Causes of Unemployment

There are 4 headings for the different forms of unemployment; frictional, cyclical (demand deficient), real wage and structural.

Real wage (aka classical) unemployment occurs when demand and supply aren’t equal. Therefore it is a disequilibria issue. This can occur if the wages demanded by the labour force are higher than the amount that industry is willing to pay. Hence classical unemployment can occur through government intervention (by establishing minimum prices; in the UK the national minimum wage is an example of a policy which can lead to classical unemployment), trade unions bargaining for higher wages or reserve wages (a limit set by employees as to how much they wish to earn to accept a job offer). If workers refuse employment because they aren’t offered their reserve wage then they are voluntarily unemployed.

Cyclical unemployment occurs because labour is a derived demand, if there is a deficiency in aggregate demand then the derived demand for the production of goods and services will fall, leading firms to make redundancies. Labour is a lagging economic indicator because during cyclical unemployment firms won’t immediately reduce their work force in spite of a fall in demand. This is because they don’t know how long the downturn will last and it is costly to fire a workforce, to simply rehire one and have to train the up a few weeks later (if that is the case), therefore managers hold on to their trained and experienced workers until they are sure that demand is going to be suppressed for a great period of time. Some firms may even decide to keep on their workforce during a period of time of suppressed demand if they can afford to do so and the workforce is suitable trained and experienced to make themselves vital for the firm. 

Seasonal unemployment could also come under this heading; it occurs when workers are only required during certain periods of the year/business cycle, for example retail workers may be required during the busy trading period of Christmas, or some farmers may only be needed during harvest to help collect the produce.

Frictional unemployment always occurs and happens when workers leave a job, and are technically unemployed, whilst they search for another job. They may decide to leave for personal reasons, or because they want to find a better job with higher pay/perks, or it may be because they have been laid off, also new workers entering the labour force are considered frictionally unemployed whilst they come to terms with the labour market. Imperfect information can increase frictional unemployment if unemployed members of the labour force are unaware of the existence of jobs.

Structural unemployment can occur due to capital-labour substitution (workers are replaced by machines, hence they are no longer needed) or due to a long run (permanent) decline in demand in the sector in which they work. This can be a problem of occupational and geographical immobility; workers may not be in the place where the jobs are, or may not have the skills and training to do the required work.

Hysteresis is the theory that a period of high unemployment (usually caused by demand deficiency) can lead to an increase in the value of NAIRU. That is high unemployment now can cause high unemployment in the future. The reason for this is that unemployment has long term effects (as well as the short term effect of not having an income other than unemployment benefits) in that workers forget their skills and as they aren’t practising them they may deteriorate or at least not improve at the rate they would have done had they been in employment. Furthermore some people may become so disillusioned with the labour market that they leave it completely and remain unemployed perpetually.

Additionally hysteresis can also occur because after a negative shock, there are fewer workers who may decide to collectively bargain (in the form of a union) for higher wages. These higher wages will then keep out new workers in the future as the firm has less money to spend on new workers.

Relationships between unemployment, economic growth

Okuns Law

Okuns law is the relationship between losses in an economies productivity and unemployment. It is considered a rule of thumb, for every 1% fall in a countries unemployment rate, GDP will be operating at 2% below potential GDP.

An empirical study has shown that unemployment is largely inversely related to the rise in GDP growth (economic growth) as shown in the graph below.

Okuns law can be used to tell us how much output (GDP) can be lost when unemployment is above its natural rate. Output is related to unemployment because the labour force is a function of output.

To keep unemployment at a steady rate GDP needs to grow at the rate that productive capacity is growing. So if the PPF curve is shifting rightwards due to an improvement in the quality or quantity of a factor of production (normally increases in productivity are a factor causing an outward shift of the PPF curve), then GDP has to increase at the same rate in order to keep unemployment steady (note however that even if GDP is below this, jobs may still be created, but it also implies that the labour force is increasing at a faster rate and hence unemployment will persist). Therefore to reduce unemployment, GDP is needed to grow at a faster rate than the potential growth (if it utilised all available factors of production) of an economy. 

Jobless growth occurs when there is economic growth but employment levels continue to fall or at least remain constant. Proposed reasons are increased productivity – this can lead to higher output without the need to increase employment – and automation, leading to growth without the need for increased employment.

Under employment occurs when workers are employed only part time. Statistically they show up as employed, however they may not be working as many hours as they wish because they cannot find employment to do so.

Economic myopia occurs when firms under invest in capital and labour because they have a poor (or unfounded) estimation of long run demand in the economy. In order words they have a short-sighted take on investment based on investment now.

Page last updated on 15/04/14