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Modern Principles: Macroeconomics

Tyler Cowen

and Alex Tabarrok

Copyright © 2010 Worth Publishers • Modern Principles: Macroeconomics • Cowen/Tabarrok

Chapter 10

Unemployment and Labor Force Participation

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Introduction• A Recurring Story in American History

Many jobs have disappeared.• blacksmiths, chimney sweeps, and dark-room

technicians. New jobs have replaced old jobs.

• Agents that support computers and networks have replaced typewriter repairman.

• Jobs in the high tech areas like software engineering and biosciences have been created.

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Introduction• A Recurring Story in American History (cont.)

A wealthier society means more and better-paying jobs in older professions.• There are more than 212,000 professional

athletes in the U.S.• More than any other time in history!

• What is this chapter about? Employment and unemployment

• How are they measured?• What are their causes?

Why some people opt to work and some do not.

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Defining Unemployment• Measuring Unemployment

A person is counted as unemployed if they…• Are 16 years of age or older.• Are not institutionalized (e.g., not in prison).• Are not in the military.• Are looking for work.

The unemployment rate is the % of the labor force without a job, given by:

100forceLabor

Unemployed

100Employed Unemployed

Unemployed(%) ratent Unemployme

×=

×+

=

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Defining Unemployment• How Good an Indicator Is the Unemployment

Rate? Does not account for discouraged workers.

• These are workers that have given up looking for work who would still like to have a job.

• Discouraged workers account for 0.3% of the labor force.

• For long recessions the number of discouraged workers will be higher. Implication: In recessions that last a long

time, the unemployment rate is not as good an indicator.

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Defining Unemployment• How Good an Indicator Is the Unemployment

Rate? (cont.) Doesn’t measure the quality of jobs or how well

people are matched to their jobs.

• Examples: A taxi driver with a PhD in chemistry is counted

as fully employed. A worker with a part-time job who wants to work

full-time is counted as fully employed. Economists also look at other indicators:

• Labor force participation rate

• Number of full-time jobs

• Average wages

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CHECK YOURSELF

Other than not working, what other factors are part of the definition of unemployment?

Define the labor force.Is the labor force participation rate

close to 100 percent? How is it defined?

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Frictional Unemployment• There are three types of unemployment:

frictional structural cyclical

• Frictional unemployment: Short-term unemployment caused by difficulties of matching employee to employer. Scarcity of information creates frictional

unemployment.• The internet has probably reduced frictional

unemployment.

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Frictional Unemployment• Usually doesn’t last very long.

2005: 35% of unemployment lasted less than 5 weeks.

• Is a large share of total unemployment because: the U.S. economy is so dynamic.

• “Creative Destruction”-Joseph Schumpeter. progress is about creating new jobs and

destroying old jobs. it takes time to adjust to those shocksfrictional

unemployment is created.

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CHECK YOURSELF

What is the key cause of frictional unemployment?

To minimize frictional unemployment, unemployed workers would have to accept the first job they were offered no matter what the wage. Is frictional unemployment always a bad thing?

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Structural Unemployment• Structural Unemployment: Persistent, long-

term unemployment caused by long-lasting shocks or permanent changes in the economy. Causes:

• Large shocks that take a long time for the economy to restructure. Oil shocks: alternatives take time to create. New information technologies: create new

industries and cause the disappearance of others.

Globalization: decline of manufacturing and the rise of the service economy.

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Structural Unemployment• Structural unemployment, if it lasts long

enough, brings significant human costs. At some point unemployment can become

chronic.• The longer a worker is out of work, his or her

skills atrophy.• Hiring managers are wary of hiring workers

who have been unemployed for a long time. Who would you rather hire: a worker looking to

switch jobs or a worker who has been unemployed for five years?

• Result: Unemployment can become a trap.

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Structural Unemployment• Labor Regulations and Structural Unemployment

In the U.S. unemployment increases with a shock, then declines. In Europe unemployment has increased with shocks but has not declined.

