1. slide 0 LECTURE 6 Unemployment BUS 530: ECONOMIC CONDITIONS ANALYSIS LECTURE 6: Unemployment

2. slide 1 Contents  Economic classification of population and measurement of unemployment  Working of the labor market  Natural rate of unemployment  Types of unemployment  Causes of unemployment and policy response

3. slide 2 Learning Objectives  Understand the working of the labor market and factors contributing to unemployment  Learn about macroeconomic policies for reducing unemployment

4. slide 3 Composition of Population in terms of Economic Status

5. slide 4 Definitions used in Bangladesh Employed: A person who was either working during the previous week for one or more hours for pay or profit or working without pay in a family farm or enterprise during the week or found not working but had a job or business from which he/she was temporarily absent during the week

6. slide 5 Definitions used in Bangladesh Unemployed: A person who is involuntarily out of gainful employment during the reference period but either has been actively looking for a job or was willing to work but not looking for work because of illness

7. slide 6 Important Formulae Crude Activity Rate = Labor Force * 100% Population Refined Activity Rate = Labor Force * 100% Population ≥ 15yrs Unemployment Rate = Unemployed * 100% Labor Force

8. slide 7 Labor Force Survey 2005-06 ItemsNumber (in millions) Population148.8 Labor Force56.7 Outside the Labor Force92.1 Employed54.1 Unemployed2.6 Children below 15 years53.2 Household work, other inactive, old & disabled, discouraged worker 38.9 Crude Activity Rate (%)38.1 Refined Activity Rate (%)59.3 Unemployment Rate (%)4.5

9. slide 8 LECTURE 6 Unemployment Natural Rate of Unemployment  The unemployment rate: the fraction of the civilian workforce that is unemployed  The “Natural” rate of unemployment: The average or long-run rate of unemployment around which the economy fluctuates.  In a recession, the actual unemployment rate rises above the natural rate.  In a boom, the actual unemployment rate falls below the natural rate.

10. slide 9 Natural Rate of Unemployment  5-6% for the developed economies  Exists in the developing economies as well  Difficult to get rid of this type of unemployment  Thus when a country has 5-6% of unemployment, it is considered to be fully employed

11. slide 10 LECTURE 6 Unemployment Actual and Natural Rates of Unemployment in the U.S., 1960-2006 Percent of labor force 0 2 4 6 8 10 12 1960196519701975198019851990199520002005 Unemployment rate Natural rate of unemployment

12. slide 11 Bangladesh Unemployment Rate LECTURE 6 Unemployment

13. slide 12 LECTURE 6 Unemployment Labor Force and Unemployment Rate Notation: L = workers in labor force E = employed workers U = unemployed workers U/L = unemployment rate

14. slide 13 LECTURE 6 Unemployment Assumptions: 1.L is exogenously fixed (no population growth). 2.During any given month, s = fraction of employed workers that become separated from their jobs s is called the rate of job separation f = fraction of unemployed workers that find jobs f is called the rate of job finding exogenous s and f are exogenous

15. slide 14 The Transitions between Employment and Unemployment LECTURE 6 Unemployment Employed Unemployed s  E f  U

16. slide 15 The Steady State Condition LECTURE 6 Unemployment constant  Definition: the labor market is in steady state, or long-run equilibrium, if the unemployment rate is constant.  The steady-state condition is: s  E = f  U # of employed people who lose or leave their jobs # of unemployed people who find jobs

17. slide 16 LECTURE 6 Unemployment Finding the “EQUILIBRIUM” Unemployment Rate f  U = s  E = s  (L – U ) = s L – s U Solve for U/L: (f + s) U = s L so,

18. slide 17 LECTURE 6 Unemployment The “NATURAL” Rate of Unemployment  Therefore, the natural rate of unemployment is defined as:

19. slide 18 Class Exercise  Suppose  1% of employed workers lose their jobs  19% of unemployed workers find jobs  Find the natural rate of unemployment LECTURE 6 Unemployment

20. slide 19 Answer  Each month,  1% of employed workers lose their jobs (s = 0.01)  19% of unemployed workers find jobs (f = 0.19)  The natural rate of unemployment: LECTURE 6 Unemployment

