Download Economics Response 5 unemployment

Voluntary and Involuntary Unemployment
Suggested Response
The following response sets out in note-form what I consider to be the key points of the activity –
you may have presented your answers differently, focused on other aspects of the problem or
included relevant material not presented below.
Introduction
• Unemployment arises when
o An individual is in the labour market; but
o He is not employed (or perhaps he is underemployed (i.e. he is working
less than he desires, for example, because he can only find part-time
work)).
• Unemployment can be contrasted with economic inactivity which is when a
person chooses not to be in the labour market because, for example:
o He is in full-time education;
o He is disabled;
o He is responsible full-time for looking after his children;
o Etc.
• Unemployed people are looking for work but can’t find it.
Voluntary Unemployment
• Voluntary Unemployment might also be called microeconomic unemployment.
• There are several possible causes of Voluntary Unemployment:
o People may prefer leisure to work at the current market wage;
o People may be rejecting job offers in expectation of better job offers;
• To understand the first case consider why people work1:
o People work in order to obtain income which is used:
 To purchase goods and services;
 To save for the future – to smooth lifetime consumption;
o Time spent not working is leisure time;
o People have preferences over
 Stuff – that is
• Goods and services;
• Future consumption; and
 Leisure;
o People would prefer to consume some combination of the above;
o In order to obtain Stuff, they enter the labour market and offer to trade their
leisure for wages;
o If the current real wage does not compensate the worker enough for his
Leisure by providing Stuff, he will be unwilling to work at the current wage;
o This a rational response to the user’s preferences and market conditions –
the worker does not like the deal he is offered and rejects it;
1
Economists tend not to mention the fact that some people enjoy their work. This is because this is
embedded in their preferences – they will require a lower wage in order to work to account for their joy.
1
•
•
•
Although the behaviour described above is rational:
o It may still be socially inefficient if the reason the worker prefers leisure is
because state benefits are preferable to a low-income job;
o This is why tax credits are offered to low income workers to ensure that
work is always preferred to leisure;
To understand the second case consider the following situation:
o Suppose a person has an expectation of the real wage he can obtain;
o This expectation is higher than the employers’ belief of the market wage;
o In this case, no deal is possible
 The employee thinks he is undervalued by the offer;
 The employer thinks the offer is fair;
o As job searches continue, both employer and employee will adjust their
expectations and beliefs
 The employee realises he needs to cut his wage demand;
 The employer realises that he cannot obtain workers at this wage;
o In the end a deal is possible when employer / employee’s beliefs match;
o In the economy generally, there is a certain amount of unemployment
caused by this sort of job search behaviour – this is frictional
unemployment;
In Classical or New Classical Economic Theory,
o All Unemployment is effectively Voluntary;
o There is a level of Unemployment known as full employment or the natural
rate of employment;
o Full employment is the equilibrium level of unemployment;
o Attempts to reduce unemployment below the full employment level by
expanding demand will be ineffective and will lead to
 Higher inflation – this is because
• Nominal Wages will be bided up; and
• Because in perfect competition prices equal marginal cost –
higher wages merely lead to higher prices (note: real wages
remain the same – they are determined by supply factors);
 Redistribution of output between different sectors of the economy;
o The only way to reduce the level of voluntary unemployment is by SupplySide measures including
 Reducing the marginal rate of taxation
• This makes work more worth-while and hence alters the
optimal choice in the trade-off between leisure and goods;
 Reducing benefits
• This makes leisure less worth-while and hence alters the
optimal choice in the trade-off between leisure and goods;
 Increasing productivity
• This increases the real wage (in perfect competition the real
wage equals the marginal productivity of the worker);
• Again, the optimal choice in the trade-off between leisure and
goods is thereby changed;
 Increasing the efficiency of job search
• This reduces the level of frictional unemployment;
 Convincing people to work harder
• This alters preferences over leisure and goods;
2
Voluntary
Unemployment
Real
Wage
D
S
W*
E
•
In this diagram the Supply and Demand for Employment is demonstrated
o The equilibrium real wage is W*
o People willing to Supply labour only for more than W* are voluntarily
unemployed as the market real-wage does not please them;
Involuntary Unemployment
• Involuntary Unemployment might be called macroeconomic unemployment.
• Keynes’ definition of Involuntary Unemployment is when a person is willing to
work at the current real wage but is unable to do so [because of low demand];
o Involuntary unemployment was Keynes’ response to the mass
unemployment
 Seen in Britain in the interwar period; and
 Seen throughout the world during the Great Depression;
• Keynes adopted the perfect competition of the Classical writers that proceeded
him but introduced a nominal rigidity
o The nominal wage was made downwardly rigid;
o The rationale behind this nominal rigidity was that employers would be
unable to reduce the nominal wage even when there was excess labour
supply (high unemployment) because the workforce would not permit it
 E.g. The existing workers would go on strike etc;
 Further, the employer would not be able to introduce differential
wages for new and old employees for similar reasons;
o In a perfect competition model, only a fall in the real wage can lead to an
increase in employment
 The real wage is, of course, the ratio between the nominal price of
goods (the price level) and the nominal wage;
3
Since the nominal wage is fixed the only way to reduce the real
wage is by increasing the price level – which individual unemployed
workers cannot do – hence they become involuntary unemployed;
o Demand for labour thereby becomes determined in the goods market
 Since Supply of the Good depends on the nominal wage which is
fixed – this is not the important factor;
 Demand of the Good is the important factor – hence an increase in
demand can lead to an increase in employment provided that there
is sufficient unemployment to avoid the bidding war problem
described above;
 Higher demand leads to higher nominal prices, which leads to lower
real wages which leads to more employment;
In the Post-War period, the paradigm become the Neoclassical Synthesis under
which
o Unemployment / Output in the short-term is determined by demand;
o In the long-run, the natural rate of employment of the classical model
applies and attempts to expand demand through fiscal / monetary policy
have the effect only of increasing inflation;
o This is because in the long-run prices are flexible enough to avoid the
involuntary unemployment created by the nominal rigidity in Keynes’
model;
New Classical Economists reject the notion of involuntary unemployment
o Although it is observably true that demand can lead to increases in
employment, they note that it also leads to higher inflation;
o They argue that these increase in employment are not because of
involuntary unemployment but because of incorrect expectations;
o In the New Classical Model, people are voluntarily unemployed
 Some of these people would be willing to work if the real wage was
increased – because this would change the optimal trade-off for
them;
 However, employers would employ fewer people if the real wage
was increased – because this would change the profit maximisation
point for them;
o To solve the dichotomy, the New Classists argue that employers and
employees may have different expectations of the price of goods
 Assume the employers know the price of goods;
 Employees form an expectation of the price of goods ex ante (i.e.
before contracting) but can only discover the price ex poste;
 They form a wage under their expectation;
 If the Government causes inflation by expanding the money supply
or through fiscal policy (which bids up prices etc) this tricks the
employees (because prices were greater than they expected);
 The employers increase the nominal wage in line with the increase
in prices but the employees think this is an increase in the real
wage so they are willing to work an extra amount;
 Eventually, however, they realise what is going and the level of
employment returns to the previous level;
 The employees also adjust their expectations so that in order to
achieve the same effect the government will have to increase
inflation by even more;

