UNIT 13 NOMINAL AND REAL RIGIDITIES

Structure
13.0 Objectives
13.1 Introduction
13.2 New Classical School versus New Keynesian School
13.3 Nominal Rigidities versus Real Rigidities
13.4 Nominal Rigidities and Menu Costs
13.4.1 Menu Costs
13.4.2 Mankiw Model of Nominal Rigidities
13.5 Real Rigidities
13.5.1 Real Rigidities in the Goods Market
13.5.2 Real Rigidities in the Credit Market
13.5.3 Real Rigidities in the Labour Market
13.6 New-Keynesian Theories of Wage Rigidity
13.7 Efficiency-Wage Theories
13.8 Efficiency-Wage Model: An Example
13.8.1 Specification of the Model
13.8.2 Solution of the Model
13.8.3 Implications of the Model Solution
13.8.4 Possible Extensions of the Model
13.9 Contracting and Insider-Outsider Models
13.10 Let Us Sum Up
13.11 Answers/ Hints to Check Your Progress Exercises

13.0 OBJECTIVES
After going through this unit you should be in a position to

 explain why prices need not be flexible in the real world;

 distinguish between nominal and real rigidities;

 identify the different kinds of rigidities in the real world;

 explain why real wage rigidity and unemployment can emerge because of
contracting; and

 explain the unemployment situation in an economy through the insider-

outsider model.


Prof. Avadhoot Nadkarni (retd.), University of Mumbai
Labour Markets
13.1 INTRODUCTION
The classical theory of the macro economy assumes that the economy is perfectly
competitive and that wages and prices are perfectly flexible. It is this
characteristic of perfect flexibility of wages and prices that enables the classical
economists to conclude that the perfectly competitive economy will always be at
full employment irrespective of aggregate demand conditions. According to the
classical and, subsequently, the new classical schools, when aggregate demand
goes up it is the aggregate price level that increases because the economy is at
full employment and the aggregate output cannot increase. On the other hand,
when demand falls at the full employment level of output, wages and prices fall
in the goods and the labour markets, respectively. The aggregate price level falls
and the employment of labour is not affected.
The Keynesians, on the other hand, postulate rigidity of wages and/or prices.
Suppose the economy is at full employment and aggregate demand goes down.
The adjustment in the economy happens not through a downward adjustment of
wages/ prices, but through a fall in employment and output. It is this different
response of the economy to changes in aggregate demand that leads to different
conclusions that the Classical and the Keynesian economists reach about the
possibility of the existence of persistent unemployment in the economy. The
flexibility versus rigidity of prices and wages hence becomes an important
theoretical issue in determining whether an economy can exhibit persistent
unemployment. In practice, since prices will neither be fully rigid nor perfectly
flexible, the issue reduces to the rate of adjustment of wages and prices to
changes in aggregate demand.
This basic difference between the classical and the Keynesian economists
continues to exist between the New Classicals and the New Keynesians. In this
unit we study how the New Keynesians rationalise the rigidity of prices and
wages in a modern economy and how they thereby conclude that an economy
will be subjected to booms and busts. We begin by understanding certain
important differences between the New Classical and the New Keynesian
Schools.

13.2 NEW CLASSICAL SCHOOL VERSUS NEW

KEYNESIAN SCHOOL
We know that Keynesian economics was propounded as a revolution against the
then prevailing orthodoxy of the Classical School. In time, however, the
Keynesians themselves established orthodoxy. The Keynesians were helped in
establishing their own orthodoxy, initially through the Neo-Classical synthesis of
the Classical and Keynesian schools involving the IS-LM model, and then
through the AS-AD model. You have studied these models in Block 1. This latter
synthesis through the AS-AD curves produced a model that had Keynesian
properties in the short-run and classical properties in the long run. As aggregate
demand falls, the downward rigidities of prices and wages produces
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unemployment in the short-run, but full employment is restored in the long run as Nominal and Real
Rigidities
prices and wages adjust slowly. The Keynesian revolution was appropriated
within the mainstream through the AS-AD model.
The ideas of rational expectations (see Unit 7) and real business cycles (see Unit
12) that came up in the 1970s developed into the New Classical School. This
School was a revolution against the Keynesian orthodoxy that had by now
established itself. It propounded wage-price flexibility in a perfectly competitive
setting of optimising individuals so that there was no basis for the existence of
Keynesian unemployment even in the short run.
The New Classical ideas, though theoretically elegant and intellectually
appealing, flew in the face of empirical realities in a world characterised by
periodic booms and busts. The Keynesian ideas, on the other hand, attempted to
explain the real world, but did not rely on the tools of mainstream economics like
optimisation in the context of individuals who form expectations rationally. We
can say that the microeconomic foundations underlying the Keynesian
macroeconomics were weak.
Thus, a question could be asked to the Keynesians: Why would rational firms not
increase product prices when money supply is known to have increased, since
economic theory predicts that prices would ultimately increase as a consequence
of increase in money supply and rationally formed expectations require the
individuals to increase prices? It suffices to say, for now, that the New Keynesian
School emerged in the 1980s as a counter-revolution against the New Classical
ideas of the 1970s. The New Keynesians attempted to construct models that were
empirically well grounded in the sense that they made more realistic assumptions
about the macroeconomic world. Moreover, these models were theoretically
elegant in that they explained through models of rational optimising individuals
why firms would not increase prices in the face of increased money supply.
Upward rigidity in prices would prevail in spite of the fact that not increasing
prices could, apparently at least, lead to a fall in profits.
You should note two characteristics of the New Keynesian School at this point.
The first makes it very different and the second not so different, from the New
Classicals:
(i) Imperfect Competition: New Classicals assume that firms do not change
prices if they so wish, i.e., they have the power to set prices. Unlike in the New
Classical world, the New Keynesian firms are operating in markets with some
degree of monopoly power. That is an important difference between the two
schools: the New Classicals assume perfect competition and the New Keynesians
work in the context of imperfectly competitive markets. We also had this in mind
when we said that the New Keynesian models are empirically well grounded.
(ii) Analytical Tools: When it comes to the use of analytical tools, the New
Keynesians are no different from the New Classicals. They build models to show
why optimising, rational individuals do hold prices fixed when macroeconomic

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Labour Markets conditions demand that prices be changed. In setting up their counter-revolution,
the New Keynesians meet the New Classicals on their home grounds, using the
same tools of optimising behaviour of individuals in their models. You must
note, in this context, that though we have associated the rational expectations
revolution (along with the real business cycle theory) with the New Classical
School, there is nothing intrinsic about rationally-formed expectations that make
them any closer to the New Classical way of doing things than to the New
Keynesian. The New Keynesian models can as much be propelled by individuals
who are not only rational in the sense that they optimise, but also in the sense that
they form expectations rationally.

13.3 NOMINAL RIGIDITIES VERSUS REAL

RIGIDITIES
Before we proceed further we must make an important distinction – that between
nominal and real rigidities. In Section 13.2 above, we have been referring to
nominal rigidities. Nominal rigidities are said to exist when nominal prices and
wages do not change in the face of conditions that call for their change. As you
have seen in earlier units, this will lead to Keynesian unemployment. But
unemployment can also come about because of certain real rigidities in the
economy. Such rigidities can exist in the goods market, the labour market or even
the market for credit.
There could be reasons why the real wage paid in the labour market is higher
than the market-clearing wage. This will, of course, lead to unemployment of
some of those who are willing to work at a lower (market-clearing) wage. We are
not talking here about the nominal wage not changing when it needs to change,
but about firms rationally and voluntarily deciding to pay higher real wages to
their workforce because they find it to their advantage in some way. We will
explain this concept of real rigidities better when we list out all such rigidities in
Section 13.5 and the sub-sections therein.
The New Keynesian economists stress both the nominal and real rigidities to
explain the presence of booms and bust/ persistent unemployment in the real
world. We explain nominal rigidities further in Section 13.4 and then consider
real rigidities in greater detail in Section 13.5.
Check Your Progress 1
1. Why is the distinction between flexibility and rigidity of prices important in
macroeconomic theory?
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 2. Based on your answer to Question 1 above, bring out a few points of Nominal and Real
Rigidities
distinction between the New Classicals and the New Keynesians.
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3. Distinguish between nominal and real rigidities.
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13.4 NOMINAL RIGIDITIES AND MENU COSTS