21. slide 20 Policy Implications LECTURE 6 Unemployment  Any policy aimed at lowering the natural rate of unemployment must either reduce the rate of job separation (s) or increases the rate of job finding (f).  Similarly, any policy that affects the rate of job separation (s) or the rate of job finding (f) also changes the natural rate of unemployment, Because:

22. slide 21 LECTURE 6 Unemployment Why is there Unemployment?  If job finding were instantaneous (s = 0, f = 1), then all spells of unemployment would be brief, and the natural rate would be near zero.  There are two reasons why f 0: 1. job search 2. wage rigidity

23. slide 22 LECTURE 6 Unemployment Job Search & Frictional Unemployment  Frictional unemployment: The unemployment caused by the time it takes workers to search for a job  Occurs even when wages are flexible and there are enough jobs to go around  Occurs because  workers have different abilities, preferences  jobs have different skill requirements  geographic mobility of workers not instantaneous  flow of information about vacancies and job candidates is imperfect

24. slide 23 LECTURE 6 Unemployment Sectoral Shifts  defintion: Changes in the composition of demand among industries or regions.  example: Technological change more jobs repairing computers, fewer jobs repairing typewriters  example: A new international trade agreement labor demand increases in export sectors, decreases in import-competing sectors  Result: frictional unemployment

25. slide 24 Structural change over the long run - US LECTURE 6 Unemployment

26. slide 25 Structural Change in Employment: Bangladesh LECTURE 6 Unemployment

27. slide 26 LECTURE 6 Unemployment More examples of Sectoral Shifts  Late 1800s: decline of agriculture, increase in manufacturing  Late 1900s: relative decline of manufacturing, increase in service sector  1970s: energy crisis caused a shift in demand away from gas guzzlers toward smaller cars.

28. slide 27 LECTURE 6 Unemployment Public Policy and Job Search Govt programs affecting unemployment  Govt employment agencies: disseminate info about job openings to better match workers & jobs.  Public job training programs: help workers displaced from declining industries get skills needed for jobs in growing industries.

29. slide 28 LECTURE 6 Unemployment Unemployment insurance (UI)  UI pays part of a worker’s former wages for a limited time after losing his/her job.  UI increases search unemployment, because it reduces  the opportunity cost of being unemployed  the urgency of finding work  Rate of job finding, f  Studies: The longer a worker is eligible for UI, the longer the duration of the average spell of unemployment.

30. slide 29 LECTURE 6 Unemployment  By allowing workers more time to search, UI may lead to better matches between jobs and workers, which would lead to greater productivity and higher incomes. Benefits of UI

31. slide 30 Unemployment Benefits  Provided in developed countries  Eligibility excludes new entrants to the labor force and those giving up job voluntarily  Raises aggregate demand and contributes toward early recovery of an economy from recession

32. slide 31 LECTURE 6 Unemployment Why is there Unemployment?  Two reasons why f < 1: 1. job search 2. wage rigidity DONE Next  The natural rate of unemployment:

33. slide 32 LECTURE 6 Unemployment Unemployment from Real Wage Rigidity & Structural Unemployment Labor Real wage Supply Demand Unemployment Rigid real wage Amount of labor willing to work Amount of labor hired If real wage is stuck above its equilibrium level, then there aren’t enough jobs to go around.

34. slide 33 LECTURE 6 Unemployment Unemployment from Real Wage Rigidity Then, firms must ration the scarce jobs among workers. Structural unemployment: The unemployment resulting from real wage rigidity and job rationing. If real wage is stuck above its equilibrium level, then there aren’t enough jobs to go around.

35. slide 34 LECTURE 6 Unemployment Reasons for Wage Rigidity 1. Minimum wage laws 2. Labor unions 3. Efficiency wages

36. slide 35 LECTURE 6 Unemployment The Minimum Wage exceed  The minimum wage may exceed the equilibrium wage of unskilled workers, especially teenagers.  Studies: a 10% increase in min. wage reduces teen employment by 1-3%  Tendency for firms to substitute towards illegal workers (who are not bound by the min. wage)  But, the minimum wage cannot explain the majority of the natural rate of unemployment, as most workers’ wages are well above the minimum wage.

