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The labor market

Use the model of demand and supply for labor to explain how wages and employment are determined.

Define unemployment and explain its three categories.

Explain the natural rate of unemployment.

Explain how government policies affect the unemployment rate.

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Learning Objectives
After studying this chapter, you should be able to:
8.1

8.2
8.3
8.4

If firms have trouble finding workers…

… Why is the unemployment rate so high?

During the recession of 2007-2009, the unemployment rate rose above 10%.

In September 2012, more than three years after the end of the recession, unemployment still at 7.8%.

Some economists calling this the “new normal”.

However many jobs are going unfilled:

Ernst & Young having trouble finding enough skilled accountants.

Deloitte report: 600,000 manufacturing jobs going unfilled because of lack of skilled workers.

Structural unemployment results from a persistent mismatch between skills of workers, and job requirements.

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The unemployment rate in the United States did not fall below 8% until more than three years after the end of the 2007–2009 recession.

Has the natural rate of unemployment increased?

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Key Issue and Question

Issue:

Question:

The labor market

Labor markets are “front-and-center”: when people think about the economy, they often think about the labor market.

We talk about an economy as doing well when it reaches full employment.

But even full employment doesn’t mean everyone who wants a job has a job.

Real labor markets are dynamic in nature, with millions of workers entering and leaving employment each year.

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Use the model of demand and supply for labor to explain how wages and employment are determined.

8.1

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Learning Objective

Nominal and real wages

Real wages (w) represent the purchasing power of the nominal wage (W).

If the nominal wage in 2012 averages $40 per hour, and the price level is 1, then the real wage is also $40 per hour.

Inflation would erode the real wage if prices rose and the nominal wage remained unchanged.

If the economy experiences a 3% inflation rate while nominal wages are constant, then the real wage will fall:

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The demand for labor services

Firms hire workers because they produce output. They hire workers as long as the marginal product of labor is at least as great as the cost of hiring.

Marginal product of labor (MPL) The extra output a firm receives from adding one more unit of labor, holding all other inputs and efficiency constant.

The labor demand curve

Figure 8.1

The labor demand curve is the same as the marginal product of labor curve.

It slopes downward, because of diminishing returns to adding an additional worker.

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Shifting the labor demand curve

The labor demand curve is a derived demand curve; the number of workers demanded derives from their profitability to firms.

If new technology allows workers to be more productive, firms will want to hire more of them at any given wage: an increase in labor demand.

Shifting the labor demand curve

Figure 8.2

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The supply of labor services

The real wage (w) can be thought of as the opportunity cost of leisure, since an additional hour of work means you forgo an hour of leisure.

The price of leisure rises as the wage increases, therefore you consume less of it via a substitution effect.

The income effect leads people to want to consume more leisure as their income rises, thus people work less.

In the short run, in the aggregate labor market the substitution effect tends to outweigh the income effect.

Implication is that at higher wages there is more labor provided.

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The labor supply curve

Higher real wages lead to an increased quantity of labor supplied due to substitution effects outweighing income effects in the short run.

Therefore, the labor supply curve slopes upward.

The labor supply curve

Figure 8.3

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Factors that shift the labor supply curve

Factors that shift the labor supply curve to the left:

Increases in wealth.

Increases in preferences toward leisure over work.

Increases in income taxes.

Opposite changes would shift the labor supply curve to the right: an increase in labor supplied.

Shifting the labor supply curve

Figure 8.4

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Labor market equilibrium

Point A represents the equilibrium real wage rate (w*) and an equilibrium quantity of labor (L*).

At a wage below w* such as w1, the quantity of labor demanded exceeds the supply and a shortage of labor exists.

Equilibrium in the labor market

Figure 8.5

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The effect of technological change

New software would allow employees to do their work more quickly, increasing their MPL at each wage, shifting the labor demand curve to the right.

At point B, the new equilibrium has a higher equilibrium wage (w2* > w1*) and a higher quantity of labor in terms of hours worked (L2* > L1*).

The effect of technology on the labor market equilibrium

Figure 8.6

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Of course, technological change will hurt some workers, in industries replaced by the technology; but overall the real wage and employment will rise.

Why don’t people work as much as they did?

Over the course of the 20th century, the average work week fell from around 50 hours per week, to less than 40.

From 1950 to 2011, total household wealth in the United States increased from $7 trillion to $52 trillion, measured in 2005 dollars.

Predict the effect this increase in wealth had on the equilibrium real wage and the level of employment.

Use a graph to support your answer.

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Solved Problem

Why don’t people work as much as they did?

Step 1 Review the chapter material.

