CHAPTER 7

Unemployment and the Labor

Market
Pakistan's Labour Force Participation Rate = 52.6 %
 Pakistan's Labour Force Participation
Rate = 52.6 %
 Types of Unemployment
• Involuntary Unemployment
• Voluntary Unemployment
• Frictional Unemployment
• Structural Unemployment
• Cyclical Unemployment 
• Seasonal Unemployment
• Disguised Unemployment
Involuntary unemployment
• Involuntary unemployment
means a situation in which
all the able persons who are
willing to work at prevailing
wage rate do not get
job/work

•Such People are physically and mentally

fit to work and also willing to work at the
going wage rate but cant find job
• Hence, they are unemployed against their
wishes.
Structural unemployment
• Structural unemployment occurs when
there is the long-term changes
happened in the patterns of production
and demand within an economy .

• This kind of unemployment takes place when there is numerous

transform in technology and consumer demand in the economy. For
example, when computers were initiate many workers were displacing
because of a divergence between the accessible skills of the workers
and the obligation of the job.
• Though jobs were accessible, there was a demand for a new category
of ability and qualification. So, persons having old skills are not able to
get employment and job opportunity in the distorted economic
domination and stay unemployed. This is known a structural
unemployment.
 For example the current global slowdown, due to
coronavirus, many workers in the region of the globe
lost their jobs.
Seasonal unemployment

slide 12
 Underemployment
• Underemployed workers have jobs, but they
aren't working to their full capacity or skill
level.
• This includes those who are working part-time
but would prefer full-time jobs.
• It also includes those who are working in jobs
where they aren't being utilized.
 In the up coming slides, you will
learn…
…about the natural rate of unemployment:
•what it means
•what causes it
•understanding its behavior in the real world
 Natural Rate of Unemployment

• Natural rate of
unemployment consists of two main
types of unemployment: frictional and
structural.
• The average rate of unemployment around which the
economy fluctuates.
• In a recession, the unemployment rate rises above the
natural rate.
• In a boom, the unemployment rate falls below the
natural rate.
• A healthy economy will have a natural unemployment
rate of 4.5%-5%. slide 16
 Actual and natural rates of unemployment in the U.S.,
1960-2006
12
P Unemployment rate
er 10
ce
nt 8
of
la 6
bo
r 4 Natural rate of
fo
rc
2 unemployment
e
0
1960 1965 1970 1975 1980 1985 1990 1995
2000
Unemployment
2005
 A first model of the natural rate

Notation:
L = # of workers in labor force
E = # of employed workers
U = # of unemployed
U/L = unemployment rate

Unemployment CHAPTER 6 slide 18

• Solving For U/L
• (F*U)=S*L-S*U
• (F*U)+S*U=S*L
• F(U)+S(U)=S*L
• (F+S) U=S*L
 Policy implication for reduction
of unemployment

A policy will reduce the natural rate of

unemployment only if it lowers s or
increases f.

Where
s is called the rate of job separations
f is called the rate of job finding

Unemployment
 Why is there unemployment?

If job finding were instantaneous (f = 1),

then all spells of unemployment would be
short, and the natural rate would be near
zero.
There are two reasons why f < 1:
1. job search
2. wage rigidity
(f is called the rate of job finding)

Unemployment
Job search

Frictional Unemployment: Caused by the time it

takes workers to search for a job
• It 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

Unemployment
 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: Structural unemployment

Unemployment
Industry shares in U.S. GDP, 1960-2000
Structural change over the long run
Agriculture
Manufacturing
1960 Other industry 2000
Services
57.9% 73.5%

4.2%
1.6%

9.9% 17.2%
28.0% 7.7%

Unemployment
 More examples of sectoral shifts

 Late 1800s: decline of agriculture, increase in

manufacturing
 Late 1900s: relative decline of manufacturing,
increase in service sector

In our dynamic economy, smaller sectoral shifts

occur frequently, contributing to frictional
unemployment.

