The Best Essay on Unemployment | Macroeconomics

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Unemployment can be divided into different types according to the reasons for its occurrence. For example, there is frictional unemployment, which arises when a person is temporarily unemployed while moving between jobs. Similarly, there is structural unemployment, when people find their skills are not employable because they have become technologically redundant or there is no demand for them in certain regions of the country where they live.

These types of unemployment are easy to explain. By comparison, there is an enduring controversy associated with the attempts to unravel what, if any, are the differences between classical and Keynesian unemployment. The classical economists believed in the Say’s Law of Markets and in wage-price flexibility. The operation of the Say’s Law (which states that demand creates its own supply) and sufficient wage-price flexibility, they believed, would ensure automatic full employment.

Thus, in the classical theory, there was no possibility of unemployment. If there occurred any unemployment it would be of a purely temporary nature. The cause of such unemployment was too high a real wage. And such unemployment would disappear quickly due to fall in real wage.

The intuition behind the classicists’ analysis of unemployment comes from the standard apparatus of supply and demand curves. They have reached the conclusion that if the labour market does not equilibrate, it must be because the price, i.e., the real wage, is set at an inappropriate (and not at the market-clearing) level.

The demand for labour originates from the profit-maximising decisions of firms. Under competitive conditions, this leads firms to equate the real wage with the marginal product of labour. Hence the demand for labour schedule is a direct reflection of the marginal physical product of labour (MPP_L) function.

With a well-behaved aggregate production function, the MPP_L will be a decreasing function of the level of employment, and so the demand for labour varies inversely with the real wage. Consequently, if the supply of labour exceeds the demand and there is a problem of unemployment, then the solution lies with a fall in the real wage as this will increase the quantity of labour demanded and close the unemployment gap.

In his General Theory Keynes disputed the classical analysis of unemployment and the associated policy prescriptions. He introduced the concept of involuntary unemployment that had something to do with inadequate demand in final commodity markets and which could be remedied with the management of demand by fiscal policy and possibly by monetary policy too.

In explaining the cause of unemployment, Keynes focuses on the role of nominal wage inflexibility. In his view, unemployment results from an inflexible money wage which prevents the real wage from adjusting downwards to increase the demand for labour. Thus the unemployment problem originates from an inappropriate real wage.

According to Keynes, the equality of the real wage to the marginal disutility of employment corresponds to the absence of ‘involuntary’ unemployment. (Keynes makes the simplification that the marginal utility of income is constant so that the marginal disutility of employment is the same as the marginal rate of substitution of income for leisure.) Keynes excluded frictional unemployment from involuntary unemployment.

However, it is important to note that Keynes also excluded unemployment “due to the refusal or inability of a unit of labour, as a result of legislation or social practices or of a combination for collective bargaining or of a slow response to change or of mere human obstinacy, to accept a reward corresponding to the value of the product attributable to its marginal productivity”.

Thus, Keynes chose to exclude union wage differentials as well as minimum wage legislation as sources of involuntary unemployment. Clearly, Keynes wanted to focus on a particular type of involuntary unemployment.

Don Patinkin also used the static labour supply definition in his well-known analysis of involuntary unemployment:

The norm of reference to be used in defining involuntary unemployment is the supply curve for labour as long as workers are ‘on their labour supply curve’—that is, as long as they succeed in selling all the labour they want to at the prevailing real wage rate—a state of full employment will be said to exist in the economy.

The above definition of involuntary unemployment based on the labour supply curve was used by the ‘classical’ economists. For example, in 1914 A. C. Pigou proposed measuring involuntary unemployment of a group of persons by the number of hours that these persons would have been willing to provide at the current rate of wages under current conditions of employment.

According to Keynes, however, classical theories (such as Pigou’s) did not admit the possibility of involuntary unemployment by union wage differentials or minimum wage legislation. But Keynes chose to classify this as voluntary.

The Natural Rate of Unemployment (NRU):

There are two conceptually’ separate reasons why the real wage may fail to adjust to the competitive equilibrium value. Firstly, the institutions of the economy may not correspond to those of a competitive economy: information may be costly, there may be traces of monopoly, etc.

