2. Models on unemployment
Search model
Implicit contract model
Efficiency wage model
Insider-outsider model
Sectoral shifts hypothesis

3. Common goal of these models
They all aim to explain why unemployment would exist as a long-run phenomenon
Except the search model, they all try to explain why wage rage fails to adjust down to clear the market.

4. Review of search model
Workers must search employers for a job and don’t get offers from everyone at once
This causes workers to stay at a firm while searching for a job that pays a higher wage
There is incentive for employers to choose a wage which is lower than market wage
Trade-off between offering a higher wage and having a more stable labour force (fewer quits) and lower profit

5. One more word on search modelTC TB TC TB
Search duration MC MB MC MB
Search duration

6. Implicit contract model (Main Idea)
Dual Function of Wage:
Market clearing
Also functions as insurance for workers’ income
PS: Moral hazard and adverse selection make income insurance difficult to offer

7. Implicit contract model (Assumptions)
Workers are more risk-averse than employers. Usually we can assume workers are risk-averse and employers are risk-neutral.
Uncertainty in product market, and therefore in labour demand.
Symmetric information: both sides know the distribution of possible outcomes and can observe the realized ones.
Homogeneous workers.
Inelastic labour supply.

8. Implicit contract model (graph)

9. Implicit contract model (conclusions)
The model well explains why unemployment exits even in good years.
The model implies that labour market is not spot clearing.

10. Implicit contract model (Empirical Evidence)
Beaudry and DiNardo (1991, JPE)
Idea: if wages are determined by spot cleaning markets, past labor market conditions affect current wages.
Strategy: Test whether starting wages during recession affect current wages.
Results in favour of the implicit contract model.

11. Efficiency Wages Model (main idea)
Firms are not willing to reduce wage because it reduces workers’ productivity (and therefore reduces profit), even when unemployed workers are willing to accept lower wage.
Efficiency wages arise when it is difficult to monitor worker output.
The above-market efficiency wage generates involuntary unemployment.

12. Why don’t employers lower wage?
In developing countries, lowering wage may reduce nutrition intake and therefore decrease productivity.
In general, higher wage increases opportunity cost of slacking.

13. Efficiency Wages Model (assumptions)
Labour input is the only factor that can be freely adjusted in the short run.
Output depends on not only labour, but also on efficiency parameter “e”, which is a function of wage. So Q=F(eL) where e=e(w).

14. Efficiency Wages Model (a little math)

15. Efficiency Wages Model (graph)
e/w
e=e(w) e*
Wage W*

16. The Determination of the Efficiency Wage
If shirking is not a problem, the market clears at wage w* (where supply S equals demand D). If monitoring is expensive, the threat of unemployment can keep workers in line. If unemployment is high (point F), firms can attract workers who will not shirk at a very low wage. If unemployment is low (point G), firms must pay a very high wage to ensure that workers do not shirk. The efficiency wage wNS is given by the intersection of the no-shirking supply curve (NS) and the demand curve.
Dollars
Employment NS G Q F P D E
ENS w*
wNS

17. The Impact of an Economic Contraction on the Efficiency Wage
wNS
Dollars
Employment NS D0 D1 E E1 E0 S
A fall in output demand shifts the labor demand curve from D0 to D1. The competitive wage falls from w*0 to w*. If firms pay an efficiency wage, the contraction in demand also reduces the efficiency wage but by a smaller amount.

18. The Relation Between Wage Levels and Unemployment Across Regions
Rate
Wage B A
Geographic regions (such as B) that offer higher wage rates also tend to have lower unemployment rates. Efficiency wage models help explain this pattern: firms located in regions with high unemployment rates do not need to offer a very high wage to discourage shirking.

19. Efficiency Wages Model (empirical evidence)
Strauss (1986, JPE) found that nutrition increases productivity, but his estimation is subjective to the endogeneity problem. Thomas and Strauss (1995, Handbook) found a way to get around the problem, but still is subjective to measure error on calorie intake.
Subramanian and Deaton (1996, JPE) found weak effect of income on nutrition level, but significant effect on food price. They also found that a daily demand for calories can be purchased by only 5% of the daily wage.

20. Insider – Outsider theory (main idea)
Because of various forms of imperfect competition, incumbents obtaining higher wage are protected from competition from outside labour market.

21. Insider – Outsider theory (assumptions)
Replacing workers are costly (severance pay, training cost, etc.)
Outsiders cannot influence wages which are assumed to be determined by bargaining between employers and the insiders.

22. Insider – Outsider theory (graph)w Wo
Wo + C N* w*

23. Insider-outsider theory (empirical evidence)
Doiron (1995, Economica) rejects the Insider-outsider model because he found union members do not prefer increased rent for existing members as opposed to expansion of membership.

24. Sectoral shifts hypothesis (main idea)
The sectoral shifts hypothesis argues that structural unemployment arises because the skills of workers cannot be easily transferred across sectors.
The skills of workers laid off from declining industries have to be retooled before they can find jobs in growing industries.

25. Tests for Sectoral shifts hypothesis (1)
Sampson (1985, CJE) found a positive relationship between “variance of employment growth across industries” and UR.
However, Abraham and Katz (1986, JPE) argue that it is very difficult to identify the causal effect.

26. Tests for Sectoral shifts hypothesis (2)
Altonji and Ham (1990, JOLE) decomposed the sources of employment variation in Canada and found sectoral shifts accounts for only 1/10 of the variation.

27. The Phillips Curve
A downward-sloping Phillips curve can only exist in the short run.
In the long run, there is no trade-off between inflation and unemployment.

28. The Phillips Curve
Unemployment
Rate
Rate of Inflation 3 4 B A
The Phillips curve describes the negative correlation between the inflation rate and the unemployment rate. The curve implies that an economy faces a trade-off between inflation and unemployment.

29. Inflation and Unemployment in the United States, 1961-2005

30. The Short-Run and Long-Run Phillips Curves3 5 A B 7
Short Run
Long Run
Rate of Inflation
Unemployment
Rate

31. The Short-Run and Long-Run Phillips Curves
The economy is initially at point A (on the previous graph); there is no inflation and a 5 percent unemployment rate.
If monetary policy increases the inflation rate to 7 percent, job searchers will suddenly find many jobs that meet their reservation wage and the unemployment rate falls in the short run, moving the economy to point B.

32. The Short-Run and Long-Run Phillips Curves
Over time, workers realize that the inflation rate is higher and will adjust their reservation wage upward, returning the economy to point C.
In the long run, the unemployment rate is still 5 percent, but there is now a higher rate of inflation. In the long run, therefore, there is no trade-off between inflation and unemployment.

33. Percent of Unemployed in Spells of Unemployment Lasting at Least 12 Months
Country
1990
2006
2009
Belgium
68.7
56.6
44.2
Denmark
29.9
20.4
9.1
Germany
46.8
57.2
45.5
France
38.0
44.0
34.7
Ireland
66.0
34.3
29.0
Italy
69.8
52.9
44.4
Netherlands
49.3
45.2
24.8
Spain
54.0
29.5
30.2
United Kingdom
34.4
22.1
24.6
United States
5.5
10.0
16.3

34. Unemployment in Europe
The combination of…
high unemployment insurance benefits
employment protection restrictions
wage rigidity…
…probably accounts for the high levels of unemployment observed in Europe in the 1980s and 1990s.