Unemployment

Unemployment

Unemployment is a macroeconomic phenomenon that directly affects people. When a member of a family is unemployed, the family feels it in lost income and a reduced standard of living. There is little in the realm of macroeconomics more feared by the average consumer than unemployment. Understanding what unemployment really is and how it works is important both for the economist and for the consumer, as it is often discussed.

The Costs of Unemployment

Because most people rely on their income to maintain their standard of living, the loss of a job will often directly threaten to reduce that standard of living. This creates a number of emotional problems for the worker and the family. In terms of society, unemployment is harmful as well. Unemployed workers represent wasted production capability. This means that the economy is putting out less goods and services than it could be producing. It also means that there is less money being spent by consumers, which has the potential to lead to more unemployment, beginning a cycle. However, in general, while unemployment is harmful for individuals, there are some circumstances in which unemployment is both natural and beneficial for the economy as a whole.

Okun's law

We know that when there is unemployment, the economy is not producing at full output since there are people who are not working. But, what exactly is the relationship between unemployment and national output or GDP? How much would we expect the GDP to increase if unemployment fell 1%? These are useful and important questions to ask when trying to understand the costs of unemployment.

An economist named Arthur Okun looked at the relationship between unemployment and national output over the past 50 years. He noticed a general pattern and stated an equation to explain it. His equation, Okun's Law, relates the percentage change in real GDP to changes in the unemployment rate. In particular, the equation states:

% change in real GDP = 3% - 2 x (change in unemployment rate)

This equation basically says that real GDP grows at about 3% per year when unemployment is normal. For every point above normal that unemployment moves, GDP growth falls by 2%. Similarly, for every point below normal that unemployment moves, GDP growth rises by 2%. This equation, while not exact, provides a good estimate of the effects of unemployment upon output.

For example, let's say a country had an unemployment rate of 8% in one year and 6% in the next. Using Okun's law, it would be hypothesized that the percentage change in the real GDP would be 3% - 2 * (-2%) = 7%. Because 2% fewer people were unemployed the nation produced 7% more output.

Types of Unemployment

While unemployment is a general term that describes people who wish to work but cannot find jobs, there are actually a number of specific types of unemployment. Three particular types of unemployment stand out as most important, frictional unemployment, structural unemployment, and cyclically unemployment

1.   Some people who are not working are simply between jobs. This may be the result of being hired elsewhere or simply relocating. They are not actively searching for a job, but instead just waiting to begin their next job. This is called frictional unemployment because these workers are literally between jobs.

2.   Other workers have a mismatch of skills for the job or geographic area that they want to work. If a welder is displaced by a robot or if a nuclear engineer is simply no longer needed in a lab, these workers become unemployed. This type of unemployment is called structural unemployment because the structure of the job is incompatible with the skills offered by the worker.

3.   Finally, some workers may be laid off as the economy slows down. These workers possess the necessary skills, but there is simply not enough demand for their firms to continue to employ them. This type of unemployment is called cyclical unemployment because it is attributable to changes in output due to the cycles of the economy.

Calculating Unemployment

The Bureau of Labor Statistics (BLS) regularly gathers data from 60,000 households to compute a number of macroeconomic figures. One of these figures is the unemployment rate.

To compute the unemployment rate, the first step is to place people into one of three categories: employed, unemployed, or out of the labor force. People who are employed are currently working. People who are unemployed are not currently working, but are actively searching for a job and would work if they found a job. People who are out of the labor force are either not currently looking for a job or would not work if they found a job.

Once people have been placed into the appropriate categories, the total labor force can be calculated as the total number of workers who are either employed or unemployed. The unemployment rate is the ratio of the number of people unemployed over the total number of people in the labor force.

For example, let's say that a survey by the BLS reveals 20 people employed, 5 people unemployed, and 40 people out of the labor force. Then the labor force would be the sum of the employed plus the unemployed or 20 + 5 = 25 people. The unemployment rate is the ratio of the unemployed to the total labor force or (5 / 25) = 20%.

Full Employment and the Natural Rate of Unemployment

The term full employment sounds as though it means everybody is working. And indeed, full employment refers to an economic situation in which unemployment is very low. However, when the economy is at full employment there is a still small amount of normal unemployment. This unemployment exists because people are always changing between jobs creating frictional unemployment. Similarly, when new workers enter the labor market, they do not immediately gain jobs. Instead, they must search for jobs, even if only for a short period of time. This causes there to be some unemployment even when the economy is theoretically at full employment.

The natural rate of unemployment is the rate of unemployment that corresponds to full employment. Economists theorize that this is around 6% unemployment due to frictional unemployment and structural unemployment. Cyclical unemployment causes a slight variation above and below this natural rate. In general, the economy is said to be operating at full capacity when the unemployment rate is at the nature rate of unemployment. Similarly, when the unemployment rate is below the natural rate of unemployment, the economy is said to be operating above full capacity. Finally, when the unemployment rate is above the natural rate of unemployment, the economy is said to be operating below full capacity.

The Causes of Unemployment

Now that we have covered the types of unemployment and how to calculate the unemployment rate, let's go over what causes unemployment. There are four basic causes of unemployment in a healthy, working economy. These reasons for unemployment are: minimum wage laws, labor unions, efficiency wages, and job search. In the real world economy all four of these forces work together to create the unemployment that is reflected in the unemployment rate.

