Worth: Mankiw Economics 5e CHAPTE R SIX Unemployment A man willing to work, and unable to find work, is perhaps the saddest sight that fortune's inequality exhibits under the sun Thomas Carlyle Unemployment is the macroeconomic problem that affects people most directly and severely. For most people, the loss of a job means a reduced living standard and psychological distress. It is no surprise that unemployment is a frequent topic of political debate and that politicians often claim that their proposed policies would help create jol Economists study unemployment to identify its causes and to help improve le public policies that affect the unemployed. Some of these policies, such as job-training programs, assist people in finding employment. Others, such as ul employment insurance, alleviate some of the hardships that the unemployed face Still other policies affect the prevalence of unemployment inadvertently. Laws mandating a high minimum wage, for instance, are widely thought to raise employment among the least skilled and experienced members of the labor force. By showing the effects of various policies, economists help policymakers valuate their options Our discussions of the labor market so far have ignored unemployment. In particular, the model of national income in Chapter 3 was built with the assump tion that the economy was always at full employment. In reality, of course, not everyone in the labor force has a job all the time: all free-market economies ex- perience some unemployment. Figure 6-1 shows the rate of unemployment-the percentage of the labor force unemployed--in the United States since 1948. Although the rate of unem ployment fluctuates from year to year, it never gets even close to zero. The aver- age is between 5 and 6 percent, meaning that about 1 out of every 18 people wanting a job does not have one. n this chapter we begin our study of unemployment by discussing why there is always some unemployment and what determines its level. We do not study what determines the year-to-year fluctuations in the rate of unemployment until Part iv of this book. where we examine short -run economic fluctuations Here we examine the determinants of the natural rate of unemployment-the av- erage rate of unemployment around which the economy fluctuates. The natural 155 User JoENA: Job EFFo1422: 6264_ ch06: Pg 155: 23949#/eps at 100s wed,Feb13,20029:364M
User JOEWA:Job EFF01422:6264_ch06:Pg 155:23949#/eps at 100% *23949* Wed, Feb 13, 2002 9:36 AM | 155 Unemployment is the macroeconomic problem that affects people most directly and severely. For most people, the loss of a job means a reduced living standard and psychological distress. It is no surprise that unemployment is a frequent topic of political debate and that politicians often claim that their proposed policies would help create jobs. Economists study unemployment to identify its causes and to help improve the public policies that affect the unemployed. Some of these policies, such as job-training programs, assist people in finding employment. Others, such as unemployment insurance, alleviate some of the hardships that the unemployed face. Still other policies affect the prevalence of unemployment inadvertently. Laws mandating a high minimum wage, for instance, are widely thought to raise unemployment among the least skilled and experienced members of the labor force. By showing the effects of various policies, economists help policymakers evaluate their options. Our discussions of the labor market so far have ignored unemployment. In particular, the model of national income in Chapter 3 was built with the assumption that the economy was always at full employment. In reality, of course, not everyone in the labor force has a job all the time: all free-market economies experience some unemployment. Figure 6-1 shows the rate of unemployment—the percentage of the labor force unemployed—in the United States since 1948. Although the rate of unemployment fluctuates from year to year, it never gets even close to zero.The average is between 5 and 6 percent, meaning that about 1 out of every 18 people wanting a job does not have one. In this chapter we begin our study of unemployment by discussing why there is always some unemployment and what determines its level. We do not study what determines the year-to-year fluctuations in the rate of unemployment until Part IV of this book, where we examine short-run economic fluctuations. Here we examine the determinants of the natural rate of unemployment—the average rate of unemployment around which the economy fluctuates.The natural Unemployment 6CHAPTER A man willing to work, and unable to find work, is perhaps the saddest sight that fortune’s inequality exhibits under the sun. — Thomas Carlyle SIX
Worth: Mankiw Economics 5e 156 PART I1 Classical Theory: The Economy in the Long Run figure 6-1 Percen 10 8 194519501955196019651970197519801985199019952000 Year The Unemployment Rate and the Natural Rate of Unemployment in the United States There always some unemp ployment. The natural rate of unemployment is the average level around which the unemployment rate fluctuates. (The natural rate of unemployment for any particular year is estimated here by averaging all the unemployment rates from ten years ear- lier to ten years later. Future unemployment rates are set at 5.5 percent. rate is the rate of unemployment toward which the economy gravitates in the long run, given all the labor-market imperfections that impede workers from in- 6-7 Job Loss, Job Finding, and the Natural Rate of Unemployment Every day some workers lose or quit their jobs, and some unemployed workers are hired. This perpetual ebb and flow determines the fraction of the labor force chat is unemployed. In this section we develop a model of labor-force dynamics that shows what determines the natural rate of unemployment. We start with some notation. Let L denote the labor force. e the number of nployed workers, and U the number of unemployed workers. Because every Robert E Hall, " A Theory of the Natural Rate of Unemployment and the Duration of Unem- ployment, "Joumal of Monetary Economics 5(April 1979): 153-169 User JOENA: Job EFF01422: 6264_ch06: Pg 156: 26227#/eps at 100s wed,Feb13,20029:364M
