Concept of Unemployment

FRICTIONAL UNEMPLOYMENT

Even when aggregate demand is sufficient to employ all the labor force and when those who
are unemployed possess skills matching those required by firms with job openings, the
nation’s unemployment rate will remain positive. As implied in our

for new ones, (2) look for new jobs after losing previous ones, (3) enter the labor force to
seek work for the first time, (4) reenter the labor force after periods of absence, and (5) move
from one job to take another within the next 30 days. Likewise, employers continuously (1)
search for replacements for workers who quit or retire, (2) discharge some employees in
hopes of finding better ones, and (3) seek new workers to fill jobs created by expansion of
their firms. Thus unlike “auction” markets such as stock and wheat exchanges, the overall
labor market never fully “clears.” At any moment there is considerable frictional
unemployment; that is, not all active job searchers will have yet found or accepted
employment, and not all employers will have yet filled their job vacancies.

Search unemployment is an important source of frictional unemployment. This type of

unemployment is created by individuals searching for the best job offer and firms searching
for workers to fill job openings. The job search process and its relationship to unemployment
compensation and inflation are discussed in Chapter 15.

Not all frictional unemployment is of the search variety. In some instances, un- employed
workers willingly wait to be recalled from temporary layoffs or willingly wait in job queues
to obtain union jobs. In addition, efficiency wages may attract workers into the labor force
who are forced to wait for such jobs to open. These types of frictional unemployment
collectively might best be described as wait unemployment, rather than search
unemployment. Let’s briefly examine each of these potential sources of frictional
unemployment.

1 Temporary Layoffs

Although large layoffs are normally associated with recessions, temporary layoffs by firms
occur throughout the economy even during periods of robust overall ag- gregate demand.
Such layoffs may account for as much as 1 to 1.5 percentage points of the natural rate of
unemployment.6 Workers on temporary layoff normally do not search for new employment;
rather, they wait to be recalled to their former jobs. We know from our discussion of the
Household Survey that these workers are counted as unemployed.

Seasonal unemployment might also be thought of as temporary layoff and, therefore, a type
of wait unemployment. Examples: Construction workers often are unemployed during the
winter, farmworkers occasionally are unemployed between planting and harvesting seasons,
and professional athletes may be unemployed during parts of the year. In each case, these
workers are waiting to resume their jobs.

2 Union Job Queues

Unions also contribute to frictional unemployment.

reducing the number of workers demanded by firms and increasing the number of willing
suppliers of labor. In brief, some workers may be willing to wait in the employment queue for
union jobs rather than take nonunion jobs available at lower pay.

3 Efficiency Wages

Finally, efficiency wages may contribute to the relatively high rate of frictional un-
employment. Recall that efficiency wages are those that firms set above the market- clearing
levels as a way to elicit hard work, reduce costly labor turnover, or achieve some other
desirable end that adds to worker productivity. We observed earlier in Figure 7.8 that
efficiency wage payments and permanent frictional unemployment go hand in hand. As
concisely stated by DeFina,

Unemployed individuals, whether they have quit, have been fired, or have entered the labor
force for the first time, might try to get jobs by bidding down the wages of current workers.
But in contrast to the simple competitive market situation, firms will not accept those offers.
Firms have already weighed the benefits and costs of lower wages and decided that keeping
wages high yields them their greatest profit. And because the unemployed cannot bid their
way into jobs, they must instead wait until new openings arise from quits, firings, or increases
in firms’ demands for workers. They must then hope to be chosen over other

jobless persons. On the whole, unemployed persons might remain jobless for quite some
time.7

STRUCTURAL UNEMPLOYMENT

Another type of unemployment that is part of a nation’s natural rate of unemployment is

structural unemployment. This unemployment shares many of the same features as frictional
unemployment but is differentiated by being long-lived. It, therefore, can involve
considerable costs to those unemployed and substantial loss of forgone output to society.