Unemployment
 Public policy and job search

Reduction in natural rate of unemployment by

reducing fractional unemployment and it can be
possible if
Govt programs affecting unemployment
Govt employment agencies:
disseminate info about job openings to better
match workers & jobs.
Public job training programs:
help workers displaced from declining industries
get skills needed for jobs in growing industries.
Unemployment
Continue ………. Unemployment insurance

• Unemployment insurance pays part of a worker’s former wages for a

limited time after losing his/her job.
• But govt unemployment insurance increases the amount of fractional
unemployment because unemployment insurance benefits are less
pressed to search job and second likely to turn down unattractive job
offers
• In addition because of insurance they less likely to seek jobs with
stable employment prospects and are less likely to bargain for
guarantees of job security.
• Studies: The longer a worker is eligible for Unemployment
insurance , the longer the duration of the average spell of
unemployment
• Thus these behavioral changes raise the rate of job separation or job
finding
 Benefits of Unemployment
Insurance (UI)
By allowing workers more time to search, UI
may lead to better matches between jobs
and workers,
which would lead to greater productivity and
higher incomes.

Unemployment
 Why is there unemployment?

The natural rate of unemployment:

Two reasons why f < 1:

DONE
1. job search
Next  2. wage rigidity

Unemployment
Wage Rigidity
• Second cause for unemployment is wage rigidity i.e the failure of
wages to adjust to a level at which labour demand equal labour
Supply.
• When the real wage above the level equilibrium level, then supply of
labour exceeds demand for labour

• Then Firms in some way ration the scare jobs among the workers
• The unemployment resulting from wage rigidity and job rationing is
also called structural unemployment.

• Firms fail to reduce wage despit increase in labour supply and the
main reasons are :manimum wage laws, labour unions and efficiency
wages.
 Unemployment FromReal Wage Rigidity
Real Supply
If real wage is wage
stuck above
its eq’m level,
then there Rigid
aren’t enough
real
jobs to go
wage
around.
nd

Lab
Amount of or
Amount of labor
labor
willing to work
hired
Unemployment
 Unemployment From Real Wage Rigidity

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

Unemployment
 Reasons for wage rigidity

1. Minimum wage laws

2. Labor unions

3. Efficiency wages

Unemployment
Minimum Wage Laws
• Minimum Wage laws set a legal minimum on wage that firms pay
their employees
• Minimum Wage is the wage level (set by Government, either after
consultation with the social partners i.e. worker organizations and
employer associations or unilaterally) below which it is illegal for the
employer to pay his/her employees.
• In Pakistan minimum wages for semi-skilled, skilled and highly skilled
workers are determined by the minimum wage boards constituted
under minimum wage ordance 1961
• Minimum wage ordainance 1961 requires the provincial govts to
establish a minimum wage board that will recommened minimum
wage
 Minimum wages
• In the 2019-20 budget, the federal government and the provincial
governments of Khyber Pakhtunkhwa and Balochistan have raised
the minimum wage for unskilled workers from Rs 15,000 to Rs 17,500
a month.
• The government of Sindh has raised the minimum wage from Rs
16,200 to Rs 17,000 a month

• Economist believe that minimum wage has greatest impact on the

teenage unemployed because teenagers equilibrium wages tend to
be low for two reasons
• 1) first, teenagers are among the least skilled and least experienced
members of the labor force they tend to have low marginal
productivity
• 2) second teenagers are some time compensated in the form of on
job training rather direct pay (internship is an example of training in
place of wages)
Continue…..
• In contract many economists studied the impact of minimum wage on
the teenage employment and found that 10 % increase in minimum
wage reduces teenage employment by 1 to 3 %

