Chapter 14

The Function and the Flows

🔹 1. P_{en}: Employment → Nonparticipation

Meaning:
Workers who leave employment and also leave the labour force — for example, retirees,
students returning to school, or parents leaving work to care for family.

Effect on unemployment:
⬇️Increases unemployment - because these people are no longer counted as part of the
labour force (they are not unemployed; they’re nonparticipants).

🔹 2. P_{ne}: Nonparticipation → Employment

Meaning:
People who were previously out of the labour force but enter directly into jobs — for
example, new graduates hired immediately.

Effect on unemployment:
⬇️Decreases unemployment — these individuals skip unemployment entirely and move
straight into employment, reducing potential inflow to unemployment.

🔹 3. P_{un}: Unemployment → Nonparticipation

Meaning:
Unemployed workers who stop looking for work and leave the labour force — often called
discouraged workers.

Effect on unemployment:
⬇️Decreases measured unemployment, but not necessarily for a good reason — they are
no longer counted as unemployed (though they are still jobless).
🔹 4. P_{nu}: Nonparticipation → Unemployment

Meaning:
People who were not in the labour force but start actively looking for work — for
example, homemakers or retirees who decide to re-enter the job market.

Effect on unemployment:
⬆️Increases unemployment, because they add to the stock of unemployed workers while
searching for jobs.

🔹 5. P_{eu}: Employment → Unemployment

Meaning:
Job separations — workers who lose or leave jobs and become unemployed (layoffs, firings,
quits without new jobs).

Effect on unemployment:
⬆️Increases unemployment, as these workers move from employment into unemployment.

🔹 6. P_{ue}: Unemployment → Employment

Meaning:
Job finding rate — unemployed workers who successfully find jobs.

Effect on unemployment:
⬇️Decreases unemployment, as unemployed workers exit unemployment and become
employed.

🔸 Summary Table
Effect on
Flow Transition Description
Unemployment

Employment → Workers leaving jobs and exiting the labour

P_{en} ↑
Nonparticipation force. Retirements, schooling, family leave

Nonparticipation →
P_{ne} New entrants who get jobs immediately ↓
Employment

Unemployment →
P_{un} Discouraged workers leaving labour force ↓
Nonparticipation

Nonparticipation →
P_{nu} Re-entrants looking for jobs ↑
Unemployment

P_{eu} Employment → Job losses or quits without new jobs ↑

 Effect on
Flow Transition Description
Unemployment

Unemployment

Unemployment →
P_{ue} Unemployed finding jobs ↓
Employment

Summary: Frictional Unemployment

Even when the labour market is in equilibrium—where the quantity of labour demanded
equals the quantity supplied—some unemployment will still exist. This type is called
frictional unemployment.

 Reason: At any given time, some workers are between jobs — they have left one job
and are searching for another, or are entering/re-entering the labour force.

Causes of Frictional Unemployment

1. Labour market frictions:

o Information about available jobs and suitable workers is imperfect.
o It takes time and effort for job seekers and employers to find each other.
2. Labour force dynamics:
o Each period, new entrants (such as graduates) enter the job market, while
others retire or leave.
o Some workers voluntarily quit their jobs to look for better opportunities.

3. Random fluctuations in demand:

 o Some firms close or lay off workers while others expand and hire, creating
temporary mismatches.
4. Time needed for job matching:
o Because information about job openings and worker qualifications isn’t
instantly known or evaluated, matching takes time — producing short-term
unemployment.

The Theory of Job Search

The level of frictional unemployment in an economy depends on how quickly individuals

move into and out of the labor market and how fast unemployed workers find and accept
jobs.
This speed is determined by the job-search process, which reflects imperfect information
and the time it takes for workers and employers to match successfully.

A Model of Job Search

 Job seekers must search for job offers because information about vacancies and
worker characteristics is imperfect.
 Matching workers with appropriate jobs therefore takes time and effort.
 The lower the probability (P_{ue}) that an unemployed worker finds a job in a given
period, the longer the expected duration of unemployment and the higher the
unemployment rate.