User JOEWA:Job EFF01422:6264_ch06:Pg 156:26227#/eps at 100% *26227* Wed, Feb 13, 2002 9:36 AM rate is the rate of unemployment toward which the economy gravitates in the long run, given all the labor-market imperfections that impede workers from instantly finding jobs. 6-1 Job Loss, Job Finding, and the Natural Rate of Unemployment Every day some workers lose or quit their jobs, and some unemployed workers are hired.This perpetual ebb and flow determines the fraction of the labor force that is unemployed. In this section we develop a model of labor-force dynamics that shows what determines the natural rate of unemployment.1 We start with some notation. Let L denote the labor force, E the number of employed workers, and U the number of unemployed workers. Because every 156 | PART II Classical Theory: The Economy in the Long Run figure 6-1 Percent unemployed 10 8 6 4 2 0 Year 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 Unemployment rate Natural rate of unemployment The Unemployment Rate and the Natural Rate of Unemployment in the United States There is always some unemployment. The natural rate of unemployment is the average level around which the unemployment rate fluctuates. (The natural rate of unemployment for any particular year is estimated here by averaging all the unemployment rates from ten years earlier to ten years later. Future unemployment rates are set at 5.5 percent.) 1 Robert E. Hall,“A Theory of the Natural Rate of Unemployment and the Duration of Unemployment,’’ Journal of Monetary Economics 5 (April 1979): 153–169
Worth: Mankiw Economics 5e CHAPTER 6 Unemployment |15 worker is either employed or unemployed, the labor force is the sum of the em- ployed and the unemployed L=E+U In this notation, the rate of unemployment is U/L. To see what determines the unemployment rate, we assume that the labor force L is fixed and focus on the transition of individuals in the labor force be- tween employment and unemployment. This is illustrated in Figure 6-2. Let s de- note the rate of job separation, the fraction of employed individuals who lose their job each month. Let f denote the rate of job finding, the fraction of unem- ployed individuals who find a job each month. Together, the rate of job separa tion s and the rate of job finding f determine the rate of unemployment If the unemployment rate is neither rising nor falling--that is, if the labor mar- ket is in a steady state-then the number of people finding jobs must equal the number of people losing jobs. The number of people finding jobs is fU and the number of people losing jobs is sE, so we can write the steady-state condition as fU=SE. We can use this equation to find the steady-state unemployment rate. From an earlier equation, we know that E=L- U; that is, the number of employed equals the labor force minus the number of unemployed. If we substitute(L-U for E in the steady-state condition, we find fU=s(I Job Separation(s) Job Finding(f) The Transitions Between Employment and Unemployment In every period, a fraction s of the employed lose their jobs, and a fraction fof the unemployed find jobs. The rates of job separation and job finding determine the rate of unemployment. User JOENA: Job EFF01422: 6264_ch06: Pg 157: 26228#/eps at 100s wed,Feb13,20029:364M
User JOEWA:Job EFF01422:6264_ch06:Pg 157:26228#/eps at 100% *26228* Wed, Feb 13, 2002 9:36 AM worker is either employed or unemployed, the labor force is the sum of the employed and the unemployed: L = E + U. In this notation, the rate of unemployment is U/L. To see what determines the unemployment rate, we assume that the labor force L is fixed and focus on the transition of individuals in the labor force between employment and unemployment.This is illustrated in Figure 6-2. Let s denote the rate of job separation, the fraction of employed individuals who lose their job each month. Let f denote the rate of job finding, the fraction of unemployed individuals who find a job each month.Together, the rate of job separation s and the rate of job finding f determine the rate of unemployment. If the unemployment rate is neither rising nor falling—that is, if the labor market is in a steady state—then the number of people finding jobs must equal the number of people losing jobs.The number of people finding jobs is f U and the number of people losing jobs is sE, so we can write the steady-state condition as f U = sE. We can use this equation to find the steady-state unemployment rate. From an earlier equation, we know that E = L − U; that is, the number of employed equals the labor force minus the number of unemployed. If we substitute (L − U) for E in the steady-state condition, we find f U = s(L − U). CHAPTER 6 Unemployment | 157 figure 6-2 Job Separation (s) Job Finding (f ) Employed Unemployed The Transitions Between Employment and Unemployment In every period, a fraction s of the employed lose their jobs, and a fraction f of the unemployed find jobs. The rates of job separation and job finding determine the rate of unemployment
Worth: Mankiw Economics 5e 158 PART 11 Classical Theory: The Economy in the Long Run To get closer to solving for the unemployment rate, divide both sides of this equation by L to obtain Now we can solve for U/L to find U L This equation shows that the steady-state rate of unemployment U/L depends on the rates of job separation s and job finding f. The higher the rate of job ser aration, the higher the unemployment rate. The higher the rate of job finding, he lower the unemployment rate. Here's a numerical example. Suppose that 1 percent of the employed lose their jobs each month (s=0.01). This means that on average jobs last 100 months, or about 8 years. Suppose further that about 20 percent of the unemployed find a job each month (=0. 