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In this chapter, you will learn…

7 …about the natural rate of unemployment:

Unemployment and the Labor  what it means
Market  what causes it
 understanding its behavior in the real world

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Natural rate of unemployment A first model of the natural rate

Notation:
 Natural rate of unemployment:
The average rate of unemployment around which L = # of workers in labor force
the economy fluctuates.
E = # of employed workers
 In a recession, the actual unemployment rate rises
above the natural rate. U = # of unemployed
 In a boom, the actual unemployment rate falls below U/L = unemployment rate
the natural rate.

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The transitions between

Assumptions: employment and unemployment
1. L is exogenously fixed. s E
2. During any given month,
s = fraction of employed workers
that become separated from their jobs
Employed Unemployed
s is called the rate of job separations
f = fraction of unemployed workers
that find jobs
f is called the rate of job finding
s and f are exogenous f U

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The steady state condition Example:

 Definition: the labor market is in  Each month,

steady state, or long-run equilibrium,  1% of employed workers lose their jobs
if the unemployment rate is constant. (s = 0.01)
 The steady-state condition is:  19% of unemployed workers find jobs
(f = 0.19)
s E = f U
 Find the natural rate of unemployment:
# of employed
people who # of unemployed
lose or leave people who find
their jobs jobs

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Policy implication
 A policy will reduce the natural rate of
unemployment only if it lowers s or increases f.
CHAPTER 6 Unemployment
Job search & frictional unemployment
 frictional unemployment: caused by the time
it takes workers to search for a job
 occurs even when wages are flexible and there
are enough jobs to go around
 occurs because
 workers have different abilities, preferences
 jobs have different skill requirements
 geographic mobility of workers not instantaneous
 flow of information about vacancies and job
candidates is imperfect
CHAPTER 6 Unemployment
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Why is there unemployment?
 If job finding were instantaneous (f = 1),
then all spells of unemployment would be brief,
and the natural rate would be near zero.
 There are two reasons why f < 1:
1. job search
2. wage rigidity
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Sectoral shifts
 def: Changes in the composition of demand
among industries or regions.
 example: Technological change
more jobs repairing computers,
fewer jobs repairing typewriters
 example: A new international trade agreement
labor demand increases in export sectors,
decreases in import-competing sectors
 Result: frictional unemployment
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Public policy and job search Unemployment insurance (UI)

 UI pays part of a worker’s former wages for a
Govt programs affecting unemployment
limited time after losing his/her job.
 Govt employment agencies:
disseminate info about job openings to better
 UI increases search unemployment,
because it reduces
match workers & jobs.
 Public job training programs:  the opportunity cost of being unemployed
help workers displaced from declining industries  the urgency of finding work
get skills needed for jobs in growing industries. f
 Studies: The longer a worker is eligible for UI,
the longer the duration of the average spell of
unemployment.
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Benefits of UI Why is there unemployment?

 By allowing workers more time to search, The natural rate of unemployment:

UI may lead to better matches between
jobs and workers,
 Two reasons why f < 1:
which would lead to greater productivity and
higher incomes. DONE 1. job search
Next  2. wage rigidity

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Unemployment from real wage Unemployment from real wage

rigidity rigidity
Real Supply
If real wage is wage  The failure of wages to adjust to a level at which
stuck above Unemployment labor supply equals labor demand.
its eq’m level,
then there Rigid
aren’t enough real
jobs to go wage
around.
Demand

Labor
Amount of
Amount of labor
labor hired
willing to work
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Unemployment from real wage

Reasons for wage rigidity
rigidity

If real wage is 1. Minimum wage laws

stuck above Then, firms must ration the
its eq’m level,
scarce jobs among workers. 2. Labor unions
then there
aren’t enough
jobs to go 3. Efficiency wages
around. Structural unemployment:
The unemployment resulting
from real wage rigidity and
job rationing.

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1. The minimum wage 2. Labor unions

 The min. wage may exceed the eq’m wage  Unions exercise monopoly power to secure higher
of unskilled workers, especially teenagers. wages for their members.

 Studies: a 10% increase in min. wage  When the union wage exceeds the eq’m wage,
reduces teen employment by 1-3% unemployment results.

 But, the min. wage cannot explain the
majority of the natural rate of unemployment,
as most workers’ wages are well above
the min. wage.
 Insiders: Employed union workers whose interest
is to keep wages high.
 Outsiders: Unemployed non-union workers who
prefer eq’m wages, so there would be enough jobs
for them.

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Union membership and wage ratios by industry, 2005

# employed U % of wage 3. Efficiency wage theory
industry
(1000s) total ratio
Private sector (total) 105,508 8.5% 122.3  Theories in which higher wages increase worker
Government (total) 20,381 40.5 121.7
productivity by:
Construction 8,053 13.8 156.9  attracting higher quality job applicants
Mining 600 9.5 113.7  increasing worker effort, reducing “shirking”
Manufacturing 15,518 13.7 107.8  reducing turnover, which is costly to firms
Retail trade 14,973 5.8 114.0  improving health of workers
Transportation 4,379 24.4 129.2 (in developing countries)
Finance, insurance 6,304 2.1 90.7
 Firms willingly pay above-equilibrium wages to
Professional services 10,951 3.1 90.6
raise productivity.
Education 3,312 15.4 112.7
Health care 14,045 8 115.1  Result: structural unemployment.
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The duration of U.S. unemployment,

Question for discussion: average over 1/1990-5/2006

amount of time
• Use the material we’ve just covered to # of unemployed these workers spent
# of weeks persons unemployed
come up with a policy or policies
unemployed as % of total as % of total time all
to try to reduce the natural rate of # of unemployed workers spent
unemployment. unemployed
• Note whether your policy targets frictional 1-4 38% 7.2%
or structural unemployment.
5-14 31% 22.3%

15 or more 31% 70.5%

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The duration of unemployment Chapter Summary

 The data: 1. The natural rate of unemployment
 More spells of unemployment are short-term  the long-run average or “steady state” rate of
than medium-term or long-term. unemployment
 Yet, most of the total time spent unemployed  depends on the rates of job separation and job
is attributable to the long-term unemployed. finding
 This long-term unemployment is probably 2. Frictional unemployment
structural and/or due to sectoral shifts among  due to the time it takes to match workers with jobs
vastly different industries.
 may be increased by unemployment insurance
 Knowing this is important because it can help
us craft policies that are more likely to work.
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Chapter Summary

3. Structural unemployment
 results from wage rigidity: the real wage remains
above the equilibrium level
 caused by: minimum wage, unions, efficiency
wages
4. Duration of unemployment
 most spells are short term
 but most weeks of unemployment are attributable
to a small number of long-term unemployed
persons
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