Given that we must earn income to be able to acquire both life’s necessities and its luxuries, being unemployed is among the worst economic events that can befall us. It is also why the “unemployment rate” is among the most closely watched of economic variables. In many ways, the unemployment rate is a pretty good signal about the overall health of an economy, both over time and in comparison to other economies. As we shall see, some amount of unemployment is inevitable in a healthy, growing economy, but misguided government policies can cause additional unemployment, harming the citizenry in the process.
When economists talk about “unemployment,” we are using a specific definition: people who are looking for work but cannot find it. The wife or husband who stays home to raise children, the college student, and the retiree are not unemployed; they are “out of the labor force.” The “unemployment rate” is the number of people looking for work but not obtaining it divided by the total number of people either working or looking for work.
How exactly do firms decide whether to employ someone? The basic question is: will the additional revenue that this person brings to my firm be greater than the wage I will have to pay? For example, if Big Macs sell for $2 and by hiring me to help make them, McDonald’s can sell 5 more every hour, clearly they would not want to pay me more than $10 per hour, as they would lose money doing so. They could increase their profits by paying me less, but if they pay me too much less, their competition could benefit by hiring me away at a higher wage but one that was still less than the addition to revenue I was providing. In theory, my wage should get driven pretty close to $10 per hour under these conditions.
This point matters for understanding unemployment because it suggests that any worker who can produce additional value for a firm is employable at some wage. Even the teenager with few skills who produces only 2 Big Macs per hour should be employable at a wage just under $4 per hour. If so, the interesting question then is why any worker who can add to revenue is ever unemployed.
Unemployment can take place for a variety of reasons. Given that market economies are processes of dynamic change where some firms go in and out of business on a constant basis, where successful firms learn to require less labor to be productive (think about self-service gas stations or ATMs), and where the type of labor required changes over time, there will always be some unemployment. These forms of unemployment, usually called “frictional” and “structural,” imply that any given snapshot of the economy will always include some people who are between jobs or retraining for a new job. The unemployment rate that corresponds to this level of unemployment is often called the “natural rate of unemployment.”
Unemployment can be higher, however, due to misguided policies. The most common sort are those that try to boost wages above the level that corresponds to workers’ productivity. Living wage and minimum wage laws, as well as union-mandated wages that are set above the level that matches the average productivity of the relevant group of workers, will cause unemployment. If I am the teenager who can only produce $4 per hour of value, a minimum wage of $7 per hour means I will go unemployed. Minimum/living wage laws are really minimum productivity laws that cause unemployment among those people whose productivity is less than the lowest wage the law allows.
Other sorts of labor market policies can cause avoidable unemployment, or even cause the natural rate to be unnecessarily high. For example, many Western European countries have more highly regulated labor markets that make it difficult to fire unproductive workers, which in turn leads firms to want to take fewer chances hiring questionable workers. Where governments mandate that firms provide all kinds of non-wage benefits (e.g., health care, child care and the like), it becomes more expensive to hire workers and unemployment rates are higher. The freer labor markets in the United States are one explanation for its consistently lower rate of unemployment compared to other developed economies.
Finally, although unemployment is a real problem, some apparently obvious solutions are not really cures at all. Government public works programs frequently pay workers to do unproductive things and reduce employment in the private sector through the higher taxes or interest rates that pay for the programs. As noted above, making it harder to fire workers won’t work either as it only makes firms want to hire less labor in the first place. In general, allowing markets to proceed unhampered is the best way to keep the unemployment rate as low as is feasible in a dynamic, growing economy.
Courtenay email -
Welcome to this month's edition of Ask the Professor. We are pleased to once again have with us Steven Horwitz, Charles A. Dana Professor of Economics at St. Lawrence University in Canton, New York. Please remember to regularly refresh your browser throughout the discussion to see the latest comments.
Hannes Edinger email - thebottomupblog.blogspot.com
Dr. Horowitz,
Your description of unemployment elucidates the broad discussion very nicely, but I think emphasis on some parts of this topic would go a long way on focusing the debate.