In this section we examine a simplified New Keynesian model to understand why
rational profit-maximising firms would not want to change prices in the face of
macroeconomic conditions that call for such a change, a rise in money supply.
For example, a firm would not increase prices in the event of a rise in money
supply.
These kinds of models owe their existence to the work of the likes of N. Gregory
Mankiw (“Small Menu Costs and Large Business Cycles: A Macroeconomic
Model of Monopoly”, Quarterly Journal of Economics, May 1985); and George
A. Akerlof and Janet L. Yellen (“A Near Rational Model of the Business Cycle,
With Wage and Price Inertia”, Quarterly Journal of Economics, Supplement,
1985). As indicated above, these papers use the analytical tools of the New
Classicals to arrive at Keynesian conclusions. As the title of Mankiw’s paper
indicates, an important concept in understanding the nominal price rigidity is the
concept of ‘menu costs’. We examine the concept, briefly, before we explain the
model proper.
13.4.1 Menu Costs
Why do firms not change their prices very frequently? Obviously, the costs of
changing prices at frequent intervals and in small amounts must be more than the
benefits obtained from such a change. Firms prefer to wait before they make
price changes in relatively large amounts and in the mean time absorb the losses
that they would suffer by not changing prices. This of course presumes that the
firms have some monopolistic price setting power and the losses referred to
above include lower profits than would have been possible if prices had been
raised, and not necessarily actual out-of-pocket losses.
It is easy to understand this behaviour of monopolistically competitive firms
through the example of restaurants competing with each other. The term ‘menu
costs’ immediately becomes meaningful as the costs that would be incurred in
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Labour Markets changing the menu cards every time there is a change in the prices of items on
the menu. These printing costs are surely negligible, but the more important costs
are in terms of the loss of customers that a firm would face if it subjects its
clientele to the ‘irritability’ of continuous, small changes in prices.
The concept of menu costs in a modern economy is indeed broad. It is also
widely applicable, given the proliferation of automatic dispensers (e.g., coffee
machines) and pay telephones that operate on coins. It is easy to imagine the cost
that would be incurred by the suppliers if these ubiquitous machines were to be
adjusted every time a price change is effected. The firms would rather not change
their prices. It is this idea of weighing the costs of changing prices against the
benefits obtained from changing prices that is formalised in the Mankiw model
that we consider below.
13.4.2 Mankiw Model of Nominal Rigidities
There are two related reasons for which firms do not frequently change prices.
First, as we saw in the discussion on menu costs, the costs of price changes are
not negligible and could exceed the private benefits that can be obtained by the
firms in the form of increased profits. More importantly, however, the benefits to
be reckoned from price changes are not so much in the private realm, but in the
social realm. Price rigidity leads to unemployment, the social costs of which are
much higher than the private costs reckoned by the firms in terms of menu costs.
The microeconomics-based models by Mankiw, and Akerlof and Yellen show
that the private benefits of changing a price can be much smaller than the social
benefits if there is substantial monopoly power in the economy.
We follow Dornbusch, Fischer and Startz (2012) in presenting a simplified
version of the formal Mankiw model. The model relies on the fact that in
monopolistic markets firms face a downward-sloping (less than infinitely elastic)
demand curve and can set a price that deviates from the optimum profit-
maximising price without a large swing in demand away from the firm. This is
not possible in a perfectly competitive market, where every firm faces a
horizontal (infinitely elastic) demand curve – a small deviation from the optimal
price can in this situation lead to a large swing demand and profits away from the
firm. Even if a competitive firm faces the same kind of menu costs as an
imperfectly competitive firm, the loss of profits by not changing the price can be
big enough to outweigh the menu costs. A competitive firm is not, of course, a
price setter.
Not so for the imperfectly competitive firm. Mankiw showed that the potential
profits from raising prices could be very small for such firms especially if the
elasticity of demand for firm’s output is low, i.e., if monopoly power of the firm
is high, and if the deviation of the actual price from the optimal profit-
maximising price is small. The menu cost could well be higher than the potential
profits in such a case and the firm does not change its price. Other firms are
likely to be similar and they too leave their prices unchanged, with the result that
the nominal price level remains unchanged.
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The Keynesian conclusion of an increase in money supply on output rather than Nominal and Real
Rigidities
on prices follows from this. An increase in money supply, prices remaining
unchanged, leads to an increase in real money supply. This leads to an increase in
aggregate output, either through a decrease in the rate of interest (à la Keynes) or
through a real-balance effect. You should note that there would have been no
output effects in a classical model if prices were free to vary. An important
difference between the Classicals and the Keynesians is hereby established.
As Dornbusch, Fischer and Startz (2012) put it about the papers of Mankiw, and
Akerlof and Yellen:
This work provides a rigorous microeconomic justification for nominal price
stickiness. Since New Classical economists attack the rigor of the underpinnings
of Keynesian models, such justification is a key piece of Keynesian response to
rational expectations and real business cycle models. Not everyone agrees on the
empirical significance of the formulation by Mankiw and by Akerlof and Yellen,
but the work is certainly a mile stone in the New Keynesian counterrevolution.

13.5 REAL RIGIDITIES

As we brought out in Section 13.3, the New Keynesian economists rely both on
nominal and real rigidities to arrive at their conclusion that nominal changes in
money supply have real, and not merely nominal, effects on the economy. As we
indicated in Section 13.4, an increase in money supply can lead to a rise in the
aggregate output and not in the price level. The flip side of this is, of course, that
a fall in the money supply can lead to a fall in output and an increase in
unemployment.
There is, however, a view that introducing price-setting in imperfectly
competitive markets and menu costs into an economy is however not enough to
generate substantial nominal rigidity at the micro level. Further, as per this view,
menu costs can have important macroeconomic effects only in the presence of
real instead of nominal, rigidities. This is so because it can be shown that for
realistic values of elasticity of labour supply and elasticity of output demand,
price-setting firms have strong incentives to change price when aggregate
demand changes even by incurring menu costs required for changing nominal
prices. Thus if the elasticity of demand for a firm’s output is high, say 5, and the
elasticity of labour supply is low, say 0.1, then Romer (2001) shows that, for a 3
per cent fall in output, the increase in profits by changing the price is about one-
fourth of the revenue. This suggests that firms will be ready to bear even up to
one-fourth of the revenue as menu costs needed for changing the prices, if the
elasticity of output demand is high and the elasticity of labour supply is low. If
these elasticity values are realistic, then the existence of menu costs for changing
prices cannot be used as a rationale for nominal price rigidity and consequent
unemployment. Some other factors have to be invoked to explain the constancy
of nominal prices, in the face of, e.g., changes in money supply. The other factors
that have been invoked have to do with the characteristics of the goods, labour