20), so that spells of unemployment last 5 months on aver- age. Then the steady-state rate of unemployment is U 0.01 L0.01+0.20 The rate of unemployment in this example is about 5 percent. This model of the natural rate of unemployment has an obvious but impor tant implication for public policy. Any policy aimed at lowering the natural rate of un employment must either reduce the rate of job separation or increase the rate of job finding Similarly, any policy that affects the rate of job separation or job finding also changes the natural rate of unemployment Although this model is useful in relating the unemployment rate to job separation and job finding, it fails to answer a central question: Why is there unemployment in the first place? If a person could always find a job quickly, then the rate of job finding would be very high and the rate of unemploy ment would be near zero. This model of the unemployment rate assumes that job finding is not instantaneous, but it fails to explain why. In the next two sections, we examine two underlying reasons for unemployment: job search and wage rigidity 6-2 Job Search and Frictional Unemployment One reason for unemployment is that it takes time to match workers and jobs. The equilibrium model of the aggregate labor market discussed in Chapter 3 as sumes that all workers and all jobs are identical, and therefore that all workers are User JOENA: Job EFF01422: 6264_ch06: Pg 158: 26229#/eps at 100sg wed,Feb13,20029:364M
User JOEWA:Job EFF01422:6264_ch06:Pg 158:26229#/eps at 100% *26229* Wed, Feb 13, 2002 9:36 AM To get closer to solving for the unemployment rate, divide both sides of this equation by L to obtain f = s(1 − ). Now we can solve for U/L to find = . This equation shows that the steady-state rate of unemployment U/L depends on the rates of job separation s and job finding f. The higher the rate of job separation, the higher the unemployment rate.The higher the rate of job finding, the lower the unemployment rate. Here’s a numerical example. Suppose that 1 percent of the employed lose their jobs each month (s = 0.01).This means that on average jobs last 100 months, or about 8 years. Suppose further that about 20 percent of the unemployed find a job each month ( f = 0.20), so that spells of unemployment last 5 months on average.Then the steady-state rate of unemployment is = = 0.0476. The rate of unemployment in this example is about 5 percent. This model of the natural rate of unemployment has an obvious but important implication for public policy.Any policy aimed at lowering the natural rate of unemployment must either reduce the rate of job separation or increase the rate of job finding. Similarly, any policy that affects the rate of job separation or job finding also changes the natural rate of unemployment. Although this model is useful in relating the unemployment rate to job separation and job finding, it fails to answer a central question: Why is there unemployment in the first place? If a person could always find a job quickly, then the rate of job finding would be very high and the rate of unemployment would be near zero.This model of the unemployment rate assumes that job finding is not instantaneous, but it fails to explain why. In the next two sections, we examine two underlying reasons for unemployment: job search and wage rigidity. 6-2 Job Search and Frictional Unemployment One reason for unemployment is that it takes time to match workers and jobs. The equilibrium model of the aggregate labor market discussed in Chapter 3 assumes that all workers and all jobs are identical, and therefore that all workers are 0.01 0.01 + 0.20 U L s s + f U L U L U L 158 | PART II Classical Theory: The Economy in the Long Run
Worth: Mankiw Economics 5e CHAPTER 6 Unemployment 159 equally well suited for all jobs. If this were true and the labor market were in would immediately find a new job at the market wage ment: a laid-off worker Im, then a job loss would not cause unemploy In fact, workers have different preferences and abilities, and jobs have dif- ferent attributes. Furthermore, the flow of information about job candidates and job vacancies is imperfect, and the geographic mobility of workers is not instantaneous. For all these reasons, searching for an appropriate job takes time and effort, and this tends to reduce the rate of job finding. Indeed, because different jobs require different skills and pay different wages, unemployed workers may not accept the first job offer they receive. The unemployment aused by the time it takes workers to search for a job is called frictional unemployment Some frictional unemployment is inevitable in a changing economy. For many reasons, the types of goods that firms and households demand vary over time. As the demand for goods shifts, so does the demand for the labor that produces those goods. The invention of the personal computer, for example, reduced the demand for typewriters and, as a result, for labor by typewriter manufacturers. At the same time. it increased the demand for labor in the elec- tronics industry. Similarly, because different regions produce different goods, he demand for labor may be rising in one part of the country and falling in another. A decline in the price of oil may cause the demand for labor to fall in oil-producing states such as Texas, but because cheap oil makes driving less expensive, it increases the demand for labor in auto-producing states such as Michigan. Economists call a change in the composition of demand among in dustries or regions a sectoral shift. Because sectoral shifts are always occur ring, and because it takes time for workers to change sectors, there is always frictional unemployment. Sectoral shifts are not the only cause of job separation and frictional unem- ployment. In addition, workers find themselves unexpectedly out of work when their firms fail, when their job performance is deemed unacceptable, or when their particular skills are no longer needed. Workers also may quit their jobs to hange careers or to move to different parts of the country. As long as the supply and demand for labor among firms is changing, frictional unemployment is un- avoidable Public Policy and Frictional Unemployment Many public policies seek to decrease the natural rate of unemployment by reducing frictional unemployment. Government employment agencies dis- seminate information about job vacancies in order to match jobs and workers more efficiently. Publicly funded retraining programs are designed to ease the transition of workers from declining to growing industries. If these programs Icceed at increasing the rate of job finding, they decrease the natural rate of une ent Other government programs inadvertently increase the amount of fric- tional unemployment. One of these is unemployment insurance. Under User JOENA: Job EFF01422: 6264_ch06: Pg 159: 26230 #/eps at 100s wed,Feb13,20029:364M