To understand what determines this probability, Ehrenberg and Smith construct a formal
model:

1. Assumption:
Wages depend on job characteristics, not on individual worker traits.
2. Hiring standards:
Employers differ in their minimum requirements (education, skills, experience,
etc.).
These can be summarized by a variable K, representing the minimum skill level a job
requires.
3. Wage–Skill Relationship:
Each job’s wage, W(K), is a function of the required skill level (K) — higher skill
requirements correspond to higher wages.
Two employers with the same required skill level will offer the same wage.
4. Wage Distribution:
Because different jobs have different hiring standards, there exists a distribution of
wages, f(W), across job vacancies in the market.
As the required skill level KKK increases, so does the offered wage.
Reservation Wage and Duration of Unemployment

The reservation wage is the lowest wage an unemployed person is willing to accept rather
than continue searching for work. It plays a central role in determining how long
unemployment lasts.

1. Decision to Accept or Reject a Job Offer

Job seekers receive different wage offers drawn from the distribution of wages
f(W)f(W)f(W).
When an offer arrives, the worker compares it to their reservation wage (WR):

 If W≥WR: accept the job.

 If W<WR: reject and keep searching.

The duration of unemployment depends on how long it takes for an offer at least equal to
WR to arrive.

2. Factors Affecting the Reservation Wage

 Unemployment benefits / savings:

Higher benefits or financial security allow the worker to wait longer → higher WR
→ longer unemployment.
 Search costs:
Higher costs (e.g., time, effort, travel) reduce the incentive to continue searching →
lower WR→ shorter unemployment.
 Job offer frequency:
More frequent job offers make it easier to find acceptable ones → may raise WR but
shorten search duration.
 Expected wage distribution:
If the expected range of wages is high, workers hold out for better offers → higher
WR

3. Change in Reservation Wage Over Time

As time passes without receiving a satisfactory offer:

 The worker’s resources decline (benefits, savings).

 The cost of continued search rises.
  Therefore, the worker tends to lower their reservation wage to increase the
likelihood of accepting a job.

4. Implications for Frictional Unemployment

 The longer the job search, the higher the frictional unemployment rate.
 Policies that improve information (job matching services) or reduce search costs
can shorten unemployment duration.
 Generous benefits and high expectations can prolong unemployment by raising the
reservation wage.

Introduction

Frictional unemployment arises when workers are temporarily unemployed while searching
for new jobs that best match their skills and preferences. The Job Search Model, developed
within labour economics, helps explain how individuals make decisions about how long to
search for a job and what wage offers to accept. According to Ehrenberg and Smith, this
model focuses on the trade-off between the time spent searching for a better job offer and
the income lost while unemployed.

The central concept of the model is the reservation wage — the minimum wage at which a
worker is willing to accept a job offer. Changes in the reservation wage determine how long a
worker remains unemployed, thereby influencing the duration of frictional unemployment.

The Job Search Model Explained

The Job Search Model assumes that workers face uncertainty about available job offers and
their wages. Job offers arrive randomly over time, and each offer provides a different wage.
The worker’s objective is to decide whether to accept the current offer or continue
searching, given that job searching has a cost — both in terms of time and forgone earnings.

 When unemployed, an individual receives offers drawn from a wage distribution.

 The worker compares each offer to their reservation wage (Wr).
 If the offered wage (Wo) is greater than or equal to Wr, the worker accepts the job.
 If Wo < Wr, the worker rejects the offer and continues searching.

This decision-making process continues until an acceptable offer arrives, at which point
unemployment ends.

Therefore, the duration of unemployment depends on:

1. The arrival rate of job offers, and

2. The level of the reservation wage.

Graphical Illustration (Reservation Wage Change)

If the reservation wage increases (say, from Wr₁ to Wr₂), the worker will reject more job
offers, waiting for a higher-paying one. This causes the duration of unemployment to
increase, as fewer offers will now meet the higher threshold.