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Structural Unemployment• Unemployment rates in the U.S. and

Europe behave differently because of differences in labor regulations.

1. Unemployment benefits are more generous in Europe• The benefit replacement rate is much

higher in Europe.

2. Unemployment benefits last longer in Europe.• The next table shows the difference in

benefits.

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Structural Unemployment

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Structural Unemployment3.Minimum wages are higher in Europe and

unions are stronger.• The higher the minimum wage is above the

market wage, the greater unemployment will be.

• Unions have the same effect.• We can use the supply and demand model

to show the effects of minimum wage laws and unions on unemployment.

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Structural Unemployment• Effect of Minimum Wage on Unemployment

Wage

QuantityOf Labor

Demandfor labor

Supply of Labor

Minimumwage

Marketwage

Marketemployment

Employmentwith minimumwage

Unemployment

Result:Minimum wage causes unemployment

Labor supplywith minimumwage

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Structural Unemployment• Effect of union demands on unemployment

Wage

QuantityOf Labor

Demandfor labor

Supply of Labor

Unionwage

Marketwage

Marketemployment

Employmentat unionwage

Unemployment

Result:union demands can cause unemployment

Labor supplywith unionwage

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Structural Unemployment4.Employment Protection Laws

• The U.S. has the employment at-will doctrine: says that an employee may quit and

an employer may fire for any reason. many exceptions: race, religion, sex,

sexual orientation, national origin, age, or handicap status.

most basic U.S. employment law.

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Structural Unemployment4.Employment Protection Laws (cont.)

• In Europe, labor law is much different. Portugal’s law, for example, forbids at-

will employment. Throughout Western Europe: public

law and collective bargaining, not contracts, govern work rules and benefits.

Result:• Greater job security.• Greater cost of hiring and firing

workers.

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Structural Unemployment4.Employment Protection Laws (cont.)

• Greater cost of hiring and firing makes it really difficult for new workers and unemployed workers to find jobs. Imagine how difficult it would be to get a date

if every date required marriage!• World Bank “rigidity of employment index”

summarizes hiring and firing costs the higher the index, the greater the costs the next figure shows the effect of hiring and

firing costs on long-term unemployment.

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Structural Unemployment

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Structural Unemployment• A Tale of Two Riots

Outsider Riot: Paris suburbs, November 2005• Unemployment among immigrant youth was

over 30%.• French firms were reluctant to hire these

youths… partly because of discrimination high risk because they were inexperienced

and without jobs once hired, it is difficult to let them go

• They rioted and Paris was lit up by burning cars.

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Structural Unemployment• A Tale of Two Riots

Insider Riot: Central Paris, 2006• In response to the Outsider Riot

Government proposed changing the labor law so that workers under the age of 26 would be employed at-will for the first two years.

• Elite French youth felt this was an infringement on their rights.

• Called on students everywhere to protest.• Proved themselves as good at burning cars

as the Outsiders.• The government backed down.

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Structural Unemployment• In summary, European labor regulations: create valuable insurance for workers with

a full-time job. make labor markets less flexible and

dynamic. increase the duration of unemployment. increase unemployment rates among

young, minority, or otherwise “riskier” workers.

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Structural Unemployment• Labor Regulations to Reduce Structural

Unemployment Europe has begun to change some of its

labor regulations.• Reducing unemployment benefits• Adopting “active labor market policies”

Training subsidies for employers Proof they are actively seeking work

• Allowing exceptions to collective bargaining agreements. Insiders don’t want to give up their benefits.

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CHECK YOURSELF

Define structural unemployment.Why does the term “employment at-

will” accurately describe the United States but not Western European countries?

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Cyclical Unemployment• Cyclical Unemployment: short-term

unemployment that goes up in recessions.

• Lower growth is usually correlated with higher unemployment for two reasons:1. When GDP falls, firms lay off workers.

2. Idle labor and capital → economic growth is not being maximized → ↓ ability of the economy to create more jobs.

• The following two figures illustrate these points.

