Unemployment

The full employment of labour has been a key economic objective ever since the mass unemployment experienced in the 1930s. When employment levels are less than their maximum possible an economy is experiencing unemployment. If labour is employed, but not effectively used, the situation is called underemployment.

The costs of unemployment

Opportunity cost

Unemployment represents an opportunity cost because there is a loss of output that workers could have produced had they been employed. The government is also forced to spend more on unemployment benefit. The money going on unemployment benefit could be spent on hospitals or schools.

Waste of resources

Resources not employed are left idle, and this is a waste to an economy – education and training costs are wasted when individuals who have received these benefits do not work.

The Chancellor loses revenue

The unemployed do not pay income tax, and pay less indirect tax as they spend less.

Erosion of human capital

Many skills are acquired at work, and being unemployed means can mean fewer new skills are acquired, and existing skills are lost.

Lower incomes

The unemployed have lower personal incomes and lower standards of living. In addition, the unemployed also suffer relatively poor physical and mental health.

Externalities

There are further external costs associated with unemployment, such as increased crime, alcoholism and vandalism.

Hysterisis

When unemployment exists it can become embedded in the economy. For example, even those made temporarily unemployed, because, perhaps, their employer goes out of business, may find it difficult to get back into the labour market. The longer they remain unemployed, the harder it becomes to gain work. This may be because workers lose skills, or because they lose the habit of working. Over time, some workers may become permanently excluded from employment and join the ranks of the long term unemployed (unemployed over 1 year) with little prospects of work.

Measuring unemployment

Measuring unemployment accurately is made difficult because of imperfect knowledge. Not all instances of unemployment are recorded, and records of unemployment may be inaccurate. Because the unemployed are eligible for benefits, some may claim benefit even when they work. Conversely, many of the unemployed may not bother to inform the authorities, and therefore unemployment goes unrecorded.

Claimant count and ILO unemployment

The Claimant Count

The Claimant Count records those claiming unemployment benefit (Job Seekers Allowance, or JSA) and can prove they are actively looking for work. It excludes housewives and those on training schemes.

How useful is the Claimant Count?

The Claimant Count may not reflect the true level of unemployment in the UK economy, given that not all the unemployed will bother to claim, and some are deterred because they cannot prove they are looking for work. This is especially true of part-time employees who are much less likely to register as unemployed compared to full-time workers. While some individuals may fraudulently claim, it is generally recognised that the Claimant Count under-estimates actual unemployment levels.

The International Labour Organisation (ILO)

The labour force survey is undertaken by the International Labour Organisation (ILO) and is a more direct assessment of unemployment, rather than those who claim benefit. It is based on an interview of a sample of 60,000 households (approximately 100,000 people) and tries to measure unemployment as a whole, rather than those simply claiming benefits. To be considered as being unemployed individuals must:

To be regarded as being unemployed, individuals must:

Have been out of work for 4 weeks
Be able to start work in the following 2 weeks – they must be readily available for work
Be available for work for one hour per week. Therefore, part-time unemployment is included in the measurement although part-time workers are unlikely to claim unemployment benefit. This tends to make ILO unemployment rather higher than the Claimant Count. For example, according to the ONS, ILO unemployment in 2009 was 2.46 million, whereas the Claimant Count was just 1.64 million.

(SOURCE: ONS, JAN 2010)

How useful is the ILO survey?

Since 2003 it has become the government’s official measure of unemployment, although it can be argued that it over-estimates true unemployment by including people only looking for a few hours part-time work. As a sample, it can be subject to sampling error, which reduced its accuracy.

UK unemployment

European unemployment

Unemployment in Europe relatively high compared with the USA, Japan and the UK.