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Labour Markets and credit markets. These markets differ in important ways from the competitive
model. In particular, the goods and labour markets appear to be such that shifts in
demand translate into a smaller variation in prices and a larger variation in
quantities than would be predicted in a competitive set-up. In the goods market,
for example, shifts in demand for goods, in an imperfectly competitive set-up, are
not accompanied by changes in mark-ups but by changes in output. Again, in the
labour market, shifts in the demand for labour lead to large changes in
employment and small changes in real wages. Here we are referring the rigidity
in real prices in relation to quantities. Such rigidities occurring because of
specific characteristics of the goods, labour and credit markets are referred to as
real rigidities.
13.5.1 Real Rigidities in the Goods Market
The most important factor associated with real rigidity in the goods market is the
existence of imperfect competition. Imperfect competition enables producers to
be price-setters and generates rigidity in real prices in relation to quantities.
Under imperfect competition price is set, not equal to marginal cost, but as a
mark-up over cost. The mark-up covers fixed costs of production including
profits. One of the important propositions of the New Keynesian economics is
that the mark-up behaves in a countercyclical fashion, i.e., it decreases during
booms and increases over the downward phase of a business cycle. It is these
countercyclical movements of the mark-up that produce rigidity in prices of
goods. An increase in aggregate demand translates, not into an increase in prices,
but into an increase in quantities of goods produced, and thereby of employment.
Why do mark-ups behave in a countercyclical manner? Several reasons have
been postulated:
(i) Higher level of economic activity during booms reduces the importance
of costs of acquiring and disseminating information and thus makes
markets more competitive. This has been referred to in the literature as
“thick-market” effects.
(ii) It has been suggested that increased profits created by greater economic
activity make it difficult for oligopolists to maintain collusion –
incentives are generated to break away from oligopolistic structures. This
puts downward pressures on mark-ups.
(iii) It has also been suggested that mark-up is countercyclical because
marginal costs are pro-cyclical. Marginal costs are considered to be pro-
cyclical because overtime paid to workers is highly pro-cyclical and
hence expensive to firms. This, however, begs the question about why
prices are rigid in the goods market. The argument here seems to be that,
because prices are rigid, the mark-up is compressed as marginal costs rise.
We have been attempting to explain the rigidity of prices by postulating
that mark-ups fall over booms in spite of costs rising (and not because of
increase in costs) for reasons independent of the rise in costs.
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 Nominal and Real
Rigidities
When price rigidities exist in imperfectly competitive goods markets, the impact
of increase (decrease) in aggregate demand is borne by quantities leading to an
increase (decrease) in aggregate output and employment.
13.5.2 Real Rigidities in the Credit Market
You have seen in Sub-Section 13.5.1 how imperfections in the goods markets
enable firms to set prices so as to generate price rigidities, e.g., because of
countercyclical mark-ups used in setting the prices oligopolistically. You know
that such price rigidities have macroeconomic consequences, e.g., changes in
aggregate demand influence output and employment rather than prices.
Imperfections in the credit market too similarly have macroeconomic
consequences. The imperfections in the credit market which have
macroeconomic consequences are broadly classified as rigidities in the credit
market. In this sub-section we examine some of the macroeconomic
consequences of these credit-market rigidities.
Imperfections arise in the credit market primarily because of asymmetric
information between lenders and borrowers. Borrowers are better informed than
the lenders about the quality of their investment projects and even the probability
of success of the projects. It has been shown that these type of information
asymmetries can have important microeconomic consequences like equilibrium
credit rationing, need for financial intermediation, and need for government
intervention.
But, more importantly for us, credit market imperfections such as information
asymmetries have macroeconomic consequences. It has been shown that in the
monetary policy transmission mechanism
(i) credit channel is more important than money supply channel, and
(ii) credit-rationing is more important than increase in interest rate in the
implementation of a restrictive monetary policy.
Thus when a restrictive monetary policy reduces reserve money, i.e., the quantity
of bank reserves, the ability of the banks to lend is affected. The shortfall in
credit is not necessarily made up by other lenders, given the imperfections in the
credit market in the form of information asymmetries between lenders and
borrowers. Banks are actually in a better position than many of the other lenders
to overcome the adverse effects of information asymmetries through their role of
a financial intermediary. Thus, the transmission mechanism operates largely
through availability of loans. The process of credit rationing that takes place
when loans are curtailed become more important in reducing aggregate demand
than the process initiated by an increase in the rate of interest through the
reduction of money supply.
Given this importance of credit markets, credit-market imperfections can
propagate and magnify the effects of real disturbances. Shocks that act initially to

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Labour Markets reduce output or to redistribute wealth from borrowers to lenders cause credit
markets to function less efficiency which leads to a further decline in output
through the credit channel. It has been shown that disturbances that would have
mild effects with Walrasian credit markets (e.g., with no asymmetries of
information between lenders and borrowers) can cause a financial collapse in the
presence of such imperfections because of the magnification effects.
13.5.3 Real Rigidities in the Labour Market
New Keynesian theories of the labour market help in explaining the existence of
involuntary unemployment. The theories also attempt to explain why changes in
aggregate demand lead to larger changes in employment and relatively smaller
changes in the real wage in the labour market. One of the reasons postulated for
the existence of unemployment in the labour market is that firms voluntarily pay
higher real wages, as compared to the market-clearing wage, to the workers on
their rolls with a view to increasing their efficiency and/ or with a view to
providing them the incentives not to shirk work in a situation where the effort
level of the workers cannot be perfectly monitored. The imperfections caused
thereby in the labour market lead to unemployment. We will consider efficiency
wage model postulated in New Keynesian theories of unemployment in greater
details later in this Unit.
Check Your Progress 2
1. What are menu costs?
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2. How can the concept of menu costs be used to rationalise nominal price
rigidities?
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3. Why do real rigidities occur in the following markets?
1. Goods market
2. Labour market
3. Credit market

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 ....................................................................................................................... Nominal and Real
Rigidities
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13.6 NEW-KEYNESIAN THEORIES OF WAGE

RIGIDITY
Two phenomena about the labour market need to be explained: the persistence of
unemployment and the moderately pro-cyclical behaviour of real wages. When
aggregate demand increases, labour markets respond typically by a larger
increase in employment and a relatively smaller increase in real wages, i.e.,
quantities respond more than prices. But real wages do respond cyclically,
however moderately.
This point helps us to understand the difference between Keynesian and New-
Keynesian theories of unemployment. Though both kinds of theories help explain
persistent unemployment, it is only some of the new-Keynesian theories that
explain why wages behave pro-cyclically, though only moderately so. The
Keynesian theory implies that wages behave counter-cyclically. This follows
from the assumption of a constant nominal wage. Given the nominal wage rate
W, the real wage W/P falls during an expansion as the price level P gradually
increases. It is this fall in the real wage that induces firms to employ more labour
and produce higher output as aggregate demand increases. During contraction, on
the other hand, real wages rise as prices fall, nominal wages remaining
unchanged. The Keynesian model thus implies a counter-cyclical behaviour of
real wages. This is not in accordance with the empirically observed behaviour of
real wages. In real world we see that real wage increases during periods of boom
and decreases during recession.
The new-Keynesian models imply an advance over the Keynesian model to the
extent that they imply a pro-cyclical behaviour for real wages, in accordance with
empirical observations.

13.7 EFFICIENCY-WAGE THEORIES

Efficiency wage theories are non-Walrasian theories in as much as they postulate
payment of wages that are higher than market-clearing wages. The persistence of
unemployment follows as a direct consequence of higher wages. The efficiency
wage theories rationalise the existence of higher than market clearing real wages.
Broadly speaking, firms pay higher than market-clearing real wages because the
benefits accruing from higher wages are more than the cost of paying higher
wages. The higher benefits can accrue for the following reasons:

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Labour Markets (i) At a very basic level, higher wages enable higher consumption for workers,
including higher nutrition, and this is expected to increase the work capacity
of the hired workers. The point is more valid at lower levels of standards of
living than are prevalent in the developed economies.
(ii) Higher wages may get into the pool of workers with a higher reservation
wage, i.e., the minimum wage that should be offered to a worker to induce
him to supply his labour on the market. Workers with a higher reservation
wage are expected to have superior abilities along directions that cannot be
directly observed and duly compensated for on the market. These higher
abilities in the pool of employed workers are expected to benefit the firm.
(iii) A higher than market wage can build loyalty and a sense of belonging among
workers and induce higher effort. This point is better understood in the
context of the opposite situation of a lower wage, which is expected to have
effects like generating anger and a desire for revenge, thereby leading even to
a sabotage by the workers.
(iv) At a more sophisticated level, a higher wage generates incentives for workers
to avoid work-shirking behaviour in situations where the firms cannot
monitor the work effort perfectly. Workers do not want to be caught shirking
in such valuable jobs, for they could be fired if caught shirking and may be
able to replace the job, if at all, by one which pays only a market-clearing and
hence a lower wage.
Some of the above ideas have been developed into more formal models in the
literature. In the next Section you will go through one such model that analyses
the determination of efficiency wages.

13.8 EFFICIENCY WAGE MODEL: AN EXAMPLE

As you know, we construct a model by making many simplifying assumptions.
We specify the model, indicate its solution, and bring out all the implications of
the solution. In this section we present an efficiency wage model in line with of
Romer (2001).
13.8.1 Specification of the Model
We consider a model with M firms and analyse a representative firm. We specify
a simple Neo-Classical production function with a single input, labour. However
labour enters the production function, not in physical units, but in efficiency
units. The production function for a representative firm is hence of the form:
Y = F (e.L)
Y is the total output produced. L is the number of physical units of labour hired
by the firm. e.L is the efficiency units of labour. You can look upon e.L as the
total effort undertaken by the L units of hired labour.
Higher the index of effort, e, exerted by individual units of labour, higher the
total labour input in efficiency units.
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By saying that the production function is of the Neo-Classical kind, we mean that Nominal and Real
Rigidities
the total output increases as the efficiency units of labour used increase, but at a
decreasing rate. In other words, marginal product of the efficiency units of labour
is positive but decreases as the total labour effort expended in the production
process increases. In symbols it amounts to the standard assumptions you have
seen in Unit 3, that is, F’>O;F”<O
The model further specifies that the individual effort, e, depends on the wage rate
– higher the wage rate, w, higher is the effort exerted by individual physical unit
of labour. The effort function can be specified as:
e = e (w)
It is also assumed that there are N workers in the economy, each supply one unit
of labour inelastically: an increase in wage rate leads, not to an increase in
physical labour supplied by an individual worker, but to an increase in the effort
expended.
13.8.2 Solution of the Model
The model is solved by making the usual behaviouristic assumption about the
firm: that the firm hires labour so as to maximise its profits. The profits of the
firm are defined as:
 = Y – w.L
w is the real wage paid by the firm and, as you have seen above, Y is the total
output of the firm. L is of course the number of units of physical labour hired by
the firm.
After substituting for Y in the above profit function, the problem reduces to the
following two-variable maximisation problem in calculus, viz., determine L and
w so as to maximise z = F (e (w).L) – w.L. Following the usual calculus
techniques to solve a maximisation problem, this problem is solved by taking the
partial derivatives of z respectively with respect to w and L and equating each of
these to zero. This gives us two equations in two unknowns, w and L, which can
be solved simultaneously to obtain the equilibrium, profit maximising, values of
w and L.
Instead of obtaining the solution explicitly, we can characterise it by examining
the first of the above two equations obtained by equating the partial derivative of
z with respect to L to zero. The equation reduces to
w.e’(w)/e (w) = 1
e’(w) is the derivative of the effort function with respect to w, giving the increase
in effort per unit increase in the real wage, for infinitely small increases in the
wage rate. You will be able to recognise the L.H.S. expression of the above
equation as the elasticity of the effort function e(w) with respect to the real wage
rate w. What the equation states is that, at the optimum, the elasticity of effort
with respect to wage is unity, i.e., the real wage rate is so determined that, at the

