Unemployment
Gavin Cameron University of Oxford
OUBEP 2006
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introduction• “When in any country the
demand for those who live by wages… is continually increasing; when every year furnishes employment for a greater number than had been employed the year before, the workmen have no occasion to combine to raise their wages. The scarcity of hands occasions competition among masters, who bid against one another, in order to get workmen…” Adam Smith (1776)
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job separation and job finding• The workforce= employed + unemployed
• L=E+U• When unemployment is stable, the number of job
separations must equal the number of jobs found.• sE=fU
• but since E=L-U• s(L-U)=fU, divide both sides by L to obtain• s(1-U/L)=fU/L and solve for U/L to find• (U/L)*= s/(s+f)
• The steady-state unemployment rate is an increasing function of the job separation rate and a decreasing function of the job finding rate.
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labour supply
When real wages rise, the budget line rotates around point A (the endowment of time remains unchanged) and becomes steeper. This allows both consumption and leisure to increase at the same time (income effect). Because leisure is more expensive, however, some is given up (substitution effect). In the case depicted here, the substitution effect dominates at first, but not in the extreme.
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the supply of labour
employment
Individual
Aggregate
The aggregate curve is less steep than for an individual since new workers enter the workforce as wages rise.
real wage
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the demand for labour
employment
labour demand, Ld
A competitive firm demands labour up until the point where MC=MR, that is W=MPL*P, which is the same as W/P=MPL
As more workers are added into the workforce, for a given level of capital and technology, the marginal product of labour, and hence the demand for labour, falls.
real wage
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the natural rate of unemployment
employment
labour demand, Ld
labour supply, Ls workforce
natural rate
equilibrium employment
equilibrium wage
real wage
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the natural rate and the NAIRU• The natural rate model assumes that markets clear and that
there is competition in all markets.• In fact, the labour market may be dominated by unions.• If so, there is bargaining between unions and firms. • Other things being equal, this will raise the level of
unemployment for any given real wage.• Also, goods markets may be dominated by a few large
sellers (imperfect competition) in which case the labour demand curve may be less steep, possibly even horizontal.
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wage bargaining• Unemployment is the means by which the competing claims
of employers and unions are reconciled.• Unions bargain over wages relative to prices (the wage-
setting curve) and reduce their demands when unemployment is high.
• Unions care about the employed (insiders) without caring too much about the unemployed (outsiders).
• Employers set prices relative to wages: this leads to a relatively flat labour demand schedule (the price-setting curve).
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wage-setting and price-setting
employment
price-setting: firms set a constant mark-up of prices over costs, PS
labour supply, Lsworkforce
wage-setting, WSreal wage
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two views of the labour market• The natural rate model suggests that most equilibrium
unemployment is voluntary in the sense that workers could find jobs at the current real wage, but choose not to.
• The NAIRU model suggests that some equilibrium unemployment is involuntary in the sense that workers would like to work at the current real wage but cannot find jobs.
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the NRU and the NAIRU
employment
labour supply, Ls
workforce
voluntary
NAIRU
wage-setting, WS
price-setting: firms set a constant mark-up of prices over costs, PS
real wage
labour demand, Ld
involuntary
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unemployment equilibrium• Unions claim real wages that rise with employment:
target wage = base + aggression (employment)• Firms offer real wages as a proportion of labour
productivity:feasible wage = productivity * (100%-markup)
• In equilibrium, the target wage equals the feasible wage when:employment= productivity * (100%-markup) – base
aggression• If productivity and the markup don’t vary with employment,
then we have the horizontal price-setting curve from the NAIRU diagram.
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minimum wages in a secondary labour market
employment
labour demand, Ld
labour supply, Lsworkforce
equilibrium employment
equilibrium wage
real wage
The secondary labour market (typically for unskilled, young workers) is potentially vulnerable to the effect of a minimum wage.
minimum wage
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a monopsony labour market
employment
labour demand Ld
labour supply Ls
marginal cost of labour
A monopsonist who pays all workers the same equates its demand for labour with its marginal cost, Wm, when setting employment at Em.
equilibrium wage
competitive wage
Em Ec
real wage
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why pay above the going rate?• In 1914, the Ford Motor Company
paid its workers $5 per day when the going rate was between $2 and $3. Why?
• “A low wage business is always insecure… The payment of five dollars a day for an eight hour day was one of the finest cost-cutting moves we ever made”, Henry Ford
• Why would this policy reduce costs?• Workers might work harder and staff
turnover might be reduced because workers don’t want to run the risk of a big cut in wages (moral hazard). The firm may also attract better quality workers.
• If many firms pay efficiency wages, it will be harder for the unemployed to find jobs, and so unemployment will be higher.
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how to reduce unemployment• Active Labour Market Policies: training and work
experience schemes for long-term unemployed, unskilled, youths, women, older workers;
• Reform of the benefit system, especially duration;• Limitations on union power – no closed shops, no secondary
picketing, secret ballots; • Changes to wage bargaining, especially increased employer
coordination;• Tax reform (lower payroll taxes for the unskilled etc);• Increased labour mobility.• Flexicurity: Cuts to employment protection, coupled with
active labour market policies;
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how not to reduce unemployment• Cunning demand-side policies (unlikely to have much effect
in the long-run, plus very expensive);• Job-sharing or cuts in working hours;• Increased investment by firms (although this will raise
wages);• Protectionism (any benefit to workers massively outweighed
by costs to consumers).
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Source: Faggio and Nickell (2006)
unemployment around the world
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Source: BIS (2006)
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Source: O’Mahony and Van Ark (2003), table I.1.
Source: OECD (2005)
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summary• “When large numbers of
people are out of work…. unemployment invariably follows”, Calvin Coolidge (US President, 1923-1929).
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syndicate topics• What is the effect on unemployment of (a) a fall in union
strength or (b) a fall in real benefits?• Would unemployment fall if working hours were cut?• Do firms pay workers their marginal product?• Is competition from the South a cause of unemployment in
the North?• Why has the relative pay of the unskilled fallen since 1980?• What are the current trends in unemployment around the
world?