•
•
4
The result is that attempting to increase employment above the
natural rate will lead to higher inflation, attempting to keep it there
will lead to accelerating inflation;
The New Keynesian approach is based on imperfect competition and
expectations
o Consider two relationships which both link real wages and unemployment
 The Price Setting relationship;
 The Wage Demand relationship;
o In imperfect competition, there is mark-up pricing (pricing over real wages
or costs) – the mark-up does not depend on the level of unemployment;
o The Wage Demand relationship arises out of wage bargaining
 Workers bargain for higher real wages;
 The real wage workers bargain for will be higher than the marginal
product of labour in a perfectly competitive market;
 Because employers are not willing to employ as many workers at
this level above the marginal product of labour – there is involuntary
unemployment because some workers who would be willing to work
at this real wage cannot because the existing workforce (the
insiders) have insisted on higher real wages even though the
unemployed (the outsiders) are effectively shut out of the market;
 The ability of workers to bargain for higher real wages depends on
the level of unemployment
• The higher unemployment the less the difference between
the marginal product of labour and the real wage;

•
Real
Wage
W’
D
S
W*
E’
E*
E
5
E’’
o In this diagram, the workers have forced the real wage from W* to W’
which means that the employer is employing only E’ people (see the
Demand curve);
 Everyone from E’ to E’’ on the Supply Curve is involuntarily
unemployed since they are willing to work at W’ but cannot;
 Everyone from E’’ above is voluntarily unemployed;
o An alternative explanation of this relationship is efficiency wages
 Firms pay higher real wages to motivate their staff or to discourage
them from shirking;
 The markup over the marginal product again varies with the level of
unemployment since high unemployment itself is itself an incentive;
o When the level of unemployment is such that the real wage determined by
price-setting and wage demand is inconsistent, there is accelerating /
decelerating inflation depending on whether unemployment is higher than
this level or lower – unemployment determines inflation
 There exists a level of unemployment at which inflation is stable this
is the so-called NAIRU or non-accelerating inflation rate of
unemployment;
 Unlike the natural rate of employment, there may be both voluntary
and involuntary unemployment at the NAIRU;
 When unemployment is lower than NAIRU, workers push for higher
real wages and firms increase prices (due to mark-up pricing) to
compensate which leads to accelerating inflation;
 When unemployment is higher than NAIRU, workers do not push for
higher real wages and hence inflation slows;
 At NAIRU, the price implied by the real-wage demanded by the
workers is compatible with the firms demands and hence inflation is
stable;
o Supply side measures alter the NAIRU by e.g. introducing more
competition etc or reducing voluntary unemployment;
o Demand side measures can lower unemployment beyond the NAIRU but
this will lead to an acceleration in inflation;
o Just as in Keynes earlier model, it is price rigidity that leads to the
existence of involuntary unemployment
 The mark-up pricing;
 The bargaining over real wages;
o The explanation is that workers and firms negotiate over claims to output
and that in this negotiation inflation is determined.
6