Structural unemployment is caused by changes in the composition of labor supply and

demand; it is a “square pegs, round holes” phenomenon. This unem- ployment generally has
one or both of the following dimensions. First, it may result from a mismatch between the
skills needed for available jobs and the skills possessed by those seeking work. Second,
structural unemployment may occur because of a geographic mismatch between the locations
of job openings and job seekers. Examples of structural unemployment abound: Robotics
technology and the increase in the market share of imports greatly reduced employment in the
U.S. textile industry over the past three decades. Many of the workers who were dis- placed
did not have the skills required for positions that were open, such as in ac- counting and
computer programming. Similarly, improvements in agricultural technology over the past 100
years caused job losses for many farm operators and laborers who did not possess readily
transferable job skills in expanding areas of employment and who were not geographically
mobile. Unemployment resulting from job losses associated with the spate of mergers in the
United States during the 1990s is another example of structural unemployment, as is
unemployment result- ing from the deregulation of the trucking and airline industries.

Displaced Workers
In recent decades many of the people who were structurally unemployed were displaced
workers—individuals who had lost their jobs specifically because of per- manent plant
closings or job cutbacks. A total of 4.3 million workers 20 years of age and older who had
been at their jobs at least three years were displaced between January 2011 and December
2013. By January 2014, 61.3 percent of these workers were reemployed in new jobs. Another
17.9 percent of them had left the labor force. Finally, 20.8 percent of the displaced workers
were still unemployed and looking for work. This 20.8 percent figure was more than triple
the overall unemployment rate in 2014. Of the full-time workers who were back at work, 47.6
percent were earning less than before they were displaced. About one-third were earning 0 to
19 percent more than before, and about one-fifth were earning at least 20 percent more.8

Not all plant closures and job cutbacks occur where we would most expect them: in declining
industries or industries hurt by import competition. The level of employment within firms is
surprisingly volatile from one year to the next, independent of the busi- ness cycle or major
industry trends. Jobs themselves are more unstable than generally

thought, implying that much structural unemployment results from workers being in the
wrong place at the wrong time. Changes in labor demand within firms alone may account for
as much as one-fourth of the natural rate of unemployment.9

The extent of structural unemployment depends on the degree of the composi- tional changes
in labor demand and supply and the speed of the adjustments of the imbalances and
mismatches. Training and retraining play a key role in this adjust- ment process, and efforts
to shorten the duration of structural unemployment nor- mally involve retooling of skills to
match job vacancies.

DEMAND-DEFICIENT UNEMPLOYMENT

In many years, the unemployment rate greatly exceeds the 4.0–5.0 percent natural rate. For
example, unemployment was 8.5 percent in 1975, 9.7 percent in 1982, and 9.6 percent in
2010. In the depth of the Great Depression (1933), 24.9 percent of the labor force was
unemployed. These high unemployment rates are by-products of recessions and depressions
and result from deficiencies in aggregate demand that force firms to lay off and discharge
workers. The evidence strongly suggests that declines in aggregate demand—rather than, say,
differences between expected and actual inflation rates—are the primary cause of cyclic
unemployment.11

Graphic Analysis

The analytical framework we developed earlier helps clarify demand-deficient or cyclic

unemployment. In Figure 18.6(a) we depict a sharp, unexpected decline in aggregate
demand, shown as the movement from D to D1. Keynesians view a de- cline in investment or
consumption spending as the usual cause of such a shift, whereas monetarists look to a
reduction in the money supply as the underlying culprit. Irrespective of the cause, the fall in
aggregate demand decreases real output from the full-employment level Qn by the amount
QnQ1.
As shown in graph (b) of Figure 18.6, the decline in aggregate demand in graph (a) reduces
the derived aggregate demand for labor from DL to DL1. In technical terms, this decline in
labor demand occurs because the lower price level P1 in graph (a) reduces revenue to
producers; that is, marginal revenue product in the aggregate falls. More generally, firms
experience rapid rises in their inventories because they are unable to sell their existing output.
They, therefore, curtail their production and reduce their demand for labor. Put simply, they
no longer wish to hire as many workers at each wage rate as previously.

Let’s assume, for reasons we will explore shortly, that the wage rate in graph (b) remains at
W0. We note that employment declines from the natural level En to the smaller amount E1.
At wage W0, a individuals desire work—and previously were working—but firms employ
only b workers. Thus, ab workers are cyclically unemployed.