Conversely, if the reservation wage decreases, more offers become acceptable, and
unemployment duration shortens.
Factors Affecting the Reservation Wage

According to Ehrenberg and Smith, several factors shift the reservation wage:

1. Unemployment Benefits
o Higher unemployment benefits raise Wr, since the opportunity cost of
accepting a low-wage job increases.
o Workers can afford to search longer, increasing frictional unemployment
duration.
2. Search Costs
o Higher search costs (e.g., transportation, time) lower Wr, as continuing to
search becomes more expensive.
3. Expected Wage Distribution
o If workers believe better offers are likely, Wr rises because they expect higher
potential rewards from continued search.
4. Discount Rate
o Impatient workers (with high discount rates) prefer current income to future
income, so they set a lower Wr and accept jobs faster.
5. Labour Market Conditions
o In a booming economy with many vacancies, Wr increases since workers
expect better offers.
o In a recession, Wr falls due to fewer opportunities.

Implications of the Job Search Model

1. Explains Frictional Unemployment

o Not all unemployment is involuntary; some is due to rational job searching
behaviour aimed at finding a good job match.
2. Policy Implications
o Government policies such as unemployment insurance, job information
systems, and labour mobility programs can affect the duration of frictional
unemployment by influencing reservation wages and search efficiency.
3. Efficiency in Labour Market Matching
o A certain level of frictional unemployment is necessary for efficient job
matching — allowing workers to find jobs that best suit their skills.
4. Effect of Unemployment Benefits
o While benefits improve welfare and allow better job matching, overly
generous benefits may prolong unemployment by increasing reservation
wages.
5. Explains Wage Differentials
o Workers with different search costs, expectations, or preferences will have
different reservation wages, leading to wage dispersion across identical
workers.
Conclusion

The Job Search Model, as discussed by Ehrenberg and Smith, provides a theoretical
foundation for understanding frictional unemployment and the role of reservation wages.
It shows that unemployment duration is not merely a result of job scarcity, but also of
individual decisions about which jobs to accept and when. A higher reservation wage leads
to longer search times, while a lower reservation wage shortens unemployment spells.
Thus, this model bridges microeconomic behaviour (individual choice) with macroeconomic
outcomes (overall unemployment), offering valuable insights for both policymakers and
labour economists.

occupational and regional causes of structural unemployment

Introduction

Structural unemployment occurs when there is a mismatch between the skills or location
of workers and the requirements or location of available jobs. Unlike frictional
unemployment, which is temporary and due to job search, structural unemployment is
persistent and results from fundamental shifts in the economy.
According to Ehrenberg and Smith, structural unemployment reflects changes in the
structure of production, technological progress, and geographical shifts in employment
opportunities. Two key sources of structural unemployment are occupational causes and
regional causes.

1. Occupational Causes of Structural Unemployment

Occupational causes arise when workers’ skills or training no longer match the skills
demanded by employers in growing sectors of the economy.

a) Technological Change

 Technological progress (such as automation, robotics, or AI) can make certain

occupations obsolete.
 Workers who previously held these jobs may find that their skills are outdated,
leading to unemployment unless they can retrain or acquire new competencies.
 For example, automation in manufacturing has reduced demand for assembly-line
workers, while increasing demand for technicians and programmers.

b) Shifts in Industrial Structure

 As economies evolve, demand for goods and services changes — for example,
moving from agriculture and manufacturing toward services and technology
industries.
 Workers employed in declining industries face occupational immobility, since their
qualifications and experience do not transfer easily to new industries.
c) Inadequate Training and Education

 Structural unemployment can result from insufficient education systems or training

programs that fail to equip workers with the skills needed in emerging sectors.
 Young workers entering the labour market may also find that their education does not
match employer needs.

d) Skill Mismatch and Labour Market Rigidity

 When labour markets are rigid (e.g., slow retraining programs, licensing restrictions),
workers cannot quickly adapt to new occupations.
 This prolongs unemployment even when vacancies exist.

