Why unemployment exists
The four reasons Mankiw gives for an economy's natural rate of unemployment: job search, minimum wages, unions and efficiency wages.
FinanceA company's marketAbout 6 min: 3 reading, 3 practiceUpdated
General education, not financial advice.
- Tell frictional from structural unemployment
- Explain how job search and unemployment insurance affect unemployment
- Explain why minimum wages, unions and efficiency wages can hold wages above equilibrium
Builds toward: Judge a company. Read a company's accounts, apply Graham's tests, and make a rough valuation.
A company's market: pricing power, taxes and trade: lesson 15 of 15
- A company's market
- Price elasticity of demand 6 min
- Elasticity and total revenue 5 min
- Consumer and producer surplus 4 min
- Market efficiency 5 min
- Price ceilings and floors 6 min
- Who really pays a tax 5 min
- Deadweight loss 5 min
- How tax size changes the loss 5 min
- Absolute and comparative advantage 5 min
- Why trade helps both sides 5 min
- Winners and losers from trade 5 min
- Tariffs and quotas 5 min
- What makes productivity grow 5 min
- Growth policy 5 min
- Why unemployment exists 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 15
What it is
Mankiw gives four explanations for why there is always some unemployment. They fall into two kinds.
Frictional unemployment comes from the time it takes to match workers with suitable jobs. It usually explains short spells.
Structural unemployment arises when there are too few jobs for everyone who wants one, because the wage is held above the level that balances supply and demand. It usually explains longer spells.
1. Job search (frictional). Workers differ in skills and tastes, jobs differ, and information spreads slowly, so finding a good match takes time. As the economy changes, with some industries growing and others shrinking, some job search is inevitable. Policies can affect it:
- Job-matching help (for example, employment services and training) can shorten searches.
- Unemployment insurance protects people's incomes after job loss, but it also reduces the urgency of finding work, so it tends to raise frictional unemployment. Mankiw notes that this doesn't make it bad policy: it reduces hardship and may help people find jobs that suit them better.
Quick check
Tap an answer to check it.
A graduate spends three months finding the right first job. What kind of unemployment is this?
- Structural unemployment comes from wages held above equilibrium
Show answer
Frictional. It is the time taken to match a worker with a suitable job.
Why it matters
The other three explanations are reasons the wage may stay above equilibrium, so the quantity of labour supplied exceeds the quantity demanded:
2. Minimum-wage laws. A binding minimum wage creates a surplus of labour. Mankiw notes that it is not the main cause of unemployment overall, since most workers earn well above it, but it matters for the least skilled and least experienced, such as teenagers.
3. Unions. A union bargains collectively with employers over pay and conditions; the threat of a strike gives it power. Union wages are above what non-union workers earn, so union members (insiders) gain while others (outsiders) may find fewer jobs. Mankiw reports that only about 12% of US workers belonged to unions, against about a third in the 1940s and 1950s, and that unions remain stronger in many European countries. Economists disagree on whether unions are good for the economy: critics see them as a cartel that raises wages and causes unemployment; supporters say they balance the power of large employers and help firms respond to workers' concerns.
4. Efficiency wages. Firms may choose to pay above the market wage because it makes workers more productive. Mankiw describes four versions:
- Health: better-paid workers eat better and are more productive (most relevant in poor countries).
- Turnover: higher pay makes workers less likely to quit, saving hiring and training costs.
- Quality: higher pay attracts better applicants.
- Effort: workers who would lose a well-paid job are less likely to shirk.
His example: in 1914 Henry Ford introduced a 5-dollar working day, about twice the going wage. Long queues of job-seekers formed, and turnover and absenteeism fell. Mankiw reports that productivity rose so much that Ford's costs fell even with the higher wage.
Worked example
A labour market (thousands of workers, made up):
| Wage | Supplied | Demanded |
|---|---|---|
| 8 | 400 | 500 |
| 10 | 450 | 450 |
| 12 | 500 | 400 |
| 14 | 550 | 350 |
- Equilibrium wage: 10, with 450 employed and no structural unemployment.