The full decline in employment and emergence of unemployment rest on the crucial
assumption that the wage rate in our model does not fall. If it were to decline to W1, firms
would adjust their employment to E2 (point c). We note that employment is only E2 at W1,
compared to En at the original W0 equilibrium. The E2En decline in employment, however,
would be voluntary on the part of these workers. As shown by segment ca of the labor supply
curve, these workers have reservation wages that exceed the new lower wage W1. Because
the E2En workers voluntarily withdraw from the labor force, they are not officially
unemployed.

Just how flexible downward are nominal wages in the U.S. economy? Although nominal
wages eventually do fall under pressure of slack aggregate demand, they

Another reason that nominal wages are inflexible downward is that firms themselves may
favor temporary selective layoffs to across-the-board temporary wage reduc- tions. The latter
might cause higher-skilled, more experienced workers in whom a
Wage Rigidity

Why are nominal wages relatively inflexible downward? Several diverse explana- tions have
been cited.

1 Unions

Unions are one reason why nominal wages are rigid downward. Unions view wage cuts as
“givebacks” of previous hard-earned collective bargaining gains and thus vig- orously resist
wage reductions. Reductions in nominal wages do occur in unionized industries, but normally
only after severe cutbacks in employment have occurred. Unions appear to prefer layoffs to
temporary wage reductions. The latter affect all workers, whereas layoffs usually affect only
a small percentage of the firm’s workforce and normally involve people with little seniority.
Thus, a majority of workers benefit by a layoff policy as contrasted to wage cuts, and elected
union leaders are likely to be responsive to this majority when negotiating wage and layoff
provisions.

2 Bias toward Layoffs by Firms

irm has invested large amounts of training to quit and take jobs elsewhere. The lay- off
strategy allows the firm to “inventory” or “hoard” this skilled labor and instead lay off
workers who are more easily replaced if they happen to take alternative em- ployment rather
than wait for a callback. Furthermore, the existence of unemploy- ment compensation and the
way it is financed bias the decision toward layoffs. Those laid off experience a net loss of
income that is much less than the full decline in wages; therefore, they will be less likely to
accept other permanent jobs during this period. Also, because the taxes paid by firms to the
unemployment compensation program are not perfectly related to layoff experience, firms
that dismiss substantial numbers of workers are subsidized by the tax payments of other
firms. Stated techni- cally, the unemployment benefits received by workers who are
temporarily unemployed exceed the incremental tax cost to the firms that lay them off.13

3 Implicit Contracts

A closely related reason that wages appear to be inflexible downward during recessions is
that implicit contracts govern many employment relationships. Implicit contracts are
informal, often unstated, understandings that are “invisible handshakes.” 14 One common
feature of many implicit contracts is an understanding that the firm will maintain existing
nominal wages and pay cost-of-living wage increases except under severe economic
conditions, such as impending bankruptcy. In return for this guaran- tee, employers obtain the
right to lay off workers in response to cyclic declines in the demand for their products. By
providing “insurance” against wage declines during re- cessions, employers can attract
workers at a lower average wage. In addition, the “fixed wage–variable employment”
contract provides firms with certainty in the reduction of the wage bill (wage × number of
worker-hours) compared to the uncertainty associ- ated with a wage reduction, which might
cause some highly valued workers to quit. Finally, these contracts may produce positive
“reputation effects” that may allow firms to attract better-quality workers who require less
supervision.

4 Insider–Outsider Theories

Recently a set of so-called insider–outsider theories has emerged that purports to ex- plain
downward wage rigidity on the basis of “insiders” and “outsiders.”15 Insiders are

employed people who have some degree of market power; outsiders are unemployed people
who are unable or unwilling to underbid the existing wage rate to gain employ- ment. In
terms of Figure 18.6(b), outsiders are represented by distance ab at wage W0.

Why are outsiders unable or unwilling to secure jobs for themselves by bidding down the
wage rate to, say, W1 in Figure 18.6(b)? They may be unable to do this because firms may
view the cost of hiring them as being prohibitive. Firms may expect that if they hire outsiders
at less than the existing wage rate, the remaining incumbent workers will withhold
cooperation from those who “stole” jobs. Where workplace cooperation is important in the
production process, the firms’ output and profits will surely suffer. Moreover, even if firms
were willing to hire outsiders, this group may be unwilling to offer their services for less than
the present wage rate for fear of being harassed by remaining incumbent workers.