Within this institutional context, markets are assumed to clear and the associated level of unemployment is termed as the ‘natural’ rate of unemployment.

In the language of Milton Friedman:

“The ‘natural rate of unemployment’ is the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labour and commodity markets, including market imperfections, stochastic variability in demands and supplies, cost of gathering information and so on”.

Consequently, one way that unemployment might be tackled is through policies which attempt to lower the ‘natural’ rate by removing market imperfections.

A ‘natural’ rate of unemployment is the level of unemployment where inflation is anticipated. For this reason the term the non-accelerating inflation rate of unemployment (NAIRU) is often preferred to the title ‘natural’ to describe the level of unemployment.

The current view is that the natural rate of unemployment is the rate towards which the dynamic system is converging for a given underlying general equilibrium stochastic structure. It takes into account the actual structural characteristics of the labour and commodity markets, including market imperfections, search and mobility costs.

In simple terms, it may be regarded as that level of unemployment which nonetheless remains at full employment.

In truth, NRU is essentially a long-term phenomenon. It is the rate of unemployment towards which the economy gravitates in the long run, subject to the existing imperfections in the labour market which make it difficult for workers to find jobs easily and quickly.

According to Milton Friedman who introduced the term ‘natural rate’ argues that the term ‘natural’ is useful in separating the real forces from the monetary sources. Viewed from this perspective an important feature of the natural rate as emphasised by Friedman (1968) and E. Phelps (1967, 1970) is that it does not correspond to any particular rate of inflation. For any appropriately defined long run, the key implication of this is that there is no long-run trade-off between inflation and unemployment.

Following the Friedman lead, the natural and cyclical rates of unemployment are most often treated as separate and independent components. According to this view, cyclical unemployment is characterised as being included by temporary fluctuations in conditions resulting in temporary deviations of the actual rate from the natural rate of unemployment.

Empirical evidence, however suggests considerable covariance between cyclical and structural unemployment. For example, structural unemployment is likely to increase during recessions since firms in declining industries may find it optimal to accelerate eventual reductions in their labour force at such times. Significant covariance’s of this sort raise fundamental questions about the causality of unemployment as well as whether the natural rate of unemployment is an operative concept.

Since structural unemployment is most often interpreted as a component of the natural rate, this raises serious questions about whether natural and cyclical rates of unemployment are separate, independent and indentifiable components.

To sum up, there are two features of the NRU. Firstly, it is an inherently dynamic concept. Secondly, the natural rate is clearly not a fixed and immutable constant. Variations in the composition of the labour force, the rate of structural change, the flow of information and other factors affecting labour force mobility will change the natural rate.

There is widespread agreement in macroeconomics that when there are informational inadequacies leading to sticky prices and difficulties in forming expectations, unemployment may deviate from its ‘natural’ level.

According to Friedman, the government’s demand management policies may influence the ‘natural’ rate. He argues that the variability of inflation is directly related to the level of inflation.

So, more noise enters into price signals at higher rates of inflation with the result that the ‘natural’ rate rises with the rate of inflation,

In 1980 Tobin argued that “the operational NAIRU gravitates towards the average rate of unemployment actually experienced. Among the mechanisms which produce that result are improvements in unemployment compensation and other benefits enacted in response to higher unemployment, loss of on-the-job training and employability by the unemployed, defections to the informal and illegal economy, and a slowdown in capital formation as business firms lowers their estimates of needed capacity.”

If such hysteresis effects are accepted, then an expansionary demand policy — which leaves unemployment ‘temporarily’ below the ‘natural rate — will have a permanent influence because it contributes to reducing the ‘natural’ rate itself.

Job Search and Frictional Unemployment:

In recent years economists have been concerned with frictional unemployment. One proximate cause of unemployment is the mismatch between workers and jobs. Since labour is not homogeneous, a job loss does not immediately lead to job finding. Workers who are laid-off do not find a job easily and quickly.

Job finding itself is a resource-consuming and a time-consuming endeavour. The unemployment caused both the time required by a worker is called frictional unemployment. Such unemployment occurs because we do not live in the wonderful world of the classical economists.