Step 2 Draw a graph that shows the effect of the increase in wealth on the labor demand and labor supply curves. Increases in wealth should not affect the marginal productivity of labor, so labor demand stays fixed. Labor supply will shift to the left since individuals purchase the same quantity of goods and services, but work less.

Step 3 Use your graph to explain the effect on the real wage and quantity of labor. If the wage stayed at w1*, a shortage of workers would occur. So the equilibrium real wage will rise, and the equilibrium quantity of labor will fall.

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Solved Problem

Define unemployment and explain the three categories of unemployment.

8.2

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Learning Objective

Categories of unemployment

To better understand unemployment, economists have found it useful to analyze three categories of unemployment:

Frictional unemployment

Structural unemployment

Cyclical unemployment

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Frictional unemployment and job search

Most workers spend at least some time engaging in job search.

Frictional unemployment Short-term unemployment that arises from the process of matching the job skills of workers to the requirements of jobs.

Frictional unemployment occurs because:

Workers have different skills, interests, and abilities.

Employers have different skill needs, conditions, and wages.

Workers need time to search for a job, and firms need time to find new employees.

Frictional unemployment can improve economic efficiency, because of better matching.

There is always some level of frictional unemployment.

Seasonal unemployment is a type of frictional unemployment, due to factors such as weather, variations in tourism, and holidays.

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Unemployment insurance

Unemployment insurance A government program that allows workers to receive benefits for a period of time after losing their jobs.

Unemployment insurance has efficiency benefits:

Without the “safety net”, workers are pressured to take first job offer.

So Unemployment insurance can improve matching between workers and firms (shifting demand for labor to the right).

However if benefits are too generous, it may reduce efficiency since workers can look for work for very long periods.

This is an example of moral hazard: people changing their behavior when they are insured against its consequences.

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Structural unemployment

Structural unemployment Unemployment that arises from a persistent mismatch between the job skills or attributes of workers and the requirements of jobs.

Structural unemployment is typically longer lasting than frictional unemployment.

Example: Auto manufacturers shifted employment out of Detroit, towards the Southern states in the 2007-2009 recession. Auto workers losing jobs in Detroit had to either move or find employment in a new industry.

To change industries, workers often need retraining or education.

Technological change is a source of structural unemployment.

In the U.S., technological change has tended to eliminate low-paying jobs.

Generally increased demand for more highly skilled jobs.

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Is manufacturing decline a recent phenomenon?

Is the decline of industries that produce goods a recent phenomenon?

The percentage of workers in goods-producing industries has decreased markedly since WWII.

Why? Is it because of increased international trade?

Effects of globalization are too recent to explain trend.

Better explanation: productivity growth in goods-producing industries has outpaced service-producing industries.

Example: Still takes about as long to produce a haircut now as in 1950.

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Macro Data

Cyclical unemployment

Cyclical unemployment Unemployment caused by a recession; measured as the difference between the actual level of unemployment and the level of unemployment when the unemployment rate equals the natural rate of unemployment.

Natural rate of unemployment The normal rate of unemployment, consisting of frictional unemployment plus structural unemployment.

Full employment does not mean every worker has a job.

The cyclical unemployment rate is zero at full employment.

The “full-employment rate of unemployment” is also known as the “natural rate of unemployment”

Most economists believe the natural rate of unemployment is around 5% or 6% in the U.S.

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Cyclical unemployment continues after a recession

While cyclical unemployment is caused by a recession, it does not end when the recession ends.

2012 predictions about unemployment rate:

Fed: might not return to full employment until 2014.

White House: projected unemployment rate in 2016 at 6.5%.

High unemployment rates after the end of the 2007-2009 recession

Figure 8.7

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Did structural unemployment rise?

Did the structural unemployment rate rise during the recession of 2007-2009?

Cyclical unemployment rises during recessions, and slowly dissipates over time.

Fall in unemployment after June 2009 seemed particularly slow.

In 1981-1982 recession, unemployment peaked at 10.8% in Nov. 1982.

Unemployment fell to around 7% a little over 2 years later

In 2007-2009, recession unemployment peaked at 10.0% in Oct. 2009.

In September 2012, unemployment rate still at 7.8%.

Why did the unemployment rate fall so slowly after the 2007-2009 recession?

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Making the Connection

Did structural unemployment rise?

Ideas:

Structural unemployment may have increased.

Example: Residential construction experienced 44% decrease in jobs.

Workers in industries hit hard by recession may have exited the labor force.

Firms seem to have moved away from a system of temporary layoffs to deal with recessions; firms are now using permanent layoffs instead.

Perhaps it was just that aggregate demand fell so much, and then increased so slowly, that the recovery was hindered.

When we discuss short run monetary and fiscal policies, understanding reasons for changes in the unemployment rate will become crucial.