211
Labour Markets optimum, a one per cent increase in the wage rate leads to one percent increase in
effort. This means that, at the optimum, the ratio w/e(w) remains constant, for
infinitely small changes in w. This suggests that the ratio w/e(w) is at its
minimum at the optimum.
What do you think is the economic interpretation of this ratio being a minimum
at the optimum real wage? When a firm buys one physical unit of labour at the
cost given by w, it is effectively buying e units of labour, since one physical unit
of labour expends e units of effort. That is why we said above that L physical
units of labour effectively provide e.L efficiency units of labour. The ratio w/e(w)
hence gives the per unit cost of effective units of labour. The firm sets the real
wage so as to minimise this per unit cost of effective units of labour that it
obtains by buying physical labour on the market. This means that the firm sets
the real wage rate so as to maximise the effective labour obtained for a given
outlay, assuming that the effort expended by labour is an increasing function of
the real wage. It is presumed here that, as the real wage increases, the effort
increases, first at an increasing rate and subsequently at a decreasing rate. The
real wage is set such that the rate of increase of effort with respect to the wage is
just equal to the wage. For wage rates below the optimum wage, increasing the
wage leads to a larger increase in effort; whereas for wage rates above the
optimum, increasing the wage any further leads to a lower increase in effort. At
the optimum, the marginal product of effective labour equals its cost.
13.8.3 Implications of the Model Solution
Let w* and L* be the optimum levels of the real wage and physical units of
labour hired obtained as a solution to the model for the representative firm. Since
there are M such firms, the total demand for labour is given by M.L*. We bring
out some of the implications of this solution.
(i) The solution implies that workers could remain unemployed in the model
when the wage rate is set at w*. We have assumed above in the specification
of the model that the total number of workers in the model is N.
Unemployment can exist if N > M.L*, where M.L* is the total demand for
labour when the real wage rate is the efficiency wage w*. On the other hand,
if M.L* turns out to be larger than N, then the wage is bid up above the
efficiency wage up to the point that demand N for and supply of labour are in
balance and there is no unemployment
(ii) The model implies that the increase in aggregate demand does not lead to an
increase in real wage. This is because the efficiency wage is determined
entirely by the properties of the effort function e = e(w) and there is no reason
for w* to change when aggregate demand increases. The model hence comes
close to rationalizing the empirically observed fact that in cyclical upswings,
it is employment, and not real wage, that increases – the real wage is only
moderately pro-cyclical.

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(iii) Rigidity of prices is also implied in the model. The fact that real wage and, Nominal and Real
Rigidities
hence, effort do not change during cyclical upswings means that the labour
costs of firms do not change and hence price-setting firms do not have
incentives to adjust prices. You must connect this up with the conclusions
about price rigidity that were reached in the new Keynesian models.
We thus see that the efficiency wage model not only explains the possibility
of the existence of persistent unemployment, but also suggests why the
burden of adjustment falls on employment rather than on the real wage during
cyclical changes in business activity.
13.8.4 Possible Extensions of the Model
The efficiency wage model that we considered above, however, has an important
drawback: it is unable to distinguish between short-run cyclical effects and long
run secular effects. In the real world, though the short run effect is in terms of
increased employment and hence decreased unemployment, the long run is
characterised, not by a trend decrease in unemployment, but by a trend increase
in the real wage. The model is not able to make this transition from the short to
the long run.
The efficiency wage model can however be extended to deal with the above
problem. We only indicate the directions in which such an extension can take
place and do not develop the extended model in details. The extension is
basically given effect to through modifications in the effort function. The effort
function in the earlier model was e = e (w). It is now extended as:
e = e (w, w’, u)
The real wage paid in the representative firm is w, whereas e is the effort. The
real wage available to the workers in alternative firms is denoted by w’ and the
unemployment rate in the economy is u. The inclusion of w’ and u in addition to
w as arguments in the effort function can be rationalised by examining some of
the reasons we set out at the beginning of Section 13.3 for the payment of higher
(i.e., efficiency) wages. If higher wages are paid to induce workers not to shirk
and to exert greater effort in situations where the effort cannot be continuously
monitored, then the higher wages will lead to the desired effect of workers not
shirking only if the wage rate obtained in other firms is lower and the
unemployment rate is high. If the wage rate obtained in other firms is as high and
if the unemployment rate in the economy is low then the worker will not mind
getting caught shirking because he can, with a high probability, obtain an
alternative job which is as paying as his current one. A higher (i.e., efficiency)
wage will not, in such a situation, induce him to exert greater effort. Effort e
depends positively on w, given w’ and u. Effort e, however, depends negatively
on w’ and positively on u. We can similarly work out the rationale behind the
extended effort function if reasons for paying a higher (i.e., efficiency) wage
have to do with tapping higher unobserved abilities or with engendering loyalty
or avoiding sabotage by disgruntled workers.

213
Labour Markets Such an extension of the effort function again leads to a similar solution for the
efficiency wage as in the above model with a simpler effort function. Here too
the elasticity of effort with respect to the real wage is unity at the optimum real
wage. The wage paid by any of the firms has however to be necessarily equal to
that paid by the representative firm, i.e., w = w’ in the solution. Unemployment
can also emerge in this model if, at this common efficiency wage, the total
demand for physical units of labour by the firms falls short of the total supply of
physical units of labour.
Such an extended model can account for both, a larger effect of increased
aggregate demand on employment as compared to real wage in the short run and
an absence in trend unemployment in the long run. This is shown with the help of
an example in Romer (2001). Interested learners are advised to follow the
original.
Check Your Progress 3
1. Why do firms pay higher than market-clearing wages? List out some of the
reasons.
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.............................................................................................................................
2. How would you interpret the first-order condition for optimum, viz., that the
elasticity of effort with respect to the wage is unity, in the efficiency-wage
model that you studied above?
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3. Show how unemployment can emerge in an efficiency-wage model.
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214
4. Why does an increase in demand for labour have a larger effect on Nominal and Real
Rigidities
employment than on the real wage in the efficiency wage model constructed
above?
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5. Bring out an important drawback of the efficiency wage model that uses a
simple effort function.
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13.9 CONJTRACTING AND INSIDER-OUTSIDER