User JOEWA:Job EFF01422:6264_ch06:Pg 159:26230#/eps at 100% *26230* Wed, Feb 13, 2002 9:36 AM equally well suited for all jobs. If this were true and the labor market were in equilibrium, then a job loss would not cause unemployment: a laid-off worker would immediately find a new job at the market wage. In fact, workers have different preferences and abilities, and jobs have different attributes. Furthermore, the flow of information about job candidates and job vacancies is imperfect, and the geographic mobility of workers is not instantaneous. For all these reasons, searching for an appropriate job takes time and effort, and this tends to reduce the rate of job finding. Indeed, because different jobs require different skills and pay different wages, unemployed workers may not accept the first job offer they receive. The unemployment caused by the time it takes workers to search for a job is called frictional unemployment. Some frictional unemployment is inevitable in a changing economy. For many reasons, the types of goods that firms and households demand vary over time. As the demand for goods shifts, so does the demand for the labor that produces those goods. The invention of the personal computer, for example, reduced the demand for typewriters and, as a result, for labor by typewriter manufacturers.At the same time, it increased the demand for labor in the electronics industry. Similarly, because different regions produce different goods, the demand for labor may be rising in one part of the country and falling in another. A decline in the price of oil may cause the demand for labor to fall in oil-producing states such as Texas, but because cheap oil makes driving less expensive, it increases the demand for labor in auto-producing states such as Michigan. Economists call a change in the composition of demand among industries or regions a sectoral shift. Because sectoral shifts are always occurring, and because it takes time for workers to change sectors, there is always frictional unemployment. Sectoral shifts are not the only cause of job separation and frictional unemployment. In addition, workers find themselves unexpectedly out of work when their firms fail, when their job performance is deemed unacceptable, or when their particular skills are no longer needed.Workers also may quit their jobs to change careers or to move to different parts of the country. As long as the supply and demand for labor among firms is changing, frictional unemployment is unavoidable. Public Policy and Frictional Unemployment Many public policies seek to decrease the natural rate of unemployment by reducing frictional unemployment. Government employment agencies disseminate information about job vacancies in order to match jobs and workers more efficiently. Publicly funded retraining programs are designed to ease the transition of workers from declining to growing industries. If these programs succeed at increasing the rate of job finding, they decrease the natural rate of unemployment. Other government programs inadvertently increase the amount of frictional unemployment. One of these is unemployment insurance. Under CHAPTER 6 Unemployment | 159
Worth: Mankiw Economics 5e 160 PART 11 Classical Theory: The Economy in the Long Run this program, unemployed workers can collect a fraction of their wages for a certain period after losing their jobs. Although the precise terms of the pro- gram differ from year to year and from state to state, a typical worker covered by unemployment insurance in the United States receives 50 percent of his or ler former wages for 26 weeks. In many European countries, unemployment Insurance programs are even more generous By softening the economic hardship of unemployment, unemployment insur- ance increases the amount of frictional unemployment and raises the natural rate. The unemployed who receive unemployment-insurance benefits are less pressed offers. Both of these changes in behavior reduce the rate of job finding. In ad a to search for new employment and are more likely to turn down unattractive j tion, because workers know that their incomes are partially protected by unem ployment insurance, they are less likely to seek jobs with stable employment prospects and are less likely to bargain for guarantees of job security. These be havioral changes raise the rate of job separation That unemployment insurance raises the natural rate of unemployment does not necessarily imply that the policy is ill advised. The program has the benefit of reducing workers'uncertainty about their incomes. Moreover, in- ducing workers to reject unattractive job offers may lead to a better matching between workers and jobs. Evaluating the costs and benefits of different sys tems of unemployment insurance is a difficult task that continues to be a topic of much research Economists who study unemployment insurance often propose refor that would reduce the amount of unemployment. One common proposal is to require a firm that lays off a worker to bear the full cost of that worker's un employment benefits. Such a system is called 100 percent experience rated, be- cause the rate that each firm pays into the unemployment-insurance system lly reflects the unemployment experience of its own workers. Most current programs are partially experience rated. Under this system, when a firm lays off a worker, it is charged for only part of the worke ers unen ployment benefits; the remainder comes from the program's general revenue. Because a firm pay only a fraction of the cost of the unemployment it causes, it has an incentive to lay off workers when its demand for labor is temporarily low. By reducing that incentive, the proposed reform may reduce the prevalence of temporary Unemployment Insurance and the Rate of Job Finding Many studies have examined the effect of unemployment insurance on job search. The most persuasive studies use data on the experiences of unemployed ndividuals, rather than economy-wide rates of unemployment. Individual data often yield sharp results that are open to few alternative explanations One study followed the experience of individual workers as they used up heir eligibility for unemployment-insurance benefits. It found that when User JOENA: Job EFF01422: 6264_ch06: Pg 160: 26231#/eps at 100s wed,Feb13,20029:364M