It occurs because information about job availability is not freely available to workers and, even when it is available, it is imperfect. Moreover, workers are not geographically mobile. There are various barriers to labour mobility.

These two factors conjointly reduce the rate of job finding. Moreover, since workers differ in their abilities and performances and jobs also differ in their characteristics (in terms of rewards and sacrifices) different jobs require different skills and offer different wages. This is why an unemployed worker prefers to spend time and money to search out a job of his liking rather than accepting any job that comes along the line.

Frictional unemployment is also related to shift unemployment. Some unemployment occurs due to shifts in demand for consumer goods used by households and producer (capital) goods used by firms.

Since the demand for labour is an indirect (derived) demand, change in the pattern of demand for goods leads to a change in the demand for labour that is required to produce those goods.

Likewise, since different regions of a country produce different goods, the demand for labour may rise in one region (such as Maharashtra or Gujarat) and fall in another region (Orissa or Bihar). Such unemployment caused by a change in the composition of demand among industries or regions is called shift unemployment.

This is another type of frictional unemployment. Since sectorial shifts are occurring all the time in a dynamic economy, and since workers take some time to move from one sector to another due to lack of marketable skill or adequate information, frictional unemployment is a rule rather than an exception.

Frictional unemployment occurs for various other reasons, for example, when old firms face problems of demand recession (such as the workers of Hindustan Motors), when workers’ job performance is inadequate when judged by any standard, and when workers’ particular skills are not in demand any more. This has happened in cases of silent movie actors or typists or tram drivers in most parts of the world.

Frictional unemployment also occurs when workers voluntarily leave their jobs or move from one part of the country to another part (and try to search out better jobs).

Frictional unemployment occurs due to inter-sectoral imbalance between demand and supply forces, i.e., where there is excess supply of labour in one sector offering higher wages due to the fact that some workers from numerous low-paying sectors have crowded the few high- paying sectors.

Efficiency Wage:

A proximate cause of real wage rigidity and involuntary unemployment is associated with the efficiency wage theory. This concept is based on the famous Marshallian concept — the economy of high wages. Marshall first hypothesized that high wages promote efficiency and low wages retard it.

The idea was put into effect in the American manufacturing industry by Henry Ford who followed the practice of giving higher than the prevailing market wage so that the rate of labour turnover came down to a minimum. Ford’s basic objective was to ensure that his most productive workers did not quit after a short association with the organisation.

The efficiency wage theory explains why firms do not cut wages even when there is excess supply of labour. The theory is based on the belief that a wage cut would lower a firm’s wage bill no doubt, but it would also reduce a firm’s profits by lowering worker efficiency.

Various explanations have been offered to explain how wages affect labour productivity:

(i) Improved Health and Enhanced Productivity:

In less developed countries like India, high wages enable workers to improve their health by having a more nutritional diet. Healthy workers are usually found to be more productive than half-fed worker. So, it is in the Tightness of things to give workers a wage above the equilibrium level in order to maintain a healthy work force.

(ii) Low Labour Turnover:

The higher the wage rate, the stronger the incentive of workers to stay with the firm. If the quit rate can be reduced to a minimum, a firm can achieve economy in terms of the time spent recruiting and training new workers.

(iii) Reducing Adverse Selection:

The overall quality of a firm’s labour force depends on the wages it pays to its employees. A wage cut will force a firm’s best workers to take jobs elsewhere in other firms, leaving the firm with inferior employees who have hardly any opportunity outside the firm. This is an example of adverse selection since workers are more informed about their alternative opportunities outside the firm than the firm (the employer).

This is also known as hidden characteristics. So by paying a low wage, a firm may take the risk of hiring inferior workers (who do not have any opportunity outside the firm). One way of reducing adverse selection is to pay a wage above the equilibrium level. This improves the average quality of the work force. So, labour productivity automatically improves.

(iv) Overcoming the Moral Hazard Problem:

High wages also improve worker effort. The truth is that it is not always possible to monitor the work effort of employees. It is the task of the employees themselves to decide how hard to work. This is known as moral hazard, also known as the hidden action.

