. These workers are left to fend for themselves.
Unemployment compensation does buffer the harm to some unemployed individuals, but when it reduces the personal relative costs of being jobless, it can simultaneously reduce the relative benefits from accepting an offer of a position the individual views as less than ideal, depending on the amount of benefits the individual receives. The predictable result is that people spend more time looking for ideal positions and turning down jobs that are less than perfect. This drags out the processes of search unemployment.
The harsh reality is that many workers are forced to move "down a notch" when they lose one job and must find another. Some analysts argue that generosity to the unemployed often backfires; higher relative rates of unemployment compensation make it easier for unemployed people to cling to unrealistic expectations, and to remain out of work longer.
Excessive unemployment reduces output and income, erodes human capital, and imposes widespread suffering. Classical analysis suggests that in the longer-term, the economy will equilibrate at full employment. In contrast, traditional Keynesian analysis indicates that adjustments to Aggregate Demand can restore full employment even in the shorter-term. But as Figure 6 illustrates, in recent years unemployment has been not only persistent, but growing. And increasing numbers of workers are left jobless for increasingly long periods.
Figure 6 The Upward Trend in Unemployment Rates
Average U.S. unemployment rates have risen over the past five decades. Long term unemployment (that where a worker is jobless for an extended period) has also followed an upward trend.
Source: Bureau of Labor Statistics, 1994.
The traditional Keynesian model, as we have seen, explains unemployment as a consequence of inadequate Aggregate Demand and sticky wages. Labor markets, according to Keynes, may not clear. For example, workers are often not willing to accept a reduction in their money wages, setting a floor on wages and preventing the market from clearing. Thus the price of labor may not adjust so that the quantity demanded equals the quantity supplied. Modern Keynesians (or "New Keynesians" as they are called) develop richer theoretical microfoundations to explain why labor markets sometimes fail to clear, which can lead to persistent involuntary unemployment. Within this ongoing area of research, explanations for failures of labor markets to clear can be grouped under labor contract considerations, efficiency wage theories and dual labor markets (insiders and outsiders). Before we look at the U.S. record on unemployment, we will examine each of these microeconomic foundations for new Keynesian analysis.
Unlike wheat, corn, or soybeans, labor is not traded on spot markets. (Almost no workers are employed one hour at a time, with constant re-contracting.) Transactions costs are significant in most labor negotiations. Individuals negotiate either directly or through unions with firms about wage rates and the conditions of their employment. The high costs of information and mobility (moving between jobs or hiring new employees) are major reason that most employment relationships take on a long-term nature. Even though most workers today can expect to have 5 to 7 jobs over the course of their careers, this still means that the average job is held 6 or 7 years.
Such long-term relationships imply that wages and working conditions are usually negotiated only periodically---once a year is typical. Union contracts usually extend from 2 to 3 years, with wage rates being negotiated in nominal terms---often with escalator clauses to adjust wages for inflation. Even where union agreements are not in effect, federal and/or state laws often require that overtime pay rises as the hours of work increase beyond some point.
These labor contracts (whether written (explicit) or unwritten (implicit)) mean that wages and benefits are set for lengthy periods and adjust in a lagged fashion to changes in economic conditions. Thus, when the economy turns downward, wages fall only slowly to create job openings for the unemployed. Another reason many firms reduce their wage offers only slowly during recessions is found in notion of efficiency wages.
The existence of substantial and sustained unemployment clashes with standard theories of competitive markets. According to classical theories of competitive labor markets, wage cuts would quickly and automatically eliminate unemployment (surpluses of labor). But the new Keynesians are skeptical that this is how the real world actually works.
The supply and demand for labor shown in Figure 7 yield equilibrium of qL and employment at wage wL under standard assumptions. A worker who failed to perform conscientiously (a problem known as shirking) could be fired. However, if this labor market were competitive, this worker would almost immediately find another job at wage wL. Thus, the threat of being fired would be ineffective as a disincentive against loafing or dishonesty.