37. slide 36 Minimum Wage Law  It is enacted in almost every country so that forces cannot drive it down too low.  When wages are pushed up to the level of w*, unemployment to the extent bc is created, since supply exceeds demand.  In addition, there is also unemployment to the extent of cd, which is due to people looking for better jobs

38. slide 37 Labor Market

39. slide 38 LECTURE 6 Unemployment Labor Unions  Unions exercise monopoly power to secure higher wages for their members (collective bargaining).  When the union wage exceeds the equilibrium wage, unemployment results.  Insiders: Employed union workers whose interest is to keep wages high.  Outsiders: Unemployed non-union workers who would be willing to work for lower wages, so there would be enough jobs for them.

40. slide 39 Collective Bargaining by Labor Union  Every country legalizes labor union activity to prevent excessive exploitation of labor by the employer  Experiences have shown that if politicization of labor union can be avoided and labor unions abide by the rules of the game then union activities can contribute towards congenial industrial relations

41. 105,508Private sector (total) 20,381Government (total) 14,045Health care 3,312Education 10,951Professional services 6,304Finance, insurance 4,379Transportation 14,973Retail trade 15,518Manufacturing 600Mining 122.3 121.7 115.1 112.7 90.6 90.7 129.2 114.0 107.8 113.7 156.9 8.5% 40.5 8 15.4 3.1 2.1 24.4 5.8 13.7 9.5 13.8 8,053Construction wage ratio U % of total # employed (1000s) industry wage ratio = 100  (union wage)/(nonunion wage) slide 40 Union Membership and Wage RATIOS by Industry, 2005 LECTURE 6 Unemployment

42. slide 41 LECTURE 6 Unemployment 3. Efficiency Wage Theory  Idea  Idea: higher wages increase worker productivity by:  Attracting higher quality job applicants Adverse Selection (“Adverse Selection” problem)  Increasing worker effort, reducing “shirking” Moral Hazard (“Moral Hazard” problem)  Reducing turnover, which is costly to firms  Improving health of workers: better nutrition & productivity (in developing countries)  Firms willingly pay above-equilibrium wages to raise productivity, causing structural unemployment.

43. slide 42 LECTURE 6 Unemployment

44. slide 43 LECTURE 6 Unemployment Question for discussion: Use the material we’ve just covered to come up with a policy or policies to try to reduce the natural rate of unemployment. Note whether your policy targets frictional or structural unemployment.

45. slide 44 Other Types of Unemployment and Macroeconomic Policies LECTURE 6 Unemployment

46. slide 45 Cyclical Unemployment  Y* represents full employment output level  Sometimes national output falls due to a fall in demand, this is called recession. Labor demand declines, additional unemployment to the extent of ee*  This is called cyclical unemployment

47. slide 46

48. slide 47 Stabilization Policy  Developed countries can stabilize cyclical unemployment through expansionary monetary or fiscal policies  Expansionary monetary policy increases credit supply which raises aggregate demand. An expansionary fiscal policy on the other hand reduces taxes

49. slide 48 Disguised Unemployment  Developing countries are generally not close to the full employment level. Here, unemployment does not occur due to periodic demand shortfall. These countries, like Bangladesh suffer from disguised unemployment.

50. slide 49 Structural Unemployment  Large scale unemployment caused by low productive capacity  Unlike cyclical unemployment, structural is of long-term nature  Reduction of structural unemployment requires expansion of productive capacity which takes time

51. slide 50 Seasonal Unemployment  Periodic Unemployment  Agricultural workers suffer unemployment during agricultural lean seasons. Workers in developed countries can however easily switch skills to meet varying labor demands  Can also be countered through government intervention

52. Chapter Summary 1. The natural rate of unemployment  the long-run average or “steady state” rate of unemployment  depends on the rates of job separation and job finding 2. Frictional unemployment  due to the time it takes to match workers with jobs  may be increased by unemployment insurance CHAPTER 6 Unemployment slide 51 LECTURE 6 Unemployment

53. Chapter Summary 3. Structural unemployment  results from wage rigidity: the real wage remains above the equilibrium level  caused by: minimum wage, unions, efficiency wages 4. Behavior of the natural rate in the U.S.  rose from 1960 to early 1980s, then fell  possible explanations: trends in real minimum wage, union membership, prevalence of sectoral shifts, and aging of the Baby Boomers CHAPTER 6 Unemployment slide 52 LECTURE 6 Unemployment