→ Summary: Occupational causes of structural unemployment stem from skill mismatches,

technological obsolescence, and inadequate adaptability to new job requirements.

2. Regional Causes of Structural Unemployment

Regional causes arise when job opportunities are available in some geographic areas, but
workers are located in others.

a) Geographic Immobility of Labour

 Workers may be unwilling or unable to move to regions where jobs exist due to
family ties, housing costs, or lack of information.
 For example, a worker in a declining mining town may find it difficult to relocate to a
city offering new service-sector jobs.

b) Decline of Traditional Industries in Certain Regions

 Some regions experience long-term decline due to the collapse of dominant industries
(e.g., coal mining, steel production, textile manufacturing).
 These areas suffer from persistent unemployment because new industries fail to
replace the old ones quickly enough.

c) Urban–Rural and Core–Periphery Differences

 Jobs tend to concentrate in urban or coastal regions with better infrastructure and
access to markets.
 Rural or peripheral regions may experience structural unemployment due to poor
connectivity, fewer educational opportunities, and weaker local economies.

d) Regional Wage Differentials

 If wages and living costs differ across regions, workers may not find it worthwhile to
relocate.
  High housing costs in prosperous areas can deter migration, leading to regional
unemployment disparities.

→ Summary: Regional causes reflect geographical mismatches — jobs and workers exist,
but not in the same places.

3. Interactions Between Occupational and Regional Causes

In many cases, occupational and regional causes reinforce each other:

 A worker in a declining industry (occupational mismatch) located in a declining

region (regional mismatch) faces double barriers to employment.
 Even if new jobs arise elsewhere, lack of mobility or retraining support can trap such
workers in long-term unemployment.

4. Policy Responses (Ehrenberg & Smith)

To address structural unemployment caused by occupational and regional mismatches,

Ehrenberg and Smith highlight policies such as:

 Retraining and reskilling programs to help workers transition to new occupations.

 Improved labour mobility, including housing assistance and relocation subsidies.
 Regional development programs to attract new industries to depressed areas.
 Information dissemination (job-matching systems) to link workers to vacancies
more effectively.
Conclusion

In summary, structural unemployment is a long-term form of unemployment arising from

changes in the economy’s structure.
Its occupational causes relate to skill mismatches and technological change, while its
regional causes stem from geographical immobility and uneven economic development.
Because these causes are deeply rooted in the economy’s evolution, reducing structural
unemployment requires active labour-market policies, education reform, and regional
development strategies that help workers adapt and relocate to new opportunities.

five reasons why wages may be rigid downwards

Introduction

In a competitive labour market, we would expect wages to adjust freely to changes in labour
demand and supply. However, in the real world, wages often do not fall easily, even when
unemployment rises or firms face declining demand. This phenomenon is known as
downward wage rigidity.
According to Ehrenberg and Smith, several economic and behavioural factors prevent wages
from adjusting downward. These include union behaviour, specific human capital,
asymmetric information, risk aversion, and worker status and social norms.

1. Unions

Trade unions play a major role in maintaining wages above their market-clearing level.

 Collective bargaining agreements often set wages that remain fixed over a certain
period, making downward adjustments difficult even when market conditions worsen.
 Unions are primarily concerned with protecting members’ living standards and
maintaining fairness among workers, rather than allowing wage cuts that could lead
to internal conflict.
 In some cases, unions prefer layoffs to wage reductions, reasoning that it is better for
some workers to lose jobs than for all workers to face lower pay.

Thus, unions’ efforts to protect members’ interests lead to wage rigidity, contributing to
involuntary unemployment when labour demand falls.

 Example:
In the automobile industry, powerful unions like the United Auto Workers (UAW)
in the United States have historically negotiated multi-year contracts with fixed wage
rates. When car sales drop, companies such as Ford or General Motors often reduce
employment rather than cutting the agreed-upon wages.

→ Effect: Unionization therefore makes wages sticky downward, contributing to

unemployment when firms adjust employment instead of pay.
2. Specific Human Capital

Specific human capital refers to the skills and knowledge that are valuable only to a
particular employer or firm.

