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CHAPTER 6 Unemployment

Questions for Review

1. The rates of job separation and job finding determine the natural rate of unemployment. The rate of
job separation is the fraction of people who lose their job each month. The higher the rate of job
separation, the higher the natural rate of unemployment. The rate of job finding is the fraction of
unemployed people who find a job each month. The higher the rate of job finding, the lower the
natural rate of unemployment.
2. Frictional unemployment is the unemployment caused by the time it takes to match workers and jobs.
Finding an appropriate job takes time because the flow of information about job candidates and job
vacancies is not instantaneous. Because different jobs require different skills and pay different wages,
unemployed workers may not accept the first job offer they receive.
In contrast, structural unemployment is the unemployment resulting from wage rigidity and job
rationing. These workers are unemployed not because they are actively searching for a job that best
suits their skills (as in the case of frictional unemployment), but because at the prevailing real wage
the supply of labour exceeds the demand. If the wage does not adjust to clear the labour market, then
these workers must wait for jobs to become available. Structural unemployment thus arises because
firms fail to reduce wages despite an excess supply of labour.
3. The real wage may remain above the level that equilibrates labour supply and labour demand because
of minimum wage laws, the monopoly power of unions, and efficiency wages.
Minimum-wage laws cause wage rigidity when they prevent wages from falling to equilibrium
levels. Although most workers are paid a wage above the minimum level, for some workers,
especially the unskilled and inexperienced, the minimum wage raises their wage above the
equilibrium level. It therefore reduces the quantity of their labour that firms demand, and an excess
supply of workers—that is, unemployment—results.
The monopoly power of unions causes wage rigidity because the wages of unionized workers are
determined not by the equilibrium of supply and demand but by collective bargaining between union
leaders and firm management. The wage agreement often raises the wage above the equilibrium level
and allows the firm to decide how many workers to employ. These high wages cause firms to hire
fewer workers than at the market-clearing wage, so structural unemployment increases.
Efficiency-wage theories suggest that high wages make workers more productive. The influence
of wages on worker efficiency may explain why firms do not cut wages despite an excess supply of
Chapter 6 1
 labour. Even though a wage reduction decreases the firm’s wage bill, it may also lower worker
productivity and therefore the firm’s profits.
4. Depending on how one looks at the data, most unemployment can appear to be either short term or
long term. Most spells of unemployment are short; that is, most of those who became unemployed
find jobs quickly. On the other hand, most weeks of unemployment are attributable to the small
number of long-term unemployed. By definition, the long-term unemployed do not find jobs quickly,
so they appear on unemployment rolls for many weeks or months.
5. Economists have proposed at least two major hypotheses to explain the increase in the natural rate of
unemployment in the 1970s and 1980s, and the decrease in the natural rate in the 1990s and 2000s.
The first is the changing demographic composition of the labour force. Because of the post–World-
War-II baby boom, the number of young workers rose in the 1970s. Young workers have higher rates
of unemployment, so this demographic shift should tend to increase unemployment. In the 1990s, the

Chapter 6 2
 baby-boom workers aged and the average age of the labour force increased, thus lowering the average
unemployment rate.
The second hypothesis is based on changes in the prevalence of sectoral shifts. The greater the
amount of sectoral reallocation of workers, the greater the rate of job separation and the higher the
level of frictional unemployment. The volatility of oil prices in the 1970s and 1980s is a possible
source of increased sectoral shifts; in the 1990s and early 2000s, oil prices were more stable.
The proposed explanations are plausible, but neither seems conclusive on its own.

Problems and Applications

1. a. In the example that follows, we assume that during the school year you look for a part-time job,
and that on average it takes 2 weeks to find one. We also assume that the typical job lasts 1
semester, or 12 weeks.
b. If it takes 2 weeks to find a job, then the rate of job finding in weeks is:
f = (1 job/2 weeks) = 0.5 jobs/week.
If the job lasts for 12 weeks, then the rate of job separation in weeks is:
s = (1 job/12 weeks) = 0.083 jobs/week.
c. From the text, we know that the formula for the natural rate of unemployment is
(U /L) = (s/ (s + f )) ,
where U is the number of people unemployed and L is the number of people in the labour force.
Plugging in the values for f and s that were calculated in part (b), we find:
(U/L) = (0.083/(0.083 + 0.5)) = 0.14.
Thus, if on average it takes 2 weeks to find a job that lasts 12 weeks, the natural rate of
unemployment for this population of college students seeking part-time employment is 14
percent.
2. To show that the unemployment rate evolves over time to the steady-state rate, let’s begin by defining
how the number of people unemployed changes over time. The change in the number of unemployed
equals the number of people losing jobs (sE) minus the number finding jobs (fU). In equation form,
we can express this as:
U t +1 – U t = U t +1 = sEt – fU t .

