Topic 7.2 Unemployment - Causes. Professor H.J. Schuetze Economics 371. Why is there longer term unemployment?

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1 Topic 7.2 Unemployment - Causes Professor H.J. Schuetze Economics 371 Why is there longer term unemployment? We have shown that a certain amount of frictional unemployment will exist We have not offered any explanations for longer-term unemployment Let s work through some explanations that have been proposed It s important to note that no one explanation is widely accepted Professor Schuetze - Econ

2 1. Intertemporal Substitution Hypothesis Suggests that some portion of cyclical unemployment may be voluntary Basicideaisthatrealwagesriseduring idea is rise during economic expansion and fall when the economy contracts (procyclical) This means leisure is relatively cheap during recessions -- workers consume more leisure Leisure is more expensive during expansions -- workers choose to work more Professor Schuetze - Econ Problems No strong correlation between real wages and the business cycle Wages tend to be sticky at the individual level Unlikely that unemployed workers during recessions are voluntarily unemployed Labour supply curves tend to be inelastic Professor Schuetze - Econ

3 2. Sectoral Shifts Hypothesis Helps to explain structural unemployment Shifts in demand do not affect all sectors of the economy equally At any point in time some sectors of the economy are growing while others are in decline e.g. e-business and service sectors growing while manufacturing is declining In this example, structural unemployment is created if the skills of the laid off manufacturing workers can t be easily transferred to the computer sector This is likely the case Professor Schuetze - Econ Sectoral Shifts Hypothesis Continued Can test this empirically by looking at the relationship between aggregate unemployment and the dispersion of growth rates across industries The evidence suggests that there is a positive correlation between the two Estimates suggest this accounts for about 25 to 40 percent of unemployment Professor Schuetze - Econ

4 3. Efficiency Wages With shirking (high costs of monitoring) the firm might be willing to offer higher wages to encourage workers not to shirk The wage/employment combination the firm is willing to offer depends on the unemployment rate (shirking cost) High Unemployment (costly for workers to shirk) Firm can attract non-shirking employees with a small premium Low Unemployment (low costs to shirking) Firm must pay high wage to encourage non shirking Professor Schuetze - Econ Equilibrium The equilibrium is given by the intersection of demand and the no-shirking supply curve Wage NS S The main result is that t there is unemployment even in equilibrium (E-E NS ) W NS W* D E NS E Employment The unemployment experienced is involuntary because these workers are willing to work at the current wage Firms will not hire these workers because 0 unemployment encourages shirking Professor Schuetze - Econ

5 4. Implicit Contracts Labour contracts often specify wages and the number of hours of work given aggregate economic conditions Implicit because often unwritten and unspoken Could be: fixed employment contract - person works the same number of hours per year regardless of economic conditions fixed wage contract - the worker receives the same hourly wage regardless Anything in between Professor Schuetze - Econ Implicit Contracts Helps to explain rigid wages and why firms tend to adjust using layoffs instead of wages The typical implicit contract is a fixed wage contract (incomes are relatively stable) Reflects risk-sharing between the employee and the employer Workers are more risk averse than firms Perhaps because workers wealth is in human capital which can not be diversified Thus, workers prefer arrangements where they receive a lower average wage with more certainty The firm likes such contracts because average costs are lower (albeit more variable) Professor Schuetze - Econ

6 Implicit Contracts Thus, the firm provides insurance Why is insurance not provided privately? 1. Moral Hazard -- Insurance may affect the workers behaviour such that the likelihood of unemployment increases Don t care if you lose your job (act up at work) Search longer for a better job when unemployed May not be profitable to sell insurance 2. Adverse Selection -- Insurer doesn t observe the likelihood of unemployment for a particular worker High risk individuals will be the ones who purchase insurance May not be profitable Professor Schuetze - Econ Example Wage W a Suppose workers utility is a function of the wage only u(w) i.e. hours are fixed if working There are N 0 workers who sign a contract in period 1 There is uncertainty about the product market such that there are two states, each occurring with equal probability : good (P a ) and bad (P b ) Let s start with the market clearing case for comparison S An unemployed worker receives utility u(k) k=value of leisure time W b = k D a =MP N X P a D b =MP N X P b N b N 0 Employment (N) Professor Schuetze - Econ