 When an employee and employer have invested in firm-specific training, they form a
kind of long-term relationship.
 Cutting wages may damage this relationship, reducing morale or prompting
valuable workers to leave for competitors, even if their firm-specific skills are less
useful elsewhere.
 Employers therefore often prefer to retain skilled workers and maintain their loyalty
by keeping wages stable.

In this way, the presence of specific human capital discourages firms from lowering wages,
since the long-term cost of losing trained employees may exceed the short-term savings from
wage cuts.

 Example:
Consider an aircraft engineer trained specifically to maintain Boeing aircraft within
a particular airline. The airline has spent significant resources on training, and the
engineer’s skills may not be easily transferable to other companies. The airline avoids
wage cuts to prevent the engineer from leaving, since replacing such a worker would
be costly and time-consuming.

→ Effect: Firms with high firm-specific skills avoid cutting wages, leading to rigidity even
during downturns.

3. Asymmetric Information

Labour markets often suffer from asymmetric information, meaning employers cannot
perfectly observe workers’ abilities or motivation.

 If a firm cuts wages for all workers, it may signal financial weakness or unfair
treatment, causing the most productive employees to quit.
 This creates an adverse selection problem: high-quality workers leave, while lower-
quality workers stay.
 Employers, aware of this risk, may decide not to reduce wages even in economic
downturns.

According to Ehrenberg and Smith, asymmetric information thus makes downward wage
flexibility risky for firms, as it can disrupt their workforce composition and reduce
productivity.
  Example:
A software company facing reduced demand might fear that a 10% wage cut will
push its top developers to join competitors like Google or Amazon. Losing these key
employees would damage the firm more than the savings from the wage cut. Hence, it
maintains wages and reduces hiring instead.

→ Effect: Information asymmetries discourage wage cuts, as they may unintentionally drive
away the firm’s most valuable workers.

4. Risk Aversion

Workers are generally risk-averse — they prefer stable and predictable incomes rather than
uncertain ones.

 Wage cuts increase workers’ income uncertainty, potentially reducing their

motivation and increasing turnover.
 To maintain a stable and productive workforce, employers often agree to stable
nominal wages, using layoffs or hiring freezes to adjust employment instead.
 Workers’ demand for income stability leads to contracts or implicit agreements that
make wages rigid in the downward direction.

Thus, risk aversion leads both workers and employers to favour employment adjustments
over wage adjustments in response to changing conditions.

 Example:
During a recession, a bank may freeze new hires or lay off temporary staff rather than
reducing the salaries of its permanent employees. This preserves worker confidence
and maintains morale among the remaining staff.

→ Effect: Because workers dislike wage uncertainty, firms keep wages steady to maintain
productivity, resulting in downward rigidity.

5. Worker Status and Social Norms

Social and psychological factors also contribute to wage rigidity.

 Workers often view wage cuts as unfair or damaging to their social status,
particularly when they see others in similar jobs earning the same or more.
 Employers fear that cutting wages could lower morale, increase absenteeism, or
reduce productivity, which can hurt firm performance.
 There is a strong “fair-wage norm” in many societies — the idea that workers should
be paid fairly for their effort, and that wage cuts violate this moral expectation.
As a result, firms prefer to avoid nominal wage reductions to maintain trust and good
workplace relations, even during downturns.

 Example:
A university facing budget cuts may choose to freeze professors’ salaries rather than
reduce them, to preserve fairness and reputation. Wage cuts could be seen as
disrespectful or demoralizing, especially if professors know peers at other institutions
have not experienced similar reductions.

→ Effect: Social norms about fairness and status make employers reluctant to cut pay,
reinforcing wage stickiness.

Conclusion

These factors combine to prevent wages from falling to their equilibrium level, leading to
persistent unemployment during recessions. Understanding these causes helps
policymakers design labour-market institutions and policies — such as wage subsidies,
retraining, and employment support — that reduce unemployment without undermining
worker morale or fairness.