Unemployment and Its Natural Rate by alicejenny


									                                                                                         IN THIS CHAPTER
                                                                                           YOU WILL . . .

                                                                                           Learn about the
                                                                                            data used to
                                                                                         measure the amount
                                                                                          of unemployment

                                                                                            Consider how
                                                                                           arises from the
                                                                                           process of job

                                                                                            Consider how
                                                                                         unemployment can
                                                                                             result from
                                                                                         minimum-wage laws
               AND         ITS      N AT U R A L           R AT E

                                                                                               See how
Losing a job can be the most distressing economic event in a person’s life. Most         unemployment can
people rely on their labor earnings to maintain their standard of living, and many            arise from
people get from their work not only income but also a sense of personal accom-           bargaining between
plishment. A job loss means a lower living standard in the present, anxiety about         firms and unions
the future, and reduced self-esteem. It is not surprising, therefore, that politicians
campaigning for office often speak about how their proposed policies will help
create jobs.
     In the preceding two chapters we have seen some of the forces that determine
the level and growth of a country’s standard of living. A country that saves and in-
vests a high fraction of its income, for instance, enjoys more rapid growth in its           Examine how
capital stock and its GDP than a similar country that saves and invests less. An           unemployment
even more obvious determinant of a country’s standard of living is the amount of         results when firms
unemployment it typically experiences. People who would like to work but cannot            choose to pay
                                                                                          ef ficiency wages


                               find a job are not contributing to the economy’s production of goods and services.
                               Although some degree of unemployment is inevitable in a complex economy with
                               thousands of firms and millions of workers, the amount of unemployment varies
                               substantially over time and across countries. When a country keeps its workers as
                               fully employed as possible, it achieves a higher level of GDP than it would if it left
                               many of its workers standing idle.
                                    This chapter begins our study of unemployment. The problem of unemploy-
                               ment is usefully divided into two categories—the long-run problem and the short-
                               run problem. The economy’s natural rate of unemployment refers to the amount of
                               unemployment that the economy normally experiences. Cyclical unemployment
                               refers to the year-to-year fluctuations in unemployment around its natural rate,
                               and it is closely associated with the short-run ups and downs of economic activity.
                               Cyclical unemployment has its own explanation, which we defer until we study
                               short-run economic fluctuations later in this book. In this chapter we discuss the
                               determinants of an economy’s natural rate of unemployment. As we will see, the
                               designation natural does not imply that this rate of unemployment is desirable.
                               Nor does it imply that it is constant over time or impervious to economic policy. It
                               merely means that this unemployment does not go away on its own even in the
                               long run.
                                    We begin the chapter by looking at some of the relevant facts that describe un-
                               employment. In particular, we examine three questions: How does the govern-
                               ment measure the economy’s rate of unemployment? What problems arise in
                               interpreting the unemployment data? How long are the unemployed typically
                               without work?
                                    We then turn to the reasons why economies always experience some unem-
                               ployment and the ways in which policymakers can help the unemployed. We dis-
                               cuss four explanations for the economy’s natural rate of unemployment: job
                               search, minimum-wage laws, unions, and efficiency wages. As we will see, long-
                               run unemployment does not arise from a single problem that has a single solution.
                               Instead, it reflects a variety of related problems. As a result, there is no easy way
                               for policymakers to reduce the economy’s natural rate of unemployment and, at
                               the same time, to alleviate the hardships experienced by the unemployed.

                                                    IDENTIFYING UNEMPLOYMENT

                               We begin this chapter by examining more precisely what the term unemployment
                               means. We consider how the government measures unemployment, what prob-
                               lems arise in interpreting the unemployment data, and how long the typical spell
                               of unemployment lasts.

                               HOW IS UNEMPLOYMENT MEASURED?

                               Measuring unemployment is the job of the Bureau of Labor Statistics (BLS), which
                               is part of the Department of Labor. Every month the BLS produces data on unem-
                               ployment and on other aspects of the labor market, such as types of employment,
                                                         CHAPTER 26     U N E M P L O Y M E N T A N D I T S N AT U R A L R AT E         581

length of the average workweek, and the duration of unemployment. These data
come from a regular survey of about 60,000 households, called the Current Popu-
lation Survey.
     Based on the answers to survey questions, the BLS places each adult (aged six-
teen and older) in each surveyed household into one of three categories:

x   Employed
x   Unemployed
x   Not in the labor force

A person is considered employed if he or she spent most of the previous week
working at a paid job. A person is unemployed if he or she is on temporary layoff,
is looking for a job, or is waiting for the start date of a new job. A person who fits
neither of the first two categories, such as a full-time student, homemaker, or re-
tiree, is not in the labor force. Figure 26-1 shows this breakdown for 1998.
     Once the BLS has placed all the individuals covered by the survey in a cate-
gory, it computes various statistics to summarize the state of the labor market. The
BLS defines the labor force as the sum of the employed and the unemployed:                        labor force
                                                                                                  the total number of workers,
                                                                                                  including both the employed
           Labor force    Number employed           number of unemployed                          and the unemployed

                                                                                                             Figure 26-1

                                                                                                  T HE B REAKDOWN OF THE
                                                                                                  P OPULATION IN 1998. The
                                                                                                  Bureau of Labor Statistics
                                                                                                  divides the adult population
                                                                                                  into three categories: employed,
                                       Employed                                                   unemployed, and not in the
                                                                        Labor force               labor force.
                                     (131.5 million)
                                                                      (137.7 million)
                                                                                                  SOURCE: Bureau of Labor Statistics.
       (205.2 million)

                                 Unemployed (6.2 million)

                                    Not in labor force
                                     (67.5 million)

unemployment rate                       The BLS defines the unemployment rate as the percentage of the labor force that
the percentage of the labor force       is unemployed:
that is unemployed
                                                                                Number of unemployed
                                                      Unemployment rate                                          100.
                                                                                    Labor force

                                        The BLS computes unemployment rates for the entire adult population and for
                                        more narrow groups—blacks, whites, men, women, and so on.
                                            The BLS uses the same survey to produce data on labor-force participation.
labor-force                             The labor-force participation rate measures the percentage of the total adult pop-
par ticipation rate                     ulation of the United States that is in the labor force:
the percentage of the adult
population that is in the labor force                                                       Labor force
                                                     Labor-force participation rate                               100.
                                                                                          Adult population

                                        This statistic tells us the fraction of the population that has chosen to participate in
                                        the labor market. The labor-force participation rate, like the unemployment rate, is
                                        computed both for the entire adult population and for more narrow groups.
                                             To see how these data are computed, consider the figures for 1998. In that year,
                                        131.5 million people were employed, and 6.2 million people were unemployed.
                                        The labor force was

                                                             Labor force     131.5     6.2    137.7 million.

                                        The unemployment rate was

                                                      Unemployment rate         (6.2/137.7)     100    4.5 percent.

                                        Because the adult population was 205.2 million, the labor-force participation
                                        rate was

                                               Labor-force participation rate        (137.7/205.2)    100      67.1 percent.

                                        Hence, in 1998, two-thirds of the U.S. adult population were participating in the
                                        labor market, and 4.5 percent of those labor-market participants were with-
                                        out work.
                                             Table 26-1 shows the statistics on unemployment and labor-force participation
                                        for various groups within the U.S. population. Three comparisons are most appar-
                                        ent. First, women have lower rates of labor-force participation than men, but once
                                        in the labor force, women have similar rates of unemployment. Second, blacks
                                        have similar rates of labor-force participation as whites, and they have much
                                        higher rates of unemployment. Third, teenagers have lower rates of labor-force
                                        participation and much higher rates of unemployment than the overall popula-
                                        tion. More generally, these data show that labor-market experiences vary widely
                                        among groups within the economy.
                                             The BLS data on the labor market also allow economists and policymakers to
natural rate of                         monitor changes in the economy over time. Figure 26-2 shows the unemployment
unemployment                            rate in the United States since 1960. The figure shows that the economy always has
the normal rate of unemployment         some unemployment and that the amount changes from year to year. The normal
around which the unemployment           rate of unemployment around which the unemployment rate fluctuates is called
rate fluctuates                         the natural rate of unemployment, and the deviation of unemployment from its
                                                         CHAPTER 26          U N E M P L O Y M E N T A N D I T S N AT U R A L R AT E          583

                                                                                                                   Ta b l e 2 6 - 1
                                              UNEMPLOYMENT              LABOR-FORCE
     DEMOGRAPHIC GROUP                            RATE                PARTICIPATION RATE               T HE L ABOR -M ARKET
                                                                                                       E XPERIENCES OF VARIOUS
     ADULTS (AGES 20 AND OVER)                                                                         D EMOGRAPHIC G ROUPS .
       White, male                                3.2%                         77.2%                   This table shows the
       White, female                              3.4                          59.7                    unemployment rate and
       Black, male                                7.4                          72.5                    the labor-force participation
       Black, female                              7.9                          64.8                    rate of various groups in the
     TEENAGERS (AGES 16–19)                                                                            U.S. population for 1998.
       White, male                               14.1                          56.6
       White, female                             10.9                          55.4
       Black, male                               30.1                          40.7
       Black, female                             25.3                          42.5

     SOURCE: Bureau of Labor Statistics.