The "cheeseburger" example is nice in the sense that is clearly illustrates the theory, but I think it confuses the discussion. As people concerned with the future growth of the economies in which we live, encouraging this debate to focus on the lower margin of the "productive yet unemployed" distracts from the more serious problems. For example, the structural intervention in the labor market that removes highly productive people from the private sector and moves them into marginally (if at all) productive positions in the public sector. This is a more nuanced issue, but I feel the structural impositions affecting highly productive people deserves much more attention that those on the lowest margins of productivity.
I am currently living in Italy, and the structural limitations of the formal economy stare at you at every street corner where recent immigrants peddle wares to the formally employed. In traditional unemployment counts these people would fall under the "unemployed" category even while the informal value they produce (there is always an umbrella for sale when it starts to rain!) is real, even if it doesn't enter the GDP counts.
in sum, why do economists spend so much time fighting to formalize the lower margins of "productive, yet structurally unemployed" when they exist in a grey area where they likely still provide value in the (informal) economy (cutting grass or selling umbrellas in Italy) when the real losses to productivity in our economy come from interventions that allocate highly productive people to positions where they are unable to create value?
Dr. Steven Horwitz writes:
This is a great question Hannes.
I think part of the answer is that in the US (though Canada may be more like Europe on this issue), we don't have as much of the problem with higher-skilled workers being stuck in
Steven Horwitz email -
Dr Steven Horwitz writes:
This is a great question Hannes.
I think part of the answer is that in the US (though Canada may be more like Europe on this issue), we don't have as much of the problem with higher-skilled workers being stuck in jobs that don't produce value - or leaving the country to find work that will produce more value. There's no real "brain drain" in the US. Our biggest employment problem is at the lower end of the skill spectrum. I think you are quite right that in other parts of the world, the bigger problem is the "misallocation" of highly-skilled workers to the "wrong" sorts of jobs. This not only undermines economic growth but also the earning power of the workers.
So yes, economists probably should pay more attention to those issues and I wonder whether economists in Europe actually do so. US economists, given the different focal problem here, tend not to.
Shari email -
Is there any significant correlation between unemployment rates and market wages? I would expect that higher rates of unemployment would correlate with lower market wages if we consider supply and demand is this scenario. What do you think?
Dr. Steven Horwitz writes:
There's no relationship IF market wages are free to move to adjust to changing supply and demand conditions. In an unhampered labor market, wages rise and fall as supply and demand conditions change. Barring any intervention, the quantity supplied and demanded of labor will be equal at the market-clearing wage, which implies no unemployment.
If the government passes a minimum wage law and tries to bump wages up above where supply and demand would take them, THEN you can get higher wages associated with higher unemployment, as the minimum wage prices lower-skilled workers out of the market. Remember, a minimum wage law is also a minimum productivity law: to be hired, you need to be productive enough to justify the minimum wage. That's the one clear link between higher (mandated) wages and higher unemployment.
Why would you think that unemployment would be correlated with lower wages?
Annie email -
I know that minimum wages can be harmful to labour markets, but what about ensuring that everyone makes a “living wage”? Can we really just abandon those who aren’t productive enough to make a living wage?
Dr. Steven Horwitz writes:
The so-called "living wage" is no different from minimum wage laws. The effects are the same. The reality is that such laws cannot ensure that every one actually gets *a job* at such a wage. The result would be to encourage firms to use more capital and less labor, for example, leading to more unemployment.
How do we define a "living wage?" Is it the same in Vancouver as in New York City as in my small rural town in NY state?
It's also the case that only about 1/4 of people who earn the current minimum wage are the primary earners in their households. Most min wage employees are secondary earners (like spouses working part-time) or tertiary (teenagers working part-time). The real cure for those "not productive enough" is to help them become more productive through education and training. (This is the subject of next month's "Ask the Professor" by the way!) You can't repeal the laws of supply and demand unless you want an economy where the government decides who employs whom. We know how poorly that works!
The way to help those who have little earning power is to improve their education and training. Trying to force firms to pay them more won't do the trick.
Shari email -
I assumed that if more people are unemployed then the demand for human resources would be low, and thus people would be willing to work for less money just be employed at all. But it seems that you do not equate a high level of unemployment with a low demand for human resources.