User JOEWA:Job EFF01422:6264_ch06:Pg 160:26231#/eps at 100% *26231* Wed, Feb 13, 2002 9:36 AM this program, unemployed workers can collect a fraction of their wages for a certain period after losing their jobs. Although the precise terms of the program differ from year to year and from state to state, a typical worker covered by unemployment insurance in the United States receives 50 percent of his or her former wages for 26 weeks. In many European countries, unemploymentinsurance programs are even more generous. By softening the economic hardship of unemployment, unemployment insurance increases the amount of frictional unemployment and raises the natural rate. The unemployed who receive unemployment-insurance benefits are less pressed to search for new employment and are more likely to turn down unattractive job offers. Both of these changes in behavior reduce the rate of job finding. In addition, because workers know that their incomes are partially protected by unemployment insurance, they are less likely to seek jobs with stable employment prospects and are less likely to bargain for guarantees of job security.These behavioral changes raise the rate of job separation. That unemployment insurance raises the natural rate of unemployment does not necessarily imply that the policy is ill advised.The program has the benefit of reducing workers’ uncertainty about their incomes. Moreover, inducing workers to reject unattractive job offers may lead to a better matching between workers and jobs. Evaluating the costs and benefits of different systems of unemployment insurance is a difficult task that continues to be a topic of much research. Economists who study unemployment insurance often propose reforms that would reduce the amount of unemployment. One common proposal is to require a firm that lays off a worker to bear the full cost of that worker’s unemployment benefits. Such a system is called 100 percent experience rated, because the rate that each firm pays into the unemployment-insurance system fully reflects the unemployment experience of its own workers. Most current programs are partially experience rated. Under this system, when a firm lays off a worker, it is charged for only part of the worker’s unemployment benefits; the remainder comes from the program’s general revenue. Because a firm pays only a fraction of the cost of the unemployment it causes, it has an incentive to lay off workers when its demand for labor is temporarily low. By reducing that incentive, the proposed reform may reduce the prevalence of temporary layoffs. 160 | PART II Classical Theory: The Economy in the Long Run CASE STUDY Unemployment Insurance and the Rate of Job Finding Many studies have examined the effect of unemployment insurance on job search.The most persuasive studies use data on the experiences of unemployed individuals, rather than economy-wide rates of unemployment. Individual data often yield sharp results that are open to few alternative explanations. One study followed the experience of individual workers as they used up their eligibility for unemployment-insurance benefits. It found that when
Worth: Mankiw Economics 5e CHAPTER 6 Unemployment |161 unemployed workers become ineligible for benefits, they are more likely to find new jobs. In particular, the proba lity of a person finding a new j more than doubles when his or her benefits run out. One possible explanation is that an absence of benefits increases the search effort of unemployed work ers. Another possibility is that workers without benefits are more likely to ac cept job offers that would otherwise be declined because of low wages or poor working conditions Additional evidence on how economic incentives affect job search comes rom an experiment that the state of Illinois ran in 1985. Randomly selected new claimants for unemployment insurance were each offered a $500 bonus if they found employment within 11 weeks. The subsequent experience of this group was compared to that of a control group not offered the incentive. The average duration of unemployment for the group offered the $500 bonus was 17.0 weeks, compared to 18.3 weeks for the control group. Thus, the bonus reduced the aver rage spell of unemployment by 7 percent, suggesting that more effort was devoted to job search. This experiment shows clearly that the incentives provided by the unemployment-insurance system affect the rate of 6-3 Real-Wage Rigidity and Structural Unemployment A second reason for unemployment is wage rigidity--the failure of wages to djust until labor supply equals labor demand. In the equilibrium model of the labor market, as outlined in Chapter 3, the real wage adjusts to equilibrate supply and demand. Yet wages are not always flexible. Sometimes the real wage is stuck bove the market-clearing level Figure 6-3 shows why wage rigidity leads to unemployment. When the real wage is above the level that equilibrates supply and demand, the quantity of labo supplied exceeds the quantity demanded Firms must in some way ration the scarce jobs among workers. Real-wage rigidity reduces the rate of job finding and raises the level of unemployment The unemployment resulting from wage rigidity and job rationing is called structural unemployment. Workers are unemployed not because they are ac- tively searching for the jobs that best suit their individual skills but because, at the going wage, the supply of labor exceeds the demand. These workers are simply waiting for jobs to become available Lawrence F Katz and Bruce D. Meyer, "Unemployment Insurance, Recall Expectations, and Un- employment Outcomes, " Quarterly Journal of Economics 105(November 1990): 973-1002 S Stephen A. Woodbury and Robert G Spiegelman, "Bonuses to Workers and Employers to Re- duce Unemployment: Randomized Trials in Illinois, "American Economic Review 77(September User JOENA: Job EFF01422: 6264_ch06: Pg 161: 26232#/eps at 100s wed,Feb13,20029:364M
