Chapter 7
Unemployment
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.
2
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?
3
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
4
Flows Through the Labor Market
Figure 7.1
5
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.
6
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.
7
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.
8
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.
9
The New-Keynesian Model of
the Labor Market
10
Figure 7.2
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).
11
Turnover Cost and Efficiency Wage
•
We study a special case of a turnover cost
function:
C ( w / P, L )  c( w / P ) L
•
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.
12
Firm’s Problem

w
w
 Y  L  c  L
P
P
w
w
 F ( L)  L  c    L
P
P


w
1.
0  
P
w

 
P

2.
 0  L
L
13
Choosing the Efficiency Wage

w
 1  c '    0.
P
w

 
P

w
w
 1  c '     .
P
P
• Marginal cost (1) = Marginal benefit (c’(w/P) )
14
The New-Keynesian Model of the Firm
Panel A
15
Choosing a Stock of Workers



w
w 
 F '( L)     c      0.
 P  
L
P





w
w 
 F '( L)     c      L
 P  
P



• Marginal Product = Marginal Cost
16
The New-Keynesian Model of the Firm
Panel B
17
Demand and Supply in the NewKeynesian Model of the Labor Market
Figure 7.4
18
©2002 South-Western College Publishing
A Mathematical Example
• Production Function:
Y  L  (1/ 2)  L

D 2
D
• Per-worker turnover cost:
c( w / p)  1  2( w / P)  ( w / P)2
• Labor supply:
L  w/P
S

w / P


 1/ 2, U  1/ 4.
19
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 labormarket institutions is called structural
unemployment.
2. The second deals with the control of cyclical
unemployment as it fluctuates over the
business cycle. (Chapter 8)
20
Table 7.1
21
©2002 South-Western College Publishing
Unemployment and Economic Policy
•
Possible reason:
Low-skill labor and labor market rigidity.
•
Some economists have advocated reforms to
make labor markets more flexible.
22
Homework
Question 1, 8, 10, 11
23
END