Types of unemployment

There are several types of unemployment, each one defined in terms of cause and severity. Recognised types of unemployment include the following:

Cyclical

Cyclical unemployment exists when individuals lose their jobs as a result of a downturn in aggregate demand (AD). If the decline in aggregate demand is persistent, and the unemployment long-term, it is called either demand deficient, general, or Keynesian unemployment. For example, unemployment levels of 3 million were reached in the UK in the last two recessions, between 1980 and 1982, and between 1990 and 1992. In the most recent recession of 2008-2010, unemployment levels rose to 2.4m in the last quarter of 2009, and reached a 17 year high of 2.6m by late 2011. By 2016 unemployment had fallen to 1.68m.

(SOURCE: ONS).

Demand deficient unemployment

This is caused by a lack of aggregate demand, with insufficient demand to generate full employment.

Structural unemployment

Structural unemployment occurs when certain industries decline because of long term changes in market conditions. For example, over the last 20 years UK motor vehicle production has declined while car production in the Far East has increased, creating structurally unemployed car workers. Globalisation is an increasingly significant cause of structural unemployment in many countries.

Regional unemployment

When structural unemployment affects local areas of an economy, it is called regional unemployment. For example, unemployed coal miners in South Wales and ship workers in the North East add to regional unemployment in these areas.

Classical unemployment

Classical unemployment is caused when wages are ‘too’ high. This explanation of unemployment dominated economic theory before the 1930s, when workers themselves were blamed for not accepting lower wages, or for asking for too high wages. Classical unemployment is also called real wage unemployment.

Seasonal unemployment

Seasonal unemployment exists because certain industries only produce or distribute their products at certain times of the year. Industries where seasonal unemployment is common include farming, tourism, and construction.

Frictional unemployment

Frictional unemployment, also called ‘search’ unemployment, occurs when workers lose their current job and are in the process of finding another one. There may be little that can be done to reduce this type of unemployment, other than provide better information to reduce the search time. This suggests that full employment is impossible at any one time because some workers will always be in the process of changing jobs.

Voluntary unemployment

Voluntary unemployment is defined as a situation when workers choose not to work at the current equilibrium wage rate. For one reason or another, workers may elect not to participate in the labour market. There are several reasons for the existence of voluntary unemployment including excessively generous welfare benefits and high rates of income tax. Voluntary unemployment is likely to occur when the equilibrium wage rate is below the wage necessary to encourage individuals to supply their labour.

Structural change

Over the last 30 years, employment in the service sector has increased to over 70% of total employment, while employment in manufacturing has decreased to under 20%. Since the 1940s, employment in the primary sector, including agriculture, has been less that 3% of the workforce.

Recent changes have created two-speed economy, with a booming service sector and a declining manufacturing one.

The main reasons are:

Globalisation and the rise of new ‘low cost’ overseas competitor countries.
Increased competition within the domestic product market.
The increasing comparative advantage of the UK as an international supplier of financial services.

Structural unemployment and labour mobility

Labour immobility is likely to increase structural unemployment. Although the expanding industries are growing and need labour, they are not necessarily able to employ the same workers who have been displaced in the declining industries.

There are three types of labour immobility:

Geographical immobility

Geographical immobility occurs when workers are not willing or able to move from region to region, or town to town. Geographical mobility is made worse by immense house price variation between regions. It may be extremely difficult for workers in Yorkshire to sell their home and buy an equivalent one in London.

Other factors also contribute to geographical immobility, such as strong social and family ties, and parents being unwilling to disrupt their children’s education by changing schools. The stresses of moving home can also be a deterrent to mobility for some.

Industrial immobility

Industrial immobility occurs when workers do not move between industries, such as moving from employment in the motor industry to employment in the insurance industry. Industrial immobility has affected the UK, and many other industrial countries, as the growth of service industries, and the decline of manufacturing industries, has increased the need for mobility.

Occupational immobility

Occupational immobility occurs when workers find it difficult to change jobs within an industry. For example, it may be very difficult for a doctor to retrain to be a dentist.

Industrial and occupation immobility are most likely to happen when skills are not transferable between industry and job.

Information failure also contributes to labour immobility because workers may be immobile because they do not know where all the suitable jobs for them are.