Figure 7 Efficiency Wages and Equilibrium Unemployment
Efficiency wages are set above market equilibrium to increase the costs of dismissal and reduce shirking by employees. Efficiency wages, if paid by all employers, increase the costs of being fired by creating a pool of unemployed, qs, - qe; this increases costs for dismissed employees. Such attempts by employers to reduce shirking is one of several explanations for involuntary unemployment in labor markets.
Employers are aware that shirking must be offset by other incentives. One strategy is for the firm to engage in reputation building. A reputation for seldom laying--off workers, even when business is slack, may attract top-notch workers without requiring wage premiums. In such cases, shirking, if discovered, would cause a worker to forfeit job security. On the other hand, a reputation as an unreliable and harsh employer may stimulate shirking, and the firm may be forced to expend more resources monitoring employee performance.
Another strategy to curb shirking is for the employer to pay more than prevailing market wages. A firm may start new employees at a low wage but, after newly-hired workers perform well, quickly raise their wages to a premium level. These employees would lose their premium wages if fired, and would be less likely to be able to duplicate their current salaries and benefits.
Efficiency wages are wages that exceed market-clearing wages, and are intended to raise the costs to employees of being dismissed, thereby reducing shirking.
This may seem paradoxical because, if all firms pay wages that exceed the market clearing wage, dismissal would not harm employees. Figure 7 suggests, however, that high efficiency wages (we) to control shirking reduce employment to qe. Unemployment equals qs - qe in this type of equilibrium, because qs workers are willing to work at wage we. Dismissed employees will be at least temporarily unemployed, raising their cost of shirking. Similarly, employers find it difficult to "skim" the best workers from the labor pool while only paying a market clearing wage. Thus, involuntary unemployment may be partially explained by employers' attempts to offset shirking and reduce turnover costs (workers quitting) by paying premium wages. Global competition, corporate reorganizations and down-sizing are all makeing it more difficult for firms to continue to pay premium wages to all workers. Once unemployed, workers may also face a dual labor market.
Dual Labor Markets
The concept of dual labor markets involves segmenting the national labor market in two sectors: (a) a primary non-market clearing sector paying efficiency wages (insiders) and (b) a secondary sector where the market clears, but which is much more competitive (outsiders). Almost all workers want to work in the primary sector because wages and benefits are higher.
In Figure 8, this primary sector is shown in Panel A and the secondary market is shown in Panel B. For simplicity, the total labor force at any moment is assumed fixed. High wages (w1) are paid to L1 workers in the primary sector. Any vacant primary positions are quickly snapped up by eager workers who want high pay and job security. Although, from workers' perspectives, there are shortages of high paying jobs in the primary sector, it is nearly always possible to find lower paying and less desirable jobs (burger-flipper?) in the secondary labor market, shown in Panel B. The secondary market's residual demand for labor is shown as DL2 and begins at wage w1 (point a). The residual labor supply is SL2 and this market clears at point b, an equilibrium wage of w2. Total employment is L1 + L2, resulting in unemployment of Lf - (L1 + L2) or Lf - L2. These workers represent a curious blend of both voluntary and involuntary unemployment---they continue to apply for positions in the primary sector, but are unwilling to take a job in the secondary sector.
Figure 8 Unemployment in a Dual Labor Market
Efficiency wages provide a premium for workers able to secure jobs in the primary sector (Panel A), but few workers can land these positions. Anyone willing to work at low wages finds employment quickly in the secondary market (Panel B).
Examples of workers for whom the dual labor market theory provides an explanation for unemployment would include engineers or middle-managers who lost career positions at firms in declining industries. These workers would be very reluctant to take jobs as, e.g., order takers at drive-through windows in fast food restaurants.
Recent corporate down-sizing has pushed many workers previously in the primary sector into secondary labor markets. Former "career employees" often exhaust their unemployment benefits while attempting to secure new jobs in the primary sector. A growing number of these workers now comprise the contingent labor force we described in Chapter 6---part-time and temporary employees, the self-employed, and "consultants" who offer business services.
Long-term labor contracts (whether implicit or explicit), efficiency wages, and dual labor markets all provide microfoundations to help explain wage stickiness and unemployment in an Aggregate Demand/Aggregate Supply framework.