MODELS
The models in Section 13.7 departed from the Walrasian assumption of a market-
clearing wage on efficiency considerations – it was postulated that a higher than
market-clearing wage leads to increased efficiency of workers for one reason or
another. In this section we consider briefly some models wherein the wage differs
from the Walrasian wage because of long-term relations between workers and
firms. We consider here, very briefly, two kinds of models – contracting models
and insider-outsider models.
The rationale underlying the contracting models is that firms do not hire workers
afresh each period. Workers continue to work for a firm for a large number of
years because many jobs involve firm-specific skills that are not valued as much
outside the firm and also because firms would find it costly to train new workers
in these skills afresh each period. Workers are content to stay in their current
jobs so long as their expected earnings over a much longer period than just, say,
the current year are more than the opportunities that the workers would have
outside the firm, even if in the current year their earnings are low. A worker in
the United States, for example, lasts in a job, on an average, for ten years. In such
a situation wages do not have to adjust every period to clear the labour market
and the labour market becomes non-Walrasian.
The relationships between workers and firms are determined in such cases by
long-term contracts, arrived at through collective bargaining between worker
unions and firms. We can consider two kinds of contracts.
215
Labour Markets The first kind is a fixed-wage contract under which the wage is pre-determined
and the firm is free to choose the level of employment that it provides depending
on the state of the economy that emerges in each period. Workers agree to
supply all the labour demanded by the firm. Wage rigidity and unemployment
emerge immediately in such a model. A fall in labour demand does not affect the
real wage because of the contract. The labour supply too cannot fall. The only
thing that can happen when labour demand falls is that firms reduce employment
at the fixed real wage.
The problem with this type of fixed-wage, variable employment contract is,
however, that it is not an efficient contract because, under it, the marginal
product of labour is generally not equal to the marginal disutility of work, and so
it is possible to make both parties to the contract better off. You should recollect
from your microeconomics units that contracts are said to be efficient if it is not
possible to make one of the parties better off without making the other one worse
off (pare to efficiency). This takes us to the idea of implicit contracts, which are
efficient contracts unlike the simple fixed-wage contracts.
Implicit contracts are contracts between the firm and workers wherein the firm
specifies the real wage and the employment that it will provide for each possible
state of the economy. The contracts are so called because actual contracts in the
real world do not explicitly specify employment and wage as a function of the
state of the economy. Not only are these contracts efficient, but also imply real
wage rigidity and the consequences of real wage rigidity that we have examined
in other contexts.
The insider-outsider models are a development on the contracting models,
wherein three categories of agents are recognised, viz., the firms, the workers that
are employed (insiders), and the unemployed workers (outsiders). It is in the
interest of the unemployed workers that the firms and the insider workers sign
contracts providing for lower real wages and higher employment. But the
unemployed, being outsiders, are not on the bargaining table. The real wage
rigidity, that is implied, provides a non-Walrasian characteristic to the labour
market and explains the existence of unemployment. Rich models have been built
up in the literature analysing the interactions between the three categories of
agents to explain some of the empirically observed characteristics of the labour
market.
Check Your Progress 4
1. Why are fixed-wage contracts inefficient?
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216
 Nominal and Real
Rigidities
2. What is the difference between wage contracts and implicit contracts?
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3. How do insider-outsider models explain the existence of unemployment?
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13.10 LET US SUM UP

The distinction between the Classical and the Keynesian school revolves around
their assumption about flexibility/ rigidity of wage and prices. The Classical
economists assumed prices to be flexible and thereby postulated full employment
of resources, whereas the Keynesians assumed wage/ price rigidity and thereby
rationalised the existence of persistent unemployment. This distinction between
the Classicals and the Keynesians continues between the New Classicals and the
New Keynesians.
The New Keynesian theory largely rationalises existence of unemployment
through the existence of nominal and real rigidities. Nominal rigidities refer to
the inflexibility of nominal wages and prices. Real rigidities refer to
imperfections in the goods, credit and labour markets which lead to the relative
prices and real wages being different from what would be predicted by a
competitive Walrasian model.
Mankiw builds up a model to show why nominal rigidity exists and why it could
lead to large macroeconomic consequences like aggregate unemployment. The
concept used in showing this is that of menu costs – the costs incurred in
changing prices in a situation where the firm has a price-setting power. Such
costs are large in relation to incremental profits obtained by changing the price
especially when the elasticity of demand is low and the deviation of the actual
price from the profit-maximising optimal price is not too high. The nominal price
rigidity that follows leads to unemployment.
Macroeconomic consequences like unemployment also follow from
imperfections in the goods, credit and labour markets. Such imperfections are
referred to as real rigidities. In the labour market they occur because, for

217
Labour Markets example, the real wage paid is higher than the market clearing wage for reasons
that will be dealt with in details in Unit 18. In the goods market, the real rigidity
follows from, e.g., countercyclical mark-ups used by price-setting firms, whereas
in the credit market the imperfections occur basically because of information
asymmetries.
The efficiency wage models postulate and rationalise a higher than market-
clearing wage on the ground that the benefits accruing from higher wages are
more than the costs of maintaining wages at a higher level. The benefits come
from increased efficiency of workers. The increased efficiency could be due to
increased physical efficiency of workers obtaining higher wages, or due to the
engendering of a sense of loyalty and belonging among workers, or even due to
avoidance of work shirking by workers who do not want to lose high paying jobs
if caught shirking. The efficiency wage model not only rationalises the existence
of persistent unemployment, but also produces a larger effect on employment in
the short run. The shortcoming of an efficiency wage model using a simple
version of the effort function is that it implies that there is no increasing trend in
the real wage even in the long run. This is contrary to empirically observed facts.
The shortcoming can be easily remedied by using a more complex effort
function.
The contracting and insider-outsider models rationalise wage rigidity with
reference to the fact that wages are determined by long term contracts between
workers and firms, and are not necessarily set at the market-clearing level in each
period. This immediately rationalises wage rigidity and unemployment. The
insider-outsider models provide the insight that though it is in the interest of the
unemployed workers (outsiders) that wages are contracted to be low so that
employment is higher, the unemployed in a non-competitive economy have no
power in the matter, as wages are determined through bargaining between the
employed workers (insiders interested in higher wages) and firms.

13.11 ANSWERS/ HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1. The distinction between flexibility and rigidity of prices is important because
the assumption of flexibility leads to the classical conclusion of full
employment, whereas the assumption of rigidity leads to the Keynesian
conclusion of existence of persistent unemployment. The two assumptions
give us two different ways of looking at macroeconomic phenomenon.
2. The New Classicals assume price flexibility and hence perfect competition,
whereas the New Keynesians assume price-setting power for firms in the
context of imperfect competition. There is no distinction, though in the
analytical tools of the two schools: both use optimisation models peopled by
rational individuals.

218
3. Nominal rigidities exist when prices in money terms do not change as much Nominal and Real
Rigidities
as they would under competitive conditions. Real rigidities, on the other
hand, refer to certain imperfections in the goods, labour and credit markets
which prevent relative prices and real wages from changing as much as they
would under Walrasian conditions.
Check Your Progress 2
1. Menu costs are costs incurred by price-setting firms in changing the price that
they charge. Such costs can be quite high in absolute terms if, for example,
price changes require costly adjustments to automatic dispensing machines.
2. Even if menu costs are not high in absolute terms they may turn out to be
higher in relation to the private benefit that would be obtained in terms of
increased profits by changing the price.
3. The distinction between private and social benefits becomes important in the
context of the Mankiw model because, under certain conditions defined by,
inter alia, the elasticity of demand, not much of private benefits are obtained
by a price-setting firm in terms of higher profits by changing the price. If
menu costs are higher than these private benefits, the firms do not change the
price. The price rigidity that this entails leads to unemployment. If only the
price had been changed the social benefit obtained by way of reduction in
unemployment would perhaps be higher than the menu costs.
Check Your Progress 3
1. Firms pay higher than market-clearing wages because the benefits from
higher wages could outweigh their costs. The benefits come from increasing
the work-capacity of the workers, from bringing in workers with higher
reservation wage who are expected to have higher abilities along some
unobservable dimensions, from engendering a sense of loyalty among
workers, and, above all, from generating incentives for workers to avoid
shirking in situations where the work effort cannot be perfectly monitored.
2. The condition is interpreted by understanding that when the elasticity is equal
to one, the firm minimises the per unit cost of buying effective labour, i.e.,
the firm sets the real wage so as to get the maximum per unit of effective
labour at a given cost. The firm can do such a thing because we assume that
the effort expended by labour is an increasing function of the real wage.
3. In answering this question, you will have to fully specify an efficiency wage
model and characterise its solution. Unemployment can arise in such a model
if, at the efficiency wage (which is expected to be higher than the market
clearing wage) the total demand for physical units of labour by the firms is
less than the total available supply of physical units of labour.
4. Increase in labour demand has no effect on the real wage in the model
because the real wage is determined in the model only by the characteristics

219
Labour Markets of the effort function and not by labour demand conditions. These latter
conditions, hence, only affect employment.
5. Simple effort function refers to the function wherein effort depends only on
the real wage. The efficiency wage model that uses a simple effort function is
not able to distinguish between the short run and the long run effects of
increase in demand for labour. We need a model that has a relatively larger
effect on employment in the short run and on the real wage in the long run,
which is what accords with empirical reality. The model that we have
developed in details has uniformly larger effect on employment both in the
short and the long run.
Check Your Progress 4
1. Fixed-wage contracts are inefficient because, under these contracts, the
marginal product of labour is not equal to the marginal disutility of workers,
so that it is possible to make both parties to the contract better off.
2. An important difference between a wage contract and an implicit contract is
that the former is generally inefficient, whereas the latter is efficient. Both
kinds of contracts, however, imply real wage rigidity and the usual
consequences of such real wage rigidity.
3. Insider-outsider models explain the existence of unemployment by reference
to the fact that in imperfectly competitive economies, the unemployed
workers have no power to influence the wage bargains between the employed
workers and the firms. Real wages are hence not low enough for employment
to increase.