         Percent of
        Labor Force

                  10                                                                      Unemployment rate



                                                         Natural rate of


                        1960           1965    1970       1975             1980         1985           1990           1995             2000

U NEMPLOYMENT R ATE SINCE 1960. This graph uses annual data on the unemployment
                                                                                                                  Figure 26-2
rate to show the fraction of the labor force without a job.

Source: U.S. Department of Labor.

natural rate is called cyclical unemployment. In the figure, the natural rate is                       cyclical unemployment
shown as a horizontal line at 5.5 percent, which is a rough estimate of the natural                    the deviation of unemployment from
rate for the U.S. economy during this period. Later in this book we discuss                            its natural rate

                               short-run economic fluctuations, including the year-to-year fluctuations in unem-
                               ployment around its natural rate. In the rest of this chapter, however, we ignore the
                               short-run fluctuations and examine why unemployment is a chronic problem for
                               market economies.

                                 CASE STUDY              LABOR-FORCE PARTICIPATION
                                                         OF MEN AND WOMEN IN THE U.S. ECONOMY

                                 Women’s role in American society has changed dramatically over the past cen-
                                 tury. Social commentators have pointed to many causes for this change. In part,
                                 it is attributable to new technologies such as the washing machine, clothes
                                 dryer, refrigerator, freezer, and dishwasher, which have reduced the amount of
                                 time required to complete routine household tasks. In part, it is attributable to
                                 improved birth control, which has reduced the number of children born to the
                                 typical family. And, of course, this change in women’s role is also partly at-
                                 tributable to changing political and social attitudes. Together these develop-
                                 ments have had a profound impact on society in general and on the economy in
                                      Nowhere is that impact more obvious than in data on labor-force participa-
                                 tion. Figure 26-3 shows the labor-force participation rates of men and women in
                                 the United States since 1950. Just after World War II, men and women had very
                                 different roles in society. Only 33 percent of women were working or looking for
                                 work, in contrast to 87 percent of men. Over the past several decades, the dif-
                                 ference between the participation rates of men and women has gradually di-
                                 minished, as growing numbers of women have entered the labor force and
                                 some men have left it. Data for 1998 show that 60 percent of women were in the
                                 labor force, in contrast to 75 percent of men. As measured by labor-force partic-
                                 ipation, men and women are now playing a more equal role in the economy.
                                      The increase in women’s labor-force participation is easy to understand, but
                                 the fall in men’s may seem puzzling. There are several reasons for this decline.

                                 MORE WOMEN ARE WORKING
                                 NOW THAN EVER BEFORE.
                                                     CHAPTER 26   U N E M P L O Y M E N T A N D I T S N AT U R A L R AT E       585

First, young men now stay in school longer than their fathers and grandfathers
did. Second, older men now retire earlier and live longer. Third, with more
women employed, more fathers now stay at home to raise their children. Full-
time students, retirees, and stay-at-home fathers are all counted as out of the
labor force.


Measuring the amount of unemployment in the economy might seem straightfor-
ward. In fact, it is not. Whereas it is easy to distinguish between a person with a
full-time job and a person who is not working at all, it is much harder to distin-
guish between a person who is unemployed and a person who is not in the labor
     Movements into and out of the labor force are, in fact, very common. More
than one-third of the unemployed are recent entrants into the labor force. These
entrants include young workers looking for their first jobs, such as recent college
graduates. They also include, in greater numbers, older workers who had previ-
ously left the labor force but have now returned to look for work. Moreover, not all
unemployment ends with the job seeker finding a job. Almost half of all spells of
unemployment end when the unemployed person leaves the labor force.
     Because people move into and out of the labor force so often, statistics on un-
employment are difficult to interpret. On the one hand, some of those who report
being unemployed may not, in fact, be trying hard to find a job. They may be
calling themselves unemployed because they want to qualify for a government

                                                                                                       Figure 26-3
      Participation                                                                         L ABOR -F ORCE PARTICIPATION
  Rate (in percent)
                                                                                            R ATES FOR M EN AND W OMEN
               100                                                                          SINCE 1950.      This figure shows
                                                                                            the percentage of adult men and
                                              Men                                           women who are members of the
                                                                                            labor force. It shows that over
                                                                                            the past several decades, women
                60                                                                          have entered the labor force, and
                                                                                            men have left it.

                40                                                                          SOURCE: U.S. Department of Labor.


                      1950 1955 1960   1965 1970 1975   1980 1985 1990 1995 '98

                                      program that financially assists the unemployed or because they are actually
                                      working and being paid “under the table.” It may be more realistic to view these
                                      individuals as out of the labor force or, in some cases, employed. On the other
                                      hand, some of those who report being out of the labor force may, in fact, want to
                                      work. These individuals may have tried to find a job but have given up after an
discouraged workers                   unsuccessful search. Such individuals, called discouraged workers, do not show
individuals who would like to work    up in unemployment statistics, even though they are truly workers without jobs.
but have given up looking for a job   According to most estimates, adding discouraged workers would increase the
                                      measured unemployment rate by about one-half of one percentage point.
                                          There is no easy way to fix the unemployment rate as reported by the BLS to
                                      make it a more reliable indicator of conditions in the labor market. In the end, it is
                                      best to view the reported unemployment rate as a useful but imperfect measure of

                                      HOW LONG ARE THE UNEMPLOYED WITHOUT WORK?

                                      In judging how serious the problem of unemployment is, one question to consider
                                      is whether unemployment is typically a short-term or long-term condition. If un-
                                      employment is short-term, one might conclude that it is not a big problem. Work-
                                      ers may require a few weeks between jobs to find the openings that best suit their
                                      tastes and skills. Yet if unemployment is long-term, one might conclude that it is a
                                      serious problem. Workers unemployed for many months are more likely to suffer
                                      economic and psychological hardship.
                                           Because the duration of unemployment can affect our view about how big a
                                      problem unemployment is, economists have devoted much energy to studying
                                      data on the duration of unemployment spells. In this work, they have uncovered a
                                      result that is important, subtle, and seemingly contradictory: Most spells of unem-
                                      ployment are short, and most unemployment observed at any given time is long-term.
                                           To see how this statement can be true, consider an example. Suppose that you
                                      visited the government’s unemployment office every week for a year to survey the
                                      unemployed. Each week you find that there are four unemployed workers. Three
                                      of these workers are the same individuals for the whole year, while the fourth per-
                                      son changes every week. Based on this experience, would you say that unemploy-
                                      ment is typically short-term or long-term?
                                           Some simple calculations help answer this question. In this example, you meet
                                      a total of 55 unemployed people; 52 of them are unemployed for one week, and
                                      three are unemployed for the full year. This means that 52/55, or 95 percent, of un-
                                      employment spells end in one week. Thus, most spells of unemployment are short.
                                      Yet consider the total amount of unemployment. The three people unemployed for
                                      one year (52 weeks) make up a total of 156 weeks of unemployment. Together with
                                      the 52 people unemployed for one week, this makes 208 weeks of unemployment.
                                      In this example, 156/208, or 75 percent, of unemployment is attributable to those
                                      individuals who are unemployed for a full year. Thus, most unemployment ob-
                                      served at any given time is long-term.
                                           This subtle conclusion implies that economists and policymakers must be
                                      careful when interpreting data on unemployment and when designing policies to
                                      help the unemployed. Most people who become unemployed will soon find jobs.
                                      Yet most of the economy’s unemployment problem is attributable to the relatively
                                      few workers who are jobless for long periods of time.
                                                   CHAPTER 26      U N E M P L O Y M E N T A N D I T S N AT U R A L R AT E   587