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Making the Connection

Unemployment around the world

Unemployment rates fluctuate for all countries.

Certain countries tend to have higher rates of unemployment than others.

Unemployment never falls to zero for any country.

Monthly unemployment rates around the world, 1955-2011

Figure 8.8

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Duration of unemployment around the world

The average duration of unemployment measured in months varies over time and country.

European average unemployment rates were as low as those in the U.S. in the early 1970s, but duration was much longer in Europe.

Differences in unemployment duration have important policy implications.

Unemployment duration around the world, 1977-2011

Figure 8.9

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Explain the natural rate of unemployment.

8.3

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Learning Objective

Measuring employment

Bureau of Labor Statistics (BLS) collects data on employment using several regular surveys:

Current Employment Statistics survey

“Establishment survey”

Monthly survey of 140,000 businesses and government agencies

Used to identify net changes in employment

Job Openings and Labor Turnover Survey (JOLTS)

Sample of 16,000 businesses and government agencies

Estimates number of workers finding and losing jobs

These surveys, along with the better known Current Population Survey, help the government to estimate job flows within the economy.

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How many jobs does the U.S. economy create?

The following data on total private-sector employment (in thousands) are from the establishment survey, as reported in the June 2012 BLS employment Situation report:

A newspaper article on the report commented, “Private companies sharply cut back on hiring last month, adding only a meager 82,000 jobs.”

Is the reporter accurately interpreting the data? Did the private sector create 82,000 jobs during May 2012?

March	April	May
110,871	110,958	111,040

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Solved Problem

How many jobs does the U.S. economy create?

Step 1 Review the chapter material.

Step 2 Answer the problem by explaining how to interpret the data in the BLS Employment Situation report. The BLS Employment Situation report provides data on total employment each month, as determined by the establishment survey. The change in total employment from one month to the next tells us the net change in employment. It does not tell us the total number of jobs created during a given month. In a typical month, millions of jobs are created (and millions of jobs are lost). The reporter is making a common mistake of confusing the net change in employment with the total amount of job creation.

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Solved Problem

The natural rate of unemployment

Long-run equilibrium unemployment rates are known as the natural rate of unemployment.

Sum of structural and frictional unemployment.

The natural rate varies across countries and time.

This explains in part why unemployment rates vary across countries and time.

But what determines the natural rate of unemployment?

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A simple model of the natural rate of unemployment

The natural rate of unemployment is considered the rate of unemployment with the economy in steady state. The flow of workers into unemployment equals the flow out of unemployment in the steady state.

Let f be the rate of job finding. Then each month, the number of workers finding a job is:

Let s be the rate of job separation. Then each month, the number of workers losing their job is:

The natural rate occurs where the flow in and out of unemployment is balanced:

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Deriving the natural rate of unemployment

The fraction of the labor force that is unemployed is the unemployment rate, which we denote with U. Then:

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Using the natural rate of unemployment expression

Suppose that in the long run, 1.5% of employed people lose their jobs each month, while 25% of people find a job each month. Then:

How can the natural rate of unemployment be lowered?

By raising f, the rate of job finding; or

By lowering s, the rate of job separation.

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Actual versus natural rater of unemployment

The natural rate changes less than the actual unemployment rate.

Changes to the structural and frictional unemployment rates change the natural rate.

Demographics.

Public policy.

Technological change.

Sectoral shifts.

We will discuss each of these in turn.

The actual and natural rates of unemployment for the United States

Figure 8.10

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Demographic changes

Older workforces on average have lower unemployment rates.

January 1948-May 2012 unemployment rates: 11.8% for age 16-24, 4.4% for over 25s.

Aging U.S. workforce (baby boomers) has reduced natural rate by ~0.4 points.

Women have lower unemployment rates, and higher percentages of women in the workforce lowers the natural rate of unemployment.

The share of women in the workforce increased from 28.6% to 46.6% between 1948 and 2011.

Unemployment rates since 2000: 5.9% for women, 6.5% for men.

African Americans and Hispanics have higher natural rates of unemployment, and are making up a larger proportion of the workforce.

March 1973-May 2012 unemployment rates: White 5.7%; African American 12.3%; Hispanic and Latino 9.2%.

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Public policies

Public policies such as unemployment insurance and disability benefits affect the natural rate of unemployment.

Unemployment insurance is a joint state and federal program.

Workers receive a portion of their former salaries for up to 26 weeks.

Benefits often extended during recessions (up to 99 weeks during recession of 2007-2009).

Reduces likelihood workers will accept any given job offer.

Increased benefit amounts and lengths increase the natural rate.

One study showed increasing benefits by 10% increased the duration of unemployment between 4% and 8%.