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UNIT 14 SEARCH THEORY AND
UNEMPLOYMENT
Structure
14.0 Objectives
14.1 Introduction
14.2 Search Theory and Theories of Unemployment
14.3 Search Theories – A Brief Historical Overview
14.4 A Search and Matching Model
14.4.1 Model Specification
14.4.2 Model Solution and the Equilibrium Rate of Unemployment
14.4.3 Optimality of the Equilibrium Unemployment Rate
14.4.4 Dynamics of Unemployment and Real Wages through Productivity
Shocks
14.5 Some Alternative Search Models
14.6 Significance of the Concept and Theory of Search Unemployment
14.7 Let Us Sum Up
14.8 Answers/ Hints to Check Your Progress Exercises

14.0 OBJECTIVES
After going through this unit you should be in a position to:
 explain the basic difference between Walrasian and non-Walrasian theories of
unemployment;
 appreciate that the search and matching models are an extension of the
neoclassical/ monetarist theories of employment and unemployment;
 appreciate the context in which the search theory of unemployment was
developed;
 explain the use of a specific search and matching model to determine
unemployment and its variation over time; and
 describe certain alternative search and matching models.
14.0 INTRODUCTION
A major problem with the labour market is that the demand for labour does not
match the supply of labour, with an implication that certain percentage of the
labour force remains unemployed. It is interesting to note that in the labour
market there are workers without jobs while there are jobs without workers. Thus
there are some unemployed workers who are in search of jobs and there are
certain vacancies which are waiting to be filled up. Economists attribute it to


Prof. Avadhoot Nadkarni (retd.), University of Mumbai
Labour Markets various frictions and structural issues in an economy. The problem comes up
because (i) labour as a category is heterogeneous, and (ii) certain costs (including
money and time) are involved in the recruitment process. These characteristics of
the labour market has prompted economists to propagate search and matching
models of unemployment. The neoclassical theories have the drawback that they
are unable to explain prolonged periods of involuntary unemployment
experienced by an individual that characterise the real world. In classical theory
the prevailing unemployment is always voluntary unemployment. Keynesian
theories, on the other hand, explain the real world phenomenon of unemployment
as involuntary unemployment by invoking the idea of deficiency of aggregate
demand. Keynesian models, however, lack the elegance of the neoclassical
models of employment and output. In particular, the Keynesian models do not
provide microeconomic foundations for the rigidities in prices and wages that are
postulated to show the existence of involuntary unemployment in the economy.
In this Unit we will examine further developments of these traditional theories.
The main difference between the developments based on the Neoclassical
theories and the developments springing from the Keynesian theories is that the
former are based on the Walrasian general equilibrium model of perfectly
competitive markets, whereas the latter are based on some non-Walrasian
features introduced into the analysis, e.g., imperfect competition. In a Walrasian
general equilibrium model, labour market is, like all other markets in the
economy is a perfectly competitive one and there is no reason why the market
should not clear. Involuntary unemployment is inconsistent with a Walrasian
setting, so that if unemployment exists, it must be due to some non-Walrasian
characteristics of the labour market.
The search theory that we are going to study in this unit becomes important
because it shows that unemployment can exist as an equilibrium phenomenon
even in a Walrasian setting of perfectly competitive labour markets. We begin, in
Section 14.2, placing the search theory in the context of other theories of
unemployment that you have studied, or are going to study in this block.

14.2 SEARCH THEORY AND THEORIES OF

UNEMPLOYMENT
You need to understand the search and matching theories of unemployment in the
context of other theories of unemployment. With this objective in view, we
classify, in this section, the theories of unemployment that we are studying into
four kinds.

If there is unemployment in a Walrasian labour market, unemployed workers

would immediately bid down wages until supply and demand for labour are again
in balance. If this process of bidding down wages is not working freely, there
must be distinct reasons for it. We classify the theories of unemployment
according to whether the process of wage adjustment is working or not, and

222
according to the reason why it is not working in cases where it does not work. In Search Theory and
Unemployment
particular, consider an unemployed worker, who claims to be identical to a firm’s
current workers, and who offers to work for the firm at a marginally lower wage
than the one the firm is currently paying its workers. There are four possible
responses of the firm, giving us four kinds of theories of unemployment. These
responses are:

(i) If the firm accepts the worker’s offer, we can conclude that the market for
labour is Walrasian. In this view all observed unemployment is voluntary
unemployment – unemployment of people moving between jobs and of
those who are ready to work only at wages higher than the prevalent wage
rate. This is really the Neoclassical model of unemployment referred to
above.

(ii) Secondly, the firm can respond to the unemployed worker’s offer by
saying that it does not accept the premise that the unemployed worker is
identical to the firm’s current employees. In this view, the labour market
is not a market for a homogenous commodity, but is characterised by
heterogeneity. Each job is unique and requires the unique skills that are
embodied in an individual. The unemployed workers are matched with
existing vacancies not through the market, but through a complex process
of search and match. The models of unemployment that postulate such a
process are called search and matching models.

(iii) Thirdly, the firm can respond by saying that, even though it would like to
cut the wages and employ the additional worker, it cannot do this because
it is bound by implicit and explicit agreements with its workers, arrived at
through collective bargaining, regarding the wages that have to be paid.
Wages are thus institutionally determined in these models known as
contracting models.

(iv) Lastly, the firm may respond by saying that it does not want to reduce real
wages – it believes that the benefits accruing to it from higher wages are
more than the costs of maintaining wages high. Theories that build up on
this idea are called efficiency-wage theories in an obvious reference to the
fact that higher wages impart benefits to the employing firm by improving
the efficiency of labour.

In this Unit, you will study in details one of the search and matching models of
unemployment referred to in (ii) above. You will study the contracting models
and the efficiency-wage theories of unemployment, referred to respectively in
(iii) and (iv) above, under the rubric of the New Keynesian Theories of
Unemployment in Unit 16.
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Labour Markets Check Your Progress 1
1. Why is a Walrasian general equilibrium model inconsistent with
unemployment?
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2. Suggest a classification of theories of unemployment based on the

postulated responses of a firm to an offer by an unemployed worker to
work for it at a slightly lower wage.
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14.3 SEARCH THEORIES – A BRIEF HISTORICAL

OVERVIEW
A search theory of unemployment is found even in the writings of A.C. Pigou in
the inter-war period. To explain the high unemployment in the period Pigou used
an idea you are very familiar with – that workers are unemployed because wages
are too high. Keynes contested this idea in the development of his General
Theory of Employment, Interest and Money. But initially Pigou had tried to
explain the high unemployment of the inter-war period with reference to another
idea – the idea of frictional unemployment, where unemployment arises as
workers shift between jobs, moving to jobs where their productivity is higher.
Search and matching unemployment is actually a form of frictional
unemployment – unemployment which arises because of the frictions in shifting
between jobs generated by the fact that skills are to be matched with vacancies in
the job ‘market’. Pigou himself was aware though that jobs were not shifting
around too much in the 1920s, so that he ultimately banked more on ‘workers
pricing themselves out of the market through trade union activities’ as an
explanation for the inter-war unemployment.

The idea of search unemployment was subsequently formalised in the 1970s and
1980s to make the Neo-classical Walrasian model accord with the reality of the
empirically observed and varying unemployment in the labour market, as has

224
been indicated to you in the introductory section. The importance of search in Search Theory and
Unemployment
decentralised markets was first emphasized in an influential book edited by
Edmund Phelps in 1970 (Microeconomic Foundations of Employment and
Inflation Theory, Norton, New York). This book contains some of the first formal
models using search theory to explain unemployment as an equilibrium
phenomenon. Lucas and Prescott presented in 1974 a general equilibrium model
of unemployment. In this model stochastic sectoral shocks induce workers to
move between sectors, but there is a one-period lag by workers in moving
between sectors, brought about through search and matching kind of
considerations. Unemployment is generated in the model by this lag.

