Chapter 07

Unemployment and the labour market

ECON 502 • Macroeconomics • 2022-23

Sumit Mishra
IFMR, Sri City
The Facts about the Unemployment Rate
Indian Labour Market
Indian Labour Market
Indian Labour Market
2011-12 2017-18 2018-19

Working age population (mn) 853.4 968.9 986.3

Labour force (mn) 475.0 482.7 495.7
Employed (mn) 464.6 453.3 466.7
Unemployed [(2)-(3)] 10.4 29.4 29.0
Outside labour force [(1)-(2)] 378.4 486.2 490.7
Labour Force Participation Rate 55.7 49.8 50.3
Workforce Participation Rate 54.4 46.8 47.3
Unemployment Rate 2.2 6.1 5.8
Note:
Sources and notes: NSS 2011-12, PLFS 2017-18 and PLFS 2018-19. Numbers pertain to individuals aged 25 years and above.
Job Loss, Job Finding, and the Natural Rate of
Unemployment
Let:

L be the total labour-force,

E be the total number of employed workers,

U be the total number of unemployed workers.

Job Loss, Job Finding, and the Natural Rate of
Unemployment
We assume that anyone who's part of labour force is either employed or unemployed.
Therefore,

L = E + U

The unemployment rate can be written as:

U
u =
L
Unemployment Rate
How is the unemployment rate determined?

Let s be the job-separation rate among the employed, and f be the job-finding rate among the
unemployed.

For the unemployment rate to be stable:

f U = sE

We can show that the steady-state unemployment rate is given by:

s
u =
s + f
Unemployment Rate: Example
Let job separation rate be 5% and the job finding rate be 35%.

The steady-state unemployment rate in this economy is:

5
u =
5 + 35

5
u =
40

1
u =
8

u = 12.5%.
Job-Search and Frictional Unemployment
The situation described in the previous section may not instantiate immediately.

There may be a lag between a job-posting and eventual hiring (for example).
There may be a mismatch between job on offer and worker's ability.

These scenarios may lead to a worker spending considerable time searching for their next
job.

This type of unemployment is known as the frictional unemployment.

Causes of Frictional Unemployment
"the types of goods that firms and households demand vary over time. As the
demand for goods shifts, so does the demand for the labor that produces those
goods."

Invention of personal computer may have led to fall in demand for typewriters (and
consequently the labour demand must also have fallen)

Higher oil prices may require more demand for labour oil-rich region (and may lead to a
shortfall in labour demand for industries in other regions).

These changes in the composition of demand is known as the sectoral shift.

Public Policy and Frictional Unemployment
Dissemination of information about available jobs in the economy.

Public training programs enhancing skills of the workers.

Unemployment insurance:

In the US, a worker is entitled to upto 50% of her previous wage for 26 weeks.
Mankiw argues that this inadvertently increases the natural rate of unemployment.

Economists argue for a reformed unemployment insurance system.

Firms fully bear the cost of unemployment. 100 percent experience rated
Real Wage Rigidity and Structural Unemployment
When the prevalent wages lie about the market-clearing wage, firms may ration jobs.

Thus, wage rigidity leads to a rise in the level of unemployment in the economy.

The nature of the unemployment is different (not skill mismatch, not job search).

Firms fail to hire more workers.

At the prevalent rigid wages, the firms cannot accommodate all the workers (who
demand jobs).

This phenomenon is known as the structural unemployment.

Wage Rigidity and its Causes
Minimum wage laws.

The monopoly power of unions.

Efficiency wages.
Minimum Wage Laws
When the government decides to increase the minimum wage:

firms will reduce hiring and therefore the unemployment rate may go up.
the rise in unemployment will be limited to those who are relatively less experienced
and less skilled.
Wage Rigidity and Labour Unions
The wages of unionised workers is not simply determined by demand and supply of labour.

The key to wage-determination is bargaining.

The bargaining may lead to wages going above the equilibrium wage, and therefore firms
may hire fewer workers.
Efficiency Wages
The theory posits that paying workers more makes them more productive.

Trying to lower wage-bills may inadvertently cause a slump in the productivity.

Higher wages also reduce worker turnover.

Higher wages increase the average quality of the workforce.

Paying workers efficiency wages reduces the monitoring costs.

Efficiency Wages: Ford's $5 Workday
The average wage during 1914 was about $2-$3.

Ford decided to pay $5.

We wanted to pay these wages so that the business would be on a lasting foundation.
We were building for the future. A low wage business is always insecure. . . . The
payment of five dollars a day for an eight hour day was one of the finest cost cutting
moves we ever made.

Available evidence suggests that the plan worked.

The Ford high wage does away with all the inertia and living force resistance. . . . The
workingmen are absolutely docile, and it is safe to say that since the last day of 1913,
every single day has seen major reductions in Ford shops’ labor cost.
Transitions in and out of labour force
Some may not want jobs, and want to sit out the labour force.

Some others may have given up looking for jobs due to unsuccessful search.

These discouraged workers are counted as being out of the labour force and do not show
up in unemployment statistics.
A Simple Theory
e
W = P F (u, z)

The nominal wage W depends upon three variables:

The expected price level P e .

The unemployment rate u
All other variables indexed as z.
Expected Price Level
All involved- firms as well as workers- care about real wages.
Workers care about what they can buy with the wages.
Firms care about the price of the good (P ) and the wages relative to these prices.
Typically, actual price level is not known in advance. So, workers form expectations about
the price level.
Price Determination
We know from microeconomics that the price is a function of costs.

We also know from microeconomics that costs depend upon the type of production
function.

At this point, we just simplify everything: Y = AN

Y is output, N is labour, A is some estimated measure of productivity.

One more (over)simplification: A = 1 .

What's the marginal cost here? W

In perfect competition: P = MR = MC .

But not all firms in our toy economy are competitive.

Price Determination
Some firms enjoy markup. (m)

So, in aggregate,

P = (1 + m)W

Had economy been populated with perfectly competitive firms, what would be the price
level?

P = W
The Wage Setting Relation
W = P F (u, z)

W
= F (u, z)
P
The Price Setting Relation
P = (1 + m)W

Rewrite this as:

W 1
=
P 1 + m

How do we translate this equation into English? Help!

Real wage depends upon firms’ markup price.

An increase in the markup leads firms to increase their prices given the wage they have to
pay.
Equilibrium
Equilibrium in the labour market: real wage chosen in wage setting = real wage determined
by price setting.

We can bring in the relationship between real wages and unemployment.

1
F (un , z) =
1 + m

The equilibrium unemployment rate is known as the natural rate of unemployment.

Changes in equilibrium
Suppose there is a rise in unemployment benefits. This shifts the wages upwards.

↑ unemployment benefits ⇒↑ Real wage.

Poor enforcement of anti-competition policies.

↑ markup ⇒↓ Real wage.