Disability is paid to those physically or psychologically unable to work.

Those on disability leave the labor force, reducing natural rate of unemployment (since low-skill workers are more likely to leave).

Increased temporary employment reduces natural rate of unemployment.

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Public policies—continued

People make work/leisure decisions based on their after-tax rate of pay. Therefore marginal tax rates affect motivation to work.

Ed Prescott argues differences in natural rates of unemployment between U.S. and Europe are mainly due to marginal tax rates.

But this implies elasticity of labor supply is high; most estimates place it near zero.

Labor market regulations may affect unemployment rates.

Restrictive regulations make firing difficult, encouraging conservative hiring practices—hence higher natural rate of unemployment.

Similarly, firms may switch to capital-intensive production.

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Technological change

Technological change results in short-run increases to the natural rate of unemployment.

Technology makes some jobs obsolete, increasing unemployment.

Structural unemployment created by those in jobs being phased out through technological change.

Example: Newspapers being replaced by TV and internet news—changes required skills for workers.

Resources will flow from the old to the new industries.

In the long run, technological change leads to higher real wages.

Higher wages increase the quantity of labor workers are willing to supply.

Ultimately, workers as a group are better off.

Some workers are made worse off through creative destruction.

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Sectoral shifts

Sectoral shifts occur as output and employment increase in some industries while declining in other industries.

A general long-term movement of labor from goods-producing sector to service-producing sector.

Trend not unique to U.S.: Manufacturing fell from 20% of OECD GDP in 1998 to 15% in 2009.

In developing nations, labor flowing from agricultural to manufacturing sector.

Causes temporary increase in natural rate of unemployment as labor force adjusts to new demands.

Similarly, change to more temporary or contract-based employment.

Increased natural rate of unemployment 0.2 to 0.4%.

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Are strict labor laws to blame for unemployment?

France has relatively strict labor laws.

Difficult to fire workers

Generous vacation (4-6 weeks) and sick pay

Consequently, many firms are reluctant to hire, reducing rate of job finding.

This can in part explain differences between U.S. and French unemployment rates.

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Making the Connection

Explain how government policies affect the unemployment rate.

8.4

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Learning Objective

Why does unemployment exist?

If the prevailing real wage is above the equilibrium real wage, then more workers will want jobs than can find them—unemployment.

A labor market with unemployment

Figure 8.11

But why would the real wage be above equilibrium?

We will consider three frictions that prevent the real wage from adjusting to maintain equilibrium:

Efficiency wages

Labor unions

Minimum wages

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Efficiency wages

Efficiency wage A higher-than-market wage that a firm pays to motivate workers to be more productive and to increase profits.

Rather than directly monitor workers, firms pay higher wages to motivate workers to be more productive for several reasons.

Efficiency wages:

make workers less likely to do things that lead the firm to fire them.

make workers less likely to switch jobs, so firms avoid expensive searches.

improve the quality of the pool of job applicants.

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Labor unions around the world

Labor unions bargain with employers over wages and working conditions for their members.

Typically bargain for wages higher than market rates, reducing employment.

In U.S., fewer than 7% of private-sector workers are unionized; so unlikely to be a major source of unemployment

In U.S., 36% of public-sector workers are unionized.

Does high rate of unionization result in excessive pay/benefits? Hard to judge, since many jobs have no private counterparts.

Employment at state and local governments fell about 650,000 between August 2008 and May 2012, contributing to high levels of unemployment.

Unionization rates vary across countries and time.

High rates in western and northern Europe, low rates in East Asia (comparable to U.S.).

Strength of unions has fallen over time—sectoral shifts.

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Minimum wages are legally binding minimum hourly wage rates.

Federal government in the U.S. has had a minimum wage since 1938.

Nominal value in 1938 was $0.25 per hour.

Had a limited scope in terms of which workers were affected.

Nominal minimum wage in 2010 was $7.25 per hour.

Minimum wage now applies very broadly.

Some states and localities have higher minimum wages.

California: $8.00 per hour; San Francisco, CA: $10.24 per hour.

High minimum wages can lead to increased levels of unemployment as the quantity of labor supplied increases while the quantity demanded falls.

But since relatively few workers earn minimum wage, probably not a large effect on unemployment.

Possibly greater effect on particular groups, e.g. teenagers.

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Answering the key question

“Has the natural rate of unemployment increased?”

The recession of 2007-2009 saw a very large increase in the unemployment rate, persisting for several years after the official end of the recession.

Extensions of unemployment insurance have helped people survive their unemployment spells; but have probably decreased incentives to find jobs.

However much of the increase in the unemployment rate was probably due to cyclical factors (low demand for workers), rather than an increase in the natural rate of unemployment.

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