Labour Economics assignment 1
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Chapter17.pptxChapter Eighteen Unemployment
Causes and Consequences
© 2012 McGraw-Hill Ryerson Ltd.
Prepared by Dr. Amy Peng
Ryerson University
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Learning Objectives
Explain how imperfect information can lead to a labour market equilibrium in which unemployed workers and unfilled job vacancies co-exist.
Explain how shifts in the structure of product demand can be a source of unemployment in the labour market.
Summarize empirical findings on job displacement and its consequences.
Describe leading models of worker and employer behaviour that give rise to employers paying above market wages, thus resulting in a labour market equilibrium with unemployed workers.
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© 2012 McGraw-Hill Ryerson Ltd.
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Learning Objectives
Explain the rationale for publicly provided unemployment insurance, and the ways that unemployment insurance may influence labour supply and unemployment.
Summarize the empirical evidence on the relationship between unemployment insurance and labour supply and unemployment.
Discuss mechanisms by which high unemployment may persist, and describe the relevance of these mechanisms for understanding the unemployment experience of Europe and North America.
Summarize the empirical evidence on nominal wage rigidity, and explain the relevance of this evidence for policies aimed at achieving low inflation.
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Causes of Unemployment
The minimum wage laws
Institutional factors such as unions or large public sector
Demand factors
Seasonal unemployment
Frictional unemployment associated with normal turnover of the work force
Sectoral shifts causing structural unemployment: Time lag in finding a job
High unemployment insurance
Nominal wage rigidity
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Frictional or Structural Unemployment
Search Unemployment:
Job search associated with imperfect information causes delays
Job search involves costs and benefits
Expected benefits have to be weighted against the expected costs
The condition of optimal search is a stopping rule: a minimum acceptable requirements (wage, benefits, working conditions, etc.) is chosen and the search is executed until the job that meets the acceptable requirements is found
More specifically…
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Frictional or Structural Unemployment
Employees continue to search until expected marginal benefit equal expected marginal cost
Benefits and costs of search are likely to be related to the amount of time devoted to a job search
Marginal cost is rising with the amount of job search undertaken
Optimal amount of a search will maximize the difference between B and C (see the diagram on the next page)
The difference is maximized when expected marginal benefit equals expected marginal cost at Se (see the diagram on the next page)
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Frictional or Structural Unemployment
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The optimal amount of search will maximize the difference between B and C. This difference is maximized
when the expected marginal benefit of search equals the expected marginal cost, at expected search
duration Se .
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Frictional or Structural Unemployment
Implications of imperfect information
Generally workers and firms will stop their search activities prior to being fully informed due to diminishing returns to information acquisition and also increasing costs of information acquisition. As a result:
A labour market characterized by imperfect information will not clear instantaneously
Dispersion of wage rates will occur even in a labour market with homogeneous workers and jobs
Case of dynamic monopsony
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Frictional or Structural Unemployment
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Frictional or Structural Unemployment
Factors Determining Optimal Search:
Expected benefit of job search
Expected duration of a job
Age: younger workers’ unemployment duration is lower
Institutional mechanisms of information dissemination
Internet accessibility
Number of employers with available job vacancies
Rate at which employers offer jobs
Value of leisure
Social and labour market policies
Employment insurance
Pensions
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Frictional or Structural Unemployment
Empirical evidence of job search:
More than 5% of all employed workers are looking for another job
Part time workers are looking at job advertisings or contacting employers directly
Diminishing role played by government agencies
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Search Activity of the Employed and Unemployed, 2010
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Frictional or Structural Unemployment
Sectoral Shifts and Unemployment:
Unemployment would increase in periods of major structural adjustment
High employment growth across industries is associated with periods of high unemployment
Some industries are more cyclically sensitive than others
Economic shocks have more severe consequences for unemployment
Economic dislocation causes displacement of older and less educated workers
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Frictional or Structural Unemployment
Sectoral Shifts and Institutional Rigidities:
Developed countries experience a higher increase in demand for skilled workers due to technical change
The more flexible U.S. labour market transmitted the demand shocks through prices, allowing employment to fully adjust
The more rigid European labour markets (due to government policy, protection laws, high minimum wages, and strong unions) experienced adjustments mostly in quantities rather than prices
Roles played by labour market institutions
More generous UI benefits that are associated with higher unemployment
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High-Wage Unemployment
Alternative approaches
Key assumptions of the competitive model reconsidered:
Implicit Contracts
Efficiency Wages
Insider-Outsider Theories
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High-Wage Unemployment
Implicit Contracts:
Deals with issues that arise when firms and workers are engaged in a continuing employment relationship
Seeks to explain phenomena such as rigid wages and the use of quantity adjustments
Based on the view that employment behaviour reflects risk-sharing between employers and employees
Difference in attitudes toward risk between employers and employees provide the basis for both parties to benefit from a risk sharing arrangement
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High-Wage Unemployment Implicit Contracts
Reasons for workers being more risk-averse than employers:
The main workers assets—human capital—not diversifiable (to reduce risk)
Sorting according to innate risk preferences
Entrepreneurs are mostly risk-neutral and risk-lovers
Employees (wage earners) are mostly risk-averse
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High-Wage Unemployment Implicit Contracts
Other related issues:
Moral Hazard
Individuals can influence the risk against which they are insured
Adverse Selection
Insurer cannot observe the risk that a particular insuree presents
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High-Wage Unemployment Implicit Contracts
