Chapter 6: Unemployment

1. Chapter 6: Unemployment Professor Van Horn February 24th, 2011

2. The Demand for Labor The demand for labor is determined by individual business firms. The aggregate demand for labor is the sum of all the business firms� demand for labor. The demand for labor depends on the costs and benefits of hiring additional workers.

3. The Demand for Labor How much labor do firms want to use? First, make some assumptions: The capital stock fixed, i.e., a short-run analysis. Workers are homogeneous. The labor market is competitive. Firms maximize profits.

4. The Demand for Labor So how much labor do firms want to use? A profit-maximizing firm will hire additional workers up to the point where the marginal revenue product of labor equals the nominal wage: W = MRPL = P * MPL

5. The Demand for Labor We can rewrite the equilibrium condition W = MRPL = P * MPL as: w = MPL. Why? Because w = W/P and MRPL = P * MPL.

6. The Demand for Labor How much labor do firms want to use? They weigh the costs and benefits of hiring one extra worker. If w > MPL, profits rise if number of workers declines. If w < MPL, profits rise if number of workers increases. When w = MPL, profits are maximized.

7. The Demand for Labor

8. The Demand for Labor What happens if we change the real wage rate? An increase in the real wage rate means w > MPL unless L is reduced so the MPL increases. A decrease in the real wage rate means w < MPL unless L is increased so the MPL decreases.

9. The Demand for Labor The marginal product of labor and the labor demand curve Labor demand curve shows relationship between the real wage rate and the quantity of labor demanded It is the same as the MPL curve, since w = MPL at equilibrium So the labor demand curve is downward sloping; firms want to hire less labor, the higher the real wage

10. The Demand for Labor Factors that shift the labor demand curve Note: A change in the wage causes a movement along the labor demand curve, not a shift of the curve Supply shocks: Beneficial supply shock raises MPL, so shifts labor demand curve to the right; opposite for adverse supply shock Size of capital stock: Higher capital stock raises MPL, so shifts labor demand curve to the right; opposite for lower capital stock

11. The Demand for Labor Aggregate labor demand Aggregate labor demand is the sum of all firms� labor demand Same factors (supply shocks, size of capital stock) that shift firms� labor demand cause shifts in aggregate labor demand

13. The Supply of Labor Supply of labor is determined by individuals: Aggregate labor supply is the sum of individuals� labor supply. The labor supply of individuals depends on their labor-leisure choices.

14. The Supply of Labor The income-leisure trade-off: Utility depends on consumption and leisure. Compare costs & benefits of working another day. Costs: Loss of leisure time. Benefits: More consumption because of higher income. Utility maximizing individuals will: Work another day if the benefits exceed the costs and Keep working additional days until benefits equal costs.

15. The Supply of Labor Real wages and labor supply: An increase in the real wage has 2 effects: A substitution effect: A higher real wage increases the reward for working is higher so more labor is supplied. An income effect: A higher real wage increases income for same amount of work time so a person can afford more leisure and will supply less labor.

16. The Supply of Labor A pure substitution effect: a one-day rise in the real wage. A temporary real wage increase has a pure substitution effect because the effect on wealth is negligible. Consequently, an increase in labor supply.

17. The Supply of Labor A pure income effect: winning the lottery. Winning the lottery doesn�t have a substitution effect, because it doesn�t affect the reward for working. But it makes a person wealthier, so a person will both consume more goods and take more leisure. Consequently, a reduction in labor supply.

18. The Supply of Labor The substitution effect and the income effect together: a long-term increase in the real wage. The reward to working is greater so there is a substitution effect toward more work. With higher wage, a person doesn�t need to work as much to consume the same basket of goods and services so there is an income effect toward less work.

19. The Supply of Labor The substitution effect and the income effect together: a long-term increase in the real wage. The longer the high wage is expected to last, the stronger the income effect. Thus labor supply will increase by less (or decrease by more) than for a temporary reduction in the real wage.

20. The Supply of Labor The labor supply curve, NS, relates the quantity of labor supplied to the current real wage. Increases in the current real wage raise the quantity of labor supplied. Some people work more hours. Other people enter the labor force. The labor supply curve slopes upward.

