Diverging unemployment trends across the two shores of the Atlantic Ocean Francesco Daveri

The labor market on the two shores of the Atlantic Ocean

UNEMPLOYMENT Part I: measurement Part II: causes Part I first

Dictionary: employment The International Labor Office (ILO) calls “employed” all persons above a specified age (typically 15) who during a specified brief period, either one week or one day, were in the following categories: - paid employment; - self employment This definition includes: those having worked for at least an hour in the last week or day those with a paid job, even if they did not do paid work in the last week those who did at least one unpaid hour of work in a family-owned business in the last week Actual definitions of employment still vary across industrialized countries; however, the remaining differences are in most cases not very significant

Dictionary: unemployment The ILO calls “unemployed” those individuals above 15 who:  neither performed any gainful dependent activity in the reference period nor were self-employed  are looking for a paid job  actively searched for a job in the last month  are willing to immediately accept a job offer (in two weeks) Also the individuals that are waiting for the start date of a new job are classified as “unemployed”

Dictionary: Labor Force The labor force is the total number of potential workers, inclusive of both the employed and the unemployed The labor-force participation rate is the percentage of the adult population that is in the labor force The labor force participation rate is a measure of the proportion of an economy's working-age population that is economically active It provides an indication of the relative size of the supply of labor available for the production of goods and services

Young ( 64) 20 mn Non-participants (students, sick, housewives and “househusbands” not looking for a job) 15 Total Population 60 mn Working-age population 40 mn Labor force 25 Employed 22 mnUnemployed 3 mn To better fix concepts: Italy’s population tree (with round numbers)

Checking the dictionary: labor force participation and unemployment rates in Italy The labor force participation rate is calculated as the percentage of the working-age population that is potentially employable (Italy = 25/40 = 62,5%). The average number for the Eurozone (EZ) is 71,5% (Germany is at 77,8%; Spain is at 74%) The unemployment rate is calculated as the percentage of the labor force that is unemployed (Italy = 3/25 = 12%) The EZ number is some 11%

Quick Quiz: the labor market in a fairy tale (1)Count the employed and the unemployed (2)Calculate the unemployment rate and the participation rate in the land of Snow White

The labor market in the land of Snow White Given that 1. Snow White doesn’t participate in labor market though in working age 2. Dopey (Cucciolo) is <15 and Doc and the other dwarfs within age interval. Hence: Employed = 6 (Snow White doesn’t work; Dopey <15 so excluded; Doc<64 included) Unemployed = 0 (Snow White doesn’t work BUT she is not looking for a job) Unemployment rate = 0,0% Labor force participation = 85,7% (=6/7) Female labor force participation rate = 0,0% (but female unemployment is also 0!)

Three Transatlantic unemployment puzzles 1) Before the crisis: unemployment much lower in the US than in the EZ (mind the scale on the y-axis!) 2) In : steeper rise of unemployment in the US than in the EZ 3) Since 2010: unemployment declines in the US, keeps growing in the EZ

UNEMPLOYMENT Part I: measurement Part II: causes we do Part II next (so as to solve the three puzzles)

The LABOR market is a MARKET So It works through interaction of Demand and Supply

Model of labor market under perfect competition (workers and firms take wage as given and adapt their decisions) Real Wage Employment Labor supply Labor Demand W0W0 L0L0

Why labor demand negatively sloped with respect to the real wage Firms want to maximize profits by hiring people Rule of thumb: hire as long as marginal benefit of hiring a worker higher than its marginal cost Marginal benefit from hiring: MPL (marginal productivity of labor) Amount of extra output produced by one more worker Assume: decreasing returns to extra workers (think of workers lining up in decreasing order of productivity for the firm) Marginal cost: real wage In perfectly competitive labor market, real wage (=money wage divided by price level) taken as given by firms Rule of thumb for hiring decisions: if MPL>real wage (i.e. if additional worker adds more to output than to costs) then: hire Otherwise: don’t hire

Labor demand curve: how many people companies hire for any real wage As real wage falls, demand for labor increases and MPL decreases along the same L D (hence for given capital and technology) Labor Demand=MPL Employment Real Wage W0W0 L0L0 W1W1 L1L1

What if capital is accumulated and/or better technology becomes available? Labor Demand=MPL Employment Real Wage W0W0 L0L0 L1L1 Answer: labor demand curve would shift to the right. For given wage W 0, firms can afford hiring more people New Labor Demand = MPL’

Summing up on labor demand The demand for labor on the part of a firm may go up for two reasons 1) Lower real wages (shift along the curve)  lower costs of hiring 2) Higher levels of capital and/or technology (shift of the curve)  Higher benefits/needs from hiring