54. Chapter Summary 5. European unemployment  has risen sharply since 1970  probably due to generous unemployment benefits, strong union presence, and a technology-driven shift in demand away from unskilled workers CHAPTER 6 Unemployment slide 53 LECTURE 6 Unemployment

55. slide 54 LECTURE 6 Unemployment Sectoral Shifts  U.S. Auto Industry (Detroit): Struggling for many years: falling profits, increased foreign competition, insufficient R&D - Recently, rising healthcare costs have caused significant increase in costs -Auto workers have been leaving the industry to work in the services sector…healthcare (especially nursing) is an attractive option -But transition can be painful (new skills, training, going back to school, etc)  In a dynamic economy, sectoral shifts occur frequently, contributing to frictional unemployment:  often referred to as the “cost” of economic development

56. slide 55 LECTURE 6 Unemployment Geography of a Recession U.S. Housing and Labor Markets January 2008

57. slide 56 LECTURE 6 Unemployment The Duration of U.S. Unemployment, average over 1/1990-5/2006 # of weeks unemployed # of unemployed persons as % of total # of unemployed amount of time these workers spent unemployed as % of total time all workers spent unemployed 1-438%7.2% 5-1431%22.3% 15 or more31%70.5%

58. slide 57 LECTURE 6 Unemployment The Duration of Unemployment  The data:  More spells of unemployment are short-term than medium-term or long-term.  Yet, most of the total time spent unemployed is attributable to the long-term unemployed.  This long-term unemployment is probably structural and/or due to sectoral shifts among vastly different industries.  Knowing this is important because it can help us craft policies that are more likely to work.

59. slide 58 LECTURE 6 Unemployment TREND: The Natural Rate rises during 1960- 1984, then falls during 1985-2006

60. slide 59 LECTURE 6 Unemployment Explaining the Trend: The Minimum Wage 0 1 2 3 4 5 6 7 8 9 195019551960196519701975198019851990199520002005 Dollars per hour minimum wage in current dollars minimum wage in 2006 dollars The trend in the real minimum wage is similar to that of the natural rate of unemployment.

61. slide 60 LECTURE 6 Unemployment EXPLAINING THE TREND: Union membership Since the early 1980s, the natural rate of unemploy- ment and union membership have both fallen. But, from 1950s to about 1980, the natural rate rose while union membership fell. Since the early 1980s, the natural rate of unemploy- ment and union membership have both fallen. But, from 1950s to about 1980, the natural rate rose while union membership fell. Union membership selected years yearpercent of labor force 193012% 194535% 195435% 197027% 198320.1% 200512.5%

62. slide 61 LECTURE 6 Unemployment EXPLAINING THE TREND: Sectoral shifts Price per barrel of oil, in 2006 dollars From mid 1980s to early 2000s, oil prices less volatile, so fewer sectoral shifts.

63. slide 62 LECTURE 6 Unemployment EXPLAINING THE TREND: Demographics  1970s: The Baby Boomers were young. Young workers change jobs more frequently (high value of s).  Late 1980s through today: Baby Boomers aged. Middle-aged workers change jobs less often (low s).

64. slide 63 Unemployment in Europe, 1960-2005 Percent of labor force Italy Germany France U.K. 0 3 6 9 12 1960196519701975198019851990199520002005 LECTURE 6 Unemployment

65. slide 64 LECTURE 6 Unemployment The Rise in European Unemployment  Shock Technological progress has shifted labor demand from unskilled to skilled workers in recent decades.  An increase in the “skill premium” – the wage gap between skilled and unskilled workers.  Higher unemployment, due to generous govt benefits for unemployed workers  strong union presence.

66. slide 65 LECTURE 6 Unemployment Percent of workers covered by collective bargaining United States18% United Kingdom47 Switzerland53 Spain68 Sweden83 Germany90 France92 Austria98

67. slide 66 Structural Unemployment Large scale unemployment caused by low productive capacity

68. slide 67 Structural Unemployment Supply is relatively inelastic, thus stabilization measure aimed at raising aggregate demand will have less effect on aggregate demand and hence on demand for labor. Rather it will cause general price level to rise.

69. slide 68 Actual & Potential GDP Potential GDP is when labor and all other productive assets are fully employed. The area between potential and actual GDP shows the cost of unemployment.