Chapter 6web.uvic.ca/~aahoque/Fall 2012 UVic/chapter 6.pdf · 1 Chapter 6: Unemployment. ECON204 (A01). Fall 2012 ECONOMY IN THE LONG RUN Chapter 6 Unemployment October 23, 2012

1 Chapter 6: Unemployment. ECON204 (A01). Fall 2012

ECONOMY IN THE LONG RUN

Chapter 6

Unemployment

October 23, 2012


Topics in this Chapter

Focus on the Long run unemployment rate – Natural Rate of

Unemployment – contrast with cyclical behaviour of

unemployment

what it means

what causes it

understanding its behavior in the real world


Long Run Unemployment: Natural rate of unemployment

The average rate of unemployment around which the economy

fluctuates

In a recession, the actual unemployment rate rises above the natural rate

In a boom, the actual unemployment rate falls below the natural rate

Changes over time as structural features of the labour market change. For example, Government employment policies

Level of unionisation


Figure: The Unemployment Rate in Canada


Figure 6.1 The Unemployment Rate and the Natural Rate of Unemployment in Canada


A model of the Natural Rate of Unemployment (NRU) Let,

U = number of unemployed workers

E = number of employed workers

L = the labour force = U + E, by definition

U/L = unemployment rate

Assumptions: a. L is exogenously fixed.

b. s and f are exogenous

where, s = fraction of employed workers that become separated from their jobs. s is called the rate of job separations

f = fraction of unemployed workers that find jobs. f is called the rate of job finding


The first assumption rules out people entering or exiting the labour force; i.e., no discouraged workers

Transition between E and U:

Each period s · E lose their jobs and f · U find jobs



Substituting L = E + U into the first:

s · (L − U) = f · U

s · L − s · U = f · U

s · L = (s + f) · U

Solving for U/L


Exercise

Each month,

1% of employed workers lose their jobs (s = 0.01)

19% of unemployed workers find jobs (f = 0.19)

The natural rate of unemployment:

So, the Natural rate of unemployment is 5 percent


Two implications:

a. Reducing NRU requires policies to lower s or raise f b. Any policy that affects s or f, affects NRU So far, we have assumed a non-zero level of unemployment. Put differently, we have assumed that the rate of job finding is not one. If it were, then NRU gets very close to zero.

What we need to do is explain why U exists; in particular, why f is less than one.


Why is there Unemployment?

If job finding were instantaneous (f = 1), then all spells of

unemployment would be brief, and the natural rate would be

near zero.

There are two reasons why f < 1:

job search

wage rigidity

Both can explain why U persists. Consider each in turn.


a. Job Search and Frictional Unemployment

Frictional unemployment: caused by the time it takes workers to

search for a job

Occurs even when wages are flexible and there are enough jobs

to go around

Because,

workers have different abilities, preferences

jobs have different skill requirements

geographic mobility of workers not instantaneous

flow of information about vacancies and job candidates is

imperfect


So,

Firms looking for workers, workers looking for firms

- job finding takes time, f < 1.

As well, if matching is not perfect job separations occur, s > 0.

Structural change in the economy also gives rise to s.

Changes in the composition of demand among industries or regions

For example, the more dynamic the economy, it is more likely to adopt new technologies and to undergo structural change, the more churning — requiring job separation — in the labour market; hence a higher natural rate of unemployment.

These features of the economy give rise to frictional unemployment. Not necessarily bad; some amount is inevitable.



Policies to reduce frictional unemployment

a. Providing job and worker information - improve matching

b. Re-training - improve job finding (e.g. after structural change)

We need the government to provide these services. Why? Why don’t we let individuals and firms pay directly for these services?

The answer is that there may be externalities associated with these services. For example, search effort rewards both the firm and the worker. When making her search decision, the worker only considers her return, not the firms. So search effort is less than socially optimal. As well, there may be a concern that it puts an unfair burden on a disadvantaged group so it is explained on equity grounds.


c. Experience-rated employment insurance (firm pays part or all of the

unemployment benefits of the workers it fires):

– A disincentive to lay-off, s falls.

– But, firms may hire less, f falls Policies that affect frictional unemployment:

Unemployment insurance, designed to protect people from loss of

income o It pays part of a worker’s former wages for a limited time after

losing his/her job.


Consequences o Lowers cost of search or reduces the opportunity cost of being

unemployment, f falls

o Lowers demand for employment security, s rises

Studies o The longer a worker is eligible for UI, the longer the duration of

the average spell of unemployment.

o There is ample evidence that search effort responds to incentives.

For example, as the unemployment benefits get close to running

out, the probability of finding a job raises substantially. Moreover,

it allows workers more time to search – may lead to better

matches, would lead to greater productivity and higher income.


b. Real Wage Rigidity

Classical labour market: real wage adjusts to clear the labour market.

o All those willing to work at equilibrium wage instantly find a job. o No waiting, no unemployment.