• Moreover advocates of a higher minimum wage view it a way to raise

the income of the working poor and also raise people out of poverty.
While the opponents of higher wage consider it not the best way to
help the working poor because it not only increase the labor cost that
leads to unemployment but also the minimum wage is poorly targeted
or used i. e many teenagers of the middle class homes use the salary/
wage for personal use such as vacations, nonessential goods instead
supporting families
• Many economist and policy makers believe the tax credit (tax rebate,
tax incentive ) are a better way to increase the income of the working
poor. Unlike the minimum wage, the earned income tax credit does
not raise labor cost to firms and therefore does not reduce the quality
of labor that firm demand . Its has the only disadvantage of reducing
govt tax revenue.
Labor Unions
• Unions exercise monopoly power to secure higher wages for their
members.
• Wages of workers are determined on the base bargaining between union
leaders and firms managers instead of equilibrium of demand and supply
• Results: High wages above equilibrium leads to reduction of workers and
lower rate of job findings and increase in structural unemployment.
• When the union wage exceeds the equilibrium wage rate,
unemployment results.
• 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.
• Conflicts between insiders and outsiders resolved differently in different
countries..in US wage bargaining take place at the level of farm…in
Sweden at nation level including both insiders and outsiders
Efficiency Wage Theories
• Efficiency-wage theories propose a third cause of
wage rigidity in addition to minimum wage laws and
labor unions.
• The impact of wages on worker efficiency.
• High wages make workers more productive
• There are many theories about wages and
productivity proposed by economists
• Wages influence nutrition
• High Wages reduce labor turnover
• Average quality of a firms workforce depends on
the wage rate
• High wage improves worker effort
Wages influence Nutrition
• The theory is applied mostly in developing/
poor countries
• According to this theory healthier worker is
more productive and better paid workers can
afford a more nutritious diet.
• Thus to maintain healthy workforce a firm has
to pay wages above equilibrium level.
• This theory is not applicable in rich countries
like UK, USA and Europe because wage rate is
above necessary level to maintain good health.
 High Wages Reduce Labor Turnover
• This theory is relevant to developed countries
• The theory tells about the effects of employee resignations on firm
productivity.
• Workers quit jobs for many reasons such as
Accept better positions offered by other firms
Change Careers
Low Salary
Move to other part of the country
• Firm can reduce the frequency at which its workers quit jobs and also
decrease the time and money spent on hiring and training new worker
by paying high wages

slide 42
Average Quality of a Firms Workforce Depends on
the Wage Rate
• The higher the wages the better the quality of
workforce a firm gets
• If a firm reduces wages, best employees leave the firm
and search for better salary job while only the inferior
employees remain with firm that have less alternative
opportunities.
• The firms by paying more or above the equilibrium
level, not only qualified people are selected but also
reduces the chances of adverse selection and improve
the average quality of its workforce and thereby
increase productivity
High Wage Improves Worker Effort
• According to the theory firms cannot perfectly monitor their
employees work effort and that the employees must
themselves decide how to work hard and efficiently.
• Economist recognize monitoring of employees as an
example of moral hazard which means tendency of people
to behave inappropriately when their behavior is monitored
and as a result they work less efficiently.
• Secondly when workers are paid less wages they try to shirk
and as a result they get caught and fired.
• Thus a firm can reduce the moral hazard and increase the
efficiency of their employees by paying a high wage because
by paying higher wage firm induces more of its employees
not to shrink and thus increase their productivity.
slide 44
Continue…
• All the four efficiency wage theories differ in
detail but share a common theme.
• A firm operates more efficiently if it pays its
workers a high wage, the firm may find it
profitable to keep wages above the level that
balance supply and demand
• As a result the lower level of job switching
and high unemployment.
Duration of Unemployment
• Short and long run unemployment
• Depends on reasons of unemployment and appropriate policy in
response
• Short Run is mainly due frictional unemployment that is
• Unemployed workers need time to search such jobs that suit their
skills and taste
• Long run is more due to structural unemployment that is
• Mismatch between the number of jobs available and the number of
people who want to work

• Policies for reducing unemployment depend on the reason of

unemployment. If the aim is to substantially lower natural rate of
unemployment, then govt should develop long term unemployed
policies.

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