We have discussed how the government measures the amount of unemployment,
the problems that arise in interpreting unemployment statistics, and the findings
of labor economists on the duration of unemployment. You should now have a
good idea about what unemployment is.
     This discussion, however, has not explained why economies experience un-
employment. In most markets in the economy, prices adjust to bring quantity sup-
plied and quantity demanded into balance. In an ideal labor market, wages would
adjust to balance the quantity of labor supplied and the quantity of labor de-
manded. This adjustment of wages would ensure that all workers are always fully
     Of course, reality does not resemble this ideal. There are always some workers
without jobs, even when the overall economy is doing well. In other words, the
unemployment rate never falls to zero; instead, it fluctuates around the natural
rate of unemployment. To understand this natural rate, we now examine the rea-
sons why actual labor markets depart from the ideal of full employment.
     To preview our conclusions, we will find that there are four ways to explain
unemployment in the long run. The first explanation is that it takes time for work-
ers to search for the jobs that are best suited for them. The unemployment that re-
sults from the process of matching workers and jobs is sometimes called frictional           frictional unemployment
unemployment, and it is often thought to explain relatively short spells of unem-            unemployment that results because
ployment.                                                                                    it takes time for workers to search
     The next three explanations for unemployment suggest that the number of                 for the jobs that best suit their
jobs available in some labor markets may be insufficient to give a job to everyone           tastes and skills
who wants one. This occurs when the quantity of labor supplied exceeds the quan-
tity demanded. Unemployment of this sort is sometimes called structural unem-                structural unemployment
ployment, and it is often thought to explain longer spells of unemployment. As we            unemployment that results because
will see, this kind of unemployment results when wages are, for some reason, set             the number of jobs available in
above the level that brings supply and demand into equilibrium. We will examine              some labor markets is insufficient
three possible reasons for an above-equilibrium wage: minimum-wage laws,                     to provide a job for everyone
unions, and efficiency wages.                                                                who wants one

  Q U I C K Q U I Z : How is the unemployment rate measured? x How might
  the unemployment rate overstate the amount of joblessness? How might it
  understate it?

                                 JOB SEARCH

One reason why economies always experience some unemployment is job search.
Job search is the process of matching workers with appropriate jobs. If all workers          job search
and all jobs were the same, so that all workers were equally well suited for all jobs,       the process by which workers
job search would not be a problem. Laid-off workers would quickly find new                   find appropriate jobs given
jobs that were well suited for them. But, in fact, workers differ in their tastes and        their tastes and skills
skills, jobs differ in their attributes, and information about job candidates and job

                               vacancies is disseminated slowly among the many firms and households in the

                               W H Y S O M E F R I C T I O N A L U N E M P L O Y M E N T I S I N E V I TA B L E

                               Frictional unemployment is often the result of changes in the demand for labor
                               among different firms. When consumers decide that they prefer Compaq over Dell
                               computers, Compaq increases employment, and Dell lays off workers. The former
                               Dell workers must now search for new jobs, and Compaq must decide which new
                               workers to hire for the various jobs that have opened up. The result of this transi-
                               tion is a period of unemployment.
                                   Similarly, because different regions of the country produce different goods,
                               employment can rise in one region while it falls in another. Consider, for instance,
                               what happens when the world price of oil falls. Oil-producing firms in Texas re-
                               spond to the lower price by cutting back on production and employment. At the
                               same time, cheaper gasoline stimulates car sales, so auto-producing firms in
                               Michigan raise production and employment. Changes in the composition of de-
                               mand among industries or regions are called sectoral shifts. Because it takes time for
                               workers to search for jobs in the new sectors, sectoral shifts temporarily cause un-
                                   Frictional unemployment is inevitable simply because the economy is always
                               changing. A century ago, the four industries with the largest employment in the
                               United States were cotton goods, woolen goods, men’s clothing, and lumber. To-
                               day, the four largest industries are autos, aircraft, communications, and electrical
                               components. As this transition took place, jobs were created in some firms, and
                               jobs were destroyed in others. The end result of this process has been higher pro-
                               ductivity and higher living standards. But, along the way, workers in declining in-
                               dustries found themselves out of work and searching for new jobs.
                                   Data show that at least 10 percent of U.S. manufacturing jobs are destroyed
                               every year. In addition, more than 3 percent of workers leave their jobs in a typical
                               month, sometimes because they realize that the jobs are not a good match for their
                               tastes and skills. Many of these workers, especially younger ones, find new jobs
                               at higher wages. This churning of the labor force is normal in a well-functioning
                               and dynamic market economy, but the result is some amount of frictional

                               PUBLIC POLICY AND JOB SEARCH

                               Even if some frictional unemployment is inevitable, the precise amount is not. The
                               faster information spreads about job openings and worker availability, the more
                               rapidly the economy can match workers and firms. The Internet, for instance, may
                               help facilitate job search and reduce frictional unemployment. In addition, public
                               policy may play a role. If policy can reduce the time it takes unemployed workers
                               to find new jobs, it can reduce the economy’s natural rate of unemployment.
                                    Government programs try to facilitate job search in various ways. One way is
                               through government-run employment agencies, which give out information about
                               job vacancies. Another way is through public training programs, which aim to
                               ease the transition of workers from declining to growing industries and to help
                                                    CHAPTER 26       U N E M P L O Y M E N T A N D I T S N AT U R A L R AT E   589

disadvantaged groups escape poverty. Advocates of these programs believe that
they make the economy operate more efficiently by keeping the labor force more
fully employed, and that they reduce the inequities inherent in a constantly chang-
ing market economy.
     Critics of these programs question whether the government should get in-
volved with the process of job search. They argue that it is better to let the private
market match workers and jobs. In fact, most job search in our economy takes
place without intervention by the government. Newspaper ads, job newsletters,
college placement offices, headhunters, and word of mouth all help spread infor-
mation about job openings and job candidates. Similarly, much worker education
is done privately, either through schools or through on-the-job training. These crit-
ics contend that the government is no better—and most likely worse—at dissemi-
nating the right information to the right workers and deciding what kinds of
worker training would be most valuable. They claim that these decisions are best
made privately by workers and employers.


One government program that increases the amount of frictional unemployment,
without intending to do so, is unemployment insurance. This program is de-                     unemployment insurance
signed to offer workers partial protection against job loss. The unemployed who                a government program that partially
quit their jobs, were fired for cause, or just entered the labor force are not eligible.       protects workers’ incomes when
Benefits are paid only to the unemployed who were laid off because their previous              they become unemployed
employers no longer needed their skills. Although the terms of the program vary
over time and across states, a typical American worker covered by unemployment
insurance receives 50 percent of his or her former wages for 26 weeks.
     While unemployment insurance reduces the hardship of unemployment, it
also increases the amount of unemployment. The explanation is based on one of
the Ten Principles of Economics in Chapter 1: People respond to incentives. Because
unemployment benefits stop when a worker takes a new job, the unemployed de-
vote less effort to job search and are more likely to turn down unattractive job of-
fers. In addition, because unemployment insurance makes unemployment less
onerous, workers are less likely to seek guarantees of job security when they ne-
gotiate with employers over the terms of employment.
     Many studies by labor economists have examined the incentive effects of un-
employment insurance. One study examined an experiment run by the state of Illi-
nois in 1985. When unemployed workers applied to collect unemployment
insurance benefits, the state randomly selected some of them and offered each a
$500 bonus if they found new jobs within 11 weeks. This group was then com-
pared to a control group not offered the incentive. The average spell of unemploy-
ment for the group offered the bonus was 7 percent shorter than the average spell
for the control group. This experiment shows that the design of the unemployment
insurance system influences the effort that the unemployed devote to job search.
     Several other studies examined search effort by following a group of workers
over time. Unemployment insurance benefits, rather than lasting forever, usually
run out after six months or a year. These studies found that when the unemployed
become ineligible for benefits, the probability of their finding a new job rises
markedly. Thus, receiving unemployment insurance benefits does reduce the
search effort of the unemployed.