In the 1980s, search models were built up as continuous time general equilibrium
models, in the tradition of the models built under the real business cycle theory.
Noteworthy amongst these are the models by Peter Diamond: the paper titled
“Mobility Costs, Frictional Unemployment, and Efficiency” published in the
Journal of Political Economy in 1981, and by Christopher Pissarides: the paper
titled “Short-Run Equilibrium Dynamics of Unemployment, Vacancies, and Real
Wages” published in the American Economic Review in 1985. We have
reproduced the titles of the papers for you because they provide a flavour of the
concepts and mechanisms used to rationalize unemployment as an equilibrium
phenomenon in a Walrasian model. We will examine, very briefly, the model by
Pissarides in Section 14.5. Before that, however, let us develop a more complete
model of search unemployment in the next section.
Check Your Progress 2
1. Why was it necessary to augment the neoclassical/ monetarist theory of
employment through search and matching kind of models?
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2. What is frictional unemployment?

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Labour Markets
14.3 A SEARCH AND MATCHING MODEL
It should be clear to you from the earlier section that there are a variety of models
under the rubric of search theory. In this section we examine one such model at
close quarters. Peter Howitt originally developed the model as “Business Cycles
with Costly Search and Recruiting” in the Quarterly Journal of Econometrics in
1988. The exposition here is based on Blanchard and Fischer (2000). Unlike in
other sections of this unit, the exposition in this section is necessarily more
technical. It is important to follow it through, perhaps with the help of the book,
in order to get a flavour of the kind of analysis that you will find in the literature
today. The approach is descriptive and the use of equations is minimised. Going
through equations, however, can add to the understanding of the expounded ideas
and you are advised to follow the equations-based exposition of the model in
Blanchard and Fischer (2000).
14.4.1 Model Specification
We proceed with the model specification in the following steps.
1. The economy is composed of competitive firms (F in number) and identical
workers (N in number). In each discrete time period a fraction δ of the
employed is laid off and joins the unemployment pool. The fraction δ is
called the ‘rate of separation’ in the literature. Firms hire workers from the
pool, not directly from other firms.
2. The marginal cost of hiring for each firm is an increasing function of its level
of hiring. This captures the idea that a high rate of hiring may force firms to
increase their search intensity or, in a more general model with heterogeneous
workers, to accept poor matches between workers and jobs. The marginal
cost is also a decreasing function of aggregate unemployment – high
aggregate unemployment makes it easier and cheaper for the firm to find
willing and competent workers.
3. Since each firm chooses the rate of hiring by equating the marginal cost of
hiring to the net marginal benefit of hiring, it is important to determine, in the
model, the marginal benefit of hiring to the firm. Assuming a firm to be risk
neutral, the marginal value to the firm of a worker hired in this period is the
expected present value of his marginal product so long as he works with the
firm. The marginal value, denoted by qt, is therefore an infinite sum of
discounted marginal productivities from the present period onwards to
infinity. Two discounting factors are used on each term: one, as usual, to take
account of time and the other to take account of the probability that a given
worker will have left the job by time (t + i).
4. The net marginal benefit of hiring is equal to this marginal value minus the
discounted present value of wages to be paid to the worker who is newly
hired. It is in the spirit of search and matching models to assume that there is
no labour market in which the wage is set – job matches require an explicit
search process.
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The wage is set through bargaining so as to divide the surplus from the job Search Theory and
Unemployment
between the worker and the firm. To simplify matters, it is assumed in the present
model that the worker experiences neither costs nor benefits from unemployment,
so that the total surplus from the job is just the marginal value determined in
paragraph 3 above. It is assumed that the worker obtains a share ξ of the surplus
and the firm gets (1 – ξ) with the size of ξ reflecting the bargaining power of the
worker. Thus the marginal benefit of hiring to the firm is given as a fraction of
the marginal value qt:
λt = (1 – ξ). qt
Each firm chooses the rate of hiring, ht, by equating the marginal benefit of
hiring specified in paragraph 4 above with the marginal cost of hiring determined
in paragraph 2 above
14.4.2 Model Solution and the Equilibrium Rate of Unemployment
Given the above specification, the model can be solved for the marginal benefit
of hiring, λt, and the hiring rate, ht. If the employment in the firm is denoted by
nt, it follows that nt = (1 – δ).n t-1 + ht, since employment in period t is given by
employment in period (t – 1), as adjusted for the rate of separation and the rate of
hiring. Assuming that there are F identical firms in the economy, the
unemployment rate, denoted by ut, is given by 1 – (F.nt)/N, where N is the total
number of workers in the economy. These four equations for λ t, ht, nt and ut can
be solved to obtain the equation characterising the dynamics of the equilibrium
unemployment rate:
ut = δ + {1 – δ – (F/G)λt}.u t-1
In the above equation, G is a parameter in the cost of hiring function, such that a
larger parameter value denotes higher difficulty of locating workers. The
equation clearly shows that the unemployment rate depends on its own lagged
value and the constant rate of separation, δ. It also depends on the state of
technology via its dependence on the net marginal benefit of hiring, λ t, since the
latter depends on the marginal product of worker.
When the marginal productivity of labour is postulated to have zero variance, the
natural rate of unemployment is given by
u* = δ/ {δ + (F/G).k}
A clear result emerges from this equation: the larger the separation rate, δ, and
the larger the parameter G (reflecting the difficulty of locating workers), the
higher is the rate of unemployment.
14.4.3 Optimality of the Equilibrium Unemployment Rate

The above model rigorously rationalizes the existence of unemployment. As we

will see below, shocks to productivity can also be used to explain the variability
of the equilibrium rate of unemployment over time. You should, however

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Labour Markets appreciate that the equilibrium rate of unemployment obtained in the above
model is unlikely to be socially optimal. This is so for two reasons:

(1) Hiring decision by a firm is beneficial to it to the extent that the net
marginal benefit of hiring is positive, but it imposes a cost on other firms,
an externality that is not taken into account by the hiring firm. By hiring
an extra worker, the firm decreases unemployment, and since the
marginal cost of hiring is a decreasing function of aggregate
unemployment, the marginal cost of hiring to other firms is increased.
This effect leads to too much hiring compared to the social optimum, and
thus to too low an equilibrium rate of unemployment.

(2) There is also a divergence between the social and private marginal benefit
of hiring: the former is given by qt, whereas the latter (the private benefit
to the hiring firm) is given by a fraction (1 – ξ) of qt, depending on the
bargaining power of the worker vis-à-vis the hiring firm. Since the private
benefit is less than the social benefit (ξ > 0), there is too little hiring and
thus too high an equilibrium rate of unemployment.

The two effects, in (1) and (2) above, work in opposite directions, one tending to
increase the equilibrium rate above the socially optimum rate and the other
tending to keep it below the social optimum. The net effect on the equilibrium
rate of unemployment vis-à-vis the socially optimum rate is ambiguous in the
model.

14.4.4 Dynamics of Unemployment and Real Wages through Productivity

Shocks

The model that you are studying here is in the tradition of the real business cycle
theory that you have studied in earlier units. As you know, this kind of a model
works out the implications of shocks to productivity. The model has the
following implications to employment and wages.

(1) A temporary adverse shock to productivity decreases hiring (as it

decreases the marginal productivity of labour and hence the benefit of
hiring the marginal unit of labour) and increases unemployment. As the
shock is, by definition, temporary, productivity and the net marginal value
of labour return to their original level, but, it can be shown that the
unemployment rate only slowly returns to normal through increased
hiring. Moreover, since it is cheaper for the firm to hire when there are
more unemployed, a productivity shock has greater effect on
unemployment when it is high than when it is low. This is, of course,
implicit in the non-linearity of the equation explaining u*, the natural rate
of unemployment.
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(2) The model explains why fluctuations in employment may be associated with Search Theory and
Unemployment
smaller fluctuations in real wages. This will happen if ξ, the share obtained
by workers, is constant, as is assumed in the model, and small. Real wages
vary in the model with productivity and high rates of hiring are associated
with high real wages. The model thus explains the observed empirical fact of
a pro-cyclical increase in real wages, but to a smaller extent than the increase
in employment, if the share obtained by workers is small in relation to that
obtained by the hiring firms.
Check Your Progress 3
1. Explain why introduction of search and matching introduces
equilibrium unemployment in a Walrasian model.
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2. Why is the equilibrium unemployment rate, obtained in the Howitt