This refers to the hidden tendency of workers to put sub-optimal effort if their activities are not perfectly monitored. One way of reducing this moral hazard problem is to pay a high wage. The higher the wage, the higher the cost of the worker of being dismissed.

One way of increasing labour productivity is to pay a higher than market wage. This induces more and more of a firm’s employees not to shirk. The common theme of various efficiency wage theories (presented above in a summary form) is that by paying its workers a high wage, a firm can operate more efficiently.

This is why many firms choose to pay more than the market clearing wage. This induces workers to stay with their firms and not to engage in job search activities. But efficiency wage increases the magnitude of involuntary unemployment and creates real wage rigidity.

Economic Insight: Four Models of Efficiency Wage:

There are four models of efficiency wage. The common feature of all the models is that higher than competitive wage can be profitable. All the models are based on the hypothesis that output depends on worker effort and effort, in its turn, varies directly with the wage rate. The more a firm pays, the more effort it gets.

The models originating from the presumed source of positive effort-wage relationship are of the four types:

1. Shirking Models:

In most jobs, workers enjoy some discretion in deciding how hard they work. Piece rates are often impractical because it is not only difficult but virtually impossible to count the “pieces” and counting is costly. In the shirking models, firms pay above the market wages, engage in some monitoring and fire those workers caught shirking.

By paying above market wages, firms decrease the incentive to shirk, since defection then entails loss of rents. According to shirking models, high wage industries are those with high monitoring costs and/ or industries which bear a relatively high cost of employee shirking.

2. Turnover Models:

Firms may also wish to pay above market clearing wages to reduce turnover. High wages are paid to reduce quits. So it follows, by deduction, that the high-wage industries are those in which turnover costs are the highest.

3. Adverse Selection Models:

According to these models, employers cannot gain an insight into the ability of workers, either as potential entrants or on the job, in a costless fashion. It is assumed that the average quality of the applicant pool increases with the wage rate. The main prediction of these models is that industries which are more sensitive to quality differences, or have higher costs of measuring quality, will offer higher wages.

4. Fair-Wage Models:

The premise of these models is that workers will exert more effort if they feel that they are being treated fairly. This premise gives firms an incentive to pay wages above competitive levels whenever their workers’ perceived fair wage exceeds the competitive wage.

If workers believe that fairness requires firms to share rents with employees, then fair wage models predict that industries with high profits will be those which pay high wages. In Fig. 1, we show profit-wage trade-off. In short, industries’ high wages lead to low profits as is shown by the profit-wage curve pw₁.

If the wage rate is pushed up from w₁ to w₂, the rate of profit falls from π₁ to π₀ . In other industries high wages lead to high profit as shown by the curve pw₂. If the wage rate is pushed up from w₁ to w₂, the rate of profit goes up from to π₀ to π₁.

The fair wage models also predict high wages in industries where teamwork and worker expectations are particularly important. However, the four models are not mutually exclusive. Firms might well pay above competitive wages to reduce shirking and, thus, attract high-quality applicants and improve worker morale.

Effect of Minimum Wage on Employment:

Since the government does not hire surplus labour in the way it buys surplus agricultural output, a labour surplus takes the form of unemployment which tends to be higher under minimum wage laws than in a free market. In general, those whose employment prospects are reduced most by minimum wage laws are the young, less experienced and less skilled.

As in all cases, a ‘surplus’ is a price phenomenon. Unemployed workers are not surplus in the sense of being useless or in the sense that there is no work for them. Most of these workers are perfectly capable of producing goods and services, even if not to the same extent as more skilled workers. The unemployed are made idle by wage rates artificially set above the level of their productivity.

Moreover, unemployed youth are prevented from acquiring the job skills and experience which could make them more productive—and, therefore, higher earners—in near future. Due to minimum wage laws, unemployment in European countries is higher than that in the USA. Since Switzerland and Hong Kong do not have minimum wage laws, they have very low unemployment rates. In recent years, some countries have allowed their real minimum wage levels to be eroded by inflation.