                                   Even though unemployment insurance reduces search effort and raises unem-
                               ployment, we should not necessarily conclude that the policy is a bad one. The
                               program does achieve its primary goal of reducing the income uncertainty that
                               workers face. In addition, when workers turn down unattractive job offers, they
                               have the opportunity to look for jobs that better suit their tastes and skills. Some
                               economists have argued that unemployment insurance improves the ability of the
                               economy to match each worker with the most appropriate job.
                                   The study of unemployment insurance shows that the unemployment rate is
                               an imperfect measure of a nation’s overall level of economic well-being. Most
                               economists agree that eliminating unemployment insurance would reduce the
                               amount of unemployment in the economy. Yet economists disagree on whether
                               economic well-being would be enhanced or diminished by this change in policy.

                                  Q U I C K Q U I Z : How would an increase in the world price of oil affect the
                                  amount of frictional unemployment? Is this unemployment undesirable?
                                  What public policies might affect the amount of unemployment caused by this
                                  price change?

                                                           M I N I M U M - WA G E L AW S

                               Having seen how frictional unemployment results from the process of matching
                               workers and jobs, let’s now examine how structural unemployment results when
                               the number of jobs is insufficient for the number of workers.
                                    To understand structural unemployment, we begin by reviewing how un-
                               employment arises from minimum-wage laws—a topic we first analyzed in
                               Chapter 6. Although minimum wages are not the predominant reason for unem-
                               ployment in our economy, they have an important effect on certain groups with
                               particularly high unemployment rates. Moreover, the analysis of minimum wages
                               is a natural place to start because, as we will see, it can be used to understand some
                               of the other reasons for structural unemployment.
                                    Figure 26-4 reviews the basic economics of a minimum wage. When a
                               minimum-wage law forces the wage to remain above the level that balances sup-
                               ply and demand, it raises the quantity of labor supplied and reduces the quantity
                               of labor demanded compared to the equilibrium level. There is a surplus of labor.
                               Because there are more workers willing to work than there are jobs, some workers
                               are unemployed.
                                    Because we discussed minimum-wage laws extensively in Chapter 6, we will
                               not discuss them further here. It is, however, important to note why minimum-
                               wage laws are not a predominant reason for unemployment: Most workers in the
                               economy have wages well above the legal minimum. Minimum-wage laws are
                               binding most often for the least skilled and least experienced members of the labor
                               force, such as teenagers. It is only among these workers that minimum-wage laws
                               explain the existence of unemployment.
                                    Although Figure 26-4 is drawn to show the effects of a minimum-wage law, it
                               also illustrates a more general lesson: If the wage is kept above the equilibrium level for
                               any reason, the result is unemployment. Minimum-wage laws are just one reason why
                                                      CHAPTER 26    U N E M P L O Y M E N T A N D I T S N AT U R A L R AT E   591

                                                                                                         Figure 26-4
                                                                                              U NEMPLOYMENT FROM A
                                                                   Labor                      WAGE ABOVE THE E QUILIBRIUM
                                        Surplus of labor
                                                                   supply                     L EVEL . In this labor market,
       Minimum                                                                                the wage at which supply and
           wage                                                                               demand balance is WE. At this
                                                                                              equilibrium wage, the quantity of
            WE                                                                                labor supplied and the quantity
                                                                                              of labor demanded both equal LE.
                                                                                              By contrast, if the wage is forced
                                                                                              to remain above the equilibrium
                                                                                              level, perhaps because of a
                                                                    Labor                     minimum-wage law, the quantity
                                                                                              of labor supplied rises to LS, and
                                                                                              the quantity of labor demanded
             0                     LD           LE         LS         Quantity of             falls to LD. The resulting surplus
                                                                          Labor               of labor, LS–LD, represents

wages may be “too high.” In the remaining two sections of this chapter, we con-
sider two other reasons why wages may be kept above the equilibrium level—
unions and efficiency wages. The basic economics of unemployment in these cases
is the same as that shown in Figure 26-4, but these explanations of unemployment
can apply to many more of the economy’s workers.
     At this point, however, we should stop and notice that the structural unem-
ployment that arises from an above-equilibrium wage is, in an important sense,
different from the frictional unemployment that arises from the process of job
search. The need for job search is not due to the failure of wages to balance labor
supply and labor demand. When job search is the explanation for unemployment,
workers are searching for the jobs that best suit their tastes and skills. By contrast,
when the wage is above the equilibrium level, the quantity of labor supplied ex-
ceeds the quantity of labor demanded, and workers are unemployed because they
are waiting for jobs to open up.

  Q U I C K Q U I Z : Draw the supply curve and the demand curve for a labor
  market in which the wage is fixed above the equilibrium level. Show the
  quantity of labor supplied, the quantity demanded, and the amount of

                                                                                              a worker association that bargains
A union is a worker association that bargains with employers over wages and                   with employers over wages and
working conditions. Whereas only 16 percent of U.S. workers now belong to                     working conditions

                                            and the prospect, for those who know         taxes. Employer/employee-funded taxes
                                            how to work the system, of remaining on      this year alone totaled 52.8 billion
                                            benefits for life. So blatantly do people    deutsche marks, or nearly $30 billion.
      German Unemployment                   abuse this system that Chancellor Hel-             But high labor costs are a major
                                            mut Kohl once critically described his       reason companies are now fleeing for
                                            country as “Leisurepark Germany.” . . .      cheaper, neighboring Poland—meaning
                                                 Now—partly because . . . such gen-      job losses for Germany. At the same
                                            erous benefits are seriously straining the   time, unemployment benefits have be-
                                            nation’s economy—questions are being         come something of a velvet coffin for the
                                            raised about whether one way to combat       unemployed, discouraging them from
MANY EUROPEAN COUNTRIES HAVE UN-            unemployment is to reform the social         taking jobs. Until recently, workers who
employment insurance that is far more       welfare system itself. . . .                 worked part-time were effectively penal-
generous than that offered to U.S.               Combating unemployment, always a        ized, as they would receive less unem-
workers, and some economists believe        hot topic here, leapt back into public de-   ployment benefits if they were laid off.
that these programs explain the high
                                            bate last week, after the German Labor             And generous unemployment bene-
European unemployment rates. The
                                            office released figures showing that job-    fits mean there is no incentive to take
following article discusses the recent
debate over unemployment insurance          lessness inched up to 11.7 percent in        part-time or low-paid work—a strategy
in Germany.                                 September, the fifth consecutive post-       adopted to fight unemployment in
                                            war record. . . .                            other countries, including the United
                                                 The unease here also stems from         States. . . .
                                            memories of when Germany last faced                These benefits are so good that ex-
             F o r G e r m a n y,           such levels of joblessness: 1933, when       ploiting them is something of a national
      Benefits Are Also a Burden            the unemployed were so desperate they        sport. In a recent, and not uncommon,
                                            begged in the streets for spare change,      conversation overheard in a Berlin cafe,
          BY ELIZABETH NEUFFER              relied on soup kitchens for meals, and       a woman bragged about how she was
BERLIN—They grumble and grouse as           ushered the Nazis into power.                using her Sozialhilfe to pay for a vacation
they wait for their benefit checks at a          Postwar Germany’s reaction was to       in Italy. Some Germans even register in
local unemployment office here—about        create a massive welfare state, designed     several districts, knowing it’s unlikely
the lack of jobs, about the stupidity of    to squelch social unrest through social      they will be caught for receiving multiple
German politicians, about how outra-        benevolence. “It’s more important to         benefits.
geously high taxes are.                     have modestly happy people on benefits             Not surprisingly, more than 60 per-
     What today’s unemployed Germans        than poverty and all its side effects such   cent of Germany’s unemployed are long-
don’t complain about is this: the size of   as a high crime rate as in the United        term unemployed.
their benefit checks.                       States,” said Heiner Geissler, a leading           “People are used to, and heavily
     “I get unemployment benefits, I        figure in the ruling CDU party.              rely on, ‘Father State,’ ” said Dieter
make some money working on the black             It is becoming increasingly clear,      Hundt, president of the Confederation of
market, I make a living,” says Michael      though, that preserving benefits has         Germany Employers’ Association. “We
Steinbach, a 30-year-old electrician who    trapped Germany in something of a vi-        are a bit spoiled by a too tightly woven
sports a well-ironed shirt, fashionable     cious circle.                                social net, which doesn’t encourage the
glasses, and a briefcase as he waits his         The nation’s high-cost social welfare   individual enough to improve his own
turn at the Prenzlauer Berg unemploy-       system is one reason its labor costs are     situation.”
ment office. “For now, it’s comfortable.”   among the highest in the world: Both
     Germany’s social welfare system        employees and employers must pay             SOURCE: The Boston Globe, October 12, 1997, p. F1.
takes good care of the jobless, with ini-   generously into the system, so they
tial average monthly checks of nearly       need higher wages and profits. More
$900 per month for someone married—         than half of a worker’s paycheck goes to
                                                    CHAPTER 26      U N E M P L O Y M E N T A N D I T S N AT U R A L R AT E   593