- If unions, a minimum wage or efficiency-wage policies hold the wage at 12: 500 want work, 400 are hired, so 100 are structurally unemployed.
- At 14: 550 want work, 350 are hired: 200 unemployed.
Common mistake
Treating all unemployment as a sign that something is broken. Some frictional unemployment comes from a healthy, changing economy, as people move between jobs and industries. Structural unemployment, by contrast, means there aren't enough jobs at the going wage.
Key terms
- frictional unemployment
- unemployment from the time workers take to find jobs that suit them
- structural unemployment
- unemployment because there are fewer jobs than workers at the going wage
- job search
- the process of matching workers with appropriate jobs
- unemployment insurance
- a government programme that partly protects workers' incomes when they lose their jobs
- union
- a worker association that bargains with employers over wages, benefits and working conditions
- collective bargaining
- the process by which unions and firms agree the terms of employment
- strike
- the organised withdrawal of labour by a union
- efficiency wages
- above-equilibrium wages paid by firms to raise worker productivity
Practise the key terms
Tap a card to turn it over. 8 cards.
| Front | Back |
|---|---|
| frictional unemployment | unemployment from the time workers take to find jobs that suit them |
| structural unemployment | unemployment because there are fewer jobs than workers at the going wage |
| job search | the process of matching workers with appropriate jobs |
| unemployment insurance | a government programme that partly protects workers' incomes when they lose their jobs |
| union | a worker association that bargains with employers over wages, benefits and working conditions |
| collective bargaining | the process by which unions and firms agree the terms of employment |
| strike | the organised withdrawal of labour by a union |
| efficiency wages | above-equilibrium wages paid by firms to raise worker productivity |
Practice
Work it through
Using the worked example's table, a minimum wage of 14 is introduced.
- From the table
- From the table
- 550 − 350
- 450 − 350
Sort it
Which group does this belong to?
A worker leaves a shrinking industry and searches for a new job
Matching takes timeShow answer
Frictional. Matching takes time
A union wage above equilibrium leaves outsiders without jobs
Too few jobs at the going wageShow answer
Structural. Too few jobs at the going wage
A firm pays above market to cut quit rates, so fewer are hired
An efficiency wageShow answer
Structural. An efficiency wage
A recent graduate searches for a suitable first job
Job searchShow answer
Frictional. Job search
Quick quiz
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Which efficiency-wage theory fits Henry Ford's 5-dollar day best, from the effects Mankiw describes?
- Mankiw says the health version matters most in poor countries
Show answer
Turnover (and effort): turnover and absenteeism fell, and productivity rose. Ford's workers stayed longer and turned up more reliably.
How can unemployment insurance raise unemployment?
- It is a separate policy
Show answer
It makes job search less urgent, so the unemployed take longer to accept a job. It reduces the cost of being unemployed; Mankiw notes it also reduces hardship.
Why does Mankiw say the minimum wage is not the main cause of unemployment overall?
- Where it binds, it does
Show answer
Most workers earn well above it, so it binds only for some groups, such as teenagers. It matters for the least skilled and least experienced.
In short
- Frictional unemployment: the time it takes to match workers and jobs; unemployment insurance can lengthen it.
- Structural unemployment: wages held above equilibrium by minimum wages, unions or efficiency wages.
- Efficiency wages: health, turnover, quality and effort; Ford's 5-dollar day.
- Economists disagree on whether unions help or harm the economy.
Mastery check
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Check yourself
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Name Mankiw's four explanations for the natural rate of unemployment.
Show answer
Job search, minimum-wage laws, unions and efficiency wages.
What is the difference between frictional and structural unemployment?
Show answer
Frictional comes from the time it takes to find a suitable job; structural from there being too few jobs at the going wage.
Why would a firm choose to pay more than the market wage?
Show answer
To raise productivity: healthier, more loyal, higher-quality or harder-working staff (efficiency wages).
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 15.
- On this site: Measuring unemployment and Price ceilings and floors.
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