The Central Hypothesis of Implicit Contract Theory:
The firms provide insurance only to its own employees, thus avoiding adverse selection problem
The firm controls the probability of income loss due to layoff or wage/hour reduction, thus avoiding the moral hazard problem
Implicit contract theory applies to situations in which there is a long-term attachment between the firm and its workers
Symmetric vs. asymmetric information
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High-Wage Unemployment Implicit Contracts
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In the good state, N0 workers are employed at Wa; in the bad
state, Nb employed workers
earn Wb, and unemployed workers “earn” k
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High-Wage Unemployment
Wage and employment with market-clearing:
Base case without implicit contracts
N0 workers attached to the firm and the value of leisure is k
Supply is perfectly elastic
In the good state N0 workers are employed, earning Wa
In the bad state, Nb workers are employed, earning Wb
Earning variability is reduced with implicit contracts
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High-Wage Unemployment Implicit Contracts
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In the good state, N0 workers are employed at W*; in the bad state, Nb* employed workers earn W*
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High-Wage Unemployment Implicit Contracts
Wages and employment with implicit contracts:
In the good state, employment will be at N0 at a wage of W*
In the bad state, employment will be higher at Nb* and wages at W*
For workers it represents reduction in the risk
Firms are paying lower wages
Firms and workers are better off with risk-sharing
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High-Wage Unemployment Implicit Contracts
Main features of optimal contract:
Contract provides a rigid wage, independent of the state that is realized
Layoffs may occur in weak states of demand
The contract wage W* is lower than the market clearing wage in the good state
Both parties benefit from a risk sharing arrangement
Optimal contact reduces income uncertainty
The contract represents tradeoff between risk sharing and production efficiency
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High-Wage Unemployment
Efficiency Wages:
Firms choosing to pay wages above market clearing level
Enhance worker productivity
Improve worker morale
Discourage shrinking and absenteeism
Reduce turnover
Discourage unionization
Workers who eat better work harder
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Nutritional Efficiency Wage Model
Output of rice is given by Q = F(eL)
Efficiency, e, depends on wage paid e =e(W)
Firm’s profit is given by
Π = (F(eL) x L) – WL = g(W; L) – WL
If the firm reduces labour costs by paying a lower wage, these labour savings may be offset by a drop in labour productivity, so that the lower wage actually reduces profits.
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High-Wage Unemployment Efficiency Wage Determination
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Maximizing profits requires choosing the wage on g(W;L) that lies on the
steepest ray Q/W.
This tangency implies that the slopes of the two functions are equal;
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High-Wage Unemployment Efficiency Wage Determination
Productivity increases only slowly at first when wage is increasing
Only when workers reach a certain threshold, we see an increase in efficiency
Diminishing returns take over
Higher wages beyond some point will have a small impact on productivity
Firm maximizing profits (minimizing costs) at Q/W
Optimum occurs at W* at the tangency where profits are maximized
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High-Wage Unemployment
Insider-Outsider Theory:
Another explanation of wage inflexibility and unemployment
Persistent unemployment typically focuses on the wage determination process—wages may not adjust quickly to eliminate excess supply of labour
Wage setting is determined by bargaining between the employer and its existing work force (the “insider”)
The unemployed (the “outsider”) has little influence on the outcome
It’s costly to the firm to replace some of the existing workers
Increased bargaining power of the “insider” to raise wages, given the excess supply of labour, the “outsider”
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Deficient-Demand Unemployment and The Phillips Curve (Appendix)
The Phillips Curve:
Represents negative relationship between aggregate money wage changes and unemployment in the economy as a whole
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Unemployment Insurance and Unemployment
Economic Rationale for UI:
UI: provide workers with protection against the risk of income loss due to unemployment
Affects the incidence and duration of unemployment by altering the incentives facing workers and firms
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Unemployment Insurance and Unemployment
The effect of unemployment insurance on the incidence and duration of unemployment:
UI affects the incidence and duration of search by altering the costs and benefits of the job search
For the employed, the increase in benefit rate makes the job search more attractive, hence increasing the incidence of unemployment
For the unemployed, more generous UI lowers the costs of a job search, increasing the duration of job search and, hence increasing the unemployment rate
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Unemployment Insurance and Unemployment
The effect of unemployment insurance on the incidence and duration of unemployment:
More generous UI decreases the weeks worked
Higher benefits could also alter the behaviour of those who are not eligible for UI by accepting jobs quickly in order to qualify for subsequent UI benefits
The impact on the labour force participation
Repeated users
Regional extended benefits
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The Challenge of Persistent Unemployment
In many European countries unemployment rates have increased substantially since 1970s yet the inflation rate has been sustained. What can explain this situation?
One reason being the “insider”–“outsider” model, explained earlier
An alternative model is referred to as Hysteresis:
Occurs when unemployment rate drifts upward/downward without tendency to return to the equilibrium
Hysteresis exists when short run shocks have permanent effects
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Nominal Wage Rigidity and Low Inflation
The institutional features of the labour market result in downward nominal wage rigidity, even in the presence of substantial unemployment.
The pursuit of low inflation may have a permanent cost in the form of higher unemployment and reduced national output.
Empirical studies with both Canadian and U.S. data do find a substantial spike at zero inthe distribution of annual wage changes.
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Summary
Causes and consequences of unemployment
Optimal search and the factors
Sectoral shifts, unemployment, and institutional rigidities
Implicit contracts and their features
Efficiency wages and influences
The Phillips curve and natural unemployment rate (appendix)
Expected inflation and the results
UI rationale and its effects on unemployment
Nominal wage rigidity and low inflation
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