A resulting problem with labour market immobility is that it can create regional unemployment, which is a type of structural unemployment. This means that a change in the structure of industry leaves some people unable to respond by changing job, industry, or location and as a result, they remain temporarily or permanently unemployed.

Immobility can also lead to rising labour costs, as firms have to increase wages to encourage workers to re-locate.

Labour market or government failure?

New Classical economists would tend to see structural unemployment as an example of government failure. Labour markets do not clear, they argue, because wages are not allowed to adjust effectively, and the price mechanism is distorted. By removing distortions and imperfections in the labour market, workers would move more quickly from job to job.

For example, by keeping welfare benefits to a minimum there is an incentive to retrain and look for paid work. Welfare benefits can trap individuals into a life of unemployment because of the effects of moral hazard and the disincentive effect it creates. This increases labour immobility, and hence contributes to structural unemployment.

However, labour immobility can also be addressed from the perspective of labour market failure. Training and re-training are regarded as merit goods, where individuals under perceive the long term benefit to themselves. They also fail to appreciate the positive externalities that training and re-training generate for the wider community. This means that there is a significant role for the state in providing free or subsidised training and retraining programmes.

In addition, there is the potential situation of labour market poaching. Why should a firm in the booming service sector provide free training to a displaced worker from the manufacturing sector if the worker will leave for another job shortly after training? Why should firms do any training at all if they believe that workers will be poached by higher wages? The poacher can, of course, afford to pay higher wages because of savings in training costs.

The natural rate of unemployment

This is a term associated with New Classical and monetarist economists. It is defined as the rate of unemployment that still exists when the labour market it in equilibrium, and includes seasonal, frictional and voluntary unemployment. The concept was used by the US economist Milton Friedman to help explain the connection between unemployment and inflation, as demonstrated by the Phillips Curve. Friedman argued that if unemployment falls below the natural rate there will be an increase in the rate of inflation.

NAIRU and sustainable employment

The Non-Accelerating-Inflation Rate of Unemployment (NAIRU) is a similar concept to the NRU. Short-run NAIRU is the short run level of unemployment where inflation is neither likely to rise or fall. Long-run NAIRU is defined as the rate of unemployment at which inflation stabilises once any short run shocks have worked their way out the macro-economy. Long-run NAIRU is usually assumed to be the level of unemployment that exists when the economy is operating on its long run Phillips Curve. The implication is that a level of unemployment below NAIRU is unsustainable for an economy. It is clear that NAIRU is a significant policy concept which has helped shape modern macroeconomic policy.

See: Bank of England paper, Measuring Short Run NAIRU

In the 1980s it was generally thought that NAIRU in the UK was around 7%. However, according to most economists, a combination of factors, including effective supply-side policy and the general increase in ‘rational expectations’ on the part of employers, workers and trade unions has reduced NAIRU to around 5%.

Why is there still unemployment when the economy is in equilibrium?

There are two rival views:

The New Classical view

New-Classical economists argue that if unemployment exists when the labour market is in equilibrium it must be caused by individuals choosing not to work. In other words, it is voluntary unemployment.

The New Keynesian view

The New-Keynesian perspective is that unemployment may still persist when the labour market is in equilibrium for three possible reasons.

Wage rigidities – in reality wages are slow to adjust to changes in either the demand or supply of labour, meaning that markets do not clear quickly.
Efficiency wage theory – firms must set wages above market clearing to ensure a supply of ‘good’ workers.
Insider-outsider theory – some workers are permanently excluded from participating in labour markets.

Efficiency wage theory

This New Keynesian interpretation of NAIRU suggests that information failure is common in the labour market – information is asymmetric and employers do not know how productive workers are until after they have employed them.

Good workers have a higher reservation wage, which is the minimum wage at which workers are prepared to work.

Firms need to set their wage above equilibrium to ensure a supply of good workers because low pay will only attract inferior workers (See: The Lemon’s problem). In this case, higher wages are efficient because they enable the best workers to be employed, but, this leaves some unemployed, even at equilibrium.