Recall from the text that L = Et + U t , or Et = L – U t , where L is the total labour force (we will assume
that L is constant). Substituting for Et in the above equation, we find:
U t +1 = s (L – U t ) – fU t .

Dividing by L, we get an expression for the change in the unemployment rate from t to t + 1:
U t +1 /L = (U t +1 /L) − (U t /L) =  U /Lt +1 = s (1 – U t /L) – fU t /L.

Rearranging terms on the right-hand side of the equation above, we end up with line 1 below. Now
take line 1 below, multiply the right-hand side by (s + f)/(s + f) and rearrange terms to end up with
line 2 below:

Chapter 6 3
  U /L t +1 = s – (s + f ) U t /L
= (s + f ) s/ (s + f ) – U t /L .

The first point to note about this equation is that in steady state, when the unemployment rate equals
its natural rate, the left-hand side of this expression equals zero. This tells us that, as we found in the
n
text, the natural rate of unemployment (U/L) equals s/(s + f). We can now rewrite the above
n

expression, substituting (U/L) for s/(s + f), to get an equation that is easier to interpret:
 U /L t + 1 = (s + f )(U /L) – Ut /L .
n

This expression shows the following:

If U t /L  (U /L) (that is, the unemployment rate is above its natural rate), then  U /L t +1 is negative:
n

the unemployment rate falls.

If U t /L  (U /L) n (that is, the unemployment rate is below its natural rate), then  U /L t +1 is positive:

the unemployment rate rises.

This process continues until the unemployment rate U/L reaches the steady-state rate (U/L)n.
3. Call the number of residents of the dorm who are involved I, the number who are uninvolved U, and
the total number of students T = I + U. In steady state the total number of involved students is
constant. For this to happen we need the number of newly uninvolved students, (0.10)I, to be equal
to the number of students who just became involved, (0.05)U. Following a few substitutions:
(0.05)U = (0.10)I
= (0.10)(T – U),
so

U 0.10
=
T 0.10 + 0.05
2
= .
3

We find that two-thirds of the students are uninvolved.

4. Consider the formula for the natural rate of unemployment,

U s
= .
L s+ f

If the new law lowers the chance of separation s, but has no effect on the rate of job finding f, then
the natural rate of unemployment falls.
For several reasons, however, the new law might tend to reduce f. First, raising the cost of firing
might make firms more careful about hiring workers, since firms have a harder time firing workers
who turn out to be a poor match. Second, if searchers think that the new legislation will lead them to
spend a longer period of time on a particular job, then they might weigh more carefully whether or

Chapter 6 4
 not to take that job. If the reduction in f is large enough, then the new policy may even increase the
natural rate of unemployment.

Chapter 6 5
5. a. The demand for labour is determined by the amount of labour that a profit-maximizing firm wants
to hire at a given real wage. The profit-maximizing condition is that the firm hire labour until the
marginal product of labour equals the real wage,

W
MPL = .
P

The marginal product of labour is found by differentiating the production function with respect
to labour (see Chapter 3 for more discussion),

dY
MPL =
dL
d (K 1/3 L2/3 )
=
dL
2 1/3 −1/3
= K L .
3

In order to solve for labour demand, we set the MPL equal to the real wage and solve for L:

2 1/3 −1/3 W
K L =
3 P
−3
8 W 
L= K .
27 P

Notice that this expression has the intuitively desirable feature that increases in the real wage
reduce the demand for labour.
b. We assume that the 1,000 units of capital and the 1,000 units of labour are supplied inelastically
(i.e., they will work at any price). In this case, we know that all 1,000 units of each will be used
in equilibrium, so we can substitute them into the above labour demand function and solve for
W
.
P

−3
8 W 
1, 000 = 1, 000
27 P
W 2
= .
P 3

In equilibrium, employment will be 1,000, and multiplying this by 2/3 we find that the workers
earn 667 units of output. The total output is given by the production function:

Y = K 1/3 L2/ 3
= 1, 0001/31, 000 2/3
= 1, 000.

