Unemployment and the Labour Market

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[1]In order to evaluate whether an economy satisfies the provision of employment to all who seek it, a model for the labour market is developed. The model is developed largely from the view of those who demand labour, that is the employers (firms), in order to understand what influences the amount of labour in the economy.


Textbook Readings

Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011), pp. 72 - 98.


[2]In order to make the analysis simpler, the following simplifications or assumptions are taken:

  1. Firms are price takers- that is, firms cannot influence the price they receive for their product. They can respond to price changes but not control it.
  2. Workers are wage takers- that is, workers cannot affect the wages given to them for their work.

Wages and the Demand for Labour

Demand for labour as a function of real wages

[3]The first question to answer is, how much labour is a firm willing to hire at a specific wage rate? The answer is that a firm will continue hiring as long as its employees are producing at a rate that provides enough income to cover the wages. The problem though, is that additional employees do not always produce as much product as other employees. This is know as diminishing returns on labour, stating that if the amount of capital and other inputs is held constant, then the greater the quantity of labour already employed, the less productive each additional worker is. There are two reasons for this phenomenon:

  1. Principle of increasing opportunity cost: a manager hiring one employee would set the employee to do the most needed job. A second employee would be hired to do the second most important job and so forth. Each additional employee is hired to do the next most important job so that the value of the work decreases as the number of employees increases
  2. Time taken to add capital: managers hiring new employees will generally need to provide them with training, new machinery or tools or other capital. Since this process takes time, often employees have to share such capital and end up getting in each other's way, reducing productivity.

For this reason, it is concluded that the lower the wage employers have to pay, the larger the amount of employees they are willing to hire. Therefore the demand for labour is said to be an inverse function of wages. This works for nominal (dollar value of) wages but we are more interested in the real purchasing power of the wages, that is, the real wage. In general the real wage is calculated as:

Real Wage = Nominal Wage/Price Index = Nominal Wage/Inflation

Shifts in Demand for Labour

[4]Shifting the labour demand outward, to the right, happens when:

  1. The relative price of their product increases
  2. The productivity of employees increases

Supply of Labour

Supply of labour as a function of real wages

[5]The suppliers of labour are employees and it is intuitive to see that employees who cannot affect their wage, will be motivated by an increase in wages. Hence the supply for labour can be said to increase as the real wage increases, so that it is an upward sloping function of the real wage.

Shifts in the Supply of Labour

[6]In general, the supply of labour is affected by the size of the population available for work. This is affected by the minimum working age, immigration, emigration, mortality rates and the age of people leaving the workforce. It can be said that an increase in the number of people available for work shifts the supply for labour curve outwards, to the right.

Demand and Supply for Labour

Supply and Demand of labour as a function of real wages

[7]By putting the two curves together, it is possible to find the equilibrium position where a real wage is matched up to a number of employees that satisfy both the demand and the supply. If the real wage is above the equilibrium wage, then the demand for labour is relatively low (since firms are not willing to hire a lot of people at high wages) while the supply is relatively high (since more employees would want the high wages). In such a situation there is excess supply but according to the model, market forces will force the situation to be resolved. This will happen when firms will only hire a few people and those not hired would have an incentive to offer their work for lower wages, effectively pushing down the supply curve. As this happens, firms are willing to hire those people at the lower wages, also moving down the demand curve. As a result, firms will continue to hire until employees stop reducing their wages and equilibrium is achieved again.

Increasing Wage Inequality

[8]A theme to keep in mind when analysing the supply and demand curves is the fact that wage inequality has, and still is, increasing all around the world. Wage inequality refers to the tendency for individuals to receive different amount of wages depending on their skills (and location). Two main reasons for this are:

  1. [9]Globalisation: countries are able to trade with relative ease with each other so that each country does not have to produce all the goods it demands. As a result, different skills are required at higher demand depending on the country and depending on the supply, the wages offered differ highly. Related to this, is the ability of consumers to switch from buying from domestic producers to international producers (if the products are better, cheaper, or both). In this situation the demand for domestic products decreases, shifting the demand curve to the left and thus reducing the value of the domestic real wage. The revers happens to the international demand curve, where it shift to the right and increasing the real wages in other countries. As a result, wage inequality exists and due to the ability for major manufacturing countries to trade globally reduces the real wages of other countries.
  2. [10]Changes in Technology: due to technological changes, workers need to constantly keep updating their knowledge and skills. As a result, skilled labour is at much higher demand than unskilled labour, adding to the wage inequality.


