Lecture 30

Unemployment
The labour market
Not everyone wants a paid job.
Full-time homemakers, voluntary workers, the old and the young, and those with long-term
sickness are all excluded from the category of people seeking paid work. The people who want a
job are called the labour force. The participation rate measures how many people of working
age want to work. The labour force comprises people with a job or registered as looking for work
at the current wage rate. The participation rate is the fraction of the population of working age
in the labour force. Some people looking for work do not register as unemployed. They do not
appear in official statistics for the registered labour force or the registered unemployed. Yet from
an economic viewpoint, such people are in the labour force and are unemployed. For the
moment, our data on the labour force or the unemployed refer only to those registered.
Stocks and flows
The unemployment rate measures unemployment relative to the size of the labour force. The
unemployment rate is the fraction of the labour force without a job but registered as looking for
work. Unemployment is a stock concept measured at a point in time. Like a pool of water, its
level rises when inflows (the newly unemployed) exceed outflows (people getting new jobs or
quitting the labour force altogether). Figure 23.2 illustrates this important idea.
Figure 23.2 Labour market flows

There are three ways for workers to become unemployed. Some people are sacked or made
redundant (job-losers); some are temporarily laid off but expect eventually to be rehired by the
same company; and some voluntarily quit their existing jobs. But the inflow to unemployment
also comes from people not previously in the labour force:

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School leavers (new entrants) and people who, having left the labour force, are now returning to
look for a job (re-entrants). People leave the unemployment pool in the opposite direction. Some
get jobs. Others give up looking for jobs and leave the labour force completely. Some of this
latter group may simply have reached the retirement age at which they get a pension, but many
are discouraged workers. Discouraged workers, pessimistic about finding a job, leave the labour
force.
Types of unemployment
We now develop a theoretical framework in which to analyse unemployment. We can classify
unemployment by the source of the problem or by the nature of behaviour in the labour market.
Frictional unemployment is the irreducible minimum unemployment in a dynamic society.
Frictional unemployment includes people whose handicaps make them hard to employ. More
importantly, it includes people spending short spells in unemployment as they hop between jobs
in a dynamic economy. As the labour force evolves, and the skill needs of employers change with
new products, services and technologies, finding more effective matches between what workers
can offer and what firms require is a significant part of remaining efficient and sustaining
productivity growth. Since perfect matching cannot be achieved instantaneously, it is important
to recognize that some unemployment is actually good for the economy if it corresponds to a
vigorous search for better job matching.
Frictional unemployment is sometimes called search unemployment. Structural unemployment
arises from the mismatch of skills and job opportunities as the pattern of demand and supply
changes.
Structural unemployment reflects the time taken to acquire human capital.
A skilled steelworker may have worked for 25 years but is made redundant at age 50 when the
industry contracts in the face of foreign competition. That worker may have to retrain in a new
skill which is more in demand in today’s economy. Firms may be reluctant to take on and train
older workers who have only a short remaining working life in which to repay the expensive
investment.
Such workers are victims of structural unemployment. Structural unemployment implies that the
market price for a worker’s skill has fallen because of a shift in supply or demand, often caused
by new technology or changes in international competition.
Faced with a job offer at a low wage, the worker may prefer to retrain in order to earn something
closer to the previous wage; if there are few such opportunities, the worker may become
unemployed. Even low-skilled, low-paid alternatives may be difficult to find. Many such jobs are
now outsourced abroad, and domestic service employers may prefer younger workers with fewer
demands. A third type of unemployment is purely the consequence of a fall in aggregate demand.
Only when demand has returned to its long-run level is demand-deficient unemployment
eliminated.

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Demand-deficient unemployment occurs when output is below full capacity.
Equilibrium unemployment
Figure 23.4 shows the labour market. The labour demand schedule LD slopes down. Firms
demand more workers at a lower real wage because the cost of labour is lower. As in most
economic applications, demand curves slope downwards. The LF schedule shows the number of
people in the labour force. A higher real wage increases the number of people wishing to work.
This is not as obvious as it may at first appear. A higher wage increases the benefit of an hour of
work relative to an hour of leisure.
Figure 23.4 Equilibrium unemployment

The substitution effect leads to a desire to work more and consume less leisure. But there is also
an income effect. A higher wage makes people richer, raising the quantity of goods and leisure
demanded. This income effect makes people less interested in working when wages are higher.
Figure 23.4 shows that higher real wages do increase the size of the labour force, but by only a
little. The LF schedule is pretty steep. The schedule AJ shows how many people accept job offers
at each real wage. The schedule is to the left of the LF schedule: only people in the labour force
can accept a job. Hence, at any horizontal level corresponding to a particular market wage, the
AJ schedule must lie to the left of the LF schedule. How far AJ lies to the left of LF depends on
several things. Some people are inevitably between jobs at any point in time. Also, a particular
real wage may tempt some people into the labour force even though they will accept a job offer
only if it provides a higher real wage than average. We draw these schedules for a given level of
jobseeker’s allowance. When wages are high, jobseekers grab available jobs. The two upward-
sloping schedules are close together. When wages are low (relative to unemployment benefit),
potential workers are more selective in accepting job offers. People invest in searching longer for
an even better job. The two schedules are further apart. Labour market equilibrium is at E in
Figure 23.4. Equilibrium employment is N*. The distance EF is equilibrium unemployment. This
unemployment is entirely voluntary. Equilibrium unemployment (also called the natural rate of
unemployment) is the unemployment rate when the labour market is in equilibrium.