User JOEWA:Job EFF01422:6264_ch06:Pg 161:26232#/eps at 100% *26232* Wed, Feb 13, 2002 9:36 AM 6-3 Real-Wage Rigidity and Structural Unemployment A second reason for unemployment is wage rigidity—the failure of wages to adjust until labor supply equals labor demand. In the equilibrium model of the labor market, as outlined in Chapter 3, the real wage adjusts to equilibrate supply and demand.Yet wages are not always flexible. Sometimes the real wage is stuck above the market-clearing level. Figure 6-3 shows why wage rigidity leads to unemployment.When the real wage is above the level that equilibrates supply and demand, the quantity of labor supplied exceeds the quantity demanded. Firms must in some way ration the scarce jobs among workers. Real-wage rigidity reduces the rate of job finding and raises the level of unemployment. The unemployment resulting from wage rigidity and job rationing is called structural unemployment.Workers are unemployed not because they are actively searching for the jobs that best suit their individual skills but because, at the going wage, the supply of labor exceeds the demand.These workers are simply waiting for jobs to become available. CHAPTER 6 Unemployment | 161 unemployed workers become ineligible for benefits, they are more likely to find new jobs. In particular, the probability of a person finding a new job more than doubles when his or her benefits run out. One possible explanation is that an absence of benefits increases the search effort of unemployed workers.Another possibility is that workers without benefits are more likely to accept job offers that would otherwise be declined because of low wages or poor working conditions.2 Additional evidence on how economic incentives affect job search comes from an experiment that the state of Illinois ran in 1985. Randomly selected new claimants for unemployment insurance were each offered a $500 bonus if they found employment within 11 weeks.The subsequent experience of this group was compared to that of a control group not offered the incentive.The average duration of unemployment for the group offered the $500 bonus was 17.0 weeks, compared to 18.3 weeks for the control group. Thus, the bonus reduced the average spell of unemployment by 7 percent, suggesting that more effort was devoted to job search.This experiment shows clearly that the incentives provided by the unemployment-insurance system affect the rate of job finding.3 2 Lawrence F. Katz and Bruce D. Meyer,“Unemployment Insurance, Recall Expectations, and Unemployment Outcomes,’’ Quarterly Journal of Economics 105 (November 1990): 973–1002. 3 Stephen A.Woodbury and Robert G. Spiegelman, “Bonuses to Workers and Employers to Reduce Unemployment: Randomized Trials in Illinois,’’ American Economic Review 77 (September 1987): 513–530
Worth: Mankiw Economics 5e 162 PART 11 Classical Theory: The Economy in the Long Run fiqure 6-3 Real wage Real-Wage Rigidity Leads to Job Supply Rationing If the real wage is level, then the supply of labor Amount of exceeds the demand. the result is unemployment. Amor Demand labor hired Labor Amount of labor To understand wage rigidity and structural unemployment, we must examine why the labor market does not clear. When the real wage exceeds the equilib- rium level and the supply of workers exceeds the demand, we might expect firms to lower the wages they pay. Structural unemployment arises because firms fail to reduce wages despite an excess supply of labor. We now turn to three causes of this wage rigidity: minimum-wage laws, the monopoly power of unions,and efficiency w Minimum-Wage Laws The government causes wage rigidity when it prevents wages from falling to equilibrium levels. Minimum-wage laws set a legal minimum on the wages that firms pay their employees. Since the passage of the Fair Labor Standards Act of 1938, the U.S. federal government has enforced a minimum wage that usually has been between 30 and 50 percent of the average wage in manufacturing. For most workers, this minimum wage is not binding, because they earn well above the minimum. Yet for some workers, especially the unskilled and inexperienced, the minimum wage raises their wage above its equilibrium level. It therefore reduces the quantity of their labor that firms demand. Economists believe that the minimum wage has its greatest impact on teenage unemployment. The equilibrium wages of teenagers tend to be low for two reasons. First, because teenagers are among the least skilled and least experienced members of the labor force, they tend to have low marginal pro- ductivity. Second, teenagers often take some of their"compensation"in the User JOENA: Job EFF01422: 6264_ch06: Pg 162: 26233 #/eps at 100s wed,Feb13,20029:364M
User JOEWA:Job EFF01422:6264_ch06:Pg 162:26233#/eps at 100% *26233* Wed, Feb 13, 2002 9:36 AM To understand wage rigidity and structural unemployment, we must examine why the labor market does not clear.When the real wage exceeds the equilibrium level and the supply of workers exceeds the demand, we might expect firms to lower the wages they pay. Structural unemployment arises because firms fail to reduce wages despite an excess supply of labor. We now turn to three causes of this wage rigidity: minimum-wage laws, the monopoly power of unions, and efficiency wages. Minimum-Wage Laws The government causes wage rigidity when it prevents wages from falling to equilibrium levels. Minimum-wage laws set a legal minimum on the wages that firms pay their employees. Since the passage of the Fair Labor Standards Act of 1938, the U.S. federal government has enforced a minimum wage that usually has been between 30 and 50 percent of the average wage in manufacturing. For most workers, this minimum wage is not binding, because they earn well above the minimum.Yet for some workers, especially the unskilled and inexperienced, the minimum wage raises their wage above its equilibrium level. It therefore reduces the quantity of their labor that firms demand. Economists believe that the minimum wage has its greatest impact on teenage unemployment. The equilibrium wages of teenagers tend to be low for two reasons. First, because teenagers are among the least skilled and least experienced members of the labor force, they tend to have low marginal productivity. Second, teenagers often take some of their “compensation’’ in the 162 | PART II Classical Theory: The Economy in the Long Run figure 6-3 Real wage Labor Supply Demand Amount of unemployment Amount of labor hired Amount of labor willing to work Rigid real wage Real-Wage Rigidity Leads to Job Rationing If the real wage is stuck above the equilibrium level, then the supply of labor exceeds the demand. The result is unemployment