[11]The rate of unemployment in the economy is a useful indicator of the conditions of the labour market. Low unemployment rates indicates that jobs are secure and relatively easy to find and that wages are increasing as firms compete to retain their employees.

Measuring Unemployment

[12]Measuring unemployment is relatively simple and there are two measures we use: the unemployment rate and the participation rate. Before defining how they are calculated, some useful categories of the population to note are:

  1. Employed- these are people fifteen years or older who have worked (even for an hour) in the past week or were on vacation/sick leave from regular work
  2. Unemployed- these are people who have not worked at all in the past week but have made an effort to find work
  3. Out of Labour Force- these are people who have not worked in the past week and have not looked for any. This category includes full time students, retirees, and people unabled to work due to disability.

The labour force is then defined as the total number of people who are employed and and unemployed.

The unemployment rate is simply given by the number of unemployed people divided by the labour force. The participation rate is given by the labour force divided by the total amount of people of working age (15-64 year olds).

Costs of Unemployment

[13]The obvious costs of unemployment are the loss in output since the economy is not utilised to its full potential. More specifically however, when unemployment rates are high, people who do not work often have to stop paying taxes and instead rely on government benefits in order to live. As a result taxes and the budget deficit are likely to increase. Other problems are psychological (such as depression and loss of self esteem) and social (such as increased crime, drug and alcohol use and domestic violence). The total sum of all of these issues can often lead to people completely opting out from trying to find work, effectively decreasing the participation rate.

Types of Unemployment

[14]To understand why unemployment occurs so that it can be dealt with, economists have found that there are three broad types of unemployment. Each of these types bears its own costs and has its own solution. The three categories are:

  1. Frictional- unemployment due to people trying to find (new) jobs. These include school/university leavers or workers who have decided to leave a firm for various reasons
  2. Structural- unemployment due to people not having the right skills for the labour demanded
  3. Cyclical- unemployment due to the natural business cycle

Notice that the first two categories are likely to occur regardless of the state of the economy whereas the third is directly related to how well the economy is performing. For this reason, the first two categories put together are sometimes referred to as the natural rate of unemployment.

The costs of frictional unemployment are usually very minimal as it is temporary so that the psychological and economic effect aren't always felt. In another sense, it may even be seen as beneficial since it encourages people to find a job that really matches their personalities or skills and in the long run be more effective workers. By contrast, structural unemployment causes much higher costs as those unemployed do very little useful work for long periods of time and their skills usually decline with time since they aren't being used. Furthermore, it can cause psychological problems that then lead to heavier social issues as mentioned above. In contrast again, cyclical unemployment is generally short lived but is tied to recessions in the economy (and hence reductions in GDP) and hence is associated with many costs.

Impediments to Full Employment

[15]So far, the supply and demand for labour model seems useful in explaining trends in the labour market. However in reality, many factors contribute to the market being away from equilibrium. Some of these factors are:

  1. Minimum wage laws: by imposing a minimum wage, the supply of labour increases while the demand decreases, shifting away from equilibrium and causing unemployment equal to the difference between the amount supplied and amount demanded. The reason these laws are used is that with minimum wage laws, those are paid better than without the laws and generally it benefits more people than harms them.
  2. Labour unions cause similar affects as minimum wage laws as unions negotiate for higher wages and better working conditions. The higher wages are often accompanied by firms letting off people to afford the new wages, causing unemployment.
  3. Unemployment benefits maintain the unemployed able to support themselves but may also cause complacency and lengthen the unemployment period for some workers as they look for work less intensively.
  4. Government regulations such as health and safety standards and anti discrimination laws affect the labour market as well. Many of them are beneficial but many cause employers to increase their costs, thus lowering their demand for labour.


"Textbook" refers to Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011).

  1. Textbook p.72
  2. Textbook p. 72
  3. Textbook p.72
  4. Textbook p.76
  5. Textbook p.79
  6. Textbook p.80
  7. Textbook p.80
  8. Textbook p.82
  9. Textbook p. 85
  10. Textbook p.87
  11. Textbook p. 90
  12. Textbook p.90
  13. Textbook p. 92
  14. Textbook p. 92
  15. Textbook p. 94
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