Notice that workers get two-thirds of output, which is consistent with what we know about the
Cobb–Douglas production function from Chapter 3.

Chapter 6 6
 c. The congressionally mandated wage of 1 unit of output is above the equilibrium wage of 2/3 units
of output.
d. Firms will use their labour demand function to decide how many workers to hire at the given real
wage of 1 and capital stock of 1,000:

8
L= 1, 000(1) −3
27
= 296,

so, 296 workers will be hired for a total compensation of 296 units of output. To find the new
level of output, plug the new value for labour and the value for capital into the production function
and you will find Y = 444.
e. The policy redistributes output from the 704 workers who become involuntarily unemployed to
the 296 workers who get paid more than before. The lucky workers benefit less than the losers
lose as the total compensation to the working class falls from 667 to 296 units of output.
f. This problem does focus the analysis of minimum-wage laws on the two effects of these laws:
they raise the wage for some workers while downward-sloping labour demand reduces the total
number of jobs. Note, however, that if labour demand is less elastic than in this example, then the
loss of employment may be smaller, and the change in worker income might be positive.
6. a. The labour demand curve is given by the marginal product of labour schedule faced by firms. If
a country experiences a reduction in productivity, then the labour demand curve shifts to the left
as in Figure 6–1. If labour becomes less productive, then at any given real wage, firms demand
less labour.

b. If the labour market is always in equilibrium, then, assuming a fixed labour supply, an

Chapter 6 7
 adverse productivity shock causes a decrease in the real wage but has no effect on employment
or unemployment, as in Figure 6–2.

c. If unions constrain real wages to remain unaltered, then as illustrated in Figure 6–3,
employment falls to L1 and unemployment equals L − L1 .

Chapter 6 8
 This example shows that the effect of a productivity shock on an economy depends on the
role of unions and the response of collective bargaining to such a change.
7. Real wages have risen over time in both the United States and Europe, increasing the reward for
working (the substitution effect) but also making people richer, so they want to “buy” more leisure
(the income effect). If the income effect dominates, then people want to work less as real wages go
up. This could explain the European experience, in which hours worked per employed person have
fallen over time. If the income and substitution effects approximately cancel, then this could explain
the U.S. experience, in which hours worked per person have stayed about constant. Economists do
not have good theories for why tastes might differ, so they disagree on whether it is reasonable to
think that Europeans have a larger income effect than do Americans.
8. The vacant office space problem is similar to the unemployment problem; we can apply the same
concepts we used in analyzing unemployed labour to analyze why vacant office space exists. There
is a rate of office separation: firms that occupy offices leave, either to move to different offices or
because they go out of business. There is a rate of office finding: firms that need office space (either
to start up or expand) find empty offices. It takes time to match firms with available space. Different
types of firms require spaces with different attributes depending on what their specific needs are.
Also, because demand for different goods fluctuates, there are “sectoral shifts”—changes in the
composition of demand among industries and regions—that affect the profitability and office needs
of different firms.

Chapter 6 9
More Problems and Applications

1 The Employment Insurance (EI) program was created to provide temporary financial assistance to
workers who lost their jobs or who are upgrading their skills. As of January 2017, an eligible
worker can receive up to 55 percent of his or her former wage up to a maximum of $543 per week.
Workers are eligible to receive EI for a period ranging from 14 weeks up to a maximum of 45
weeks. The region where the workers lives and the amount of contribution the worker made to EI
determine the amount and length he or she is entitled for. The EI program allows workers to
transition out of the labour force and back in the labour force while reducing the pain and hardship
usually associated with loss of revenue. Moreover, the EI program allows workers to take more
time to find the best possible job and in doing so, the program encourages a better matching
between workers and jobs.