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Cyclical Unemployment•Correlated with the business cycle

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Cyclical Unemployment

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Cyclical Unemployment• What causes cyclical unemployment?

Non “Keynesians”: Caused by real shocks that require a reallocation of resources.• Cyclical unemployment is just another

example of frictional and structural unemployment.

“Keynesians”: Caused by deficiencies in aggregate demand.• For now: consider it a mismatch between the

aggregate level of wages and the level of prices.

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Cyclical Unemployment• The Natural Unemployment Rate: Structural plus frictional

unemployment.

Note: Total unemployment changes much quicker than the natural unemployment rate.

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Cyclical Unemployment• Some final points:

The concept of frictional, structural, and cyclical unemployment are not always clear and distinct.• In good times employers may work harder to

hire. It would be correct to say that either frictional

or structural unemployment has fallen.• How well the economy absorbs displaced

workers (structural unemployment) depends on the overall economy.

One type of unemployment can turn into another.

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CHECK YOURSELF

What happens to cyclical unemployment during the business cycle?

How are economic growth and unemployment related?

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Labor Force Participation• Measuring the labor force participation rate

The % of the adult (16+) non-institutionalized civilian population who are working or actively looking for work (adult for short).

Example, U.S. 2009:

100populationAdult

forceLabor

100populationAdult

EmployedUnemployed

×=

×+

=

%5.65100million 09.235

million 04.154 =×=

Labor ForceParticipationRate

Labor ForceParticipationRate

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Labor Force Participation• What determines the labor force

participation rate?1. Lifecycle Effects and Demographics

• It varies among age groups.

Implication: As the U.S. labor force ages, the participation rate will fall

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Labor Force Participation1. Lifecycle Effects and Demographics (cont.)

It varies among countries

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Labor Force Participation• What explains the large differences in labor

force participation across countries? Example: • Belgium: only 1/3 of men ages 55-64 are

working.• U.S.: Only 1/3 of men of the same age are

retired. The answer lies with differences in incentives.

• If the incentive to work is greater than the benefit of leisure, people will work.

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Labor Force Participation2. Differences in Incentives Taxes and Benefits

• Taxes discourage work and benefits encourage non-work. Many countries penalize workers who work

past the normal early retirement age.• Netherlands in the 1990s: Working past

the age of 60 meant losing one year of government retirement benefits.

• Result: Individual working past age 60 after paying payroll taxes made less money than a worker who retired.

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Labor Force Participation2. Differences in Incentives (cont.)

Incentives and the increase in female labor force participation:

• 1948 -2008: number of women aged 25-54 in the paid labor force increased from 35% to 75%.

• What caused this? Cultural factors

• Rise of feminism

• Growing acceptance of equality Move from a manufacturing to a service

economy.

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Labor Force Participation• Differences in Incentives (cont.)

How the pill increased female labor force participation:• lowered the cost of earning a professional

degree.• lowered uncertainty about the consequences of

sex.• Result: the pill lowered the costs and increased

the incentive of women to invest in a long-term education.

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CHECK YOURSELF

The marginal tax rate (the tax on additional income) for married couples was reduced significantly during the 1980s. How would this affect the female labor force participation rate?

Some politicians want to raise the age at which people can collect Social Security benefits, likely postponing retirement for many. How will this change affect the labor force participation rate?

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Takeaway• You should know how unemployment, the

unemployment rate, and the labor force are defined. You should be able to identify the different

types of unemployment (frictional, structural, and cyclical), including giving examples of their causes.

• Even in the best of times unemployment will exist and will fluctuate. We can help employees adjust to change, but

we cannot prevent the need for adjustment.

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Takeaway• Some labor market policies intended to help

workers have increased structural unemployment. A primary reason why Europe suffers higher

unemployment than the U.S. is due to differences in labor market policies.

• Changes in labor force participation can have a large impact on the economy. Increase in the labor force participation of

women has resulted in large economic and cultural changes.

Labor force participation of older workers will become a subject of increasing concern.