unions, unions played a much larger role in the U.S. labor market in the past. In
the 1940s and 1950s, when unions were at their peak, about a third of the U.S. labor
force was unionized. Moreover, unions continue to play a large role in many
European countries. In Sweden and Denmark, for instance, more than three-
fourths of workers belong to unions.


A union is a type of cartel. Like any cartel, a union is a group of sellers acting to-
gether in the hope of exerting their joint market power. Most workers in the U.S.
economy discuss their wages, benefits, and working conditions with their em-
ployers as individuals. By contrast, workers in a union do so as a group. The
process by which unions and firms agree on the terms of employment is called col-             collective bargaining
lective bargaining.                                                                           the process by which unions
     When a union bargains with a firm, it asks for higher wages, better benefits,            and firms agree on the
and better working conditions than the firm would offer in the absence of a union.            terms of employment
If the union and the firm do not reach agreement, the union can organize a with-
drawal of labor from the firm, called a strike. Because a strike reduces production,          strike
sales, and profit, a firm facing a strike threat is likely to agree to pay higher wages       the organized withdrawal of
than it otherwise would. Economists who study the effects of unions typically find            labor from a firm by a union
that union workers earn about 10 to 20 percent more than similar workers who do
not belong to unions.
     When a union raises the wage above the equilibrium level, it raises the quan-
tity of labor supplied and reduces the quantity of labor demanded, resulting in un-
employment. Those workers who remain employed are better off, but those who
were previously employed and are now unemployed at the higher wage are worse
off. Indeed, unions are often thought to cause conflict between different groups of
workers—between the insiders who benefit from high union wages and the out-
siders who do not get the union jobs.
     The outsiders can respond to their status in one of two ways. Some of them
remain unemployed and wait for the chance to become insiders and earn the high
union wage. Others take jobs in firms that are not unionized. Thus, when unions
raise wages in one part of the economy, the supply of labor increases in other parts
of the economy. This increase in labor supply, in turn, reduces wages in industries
that are not unionized. In other words, workers in unions reap the benefit of col-
lective bargaining, while workers not in unions bear some of the cost.
     The role of unions in the economy depends in part on the laws that govern
union organization and collective bargaining. Normally, explicit agreements
among members of a cartel are illegal. If firms that sell a common product were to
agree to set a high price for that product, the agreement would be a “conspiracy in
restraint of trade.” The government would prosecute these firms in civil and crim-
inal court for violating the antitrust laws. By contrast, unions are exempt from
these laws. The policymakers who wrote the antitrust laws believed that workers
needed greater market power as they bargained with employers. Indeed, various
laws are designed to encourage the formation of unions. In particular, the Wagner
Act of 1935 prevents employers from interfering when workers try to organize
unions and requires employers to bargain with unions in good faith. The National
Labor Relations Board (NLRB) is the government agency that enforces workers’
right to unionize.

                                   “Gentlemen, nothing stands in the way of a final accord except that management
                                           wants profit maximization and the union wants more moola.”

                                    Legislation affecting the market power of unions is a perennial topic of politi-
                               cal debate. State lawmakers sometimes debate right-to-work laws, which give work-
                               ers in a unionized firm the right to choose whether to join the union. In the absence
                               of such laws, unions can insist during collective bargaining that firms make union
                               membership a requirement for employment. In recent years, lawmakers in Wash-
                               ington have debated a proposed law that would prevent firms from hiring perma-
                               nent replacements for workers who are on strike. This law would make strikes
                               more costly for firms and, thereby, would increase the market power of unions.
                               These and similar policy decisions will help determine the future of the union

                               ARE UNIONS GOOD OR BAD FOR THE ECONOMY?

                               Economists disagree about whether unions are good or bad for the economy as a
                               whole. Let’s consider both sides of the debate.
                                   Critics of unions argue that unions are merely a type of cartel. When unions
                               raise wages above the level that would prevail in competitive markets, they reduce
                               the quantity of labor demanded, cause some workers to be unemployed, and re-
                               duce the wages in the rest of the economy. The resulting allocation of labor is, crit-
                               ics argue, both inefficient and inequitable. It is inefficient because high union
                               wages reduce employment in unionized firms below the efficient, competitive
                               level. It is inequitable because some workers benefit at the expense of other
                                                               CHAPTER 26          U N E M P L O Y M E N T A N D I T S N AT U R A L R AT E       595

                                                         From a pocketbook perspective,                fits,” Professor Troy said, “the answer is
                                                   workers are absolutely better off joining           yes, you are better off in a union.”
                                                   a union. Economists across the political                  His objections to unions concern
   Should You Join a Union?                        spectrum agree. Turning a nonunion job              how they reduce profits for owners and
                                                   into a union job very likely will have a big-       distort investment decisions in ways that
                                                   ger effect on lifetime finances than all the        slow the overall growth of the econ-
                                                   advice employees will ever read about in-           omy—not how they affect workers who
                                                   vesting their 401(k) plans, buying a                bargain collectively. Professor Troy
                                                   home or otherwise making more of what               points out that he belongs to a union
                                                   they earn.                                          himself—the American Association of
SOMEDAY YOU MAY FACE THE DECISION                        Here is how the equation works,               University Professors.
about whether to vote for or against a             said Prof. Richard B. Freeman of Harvard                  Donald R. Deere, an economist at
union in your workplace. The follow-               University: “For an existing worker in a            the Bush School of Government and
ing article discusses some issues you              firm, if you can carry out an organizing            Public Service at Texas A & M University,
might consider.                                    drive, it is all to your benefit. If there are      studied the wage differential for compa-
                                                   going to be losers, they are people who             rable union and nonunion workers be-
                                                   might have gotten a job in the future, the          tween 1974 and 1996, a period when
                  O n P a y d a y,                 shareholders whose profits will go down,            union membership fell to 15 percent of
  U n i o n J o b s S t a c k U p Ve r y W e l l   the managers because there will be less             American workers from 22 percent.
                                                   profit to distribute to them in pay and,                  In every educational and age cate-
           BY DAVID CAY JOHNSTON                   maybe, consumers will pay a little more             gory that he studied, Professor Deere
With the teamsters’ success in their               for the product. But as a worker, it is aw-         found that union members increased
two-week strike against United Parcel              fully hard to see why you wouldn’t want a           their wage advantage over nonunion
Service, and with the A.F.L.-C.I.O. train-         union.”                                             workers during those years. Last year,
ing thousands of union organizers in a                   Overall, union workers are paid               he estimates, unionized workers with
drive to reverse a quarter-century of de-          about 20 percent more than nonunion                 less than a high school education earned
clining membership, millions of workers            workers, and their fringe benefits are              22 percent more than their nonunion
will be asked over the next few years              typically worth two to four times as                counterparts. The differential declined as
whether they want a union to represent             much, economists with a wide array of               education levels rose, reaching 10 per-
them.                                              views have found. The financial advan-              cent for college graduates.
      It is a complicated question, the an-        tage is even greater for workers with lit-                “It makes sense to belong to a
swer to which rests on a jumble of deter-          tle formal education and training and for           union,” Professor Deere said, “so long
minations: Do you favor collective action          women, blacks, and Hispanic workers.                as you don’t lose your job in the long
or individual initiative? Do you trust the               Moreover, 85 percent of union                 term.”
union’s leaders? Do you want somebody              members have health insurance, com-
else speaking for you in dealings with             pared with 57 percent of nonunion                   Source: The New York Times, Money & Business
your employer? Do you think you will be            workers, said Barry Bluestone, a labor-             Section, August 31, 1997, p. 1.