However, the program is not without drawbacks and may have an adverse effect on the
unemployment rate and on the natural rate of unemployment. Workers that receive EI benefits may
have less incentives to search actively and rapidly for a job and may even turn down unattractive
job offers. This type of behaviour would increase the frictional unemployment rate and the rate of
job finding. In the model in Section 6.1, this would amount to a decrease in the parameter f, the
rate of job finding. EI has also an effect on the rate of job separation. Since workers know that
they can receive financial assistance through EI if they lose their job, they may have less incentives
to search for jobs with stable employment prospects and may attach less importance to job security.
As a result, the job separation rate may be higher because of the EI program.

A higher job separation rate and a lower job finding rate lead to a higher unemployment rate and
a higher natural rate of unemployment. Because the EI program has a negative effect on both the
rate of job separation and the rate of job finding, countries with very generous EI programs such
as Canada in the 1980s tend to have high unemployment rates.

2 Investment in education tend to increase the skills of workers. Consider the effect of a new
education program that increases the productivity of already skilled workers only and not unskilled
workers. This can also happen through changes in technology that favour skilled workers at the
expense of unskilled workers. If this is the case, the demand for skilled workers will increase
relative to the demand for unskilled workers. As a result, the wage of skilled workers will increase
relative to unskilled workers leading to higher wage inequality between these two types of workers.
If the demand for skilled workers increase, this may lead to a fall in the unemployment rate for
skilled workers but not necessarily to a fall in the overall unemployment rate. For example, if the
wage of unskilled workers fall because demand for unskilled workers fall, more unskilled workers
may view the Employment Insurance program as a viable alternative. As a result, the rate of job
finding falls and the rate of job separation increases for unskilled labour. This unambiguously leads
to an increase in the unemployment rate for unskilled workers. Whether the overall unemployment
increases or not will depend among other factors on the relative strength of these two forces, the
proportion of skilled to unskilled workers, how fast wages adjust and on the generosity of the
Employment Insurance program.

Chapter 6 10
 If the investment in education is instead focused on unskilled workers, then we may see an increase
in the productivity of unskilled workers. This increase in productivity will result in higher wages
for unskilled workers. Assuming that the wages of skilled workers do not change, this results in a
reduction in the wage inequality between the two workers. Moreover, with an increase in wages,
unskilled workers will have less incentives to quit their job as the alternative of EI is now less
desirable. This leads to a fall in the rate of job separation. In addition, unskilled workers who are
unemployed now have more incentives to find a higher paying job and leave the EI program. As a
result, the rate of job finding increases. Overall, the rate of unemployment for the unskilled workers
as well as the overall unemployment rate will decrease.

3 Antiglobalization protesters are mostly concerned about income inequality, that is the growing income
gap between owners of capital and labour. They want the government to address this issue of growing
income inequality and want income to be redistributed from owners of capital to labour. Essentially,
they want governments around the world to tax capital and take the proceeds of the tax and
redistribute it to labour. However, if capital can be taxed, owners of capital can move their capital
from a high tax jurisdiction to a low tax jurisdiction. The protesters argue that this can be prevented
if governments around the world restrict the movement of capital. However, the solution is not that
simple and can lead to unintended consequences on labour income.

The problem with that argument is that by limiting the movement of capital, this will reduce
globalization, trade volumes and as shown in the appendix, the overall production of goods and
services. Essentially what happens is that the imposition of a tax on capital pushes the owners of
capital to demand a higher pretax rate of return to compensate for the tax. If the pretax rate of return
does not increase enough to compensate the owners of capital, then the latter will transfer his or her
capital to another jurisdiction with a lower tax rate. It is not farfetched to assume that some capital
will leave the country once a tax is imposed. With the fall in the amount of capital and hence capital
per worker, the owners of capital are as well off as before since they can make up for the loss in
return elsewhere. However, workers are worse off as GDP falls and the share of the pie that goes to
the workers fall. Clearly, in this case, workers do not help their cause by demanding a tax on capital.
Owners of capital can always shift their capital from one jurisdiction to another leaving them
unaffected but leaving workers worse off.

However, if the tax on capital is accompanied by a cut in payroll tax, it is shown in the appendix that
this leads to an increase in GDP. The share that goes to workers increase and labourers in this case
can be better off. The payroll tax leads to a fall in the unemployment rate and to an increase in the
productivity of capital since capital now has more labour to work with. Although owners of capital
are better off in this scenario, workers are also better off since the level of GDP and hence the size
of the pie that is distributed between owners of capital and labour increases.

Chapter 6 11