Disequilibrium unemployment
Disequilibrium unemployment
This occurs when there is disequilibrium in the labour market, specifically when
aggregate supply exceeds aggregate demand at the current wage rate. This is shown in
the figure below. At the wage rate W1 there is disequilibrium unemployment of xy. If
the wage rate were to fall to the equilibrium wage rate We, then disequilibrium
unemployment would disappear- but for some reason the wage rate W1 is unable to
fall….…..
Average real
wage rate $
ASL
There is disequilibrium unemployment of y-x
at the given wage rate W1. This wage rate is
above the market clearing wage rate of We.
W1
We
ADL
x
y
Number of workers
Causes of disequilibrium unemployment
1. Demand Deficient (cyclical) unemployment
The most significant cause of disequilibrium unemployment is a fall in aggregate
demand for all goods and services and hence for labour (as labour is a derived
demand [where demand for one good or service occurs as a result of demand for
another]). This theory was first put forward by John Maynard Keynes in the 1930s
and contributed to the differences in opinion between classical and Keynesian theory.
A fall in the demand for all goods and services (i.e. a fall in aggregate demand) will
cause a fall in the demand for labour (usually the most expensive factor of
production). This is shown on the diagram below. AD1 shifts inwards to AD2.
Keynesians argue that labour markets do not work smoothly and will resist pay cuts.
Therefore the wage rate stays at the previous equilibrium level W1. Wages may
eventually fall but this is argued to be a slow process and so the labour market does
not clear resulting in demand deficient unemployment of ‘Q1-Q2’.
Wages are ‘sticky downwards’- they are not very flexible downwards as the existing
labour supply resists wage cuts. Such is the nature of labour that wages rise easily
but resist falling as workers are not passive commodities.
This is the type of unemployment that arises with a recessionary gap. Cyclical
unemployment extends across the whole economy, and across all industries. The term
‘cyclical’ refers to fluctuating economic growth that has been exhibited globally over the
last century. Fluctuating economic growth over time is known as the business cycle. Use
an AD/AS diagram to illustrate a recessionary gap below:
Price level (GDP
Price Deflator)
Output (RGDP)