Labor supply Labor supply (from households to firms) is positively sloped with respect to wages As wage changes a Substitution effect occurs. Higher wage means price of leisure (lost income) is higher and so consume less leisure. Tends to supply more labor There might also be an Income effect. Higher wage means people have more income and want to buy more of all goods, including leisure. This effect leads to lower labor supply We assume that for most people the substitution effect prevails over the income effect. So: we draw the labor supply curve as upward sloping

Labor supply curve: how many people willing to work households feel like supplying to companies for any real wage As real wage rises, willingness to supply labor increases along same L S (hence for given unemployment subsidy or black economy wage) Real Wage Employment Labor supply W0W0 L0L0 W1W1 L1L1

What if unemployment subsidy goes down? Answer: Labor supply curve shifts downwards and therefore labor supply goes up. Now, with lower unemployment subsidy, more people (L 1 - L 0 ) induced to work at the same wage, because their outside opportunities have worsened Real Wage Employment New Labor supply W0W0 L1L1 Same effect if wage in the black economy goes down L0L0 Labor supply

Summing up on labor supply The supply of labor on the part of a household may go up for two reasons 1) Higher real wages (shift along the curve)  Higher benefits from working 2) Lower unemployment subsidies or black market wage (shift of the curve)  Lower opportunity costs from working

Summing up on the competitive labor market model

Three main features of the competitive labor mkt model 1) equilibrium (W 0,L 0 ) is there where L D and L S cross; 2) If real wage set too high (W H >W 0 ), L D L S i.e. there is excess demand for labor. Real wage must rise to eliminate excess demand Real Wage Employment Labor supply Labor Demand W0W0 L0L0 WHWH WLWL It looks as though the competitive model delivers NO equilibrium unemployment (so may be useless for our purpose …)

Unemployment in the competitive labor market In an ideal labor market, wages would adjust to balance the supply and demand for labor, ensuring full employment But there may be frictions or other obstacles causing unemployment Frictional (or search) unemployment It takes time to match workers with jobs. Meanwhile, people may stay unemployed Search unemployment is often seen as voluntary Structural (or wait) unemployment It might be the case that the number of jobs available in some labor markets is insufficient to give a job to all the job seekers Structural unemployment is typically involuntary and may have different causes

We concentrate on Structural - or Wait - Unemployment (the bad one)

Why is there structural unemployment? Three main reasons 1.Minimum wage legislation and unions 2.Efficiency wages 3.Employment Protection Legislation (EPL)

Minimum wage legislation and unions When a minimum wage is set by law or a union above the level that would balance D-S of labor, unemployment shows up Two groups of workers: the “lucky” (0L D ) & the “unlucky” (L D L S ) WEWE LELE Surplus of labor = Unemployment Labor demand Minimum wage LDLD LSLS Quantity of Labor 0 Wage Labor supply

Efficiency wages Firms may freely choose to pay efficiency wages, i.e. wages higher than in competitive markets Why?  To reduce labor turnover  To motivate workers to work harder  To make workers well fed and healthier (more relevant in poorer countries) Consequences? Same as above  Wage floor, wait unemployment, two groups of workers  Yet: this comes from company decisions, not from govt regulation or bargaining, though

Employment protection legislation (EPL) Goal: achieve labor market security by: raising employment stability giving higher chances to find a new job after a spell of unemployment raising income security for labor market participants EPL includes measures geared to protect jobs such as: Severance pay requirements Notice requirements Government approval for layoffs YET higher EPL has ambiguous effect on unemployment: Reduces probability of being fired for those holding a job Reduces probability of finding a job for those who haven’t one Overall, EPL tends to reduce the risk of job loss, but it also has an adverse effect on exit rates from unemployment, thus prolonging the average unemployment spell As such, EPL does not necessarily makes labor “more secure”, although it tends to make the existing jobs “more protected”

NOW at last READY to explain the three Transatlantic puzzles Puzzle 1: US unemployment lower before the crisis. Why? Lower minimum wage, less unionization (Lower EPL also used to make unemployment less durable) Puzzle 2: US unemployment quickly up during the crisis The other side of the coin: firms free to lay off upfront in the US and therefore labor demand falls a lot. Less so in Europe, where solidarity contracts and other contractual forms of EPL protect employment Puzzle 3: US unemployment coming down, while it stays up in Europe Stronger growth in the US helps shift labor demand to the right. Higher EPL in Europe may have made European firms more reluctant to hire and increased persistence of unemployment