dismissed if you sign a union card—or              friendly economics professor at the Uni-
that the company will send your job over-          versity of Massachusetts.
seas if a union is organized?                            The conclusion draws no argument
      But in one regard, the choice is sim-        even from Prof. Leo Troy of Rutgers Uni-
ple—and it is not the choice that most             versity, who is widely known in academic
workers have made during the labor                 circles and among union leaders for his
movement’s recent decades in the eco-              hostility to organized labor. “From a
nomic wilderness.                                  standpoint of wages and fringe bene-

                                        Advocates of unions contend that unions are a necessary antidote to the mar-
                                   ket power of the firms that hire workers. The extreme case of this market power is
                                   the “company town,” where a single firm does most of the hiring in a geographic
                                   region. In a company town, if workers do not accept the wages and working con-
                                   ditions that the firm offers, they have little choice but to move or stop working. In
                                   the absence of a union, therefore, the firm could use its market power to pay lower
                                   wages and offer worse working conditions than would prevail if it had to com-
                                   pete with other firms for the same workers. In this case, a union may balance the
                                   firm’s market power and protect the workers from being at the mercy of the firm
                                        Advocates of unions also claim that unions are important for helping firms re-
                                   spond efficiently to workers’ concerns. Whenever a worker takes a job, the worker
                                   and the firm must agree on many attributes of the job in addition to the wage:
                                   hours of work, overtime, vacations, sick leave, health benefits, promotion sched-
                                   ules, job security, and so on. By representing workers’ views on these issues,
                                   unions allow firms to provide the right mix of job attributes. Even if unions have
                                   the adverse effect of pushing wages above the equilibrium level and causing un-
                                   employment, they have the benefit of helping firms keep a happy and productive
                                        In the end, there is no consensus among economists about whether unions are
                                   good or bad for the economy. Like many institutions, their influence is probably
                                   beneficial in some circumstances and adverse in others.

                                     Q U I C K Q U I Z : How does a union in the auto industry affect wages and
                                     employment at General Motors and Ford? How does it affect wages and
                                     employment in other industries?

                                                   T H E T H E O R Y O F E F F I C I E N C Y WA G E S

                                   A fourth reason why economies always experience some unemployment—in ad-
                                   dition to job search, minimum-wage laws, and unions—is suggested by the theory
ef ficiency wages                  of efficiency wages. According to this theory, firms operate more efficiently if
above-equilibrium wages paid       wages are above the equilibrium level. Therefore, it may be profitable for firms to
by firms in order to increase      keep wages high even in the presence of a surplus of labor.
worker productivity                     In some ways, the unemployment that arises from efficiency wages is similar
                                   to the unemployment that arises from minimum-wage laws and unions. In all
                                   three cases, unemployment is the result of wages above the level that balances the
                                   quantity of labor supplied and the quantity of labor demanded. Yet there is also
                                   an important difference. Minimum-wage laws and unions prevent firms from
                                   lowering wages in the presence of a surplus of workers. Efficiency-wage theory
                                   states that such a constraint on firms is unnecessary in many cases because firms
                                   may be better off keeping wages above the equilibrium level.
                                        Why should firms want to keep wages high? In some ways, this decision
                                   seems odd, for wages are a large part of firms’ costs. Normally, we expect profit-
                                   maximizing firms to want to keep costs—and therefore wages—as low as possible.
                                                   CHAPTER 26      U N E M P L O Y M E N T A N D I T S N AT U R A L R AT E   597

The novel insight of efficiency-wage theory is that paying high wages might be
profitable because they might raise the efficiency of a firm’s workers.
    There are several types of efficiency-wage theory. Each type suggests a differ-
ent explanation for why firms may want to pay high wages. Let’s now consider
four of these types.


The first and simplest type of efficiency-wage theory emphasizes the link between
wages and worker health. Better paid workers eat a more nutritious diet, and
workers who eat a better diet are healthier and more productive. A firm may find
it more profitable to pay high wages and have healthy, productive workers than to
pay lower wages and have less healthy, less productive workers.
    This type of efficiency-wage theory is not relevant for firms in rich countries
such as the United States. In these countries, the equilibrium wages for most
workers are well above the level needed for an adequate diet. Firms are not
concerned that paying equilibrium wages would place their workers’ health in
    This type of efficiency-wage theory is more relevant for firms in less devel-
oped countries where inadequate nutrition is a more common problem. Unem-
ployment is high in the cities of many poor African countries, for example. In these
countries, firms may fear that cutting wages would, in fact, adversely influence
their workers’ health and productivity. In other words, concern over nutrition may
explain why firms do not cut wages despite a surplus of labor.


A second type of efficiency-wage theory emphasizes the link between wages and
worker turnover. Workers quit jobs for many reasons—to take jobs in other firms,
to move to other parts of the country, to leave the labor force, and so on. The fre-
quency with which they quit depends on the entire set of incentives they face, in-
cluding the benefits of leaving and the benefits of staying. The more a firm pays its
workers, the less often its workers will choose to leave. Thus, a firm can reduce
turnover among its workers by paying them a high wage.
    Why do firms care about turnover? The reason is that it is costly for firms to
hire and train new workers. Moreover, even after they are trained, newly hired
workers are not as productive as experienced workers. Firms with higher
turnover, therefore, will tend to have higher production costs. Firms may find it
profitable to pay wages above the equilibrium level in order to reduce worker


A third type of efficiency-wage theory emphasizes the link between wages
and worker effort. In many jobs, workers have some discretion over how hard to
work. As a result, firms monitor the efforts of their workers, and workers caught

                               shirking their responsibilities are fired. But not all shirkers are caught immediately
                               because monitoring workers is costly and imperfect. A firm can respond to this
                               problem by paying wages above the equilibrium level. High wages make workers
                               more eager to keep their jobs and, thereby, give workers an incentive to put for-
                               ward their best effort.
                                    This particular type of efficiency-wage theory is similar to the old Marxist idea
                               of the “reserve army of the unemployed.” Marx thought that employers benefited
                               from unemployment because the threat of unemployment helped to discipline
                               those workers who had jobs. In the worker-effort variant of efficiency-wage theory,
                               unemployment fills a similar role. If the wage were at the level that balanced sup-
                               ply and demand, workers would have less reason to work hard because if they
                               were fired, they could quickly find new jobs at the same wage. Therefore, firms
                               raise wages above the equilibrium level, causing unemployment and providing an
                               incentive for workers not to shirk their responsibilities.

                               WORKER QUALITY

                               A fourth and final type of efficiency-wage theory emphasizes the link between
                               wages and worker quality. When a firm hires new workers, it cannot perfectly
                               gauge the quality of the applicants. By paying a high wage, the firm attracts a bet-
                               ter pool of workers to apply for its jobs.
                                    To see how this might work, consider a simple example. Waterwell Company
                               owns one well and needs one worker to pump water from the well. Two workers,
                               Bill and Ted, are interested in the job. Bill, a proficient worker, is willing to work
                               for $10 per hour. Below that wage, he would rather start his own lawn-mowing
                               business. Ted, a complete incompetent, is willing to work for anything above $2
                               per hour. Below that wage, he would rather sit on the beach. Economists say that
                               Bill’s reservation wage—the lowest wage he would accept—is $10, and Ted’s reser-
                               vation wage is $2.
                                    What wage should the firm set? If the firm were interested in minimizing
                               labor costs, it would set the wage at $2 per hour. At this wage, the quantity of
                               workers supplied (one) would balance the quantity demanded. Ted would take
                               the job, and Bill would not apply for it. Yet suppose Waterwell knows that only
                               one of these two applicants is competent, but it does not know whether it is Bill or
                               Ted. If the firm hires the incompetent worker, he will damage the well, causing
                               the firm huge losses. In this case, the firm has a better strategy than paying the

                               DILBERT® By Scott Adams
                                                         CHAPTER 26       U N E M P L O Y M E N T A N D I T S N AT U R A L R AT E   599

equilibrium wage of $2 and hiring Ted. It can offer $10 per hour, inducing both Bill
and Ted to apply for the job. By choosing randomly between these two applicants
and turning the other away, the firm has a fifty-fifty chance of hiring the compe-
tent one. By contrast, if the firm offers any lower wage, it is sure to hire the incom-
petent worker.

