Chapter 12
Unemployment
“It’s a recession when your neighbor loses
his job; it’s a depression when you lose
your own.”
-Harry S. Truman
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History of Unemployment in the United States
Although the unemployment rate in the United States drifted
upward between 1960 and 1990, the economic expansion of the
1990s reduced the unemployment rate substantially.
Unemployment peaked at 9.6 percent by 2010 following
deterioration of economic conditions in 2008
Recent unemployment rates in the U.S. have exceeded
unemployment rates in Germany and France
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Unemployment in the U.S. from
1900 to 2017
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Unemployment Rates by Education Attainment, 1970-
2017
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Frictional Unemployment
Frictional unemployment arises when workers and firms need
time to locate each other and to digest information about the
potential job match.
Even a well-functioning competitive economy experiences
frictional unemployment, because some workers will
unavoidably be “between” jobs.
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Structural Unemployment
Structural unemployment arises when there is an imbalance
between the supply of workers and the demand for workers or
when unemployment arises because of a mismatch between
worker skills and the skills needed by firms.
Structural unemployment is the most concerning type of
unemployment for an economy as the skills embedded in labor
are no longer being put to productive use.
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The Rate of Unemployment
The steady-state rate of unemployment depends on the
transition probabilities among employment, unemployment, and
the nonmarket sector.
Let l = the fraction of employed workers who lose their jobs and
become unemployed
Let h = the fraction of unemployed workers who find work and
get hired
In the steady state lE = hU, and since the Labor Force is LF = E +
U, then
The Unemployment Rate, UR = U/LF = l/(l + h)
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Unemployed Persons by Reason for Unemployment,
1967-2017
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Unemployment Duration
Although most spells of unemployment do not last very long,
most weeks of unemployment can be attributed to workers who
are in very long spells.
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Unemployed Persons by Duration of Unemployment,
1948-2017
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Trends in Alternative Measures of the Unemployment
Rate, 1994-2013
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Flows Between Employment and Unemployment
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Suppose a person is either working or unemployed. At any
point in time, some workers lose their jobs and unemployed
workers find jobs. If the probability of losing a job equals ,
there are   E job losers. If the probability of finding a job
equals h, there are h  U job finders.
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Dynamic Flows in the U.S. Labor Market
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Job Search
The asking wage makes the worker indifferent between
continuing his search activities and accepting the job offer at
hand.
An increase in the benefits from search raises the asking wage
and lengthens the duration of the unemployment spell.
An increase in search costs reduces the asking wage and
shortens the duration of the unemployment spell.
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The Wage Offer Distribution
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The wage offer distribution gives the frequency distribution of potential job
offers. A given worker can get a job paying anywhere from $5 to $25 per
hour.
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Determination of the Asking Wage
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The marginal revenue curve
gives the gain from an
additional search. It is
downward sloping because
the better the offer at hand,
the less there is to gain from
an additional search. The
marginal cost curve gives the
cost of an additional search.
It is upward sloping because
the better the job offer at
hand, the greater the
opportunity cost of an
additional search. The asking
wage equates the marginal
revenue and the marginal
cost of search.
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Discount Rates, Unemployment Insurance, and the
Asking Wage
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Unemployment Compensation
Unemployment benefits are typically paid up to 26 weeks of
unemployment, but this length is frequently extended by
Congress during recessions.
The level of unemployment benefits depends on previous
earnings. The replacement ratio averages about 60 percent for
low-wage workers and about 25 percent for high-wage workers.
Unemployment insurance lengthens the duration of
unemployment spells and increases the probability that workers
are laid off temporarily.
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The Probability of Finding a New Job and UI Benefits
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Funding the UI System: Imperfect Experience Rating
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If the firm has very few
layoffs (below threshold
l0), the firm is assessed a
very low tax rate to fund
the UI system. If the firm
has had many layoffs in
the past (above some
threshold l1), the firm is
assessed a tax rate, but
this tax rate is capped at
tMAX.
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The Intertemporal Substitution Hypothesis
The intertemporal substitution hypothesis argues that the huge
shifts in labor supply observed over the business cycle may be
the result of workers reallocating their time so as to purchase
leisure when it is cheap (that is, during recessions).
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The Sectoral Shifts Hypothesis
The sectoral shifts hypothesis argues that structural
unemployment arises because the skills of workers cannot be
easily transferred across sectors.
The skills of workers laid off from declining industries have to be
retooled before they can find jobs in growing industries.
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Efficiency Wages and Unemployment
Efficiency wages arise when it is difficult to monitor worker
output.
The above-market efficiency wage generates involuntary
unemployment.
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The Determination of
the Efficiency Wage
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If shirking is not a problem, the
market clears at wage w* (where
supply S equals demand D). If
monitoring is expensive, the threat
of unemployment can keep
workers in line. If unemployment is
high (point F), firms can attract
workers who will not shirk at a very
low wage. If unemployment is low
(point G), firms must pay a very
high wage to ensure that workers
do not shirk. The efficiency wage
wNS is given by the intersection of
the no-shirking supply curve (NS)
and the demand curve.
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The Impact of an Economic Contraction on the
Efficiency Wage
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A fall in output demand
shifts the labor demand
curve from D0 to D1. The
competitive wage falls
from w*0 to w*. If firms
pay an efficiency wage,
the contraction in demand
also reduces the efficiency
wage but by a smaller
amount.
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The Phillips Curve
A downward-sloping Phillips curve can only exist in the short run.
In the long run, there is no trade-off between inflation and
unemployment.
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The Phillips Curve
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The Phillips curve describes the
negative correlation between the
inflation rate and the
unemployment rate. The curve
implies that an economy faces a
trade-off between inflation and
unemployment.
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Inflation and Unemployment in the United States,
1961-2005
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The Short-Run and Long-Run Phillips Curves
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The Short-Run and Long-Run Phillips Curves
The economy is initially at point A (on the previous graph); there
is no inflation and a 5 percent unemployment rate.
If monetary policy increases the inflation rate to 7 percent, job
searchers will suddenly find many jobs that meet their
reservation wage and the unemployment rate falls in the short
run, moving the economy to point B.
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The Short-Run and Long-Run Phillips Curves
Over time, workers realize that the inflation rate is higher and
will adjust their reservation wage upward, returning the
economy to point C.
In the long run, the unemployment rate is still 5 percent, but
there is now a higher rate of inflation. In the long run, therefore,
there is no trade-off between inflation and unemployment.
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