Worth: Mankiw Economics 5e form of on-the-job training rather than direct pay. An apprenticeship is a clas- sic example of training offered in place of wages. For both these reasons, the wage at which the supply of teenage workers equals the demand is low. The minimum wage is therefore more often binding for teenagers than for others in the labor fo Many economists have studied the impact of the minimum wage on teenage employment. These researchers compare the variation in the minimum wage over time with the variation in the number of teenagers with jobs. These studies find that a 10-percent increase in the wage reduces teenage employ ment by 1 to 3 pe The minimum wage is a perennial source of political debate. Advocates of a higher minimum wage view it as a means of raising the income of the work ing poor. Certainly, the minimum wage provides only a meager standard of living: in the United States, two adults working full time at minimum-wage jobs would just exceed the official poverty level for a family of four. Although minimum-wage advocates often admit that the policy causes unemployment for some workers, they argue that this cost is worth bearing to raise others out of poverty. Opponents of a higher minimum wage claim that it is not the best way to elp the working poor. They contend not only that the in creased labor costs would raise unemployment but also that the minimum wage is poorly targeted Many minimum-wage earners are teenagers from middle-class homes working for discretionary spending money. Of the approximately 3 million workers who earn the minimum wage, more than one-third are teenagers To mitigate the effects on teenage unemployment, some economists and poli- cymakers have long advocated exempting young workers from the regular mini- mum wage. This would permit a lower wage for teenagers, thereby reducing their unemployment and enabling them to get training and job experienc ponents of this exemption argue that it gives firms an incentive to substitute teenagers for unskilled adults, thereby raising unemployment among that group A limited exemption of this kind was tried from 1991 to 1993. Because of many restrictions on its use, however, it had only limited effect and, therefore, was not enewed by Congress. Many economists and policymakers believe that tax credits are a better way to increase the incomes of the working poor. The earned income tax credit is an amount that poor working families are allowed to subtract from the taxes they owe. For a family with a very low income, the credit exceeds its taxes, and the family receives a payment from the government. Unlike the minimum wage, the earned income tax credit does not raise labor costs to firms and therefore does not reduce the quantity of labor that firms demand. It has the disadvantage, how- ver, of reducing the governments tax revenue Charles Brown, Minimum Wage Laws: Are They Overrated? "Journal of Economic Perspectives 2 ( Summer1988):133-146 User JOENA: Job EFF01422: 6264_ch06: Pg 163: 26234#/eps at 100s wed,Feb13,20029:364M
User JOEWA:Job EFF01422:6264_ch06:Pg 163:26234#/eps at 100% *26234* Wed, Feb 13, 2002 9:36 AM form of on-the-job training rather than direct pay. An apprenticeship is a classic example of training offered in place of wages. For both these reasons, the wage at which the supply of teenage workers equals the demand is low.The minimum wage is therefore more often binding for teenagers than for others in the labor force. Many economists have studied the impact of the minimum wage on teenage employment. These researchers compare the variation in the minimum wage over time with the variation in the number of teenagers with jobs.These studies find that a 10-percent increase in the minimum wage reduces teenage employment by 1 to 3 percent.4 The minimum wage is a perennial source of political debate. Advocates of a higher minimum wage view it as a means of raising the income of the working poor. Certainly, the minimum wage provides only a meager standard of living: in the United States, two adults working full time at minimum-wage jobs would just exceed the official poverty level for a family of four.Although minimum-wage advocates often admit that the policy causes unemployment for some workers, they argue that this cost is worth bearing to raise others out of poverty. Opponents of a higher minimum wage claim that it is not the best way to help the working poor. They contend not only that the increased labor costs would raise unemployment but also that the minimum wage is poorly targeted. Many minimum-wage earners are teenagers from middle-class homes working for discretionary spending money. Of the approximately 3 million workers who earn the minimum wage, more than one-third are teenagers. To mitigate the effects on teenage unemployment, some economists and policymakers have long advocated exempting young workers from the regular minimum wage. This would permit a lower wage for teenagers, thereby reducing their unemployment and enabling them to get training and job experience. Opponents of this exemption argue that it gives firms an incentive to substitute teenagers for unskilled adults, thereby raising unemployment among that group. A limited exemption of this kind was tried from 1991 to 1993. Because of many restrictions on its use, however, it had only limited effect and, therefore, was not renewed by Congress. Many economists and policymakers believe that tax credits are a better way to increase the incomes of the working poor. The earned income tax credit is an amount that poor working families are allowed to subtract from the taxes they owe. For a family with a very low income, the credit exceeds its taxes, and the family receives a payment from the government. Unlike the minimum wage, the earned income tax credit does not raise labor costs to firms and, therefore, does not reduce the quantity of labor that firms demand. It has the disadvantage, however, of reducing the government’s tax revenue. CHAPTER 6 Unemployment | 163 4 Charles Brown, “Minimum Wage Laws: Are They Overrated?’’ Journal of Economic Perspectives 2 (Summer 1988): 133–146