22. Factors that shift the labor supply curve: Wealth: Higher wealth reduces labor supply, i.e., shifts the labor supply curve to the left. Expected future real wage: Higher expected future real wage is like an increase in wealth and reduces labor supply, i.e., shifts the labor supply curve to the left. Working age population: A rise in the working age population increases labor supply, i.e., shifts the labor supply curve to the right. Labor force participation rate: A rise in the labor force participation rate also increases labor supply, i.e., shifts the labor supply curve to the right.

24. Labor Market Equilibrium The labor market will be in equilibrium when labor supply equals labor demand. This equilibrium determines the full-employment level of employment, N, and the market-clearing real wage, w.

25. Labor Market Equilibrium

26. Labor Market Equilibrium Full-employment output = potential output = level of output when labor market is in equilibrium. Affected by changes in full employment level or production function (such as a supply shock)

27. Labor Market Equilibrium Factors that change full-employment output: Shifts in the demand for labor and/or supply of labor that affects the full-employment level of employment. Shifts in the production function from supply or productivity shocks. This will also shift the demand for labor.

28. Labor Market Equilibrium A temporary adverse supply shock.

29. Unemployment How do we measure unemployment? Three Categories: Employed, Unemployed, or Not in the labor force. Labor Force = Employed + Unemployed

30. Natural Rate of Unemployment Natural rate of unemployment: The rate of unemployment that exists when output is at full-employment level. Consists of structural and frictional unemployment. The natural rate of unemployment is the �normal� unemployment rate the economy experiences when it is neither in a recession nor a boom. In a recession, the actual unemployment rate rises above the natural rate. In a boom, the actual unemployment rate falls below the natural rate.

31. Actual and natural rates of unemployment, U.S., 1960-2010

32. A Simple Model of the Natural Rate Notation: L = # of workers in labor force E = # of employed workers U = # of unemployed U/L = unemployment rate

33. Assumptions: 1. L is exogenously fixed. 2. During any given month, s = rate of job separations, the fraction of employed workers that become separated from their jobs f = rate of job finding, fraction of unemployed workers that find jobs s and f are exogenous

34. The transitions between employment and unemployment

35. The Steady State Condition Definition: the labor market is in steady state, or long-run equilibrium, if the unemployment rate is constant. The steady-state condition is:

36. The Equilibrium Unemployment Rate f ?U = s ? E = s ? (L � U ) = s ? L � s ? U Solve for U/L: (f + s) ? U = s ? L so,

37. Example: Each month, 1% of employed workers lose their jobs (s = 0.01) 19% of unemployed workers find jobs (f = 0.19) Find the natural rate of unemployment:

38. Policy implication A policy will reduce the natural rate of unemployment only if it lowers s or increases f. Europe and the U.S. enacted different policy measures to address unemployment during the Great Recession. The U.S. enacted policies designed to increase f. Germany, instead, chose policies that decreased s. Based on the theory discussed earlier, which of these polices might we expect to have a higher impact on the natural rate?

39. Why Should We Expect 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 this does not occur (or that we expect f < 1): 1. job search 2. wage rigidity

40. Job Searches and Frictional Unemployment Frictional unemployment: unemployment due to workers searching for suitable jobs and firms searching for suitable workers. Occurs because Workers have different skill sets and preferences Jobs have different skill requirements Geographic mobility of workers Flow of information about vacancies and job candidates is imperfect Because of these dynamics, there is always frictional unemployment. How is this related to labor market efficiency?