       FYI                     In many situations in life, in-           Similarly, the worker-effort variant of efficiency-wage
   The Economics               formation is asymmetric: One         theory illustrates a general phenomenon called moral haz-
                               person in a transaction knows        ard. Moral hazard arises when one person, called the agent,
   of Asymmetric               more about what is going on          is performing some task on behalf of another person, called
    Information                than the other person. This          the principal. Because the principal cannot perfectly monitor
                               possibility raises a variety of      the agent’s behavior, the agent tends to undertake less ef-
                               interesting problems for eco-        fort than the principal considers desirable. The term moral
                               nomic theory. Some of these          hazard refers to the risk of dishonest or otherwise inappro-
                               problems were highlighted in         priate behavior by the agent. In such a situation, the princi-
                               our description of the theory of     pal tries various ways to encourage the agent to act more
                               efficiency wages. These prob-        responsibly.
                               lems, however, go beyond the              In an employment relationship, the firm is the principal
                               study of unemployment.               and the worker is the agent. The moral-hazard problem is
                                     The worker-quality variant     the temptation of imper fectly monitored workers to shirk
                               of efficiency-wage theory illus-     their responsibilities. According to the worker-effort variant
  trates a general principle called adverse selection. Adverse      of efficiency-wage theory, the principal can encourage the
  selection arises when one person knows more about the at-         agent not to shirk by paying a wage above the equilibrium
  tributes of a good than another and, as a result, the unin-       level because then the agent has more to lose if caught
  formed person runs the risk of being sold a good of low           shirking. In this way, high wages reduce the problem of
  quality. In the case of worker quality, for instance, workers     moral hazard.
  have better information about their own abilities than firms           Moral hazard arises in many other situations. Here are
  do. When a firm cuts the wage it pays, the selection of work-     some examples:
  ers changes in a way that is adverse to the firm.
                                                                    x   A homeowner with fire insurance buys too few fire ex-
       Adverse selection arises in many other circumstances.
                                                                        tinguishers. The reason is that the homeowner bears
  Here are two examples:
                                                                        the cost of the extinguisher while the insurance com-
  x    Sellers of used cars know their vehicles’ defects,               pany receives much of the benefit.
       whereas buyers often do not. Because owners of the           x   A babysitter allows children to watch more television
       worst cars are more likely to sell them than are the             than the parents of the children prefer. The reason is
       owners of the best cars, buyers are correctly apprehen-          that more educational activities require more energy
       sive about getting a “lemon.” As a result, many people           from the babysitter, even though they are beneficial for
       avoid buying cars in the used car market.                        the children.
  x    Buyers of health insurance know more about their own         x   A family lives near a river with a high risk of flooding.
       health problems than do insurance companies. Be-                 The reason it continues to live there is that the family
       cause people with greater hidden health problems are             enjoys the scenic views, and the government will bear
       more likely to buy health insurance than are other peo-          part of the cost when it provides disaster relief after
       ple, the price of health insurance reflects the costs of a       a flood.
       sicker-than-average person. As a result, people with av-
       erage health problems are discouraged by the high            Can you identify the principal and the agent in each of these
       price from buying health insurance.                          three situations? How do you think the principal in each
                                                                    case might solve the problem of moral hazard?
  In each case, the market for the product—used cars or
  health insurance—does not work as well as it might be-
  cause of the problem of adverse selection.

                                    This story illustrates a general phenomenon. When a firm faces a surplus of
                               workers, it might seem profitable to reduce the wage it is offering. But by reducing
                               the wage, the firm induces an adverse change in the mix of workers. In this case,
                               at a wage of $10, Waterwell has two workers applying for one job. But if Waterwell
                               responds to this labor surplus by reducing the wage, the competent worker (who
                               has better alternative opportunities) will not apply. Thus, it is profitable for the
                               firm to pay a wage above the level that balances supply and demand.

                                 CASE STUDY           HENRY FORD AND THE VERY GENEROUS
                                                      $5-A-DAY WAGE

                                 Henry Ford was an industrial visionary. As founder of the Ford Motor Com-
                                 pany, he was responsible for introducing modern techniques of production.
                                 Rather than building cars with small teams of skilled craftsmen, Ford built cars
                                 on assembly lines in which unskilled workers were taught to perform the same
                                 simple tasks over and over again. The output of this assembly process was the
                                 Model T Ford, one of the most famous early automobiles.
                                     In 1914, Ford introduced another innovation: the $5 workday. This might
                                 not seem like much today, but back then $5 was about twice the going wage. It
                                 was also far above the wage that balanced supply and demand. When the new
                                 $5-a-day wage was announced, long lines of job seekers formed outside the
                                 Ford factories. The number of workers willing to work at this wage far ex-
                                 ceeded the number of workers Ford needed.
                                     Ford’s high-wage policy had many of the effects predicted by efficiency-
                                 wage theory. Turnover fell, absenteeism fell, and productivity rose. Workers
                                 were so much more efficient that Ford’s production costs were lower even
                                 though wages were higher. Thus, paying a wage above the equilibrium level

                                 WORKERS OUTSIDE AN EARLY FORD FACTORY
                                                  CHAPTER 26      U N E M P L O Y M E N T A N D I T S N AT U R A L R AT E   601

was profitable for the firm. Henry Ford himself called the $5-a-day wage “one
of the finest cost-cutting moves we ever made.”
     Historical accounts of this episode are also consistent with efficiency-wage
theory. An historian of the early Ford Motor Company wrote, “Ford and his as-
sociates freely declared on many occasions that the high-wage policy turned out
to be good business. By this they meant that it had improved the discipline of
the workers, given them a more loyal interest in the institution, and raised their
personal efficiency.”
     Why did it take Henry Ford to introduce this efficiency wage? Why were
other firms not already taking advantage of this seemingly profitable business
strategy? According to some analysts, Ford’s decision was closely linked to his
use of the assembly line. Workers organized in an assembly line are highly in-
terdependent. If one worker is absent or works slowly, other workers are less
able to complete their own tasks. Thus, while assembly lines made production
more efficient, they also raised the importance of low worker turnover, high
worker quality, and high worker effort. As a result, paying efficiency wages
may have been a better strategy for the Ford Motor Company than for other
businesses at the time.

  Q U I C K Q U I Z : Give four explanations for why firms might find it
  profitable to pay wages above the level that balances quantity of labor
  supplied and quantity of labor demanded.


In this chapter we discussed the measurement of unemployment and the reasons
why economies always experience some degree of unemployment. We have seen
how job search, minimum-wage laws, unions, and efficiency wages can all help ex-
plain why some workers do not have jobs. Which of these four explanations for the
natural rate of unemployment are the most important for the U.S. economy and
other economies around the world? Unfortunately, there is no easy way to tell.
Economists differ in which of these explanations of unemployment they consider
most important.
    The analysis of this chapter yields an important lesson: Although the economy
will always have some unemployment, its natural rate is not immutable. Many
events and policies can change the amount of unemployment the economy typi-
cally experiences. As the information revolution changes the process of job search,
as Congress adjusts the minimum wage, as workers form or quit unions, and as
firms alter their reliance on efficiency wages, the natural rate of unemployment
evolves. Unemployment is not a simple problem with a simple solution. But how
we choose to organize our society can profoundly influence how prevalent a prob-
lem it is.


x     The unemployment rate is the percentage of those who          x    A second reason why our economy always has some
      would like to work who do not have jobs. The Bureau of             unemployment is minimum-wage laws. By raising the
      Labor Statistics calculates this statistic monthly based on        wage of unskilled and inexperienced workers above the
      a survey of thousands of households.                               equilibrium level, minimum-wage laws raise the
x     The unemployment rate is an imperfect measure of                   quantity of labor supplied and reduce the quantity
      joblessness. Some people who call themselves                       demanded. The resulting surplus of labor represents
      unemployed may actually not want to work, and some                 unemployment.
      people who would like to work have left the labor force       x    A third reason for unemployment is the market power
      after an unsuccessful search.                                      of unions. When unions push the wages in unionized
x     In the U.S. economy, most people who become                        industries above the equilibrium level, they create a
      unemployed find work within a short period of time.                surplus of labor.
      Nonetheless, most unemployment observed at any                x    A fourth reason for unemployment is suggested by the
      given time is attributable to the few people who are               theory of efficiency wages. According to this theory,
      unemployed for long periods of time.                               firms find it profitable to pay wages above the
x     One reason for unemployment is the time it takes for               equilibrium level. High wages can improve worker
      workers to search for jobs that best suit their tastes and         health, lower worker turnover, increase worker effort,
      skills. Unemployment insurance is a government policy              and raise worker quality.
      that, while protecting workers’ incomes, increases the
      amount of frictional unemployment.