Labour market with real rigidities: labour market does not clear because the real wage does not adjust


Unemployment from real wage rigidity


Consequences

Wait unemployment — those that would like to work at the market wage cannot find a job.

The real wage rigidity lowers the likelihood of finding a job; in other words, the rate of job finding f is lower.

Reasons for real wage rigidity

1. Minimum wage laws

2. Labor unions

3. Efficiency wages


1. Minimum wage laws Equity policy - ensure that the low paid receive a fair wage

There is considerable debate as to whether this is the best way of achieving this policy objective. First, it tends to lower employment for the less skilled (but ambiguous). Second, it is not necessarily targeted that well. Tax credits are generally preferred. Why? The minimum wage may exceed the equilibrium wage of

unskilled workers, especially teenagers. Studies: a 10% increase in minimum wage reduces teen

employment by 1-3% But, the minimum wage cannot explain the majority of the

natural rate of unemployment, as most workers’ wages are well above the minimum wage.


2. Unions - Insider Outsider Problem Firm and unions bargain to determine wage Union exercise monopoly power to secure higher wages for their

members.

Firm chooses employment When the union wage exceeds the equilibrium wage,

unemployment results. Insiders: Employed union workers whose interest is to keep

wages high.

Outsiders: Unemployed non-union workers who prefer equilibrium wages, so there would be enough jobs for them.

What about unions that bargain for job security - does that lower? Possibly, but it will also cause firms to lower demand for labour.


3. Efficiency Wages Why might firms choose to pay above the market clearing wage? Higher wages increase worker productivity

Simple arguments attracts higher quality job applicants Motivates workers to put more efforts reducing turnover, which is costly to firms improving health of workers (in developing countries)

So, firms willingly pay above-equilibrium wages to raise productivity.

Consequence Structural unemployment

Arguments based upon imperfect information


1. Adverse selection: Firms cannot observe workers’ ability (not completely)

To ensure high average quality labour force firms pay above market

wage (otherwise all the high quality workers will leave, assuming

that they have a greater chance of finding work elsewhere).

2. Moral hazard:

Firms cannot observe worker’s effort (not completely)

High real wage raises the cost of a worker losing job


3A. A Simple Model of Efficiency Wages

Firm cannot perfectly observe worker effort.

Workers have two options:

1. Work hard, receive

where, w· a is the cost of effort

2. Shirk (don’t work hard), get fired with some probability and receive b, the outside option

To stop workers shirking, the “after-effort” wage must

equal or exceed b:

>= b no shirking condition

Firm will always pay just enough, so b =


What determines b?

A fired worker faces two outcomes:

1. Employed at w with probability

where, u is the natural rate of unemployment

2. Unemployed at c.w with probability u

where, c is the fraction of w from unemployment benefits,

Expected outside option:

In equilibrium, all firms pay the same wage,

Which implies,


The higher the cost of effort, the higher the NRU.

Firms must pay more to compensate for cost of shirking so they hire less.

Higher benefits (larger c), higher u - higher benefits improve outside option (lessen the cost of being fired).


Labor Market Experience in Canada

Econometric decomposition of unemployment: Incidence

o The likelihood that an individual suffers an unemployment spell

Duration o The average length of that spell

Example: 5% unemployment could be

a) with high duration and low incidence Long run– structural unemployment

b) short duration and high incidence Short run – frictional unemployment


Data on the duration of unemployment can affect the view

about the reason of unemployment

Statistics Canada has estimated that about two-thirds of

any increase in the unemployment is due to longer

duration and one-third to higher incidence.

Policy implication: If the goal is to lower the natural

unemployment rate, policies should aim the long run

unemployed, as they account for a larger amount of

unemployment







Over the last 50 years the natural rate of unemployment has

been changing. Why?

Economists hypothesize:

1. Demographics

a. Baby booms after WWII, enter into labor force in the 1960s and the 1970s

b. Increased women unemployed labor in the 1970s

2. Sectoral shifts a. Technological change b. Natural resource price shift


3. Productivity a. In the 1970s’ productivity slowdown increased the NRU

b. Skilled biased technological change

4. Transition into and out of the Labor force

When labor force is fixed, unemployment occurs due to separation

But, if this assumption is relaxed then measurement of unemployment gets complicated. Some are unemployed because they don’t look for job

seriously Some individuals seriously look for jobs but after

unsuccessful search give up searching – discouraged workers. Not being in the labor force any more


Comparing Canadian labor market with other country labor markets

Documents

Chapter 6web.uvic.ca/~aahoque/Fall 2012 UVic/chapter 6.pdf · 1 Chapter 6: Unemployment. ECON204 (A01). Fall 2012 ECONOMY IN THE LONG RUN Chapter 6 Unemployment October 23, 2012