CHAPTER 17

UNEMPLOYMENT

LECTURE OUTLINE

1 UNEMPLOYMENT

1.1 Definition and measurement of unemployment

1.2 The causes of unemployment
1.2.1 Cyclical/Demand-deficient unemployment
1.2.2 Structural/Mismatch unemployment
1.2.3 Frictional/Search unemployment
1.2.4 Seasonal unemployment
1.3 Full employment and the natural rate of unemployment
1.4 The effects of unemployment

References
John Sloman, Economics
William A. McEachern, Economics
Richard G. Lipsey and K. Alec Chrystal, Positive Economics
G. F. Stanlake and Susan Grant, Introductory Economics
Michael Parkin, Economics
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics

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1 UNEMPLOYMENT

1.1 Definition and measurement of unemployment

Unemployment is the state of the economy in which some workers are not employed in the
production of goods and services.

The unemployed are people who are able and willing to work but who are without work.

According to the International Labour Organisation (ILO), the unemployed are persons of
working age who are without work, are available to start work within two weeks and either
have actively looked for work in the last four weeks or are waiting to take up an
appointment.

In Singapore, the labour force comprises those who are 15 years of age and over
(working-age population), who are able and willing to work, and are either employed or
actively seeking employment. The labour force is also known as the economically active
population.

The difference between the working-age population and the labour force is the
economically inactive population which comprises those who are unable to work (e.g.
those who are physically or mentally handicapped and those who are in prisons) and those
who are able but unwilling to work (e.g. housewives, students, retirees).

The unemployment rate is the number unemployed expressed as a percentage of the labour
force.

The number unemployed

The unemployment rate  -------------------------------- × 100%
The labour force

The labour force participation rate is the labour force expressed as a percentage of the
working-age population.

The labour force

The labour force participation rate  ----------------------------------- × 100%
The working-age population

Note: In economics, workers refer to people who are able and willing to work. They may
or may not have a job.

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1.2 The causes of unemployment

1.2.1 Cyclical/Demand-deficient unemployment

Demand-deficient unemployment is due to a deficiency in aggregate demand and this

usually occurs due to a decrease in aggregate demand when the economy moves into a
recession. When aggregate demand falls, firms will decrease production and hence the
demand for labour. Since real wages are inflexible downwards, demand-deficient
unemployment will occur. Downward inflexibility in real wages are often the result of
trade unions trying to protect the standard of living of their members, firms refusing to
lower real wages to avoid reducing the efficiency of their workers, or the existence of wage
contracts.

In the above diagram, the initial equilibrium real wage rate is w0. A decrease in aggregate
demand and hence the demand for labour leads to a shift in the demand for labour curve
(DL) from DL0 to DL1. At the same real wage rate w0, the supply of labour exceeds the
demand for labour which results in demand-deficient unemployment. Demand-deficient
unemployment is the type of unemployment that the government is usually more
concerned about.

The solution to demand-deficient unemployment is an increase aggregate demand and

hence the demand for labour. However, as you will see later, demand-side policies have
their limitations.

1.2.2 Structural/Mismatch unemployment

Structural unemployment is due to a change in the structure of the economy. The structure
of the economy changes when some industries expand and some industries contract and
this could be due to technological advancements, changes in comparative advantage or

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changes in the pattern of demand. When this happens, the expanding industries will create
jobs and the contacting industries will lose jobs. However, as many of the workers who will
lose their jobs in the contracting industries do not have the relevant skills and knowledge to
find jobs in the expanding industries, structural unemployment will occur. Structural
unemployment always exists.

To reduce structural unemployment, the government can provide education and training
directly, by setting up educational institutes, or indirectly, by giving grants or tax
incentives to firms to induce them to send their workers for education and training.
However, due to the effort that has to be expended on the part of the structurally
unemployed workers who are mostly low-skilled, such measures may not decrease
structural unemployment significantly. If the cause of structural unemployment is the loss
of certain comparative advantages, subsidies and tariffs can be used to support declining
industries, so that they can phase out slowly. In this case, the workers in the declining
industries will have sufficient time to acquire the relevant skills and knowledge to find jobs
in other industries. However, these protectionist measures run counter to the objective of
free trade and they may provoke retaliation.

1.2.3 Frictional/Search unemployment

Frictional unemployment is due to lack of perfect information about the job market. Since
firms are not fully informed about the types of labour available and workers are not fully
informed about the types of job available, firms and workers need time to explore the job
market and this leads to frictional unemployment. Frictional unemployment always exists.

To reduce frictional unemployment, the government can increase expenditure on setting up

more job market intermediaries. However, if firms think they are better able to assess
prospective employees by themselves and hence reluctant to post their job vacancies in the
intermediaries’ job banks, having more job market intermediaries will not lead to a
significant fall in frictional unemployment. In addition to more job market intermediaries,
an increase in job fairs may also help reduce frictional unemployment.

1.2.4 Seasonal unemployment

Seasonal unemployment is due to the low demand for certain types of labour during certain
seasons of the year. For instance, some agricultural workers are unemployed during the
off-harvest-season and some construction workers and lifeguards are unemployed during
winter. Seasonal unemployment always exists. The solution to seasonal unemployment is
the same as the solution to structural unemployment. In reality, it is difficult to decrease
seasonal unemployment significantly because a large part of it is voluntary. However,
seasonal unemployment is usually insignificant and is hence rarely a matter of social
concern.

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1.3 Full employment and the natural rate of unemployment

Full employment is the state of the economy where there is no demand-deficient

unemployment. In other words, when there is full employment, there still exists some
unemployment which comprises structural unemployment, frictional unemployment and
seasonal unemployment, and the corresponding unemployment rate. Structural
unemployment, frictional unemployment and seasonal unemployment are collectively
known as natural unemployment. The natural rate of unemployment in Singapore is
estimated to be around 2 per cent. In the US, it is estimated to be around 5 per cent.

1.4 The effects of unemployment

The costs of unemployment

Economy
High unemployment will cause the economy to lose a large amount of output.

The unemployed
High unemployment will cause a large number of people to lose their income. Further, if
the unemployed remain unemployed for a long period of time, they may lose their skills
and knowledge.

The employed
When unemployment is high, the employed will lose some of their income in the form of a
pay cut.

Firms
High unemployment will cause firms to lose a large amount of profit.

The government
When unemployment is high, the government will lose a large amount of tax revenue.

Society
High unemployment will lead to a high crime rate, high divorce rate, high suicide rate and
social unrest.

The benefits of unemployment

If the people in the economy are willing to bear with some unemployment, inflation may be
kept at a moderate rate. By the same token, the cost of eliminating unemployment may be
an intolerably high inflation rate. The inverse relationship between inflation and
unemployment can be seen from the short-run Phillips curve.

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In the above diagram, when the unemployment rate is 0, the inflation rate is 0. At zero per
cent unemployment rate, the inflation rate is 1, which may be intolerably high.

The prospect of unemployment may reduce shirking.

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