                                                         Key Concepts

labor force, p. 26-5                          discouraged workers, p. 26-10              union, p. 26-16
unemployment rate, p. 26-6                    frictional unemployment, p. 26-11          collective bargaining, p. 26-17
labor-force participation rate, p. 26-6       structural unemployment, p. 26-11          strike, p. 26-17
natural rate of unemployment, p. 26-6         job search, p. 26-11                       efficiency wages, p. 26-20
cyclical unemployment, p. 26-7                unemployment insurance, p. 26-13

                                                    Questions for Review

1.    What are the three categories into which the Bureau of        4.   Are minimum-wage laws a better explanation for
      Labor Statistics divides everyone? How does it compute             structural unemployment among teenagers or among
      the labor force, the unemployment rate, and the labor-             college graduates? Why?
      force participation rate?                                     5.   How do unions affect the natural rate of
2.    Is unemployment typically short-term or long-term?                 unemployment?
      Explain.                                                      6.   What claims do advocates of unions make to argue that
3.    Why is frictional unemployment inevitable? How might               unions are good for the economy?
      the government reduce the amount of frictional                7.   Explain four ways in which a firm might increase its
      unemployment?                                                      profits by raising the wages it pays.
                                                          CHAPTER 26   U N E M P L O Y M E N T A N D I T S N AT U R A L R AT E   603

                                                 Problems and Applications

1.   The Bureau of Labor Statistics announced that in                  b.   a manufacturing worker who loses her job at a
     December 1998, of all adult Americans, 138,547,000 were                plant in an isolated area
     employed, 6,021,000 were unemployed, and 67,723,000               c.   a stagecoach-industry worker laid off because of
     were not in the labor force. How big was the labor                     competition from railroads
     force? What was the labor-force participation rate?               d.   a short-order cook who loses his job when a new
     What was the unemployment rate?                                        restaurant opens across the street
2.   As shown in Figure 26-3, the overall labor-force                  e.   an expert welder with little formal education who
     participation rate of men declined between 1970 and                    loses her job when the company installs automatic
     1990. This overall decline reflects different patterns                 welding machinery
     for different age groups, however, as shown in the           6.   Using a diagram of the labor market, show the effect of
     following table.                                                  an increase in the minimum wage on the wage paid to
                                                                       workers, the number of workers supplied, the number
                            MEN        MEN              MEN            of workers demanded, and the amount of
              ALL MEN       16–24      25–54        55 AND OVER        unemployment.
     1970        80%          69%         96%            56%      7.   Do you think that firms in small towns or cities have
     1990        76           72          93             40            more market power in hiring? Do you think that firms
                                                                       generally have more market power in hiring today than
     Which group experienced the largest decline? Given this           50 years ago, or less? How do you think this change
     information, what factor may have played an important             over time has affected the role of unions in the
     role in the decline in overall male labor-force                   economy? Explain.
     participation over this period?                              8.   Consider an economy with two labor markets, neither of
3.   The labor-force participation rate of women increased             which is unionized. Now suppose a union is established
     sharply between 1970 and 1990, as shown in Figure 26-3.           in one market.
     As with men, however, there were different patterns for           a. Show the effect of the union on the market in which
     different age groups, as shown in this table.                          it is formed. In what sense is the quantity of labor
                                                                            employed in this market an inefficient quantity?
             ALL       WOMEN     WOMEN          WOMEN    WOMEN         b. Show the effect of the union on the nonunionized
            WOMEN       25-54     25-34          35-44    45-54             market. What happens to the equilibrium wage in
                                                                            this market?
     1970     43%       50%         45%          51%      54%
     1990     58        74          74           77       71      9.   It can be shown that an industry’s demand for labor will
                                                                       become more elastic when the demand for the
                                                                       industry’s product becomes more elastic. Let’s consider
     Why do you think that younger women experienced
                                                                       the implications of this fact for the U.S. automobile
     a bigger increase in labor-force participation than
                                                                       industry and the auto workers’ union (the UAW).
     older women?
                                                                       a. What happened to the elasticity of demand for
4.   Between 1997 and 1998, total U.S. employment                           American cars when the Japanese developed
     increased by 2.1 million workers, but the number of                    a strong auto industry? What happened to the
     unemployed workers declined by only 0.5 million.                       elasticity of demand for American autoworkers?
     How are these numbers consistent with each other?                      Explain.
     Why might one expect a reduction in the number of                 b. As the chapter explains, a union generally faces
     people counted as unemployed to be smaller than the                    a tradeoff in deciding how much to raise wages,
     increase in the number of people employed?                             because a bigger increase is better for workers
5.   Are the following workers more likely to experience                    who remain employed but also results in a greater
     short-term or long-term unemployment? Explain.                         reduction in employment. How did the rise in auto
     a. a construction worker laid off because of                           imports from Japan affect the wage-employment
         bad weather                                                        tradeoff faced by the UAW?

      c.   Do you think the growth of the Japanese auto               arise? Would the firm’s pool of customers tend to
           industry increased or decreased the gap between            become more or less healthy on average? Would the
           the competitive wage and the wage chosen by the            company’s profits necessarily increase?
           UAW? Explain.                                          13. (This problem is challenging.) Suppose that Congress
10. Some workers in the economy are paid a flat salary and            passes a law requiring employers to provide employees
    some are paid by commission. Which compensation                   some benefit (such as health care) that raises the cost of
    scheme would require more monitoring by supervisors?              an employee by $4 per hour.
    In which case do firms have an incentive to pay more              a. What effect does this employer mandate have on
    than the equilibrium level (as in the worker-effort                   the demand for labor? (In answering this and the
    variant of efficiency-wage theory)? What factors do you               following questions, be quantitative when you can.)
    think determine the type of compensation firms choose?            b. If employees place a value on this benefit exactly
11. Each of the following situations involves moral hazard.               equal to its cost, what effect does this employer
    In each case, identify the principal and the agent, and               mandate have on the supply of labor?
    explain why there is asymmetric information. How does             c. If the wage is free to balance supply and demand,
    the action described reduce the problem of moral                      how does this law affect the wage and the level of
    hazard?                                                               employment? Are employers better or worse off?
    a. Landlords require tenants to pay security deposits.                Are employees better or worse off?
    b. Firms compensate top executives with options to                d. If a minimum-wage law prevents the wage from
         buy company stock at a given price in the future.                balancing supply and demand, how does the
    c. Car insurance companies offer discounts to                         employer mandate affect the wage, the level of
         customers who install antitheft devices in their cars.           employment, and the level of unemployment? Are
                                                                          employers better or worse off? Are employees
12. Suppose that the Live-Long-and-Prosper Health
                                                                          better or worse off?
    Insurance Company charges $5,000 annually for a
                                                                      e. Now suppose that workers do not value the
    family insurance policy. The company’s president
                                                                          mandated benefit at all. How does this alternative
    suggests that the company raise the annual price to
                                                                          assumption change your answers to parts (b), (c),
    $6,000 in order to increase its profits. If the firm
                                                                          and (d) above?
    followed this suggestion, what economic problem might

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