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At the equilibrium real wage w*, N1 people want to be in the labour force but only N* accept job
offers; the remainder do not yet want to work at the equilibrium real wage. Equilibrium
unemployment includes frictional and structural unemployment. Suppose a skilled welder
earned K1000 a week before being made redundant. The issue is not why workers became
redundant (the decline of the steel industry), but why these workers will not take a lower wage
as a dishwasher to get a job. Their old skills are obsolete. Until new skills are learned, dishwashing
may be their only skill valued by the labour market. People not prepared to work at the going
wage rate for their skills, but wanting to be in the labour force, are voluntarily unemployed. A
worker is voluntarily unemployed if, at the given level of wages, she wishes to be in the labour
force but does not yet wish to accept a job.
First time round, it can be difficult to grasp the concept of voluntary unemployment. The key is
to remember that, at any instant, we are taking a snapshot of a highly dynamic labour market.
Take another look at Figure 23.4. The gross number of people flowing between employment,
unemployment and inactivity (being out of the labour force) is larger every quarter than the total
stock of unemployment. With so many people in motion, at any particular measurement point
they cannot all be recorded as employed or inactive. A voluntarily unemployed worker is
interested enough in finding a job to be in the labour force, but has not yet found a job offer that
she is prepared to accept. Such workers are still looking and still hoping. A worker involuntarily
unemployed would accept a job offer at the going wage rate.
Explaining changes in unemployment: Supply-side factors
We now discuss four reasons why equilibrium unemployment rises. First, increasing skill
mismatch can raise equilibrium unemployment. Mismatch occurs if the skills that firms demand
differ from the skills the labour force possesses. The larger is mismatch, the harder the task is to
perform, and the more likely it is that people get stuck in unemployment. When firms no longer
want the skills possessed by the existing workforce, the labour demand curve LD shifts left wards
to LD´ in Figure 23.7, leading to a lower equilibrium real wage, and an increase in equilibrium
unemployment from AB to CD. At a higher real wage, AJ and LF are closer together.
Figure 23.7 An increase in mismatch

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A second explanation of a rise in equilibrium unemployment is a rise in the generosity of
unemployment benefit relative to wages in work. A higher replacement rate may entice more
people into the labour force, shifting LF to the right. More significantly, it shifts AJ to the left.
People spend longer in unemployment searching for the right job. For both reasons, equilibrium
unemployment increases in Figure 23.8.
Figure 23.8 A higher replacement rate

A third source of changes in equilibrium unemployment has been changes in trade union power.
Trade union power is measured by the ability of unions to co-ordinate lower job acceptances,
thereby increasing wages but reducing employment. By shifting the AJ curve to the left, unions
can force up real wages but increase equilibrium unemployment. The final important source of
changes in equilibrium unemployment is changes in the size of the tax wedge between the cost
of labour to the firm and the take-home pay of the worker. A key theme of supply-side
economists is the benefits that stem from reducing the marginal tax rate.
The marginal tax rate is the fraction of each extra Kwacha that the government takes in tax. This
creates a tax wedge between the price the purchaser pays and the price the seller receives. A cut
in marginal tax rates, and a consequent increase in the take-home pay derived from the last
hour’s work, make people substitute work for leisure. If people pay less in taxes, they have to do
less work to reach any given living standard target. Suppose the marginal tax rate equals the
vertical distance AB. Equilibrium employment is then N1. The tax drives a wedge between the
gross-of-tax wages paid by firms and the net-of-tax wages received by workers. Firms wish to hire
N1 workers at the gross wage w1.

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 Figure 23.9 A cut in marginal income tax rates

Subtracting the income tax rate AB, N1 workers want to take job offers at the after-tax wage w3.
Thus N1 is equilibrium employment, where quantities supplied and demanded are equal. The
horizontal distance BC shows equilibrium unemployment: the number of workers in the labour
force not wishing to work at the going rate of take-home pay. Suppose taxes are abolished. The
gross wage and the take-home pay now coincide, and the new labour market equilibrium is at E.
Two things happen. First, equilibrium employment rises. Second, although more people join the
labour force because take-home pay has risen from w3 to w2, equilibrium unemployment falls
from BC to EF. A rise in take-home pay relative to unemployment benefit reduces voluntary
unemployment. If lower tax rates reduce equilibrium unemployment, higher tax rates increase
equilibrium unemployment.

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