Minimum Wage Laws

In microeconomics, we learned that in an efficient market, the price of a good changes to equilibrate the quantity demanded and the quantity supplied.) The labor market, in its natural form, is just like any other market. If there are unemployed workers who want jobs, the price of labor or the wage will simply drop until all of the labor force is employed. That is, this would happen if there were not government intervention into the labor market. In order to help maintain a certain standard of living among all workers, the government implements a minimum wage, which artificially inflates the wages of the workers at the bottom of the wage scale above what the firm would normally pay at equilibrium. This in turn causes the people above the minimum wage workers to demand more pay and for the people above them to do the same. Eventually, the minimum wage causes the wages of all workers to increase above the market-clearing level. When the wage demanded is greater than the wage offered, workers earn more; but in response firms will cut jobs to recoup the money they are losing, increasing unemployed workers. Raising the minimum wage therefore also increases unemployment. (The factors playing into this dynamic are more closely examined in the microeconomics 

Labor Unions

A second, and closely related, cause of unemployment, lies with the actions of labor unions. Labor unions are collectives of workers who rally together for higher wages, better working conditions, and more benefits. These unions force firms to spend more money on each worker, some in the form of wage and some in the form of benefits. Overall, this has an effect similar to the minimum wage law, where workers are demanding wages greater than the firms are willing to pay. Again, this raises the wages of workers above the market clearing level and creates a situation in which there are more people who want to work at the wage than there are firms who want to hire at the wage. In this way, labor unions increase the wages and benefits of workers who are employed, but may simultaneously increase the number of workers who are unemployed.

Efficiency Wages

A third reason for unemployment is based on the theory of efficiency wages. The basic idea behind efficiency wages is that firms benefit by paying their workers above the equilibrium wage, since higher wages produce happier, healthier, and more productive workers, and may even increase worker loyalty. But, when the firms pay efficiency wages that are above the equilibrium level, they also create an excess in the labor supply: more people want to work for the wage than there are positions. Efficiency wages, like the minimum wage and labor unions, therefore increase the wages for workers who are employed but also increase overall unemployment.

Job Search

The fourth cause of unemployment, job search, is unrelated to the labor market. Instead, it is based on ideas similar to the frictional, structural, and cyclical unemployment discussed earlier. When a person decides that he wants to work, he cannot simply become employed. Instead he much find a job. This job search often takes a bit of time. During the process of looking for the right job, the person is considered as an unemployed member of the labor force. Simply looking for a job or moving from one job to the next causes some unemployment.

Unemployment is in reality much more complex than the average consumer appreciates. For this reason, most people do not understand that some unemployment in the economy is not a problem. In fact, unemployment of certain low levels indicate that the economy is functioning neither above nor below its potential output level, at a sustainable level.

The Tradeoff Between Inflation and Unemployment

Okun's Law describes a clear relationship between unemployment and national output, in which lowered unemployment results in higher national output. Such a relationship makes intuitive sense: as more people in a nation work it seems only right that the output of the nation should increase. Building on Okun's law, another economist, A. W. Phillips, discovered a relationship between unemployment and inflation. The chain of basic ideas behind this belief follows: as more people work the national output increases, causing wages to increase, causing consumers to have more money and to spend more, resulting in consumers demanding more goods and services, finally causing the prices of goods and services to increase. In other words, Phillips showed that unemployment and inflation shared an inverse relationship: inflation rose as unemployment fell, and inflation fell as unemployment rose. Since two major goals for economic policy makers are to keep both inflation and unemployment low, Phillip's discovery was an important conceptual breakthrough, but also posed a troublesome challenge: how to keep both unemployment and inflation low, when lowering one results in raising the other?

The Phillips Curve

Phillips' discovery can be represented in a curve, called, aptly, a Phillips curve.

Figure %: The Phillips Curve

It is important to remember that the Phillips curve depicted above is simply an example. The actual Phillips curve for a country will vary depending upon the years that it aims to represent.

Notice that the inflation rate is represented on the vertical axis in units of percent per year. The unemployment rate is represented on the horizontal axis in units of percent. The curve shows the levels of inflation and unemployment that tend to match together approximately, based on historical data. In this curve, an unemployment rate of 7% seems to correspond to an inflation rate of 4% while an unemployment rate of 2% seems to correspond to an inflation rate of 6%. As unemployment falls, inflation increases.

The Phillips curve can be represented mathematically, as well. The equation for the Phillips curve states 

inflation = [(expected inflation) – B] x [(cyclical unemployment rate) + (error)] 

where B represents a number greater than zero that represents the sensitivity of inflation to unemployment.

While the Phillips curve is theoretically useful, however, it less practically helpful. The equation only holds in the short term. In the long run, unemployment always returns to the natural rate of unemployment, making cyclical unemployment zero and inflation equal to expected inflation.

Problems with the Phillips Curve and Stagflation

In fact, the Phillips curve is not even theoretically perfect. In fact, there are many problems with it if it is taken as denoting anything more than a general relationship between unemployment and inflation. In particular, the Phillips curve does a terrible job of explaining the relationship between inflation and unemployment from 1970 to 1984. Inflation in these years was much higher than would have been expected given the unemployment for these years.

Such a situation of high inflation and high unemployment is called stagflation. The phenomenon of stagflation is somewhat of a mystery, though many economists believe that it results from changes in the error term of the previously stated Phillips curve equation. These errors can include things like energy cost increases and food price increases. But no matter its source, stagflation of the 1970's and early 1980's seems to refute the general applicability of the Phillips curve.

The Phillips curve must not be looked at as an exact set of points that the economy can reach and then remain at in equilibrium. Instead, the curve describes a historical picture of where the inflation rate has tended to be in relation to the unemployment rate. When the relationship is understood in this fashion, it becomes evident that the Phillips curve is useful not as a means of picking an unemployment and inflation rate pair, but rather as a means of understanding how unemployment and inflation might move given historical data.