Lecture 27

We have \(L = E + U\), where \(L\) is the labor force, \(E\) is the number of employed workers, and \(U\) is the number of unemployed workers.
The unemployment rate is \(U/L\). The rate of job separation (severance rate) is denoted \(s\) and the rate of job finding as \(f\).
Then, the number of people finding jobs is \(fU\) and the number of people losing jobs is \(sE\). In steady state, \(fU = sE\). Equivalently,

\[\frac{U}{L} = \frac{s}{s+f}.\]

Any policy aimed at lowering the natural rate of unemployment should either reduce the rate of job separation \(s\) or increase the rate of job finding \(f\).

The two main reasons for unemployment are job search and wage rigidity.
Job search is the process of matching workers with appropriate jobs.

Efficiency-wage theories propose another cause of wage rigidity. They claim that high wages make workers more productive. There are four theories related to this:

• An increase in wage allows workers to get a more nutritious diet, which increases productivity. They can pay more than the equilibrium wage to maintain a healthy workforce. This is mostly relevant in developing countries.
• Higher wage increases the workers’ incentive to stay with the firm, which decreases hiring/training costs.
• The average quality of a firm’s workforce depends on the wage it pays to its employees. If a firm decreases its wage, the best employees may take jobs elsewhere, leaving the firm with inferior employees - this is called the adverse selection problem.
• A high wage improves worker effort. The firm cannot monitor its employees. This is known as the moral hazard problem. The higher the wage, the greater the cost to the worker being fired.

When MNCs pay more wage than the equilibrium rate, the market is not cleared. Since the supply of labour is fixed, a higher supply means lower demand. This results in unemployment.

It was observed that most spells of unemployment are short, but most unemployment observed at any given time is long-term.
The unemployment caused by the time it takes workers to search for a job is called frictional unemployment. Economists call a change in the composition of demand among industries or regions a sectoral shift.
Since sectoral shifts are always occurring, there is always frictional unemployment. In an attempt to reduce frictional unemployment, some policies inadvertently increase it instead. An example of this is unemployment insurance. In this, workers collect a fraction of their wages for a certain period after losing their jobs. This decreases the incentive to find a new job. While economists agree that eliminating this will reduce the amount of unemployment, they disagree on whether it will enhance economic well-being.

Wage rigidity is the failure of wages to adjust until labour supply eqals the labour demand. The unemployment resulting from wage rigidity and job rationing is called structural unemployment. Workers are not unemployed because they cannot find a job that complements their skills, but because the labor supply is greater than the labor demand. This is the case because the real wage is stuck above the equilibrium level. This is the result of a minimum wage law above the equilibrium wage. It should be noted that efficiency-wage theories claim that even in the presence of a minimum wage or a surplus of workers, firms should set their wage far above the equilibrium wage.

In job search, people are searching for jobs that suit their skills to open up, whereas in the above example, people are waiting for jobs to open up.

Globalization is a major cause for increased competition around the world. Developing countries provide cheap labour so many companies relocate their manufacturing plants to these nations. So, workers who were previously involved in manufacturing may become unemployed.