Worth: Mankiw Economics 5e 164 PART 11 Classical Theory: The Economy in the Long Run A Revisionist View of the Minimum Wage Although most economists believe that increases in the minimum wage reduce employment among workers with little skill and experience, some recent studies question this conclusion. Three respected labor economists--David Card Lawrence Katz, and Alan Krueger--examined several instances of minimum- wage changes in order to determine the magnitude of the employment response What they found was startling One study examined hiring by fast-food restaurants in New Jersey when New Jersey raised the state minimum wage. Fast-food restaurants are a natural type of firm to examine because they employ many low-wage workers To control for other effects, such as overall economic conditions, the New jersey restaurants were compared to similar restaurants across the river in Pennsylvania. Pennsylva- nia did not raise its minimum wage at the same time. According to standard the ory, employment in New Jersey restaurants should have fallen relative to s ployment in Pennsylvania restaurants. In contrast to this hypothesis, the data owed that employment rose in the New jersey restaurants How is this seemingly perverse result possible? One explanation is that firms have some market power in the labor market. As you may have learned in courses in microeconomics, a monopsony firm buys less labor at a lower wage than a competitive firm would In essence, the firm reduces employment in order to depress the wage it has to pay. A minimum wage prevents the monopsony firm from following this strategy and so(up to a point) can increase employment. This new view of the minimum wage is controversial. Critics have questioned the reliability of the data used in the New Jersey study. Some studies using other data sources have reached the traditional conclusion that the miniMum presses employment. Moreover, most economists are skeptical of the monopsony explanation, because most firms compete with many other firms for workers. Yet this new view has directly affected the policy debate. Lawrence Katz was the first chief economist in the Department of Labor during the Clinton administration President Clinton supported increases in the national minimum wage s sing that He was followed in this job by Alan Krueger. It is therefore not suri Unions and Collective Bargaining A second cause of wage rigidity is the monopoly power of unions. Table 6-1 shows the importance of unions in 12 major countries. In the United States, only 16 percent of workers belong to unions. In most European countries, unions play a much larger role To read more about this new view of the minimum wage, see David Card and Alan Kruege Myth and Measurement: The New Economics of the Minimum Wage(Princeton, N J. Princeton Univer- sity Press, 1995); and Lawrence Katz and Alan Krueger, The Effects of the Minimum Wage on the Fast-Food Industry "Industrial and Labor Relations Review 46(October 1992): 6-21 User JOENA: Job EFF01422: 6264_ch06: Pg 164: 26235#/eps at 1004m wed,Feb13,20029:364M
User JOEWA:Job EFF01422:6264_ch06:Pg 164:26235#/eps at 100% *26235* Wed, Feb 13, 2002 9:36 AM 164 | PART II Classical Theory: The Economy in the Long Run CASE STUDY A Revisionist View of the Minimum Wage Although most economists believe that increases in the minimum wage reduce employment among workers with little skill and experience, some recent studies question this conclusion. Three respected labor economists—David Card, Lawrence Katz, and Alan Krueger—examined several instances of minimumwage changes in order to determine the magnitude of the employment response. What they found was startling. One study examined hiring by fast-food restaurants in New Jersey when New Jersey raised the state minimum wage. Fast-food restaurants are a natural type of firm to examine because they employ many low-wage workers.To control for other effects, such as overall economic conditions, the New Jersey restaurants were compared to similar restaurants across the river in Pennsylvania. Pennsylvania did not raise its minimum wage at the same time.According to standard theory, employment in New Jersey restaurants should have fallen relative to employment in Pennsylvania restaurants. In contrast to this hypothesis, the data showed that employment rose in the New Jersey restaurants. How is this seemingly perverse result possible? One explanation is that firms have some market power in the labor market.As you may have learned in courses in microeconomics, a monopsony firm buys less labor at a lower wage than a competitive firm would. In essence, the firm reduces employment in order to depress the wage it has to pay. A minimum wage prevents the monopsony firm from following this strategy and so (up to a point) can increase employment. This new view of the minimum wage is controversial. Critics have questioned the reliability of the data used in the New Jersey study. Some studies using other data sources have reached the traditional conclusion that the minimum wage depresses employment. Moreover, most economists are skeptical of the monopsony explanation, because most firms compete with many other firms for workers.Yet this new view has directly affected the policy debate. Lawrence Katz was the first chief economist in the Department of Labor during the Clinton administration. He was followed in this job by Alan Krueger. It is therefore not surprising that President Clinton supported increases in the national minimum wage.5 5 To read more about this new view of the minimum wage, see David Card and Alan Krueger, Myth and Measurement:The New Economics of the Minimum Wage (Princeton, N.J.: Princeton University Press, 1995); and Lawrence Katz and Alan Krueger,“The Effects of the Minimum Wage on the Fast-Food Industry,” Industrial and Labor Relations Review 46 (October 1992): 6–21. Unions and Collective Bargaining A second cause of wage rigidity is the monopoly power of unions. Table 6-1 shows the importance of unions in 12 major countries. In the United States, only 16 percent of workers belong to unions. In most European countries, unions play a much larger role