41. Sectoral Shifts and Unemployment Over time, we would expect changes in the composition of demand among industries or regions. Technological change: more jobs repairing computers, fewer jobs repairing typewriters A new international trade agreement: labor demand increases in export sectors, decreases in import-competing sectors

42. Examples of Sectoral Shifts Industrial revolution (1800s): agriculture declines, manufacturing soars Energy crisis (1970s): demand shifts from larger cars to smaller ones Health care spending as % of GDP: 1960: 5.2% 2000: 13.8% 1980: 9.1% 2008: 16.2% Most of the examples on this and the previous slides are big changes that have occurred over many years. These examples give students a good idea of what sectoral shifts are. Perhaps more important for the natural rate, though, are the many smaller changes that occur more frequently. Ours is a dynamic economy: the structure of demand is shifting almost continuously, due to changes in preferences, technology, and the location of production. As a result, there is a near-continual flow of newly frictionally unemployed workers. Sectoral shifts are distinct from recessions (which also cause unemployment). In recessions, there is a general fall in demand across industries, and the unemployment that results is cyclical. Sectoral shifts, though, are changes in the composition of demand across industries, and lead to frictional unemployment as described above. Source of health expenditure data: http://www.cms.hhs.gov/NationalHealthExpendData/02_NationalHealthAccountsHistorical.asp#TopOfPageMost of the examples on this and the previous slides are big changes that have occurred over many years. These examples give students a good idea of what sectoral shifts are. Perhaps more important for the natural rate, though, are the many smaller changes that occur more frequently. Ours is a dynamic economy: the structure of demand is shifting almost continuously, due to changes in preferences, technology, and the location of production. As a result, there is a near-continual flow of newly frictionally unemployed workers. Sectoral shifts are distinct from recessions (which also cause unemployment). In recessions, there is a general fall in demand across industries, and the unemployment that results is cyclical. Sectoral shifts, though, are changes in the composition of demand across industries, and lead to frictional unemployment as described above. Source of health expenditure data: http://www.cms.hhs.gov/NationalHealthExpendData/02_NationalHealthAccountsHistorical.asp#TopOfPage

43. Unemployment insurance (UI) UI pays part of a worker�s former wages for a limited time after losing his/her job. UI increases search unemployment, because it reduces the opportunity cost of being unemployed the urgency of finding work f Peter Diamond�s search theory and impact

44. Reasons for wage rigidity 1. Minimum wage laws 2. Labor unions 3. Efficiency wages

45. Unemployment from real wage rigidity

46. Minimum Wage Laws The minimum wage may exceed the equilibrium wage of unskilled workers, especially teenagers. Is there evidence of this? Studies: a 10% increase in min. wage reduces teen unemployment by 1-3% But, the minimum wage effect cannot explain the majority of the natural rate of unemployment, as most workers� wages are well above the minimum wage.

47. Labor Unions Unions exercise monopoly power to secure higher wages for their members. 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.

48. Efficiency Wage Theory Higher wages increase worker productivity by: attracting higher quality job applicants increasing worker effort, reducing �shirking� reducing turnover, which is costly to firms improving health of workers Firms willingly pay above-equilibrium wages to raise productivity. Result: structural unemployment.

49. The duration of unemployment The data: More spells of unemployment are short-term than medium-term or long-term. Yet, most of the total time spent unemployed is attributable to the long-term unemployed. Knowing this is important because it can help us craft policies that are more likely to work. What about the current recession and duration of unemployment?

51. TREND: The natural rate rises over 1960-84, then falls over 1985-2005

52. The Real Minimum Wage The trend in the real minimum wage rises until the mid to late 1970s, then falls. This is fairly similar to the trend of the natural rate of unemployment. The U.S. Department of Labor has lots of good information on the minimum wage, at: http://www.dol.gov/dol/topic/wages/minimumwage.htm note: Two sources of data on the federal minimum wage are slightly different in the late 1960s. These small differences have no significant impact on the trend, or the lesson of this slide. The trend in the real minimum wage rises until the mid to late 1970s, then falls. This is fairly similar to the trend of the natural rate of unemployment. The U.S. Department of Labor has lots of good information on the minimum wage, at: http://www.dol.gov/dol/topic/wages/minimumwage.htm note: Two sources of data on the federal minimum wage are slightly different in the late 1960s. These small differences have no significant impact on the trend, or the lesson of this slide.

53. What About Demographics? 1970s: The Baby Boomers were young. Young workers change jobs more frequently. Late 1980s through today: Baby Boomers aged. Middle-aged workers change jobs less often. The Current Recession: What are the likely effects on s and f?

54. Unemployment in Europe, 1960-2009