Dr Steven Horwitz writes:
Right. Remember that "unemployed" means "looking for work and cannot find it." The reason they can't find it could be because firms aren't hiring, but it also could be because they are asking too high of a wage. It can be a demand or a supply problem. It's true that unemployed people might be willing to take a job at a lower wage, but the point is that the very reason they ARE unemployed is because their wage demands/expectations were too high! Unemployment doesn't necessarily "cause" lower wages, but lower wages can be a cure for temporary unemployment.
So yes, unemployment can push down market wages in the short run, but that pushes back the question of why the unemployment was there in the first place - or what was causing the wage to be too high.
Does that help Shari?
Econ Sean email -
I can see how an unproductive worker could become more productive and thus employable by receiving additional training or schooling, but shouldn’t we then be trying to keep tuition costs down by imposing a tuition freeze so that more people can afford to update their skill sets? But then doesn’t that just put us back at square one by implementing mandated pricing? How can this be overcome?
Dr. Steven Horwtiz writes:
Always good when you can see the flaws in your own argument! I don't want to head off into an extended discussion of the economics of higher education (esp. because I don't know a lot about the Canadian system). Keep in mind that we don't even need to be talking about a college education here. For most "unproductive" workers who congenitally can't find employment, the problems are more basic than that. What we really need is pre-college school system that ensures as high quality education as possible for everyone.
Increased competition in elementary and secondary education would help a lot, as public school systems tend to fall victim to the same problems as all monopolies do. Even if one thinks that *paying* for K-12 or K-13 education should be government's job, that doesn't mean you need government run schools to do it..
This is also why it's important to have a society in which the accumulation of wealth is not penalized: often times it is the wealthiest folks who provide the resources to keep the "consumer" costs of education low (think scholarships and buildings etc).
Courtenay email -
Very interesting chat so far, everyone. We only have 15 minutes remaining, so if you have any more questions or would like to respond to one of Professor Horwitz's answers, please do so now.
Unions good or bad? email -
Can you explain some of the ways that labour unions interfere with “free market” employment? Is there any place for unions within unregulated labour markets or will the market find them job security in other ways?
Dr. Steven Horwitz writes:
Great question! Let's do the "bad" first. The whole point of unions is to force wages up from where the market would clear. That's why they came into existence: to give workers joint power to try to push wages above the market clearing level. In most countries, unions can do this with various government protections. For example, firms can't fire workers who join unions and they must negotiate with a properly constituted union. Thus, in this respect, the effects of unions aren't any different from minimum wage laws: they force up wages, reducing the number of workers hired. Unions then use the dues to provide benefits for the members without jobs. The bottom line is that unions with the power of government behind them cause all kinds of problems.
However, unions do many good things too. They provide a way for employees to communicate, to present concerns to management, to band together to provide benefits for one another etc.. Firms could decide that they want to bargain collectively with the union for a variety of reasons. The key, though, is that unions have no special government powers backing them. In a free labor market, we might well see unions and they might well do a number of good things for workers. It's when they are protected in the negotiation process by gov't-granted privileges that the problems start.
Jason Kneely email -
What types of government policies result in greater unemployment levels? Does the Canadian government practice any of these?
Dr. Steven Horwitz writes:
Well minimum wage laws and the union protections we've been talking about are two of the biggies. And yes, the Canadian government practices both, as do almost all governments. Other policies include overly generous unemployment benefits, which discourage people from looking for new work as intensely as they might otherwise, and laws that mandate that firms provide certain non-monetary benefits (like health insurance in the US, or parental leave elsewhere), which have the same effects, though smaller, as minimum wage laws. Inflationary monetary policy can cause unemployment as well.
Think of it this way: anything that makes it more expensive than necessary to hire a worker will decrease the number of workers being hired. That includes, by the way, making it more difficult to *fire* a worker. Such laws cause unemployment by discouraging firms from hiring workers if they can't fire them reasonably easy.
Courtenay email -
A big Thank You to Professor Horwitz for joining us today. This concludes our discussion on unemployment. Thanks for your participation in this month's chat. Please join us next time on Friday, October 31st at 11:00am Pacific when we will discuss human capital.
