Unemployment

Chapter 7

2

Introduction

• Keynes first challenged the orthodox view that the economic system tends to return quickly to full-employment equilibrium during the Great Depression.

• We will study a model that incorporates elements from modern unemployment theories into a framework similar to that of the classical theory.

3

Explaining Unemployment

• Two dimensions:

1. Why there is any unemployment at all?

2. Why does unemployment move in a systematic way with other business cycle variables?

4

Frictional Unemployment

• The classical economists recognized that equality of demand and supply in the labor market does not imply the absence of unemployment.

• Labor turnover Frictional unemployment

5Figure 7.1

Flows Through the Labor Market

6

Cyclical Unemployment

• The increased unemployment that occurs during a recession is called cyclical unemployment.

• Keynesian : The economy does not respond to shocks as efficiently as it should. ( Nominal Rigidity)

• We will amend the classical model by allowing firms to choose the wage to describe unemployment as an equilibrium phenomenon.

7

Efficiency Wage Theory

• Firms choose to pay higher wage than the classical equilibrium wage to minimize the turnover costs.

• Three strands:1. High wage may ensure the productivity of its

workers.2. Higher wages will attract high-quality

applicants.3. Firms use the wage as a device to minimize

turnover costs.

8

The New-Keynesian Theory

• The firm explicitly recognizes its pool of workers as a stock and any given stock of workers can be associated with fast or slow labor turnover.

• The firm minimizes the costs of maintaining a stock of employed workers by adjusting the real wage.

9

The New-Keynesian Theory

• The stock of workers sent to the labor market by households is called the labor force.

- Increasing function to the real wage.

• The stock of workers employed by the firm is called employment.

- Decreasing function of real wage.

10Figure 7.2

The New-Keynesian Model of the Labor Market

11

Turnover Cost and Efficiency Wage

• In the new-Keynesian model, the firm must devote resources to the search process.

• The firm chooses its wage to minimize its wage bill:

- The wage paid to each worker.

- The cost of recruiting new workers, C(w/P, L).

12

Turnover Cost and Efficiency Wage

• We study a special case of a turnover cost function:

• In this case, turnover costs are proportional to the number of workers and the firm’s problem can be broken into two part:

1. Choose the efficiency wage to minimize cost per-worker.

2. Given the efficiency wage, choose L to maximize profit.

( / , ) ( / )C w P L c w P L

13

Firm’s Problem

( )

w wY L c L

P P

w wF L L c L

P P

1. 0

2. 0

ww PP

LL

14

Choosing the Efficiency Wage

• Marginal cost (1) = Marginal benefit (c’(w/P) )

1 ' 0.

1 ' .

wc

w PP

w wc

P P

15

The New-Keynesian Model of the FirmPanel A

16

Choosing a Stock of Workers

• Marginal Product = Marginal Cost

'( ) 0.

'( )

w wF L c

L P P

w wF L c L

P P

17

The New-Keynesian Model of the FirmPanel B

18

©2002 South-Western College Publishing

Figure 7.4

Demand and Supply in the New-Keynesian Model of the Labor Market

19

A Mathematical Example

• Production Function:

• Per-worker turnover cost:

• Labor supply:

2( / ) 1 2( / ) ( / )c w p w P w P

2(1/ 2)D DY L L

/SL w P

/ 1/ 2, 1/ 4.w P U

20

Unemployment and Economic Policy

• Two approaches:

1. Policies designed to control the natural rate are called structural policy and unemployment that results from poorly designed labor-market institutions is called structural unemployment.

2. The second deals with the control of cyclical unemployment as it fluctuates over the business cycle. (Chapter 8)

21©2002 South-Western College Publishing

Table 7.1

22

Unemployment and Economic Policy

• Possible reason:

Low-skill labor and labor market rigidity.

• Some economists have advocated reforms to make labor markets more flexible.

23

Homework

Question 1, 8, 10, 11

END