(1988) model, unlikely to be socially optimal?
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3. How does the Howitt (1988) model explain

a. An increase in unemployment
b. A smaller pro-cyclical response of real wages in relation to
employment?
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Labour Markets
14.5 SOME ALTERNATIVE SEARCH MODELS
In this section we look, briefly, at two more papers emphasizing frictions arising
due to search and matching considerations: one by Pissarides that has been
already referred to and another by David Lilien. The exposition here is again
based on Blanchard and Fischer (2000).
The model developed in Section 14.4 is just one of the many search and matching
models developed in the literature. In this section we examine, briefly, some
alternative search and matching models. One of the shortcomings of the Howitt
(1988) model that was discussed in Section 14.4 is that it simply postulates that
search and matching is undertaken by workers and firms, but does not specify the
search technology and the matching process used by workers and firms. Also the
Howitt model takes the share of workers parameter, ξ, as given. Pissarides
developed a closely related model in 1985 wherein these shortcomings were
addressed. The model clearly shows that unemployment emerges as an
equilibrium phenomenon in an otherwise neoclassical model that is characterised
by workers moving from one job to another and remaining unemployed in the
interim during their search for the right kind of job as a replacement for the job
they have discarded. The approach shows explicitly the dependence of the rate of
hiring on the characteristics of the labour markets. Moreover, unlike in the
Howitt model, the Pissarides model helps in thinking about what determines the
share of workers parameter ξ in the bargaining process between the workers and
the firms – the parameter value depends on the option that the workers have in
turning down the match and looking for another match.
Models have also been developed to capture the effects of sectoral shocks –
changes in relative productivity or changes in relative demand for goods – on
aggregate equilibrium unemployment. David Lilien emphasized frictions arising
due to the inability of labour to relocate instantaneously and costlessly between
sectors in a paper titled “Sectoral Shifts and Cyclical Unemployment” published
in the Journal of Political Economy in 1982. Consider an economy with two
sectors. Labour is immobile between sectors within periods but fully mobile
across sectors over periods. Workers in each sector supply one unit of labour
inelastically if the wage exceeds a reservation wage. Assume that the wage is
sufficiently higher than the reservation wage in both sectors and that labour is
fully employed between the two sectors. Assume further that labour demand
shifts away from sector 1 toward sector 2, so that within the period wage
increases in sector 2 and falls in sector 1. Since labour cannot shift from sector 1
to sector 2 within the period, employment cannot increase in sector 2, but falls in
sector 1 due to the decrease in labour demand. The sectoral shift hence increases
unemployment in the current period. In the following period labour reallocates
itself and aggregate employment returns to normal.

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 Search Theory and
14.6 SIGNIFICANCE OF THE CONCEPT AND Unemployment
THEORY OF SEARCH UNEMPLOYMENT
From what has been said earlier, you understand the significance of the theory of
search unemployment as an attempt to endow realism to the elegant neoclassical
model of employment and output. You should also understand the practical
significance of the concept of search unemployment as it has worked itself out in
the United States and in some of the countries of the European Union.
The idea of search unemployment gained importance in the US economy in the
1990s when the social security system was being restructured in that country. It is
easily understandable that the ability and desire of a person to keep looking for a
better job and to remain unemployed in the mean time depends in part on the
availability of unemployment benefits under such a system. The unemployment
that arises when a person quits a job to have more time to look for a better job, or
when an unemployed delays accepting a job in the hope of finding a better one, is
of course the search unemployment that we have been discussing. If all jobs are
the same, an unemployed person will take the first one offered. If some jobs are
better than others, it is worthwhile searching and waiting for a good one. The
higher the unemployment benefits, the more likely people are to keep searching
for a better job, and the more likely they are to quit their current job to try to find
a better one. It was consideration of these kinds that prompted the United States
to restructure their unemployment benefits system in the 1990s. If unemployment
rates in the European Union are by and large higher than those prevailing in the
United States in recent years, part of the explanation is the fact that it is not as
easy, as in the countries of the European Union, to obtain unemployment benefits
in the United States after the revamping of their unemployment benefits system.
Check Your Progress 4
1. Explain briefly the ways in which the search model of Pissarides goes beyond
the Howitt model.
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2. Why should a sectoral shift in labour demand generate higher aggregate

unemployment?
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Labour Markets 3. How will you use the concept of search unemployment to explain the
differences between the United States and the European Union vis-à-vis their
unemployment rates?
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14.7 LET US SUM UP

The Neo-Classical theory of employment and output is theoretically elegant, but
does not accord with the empirically observed fact of prolonged periods of high
unemployment. The search theory of unemployment attempts to remedy this
drawback of the Neo-Classical theory. The existence of unemployed workers in
the context of the Neo-Classical model would imply a fall in wages in the market
for labour. In the context of search and matching models, though, the labour
market is not a market for a homogenous commodity, but is characterised by
heterogeneity. Each job is unique and requires the unique skills that are embodied
in an individual worker. Unemployed workers are matched with existing
vacancies not through the market, but through a complex process of search and
match. This generates a frictional kind of unemployment. Indeed the origins of
the search and matching models can be traced all the way back to Pigou’s
explanation of the inter-war unemployment as the unemployment of workers
moving between jobs. More recent approaches to the theory involve construction
of models wherein the unemployment emerges as an equilibrium phenomenon
when, for example, firms decide on hiring by equating the marginal benefits and
costs of hiring, where the costs include search costs. Such an equilibrium rate of
unemployment is not a social optimum due to the divergence between, e.g.,
private and social benefits of hiring. Such models can be used to explain
variation of unemployment over time by postulating shocks to productivity, as in
the models of real business cycles. Unemployment can also emerge in models
where sectoral, as versus aggregate, shocks are postulated to productivity/
demand, in the context of frictions in moving from one job to another.

14.8 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCIES
Check Your Progress 1
1. Walrasian general equilibrium model is inconsistent with involuntary
unemployment. Labour market in this model is assumed to be competitive
and it always clears through wage adjustments at a point where labour
demand is equal to labour supply.
Any unemployment in the model is hence voluntary, i.e., of those who do not
want to supply labour at the going wage rate.
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2. Your answer to this question should be based on Section 14.2. If the firm Search Theory and
Unemployment
accepts the offer of the outside worker and employs him/her at a lower wage,
you are in the realm of the neoclassical model. If the firm believes that the
outsider-workers do not necessarily possess the skills of the insider-workers
you are postulating a search and matching model. If the firm is unable to
lower the wage fixed through collective bargaining, in spite of the firm
wanting to accept the outsider worker’s offer to work at the lower wage, you
are subscribing to a contracting theory of unemployment. Finally, if you
postulate that the firm does not reduce wage because it believes that its
benefits exceed the cost of paying a higher wage, then you are working in the
realm of New Keynesian theories like the efficiency-wage theory.
Check Your Progress 2
1. The neo-classical model was theoretically elegant, but did not accord with the
observed phenomenon of high and varying unemployment in the real world.
It was hence necessary to augment the model to bring it more in tune with
reality. The search theory attempts to do this by modelling unemployment as
an equilibrium phenomenon.
2. Frictional unemployment is unemployment of workers moving between jobs.
In the search models workers are unemployed because they do not take up the
first job that is offered to them and keep searching to find the best job that
matches their skills. The unemployment is frictional, in as much as workers
and jobs are not continuously matched.
Check Your Progress 3
1. You will have to explain this by using the model expounded in Sub-sections
14.4. 1 and 14.4.2. Alternatively, you could use ideas from two or three
different search models to explain why unemployment occurs as an
equilibrium phenomenon in such models. You will be helped further in this
by the alternative models in Section 14.5.
2. Answer to this question is in Sub-section 14.4.3. Hiring generates a private
benefit, but imposes a social cost to other firms that is not accounted for by
the hiring firm. There is also a divergence between the private and social
benefits generated by hiring.
3. Refer to Sub-section 14.4.4 to be able to answer these questions. The
variability in unemployment is explained by productivity shocks that change
the benefit of hiring and hence generate more or less unemployment in
equilibrium. The pro-cyclical response of real wages is explained by the fact
that, in the model, workers obtain a constant share, and an increase in
productivity leads to an increase in real wages. Real wages increase to a
smaller extent if the share of the workers is smaller compared to the share of
firms in output.

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Labour Markets Check Your Progress 4
1. Unlike the Howitt model, the Pissarides model specifies the search
technology used by the workers and firms. Further, the Pissarides model also
helps in understanding the factors determining the share of workers in output.
2. In a frictionless world, a sectoral shift in demand cannot generate
unemployment because a decrease in employment in the declining sector is
made up for by an increase in employment in the expanding sector. However,
if, for example, it takes time for labour to relocate perhaps due to search and
matching considerations, labour released from the declining sector can be
unemployed in the interim that it locates itself in the expanding sector firms.
3. You will have to explain the difference in the unemployment rates between
the US and the EU with reference to the differences in the two regarding
obtaining unemployment benefits. The more liberal scheme in the EU means
that a larger number of workers can remain unemployed over longer period of
time in search for a better job. However, this is not the full explanation of the
observed differences in the unemployment rates.

234