7 Example In the good state wages rise to w a and all workers in the firm s labour pool are hired (N 0 ) In the bad state wages fall to the reservation wage (k) and employment falls to N b There is no involuntary unemployment We know the outcome is efficient However, if the firm is risk neutral and workers are risk averse there are potentially Pareto improving contracts that involve risk sharing Pareto optimal contracts involve 1. Real wages independent of product demand 2. Layoffs in the bad state that are less than those under market clearing Professor Schuetze - Econ Example Wage W a w W* k S D a =MP N X P a D b =MP N X P b w = expected wage with market clearing = ½ w a + ½ k W* is the contract t wage N b * is the number of workers hired in the bad state under the contract N b N * b N 0 Employment (N) Workers are better off Expected income is lower but income is more certain Constant wage and lower risk of being laid off The firm may be better off W* is lower than the expected wage profits are higher Employing more workers in bad state lower profits Professor Schuetze - Econ

8 Implications As long as the savings are high enough in the good state the firm is better off Notice that the workers income is not fully stabilized still risk of layoff To employ all N 0 workers in the bad state w* would have to be below k (too costly) The optimal contract represents a tradeoff between risk-sharing and production efficiency With a fixed wage the firm will respond to poor market conditions by laying workers off By entering into such a contract workers that are laid off are, in some sense, voluntarily unemployed Professor Schuetze - Econ Implications Even though they would prefer to be working at the going wage once laid off Suggests that employment will fall during recessions and rise during expansions Weakness is that the model suggests that unemployment with such wage contracts will be less than if wages were allowed to adjust However, models that allow for asymmetric information (which is likely) give unemployment that is greater than under market clearing Professor Schuetze - Econ

9 Insider-Outsider Model Wage setting is determined through bargaining with insiders existing work force The outsiders unemployed have little influence on the outcome Requires costs to the firm in order to replace existing workers E.g. turnover costs or firm-specific training These costs give the insiders bargaining power Thus, the insiders are able to set wages above the market clearing level Unless wages fall enough in the other sectors of the economy unemployment will result Professor Schuetze - Econ Canada s Unemployment Insurance System Why do we have UI? 1. Absence of privately provided insurance Risk of unemployment is exacerbated by the fact that workers can t diversify human capital Moral Hazard and Adverse Selection likely prevent private insurance 2. Provide income during unemployment for optimal search Positive externalities likely l arise from getting employee-employer match right 3. An alternative to other forms of social assistance Emphasis on re-employment Professor Schuetze - Econ

10 Canada s Unemployment Insurance System The UI system in Canada was established in 1940 but has undergone a number of changes since Financed through premiums collected from employers and employees Coverage is compulsory for most workers : Major changes occurred Coverage was expanded The benefit rate was increased Minimum period of employment required was reduced Maximum benefit period was expanded Extended benefits introduced for regions with high unemployment Professor Schuetze - Econ Recent Changes to UI Both in and again between the overall generosity of UI was reduced 1996: Primarily in response to increasing Government debt major changes occurred UI was renamed Employment Insurance (EI) Qualification was based on hours worked as opposed to weeks worked Hours needed depends on local unemployment rate (requires as little as 420 hours) intensity rule introduced reducing the replacement rate for repeat users Became more means tested family income 2000: intensity rule dropped, claw back rate reduced Professor Schuetze - Econ

11 Labour Market Impacts of UI These changes provide a useful environment to test unemployment theories Incidence and Duration Likely impact depends on whether the individual is employed, unemployed and eligible, or ineligible If employed, increasing the benefit rate makes unemployed search more attractive Expect incidence of unemployment to rise Evidence supports this If unemployed and eligible, increasing the benefit rate reduces the marginal cost of search Average duration of search will rise General results are consistent with this Professor Schuetze - Econ Labour Market Impacts of UI Researchers also find a spike in the probability of leaving UI when benefits are exhausted If unemployed and ineligible, changes in the benefit rate may also affect search behaviour Lowers the marginal benefit of search for these workers It might make sense to accept the first job that comes along in order to qualify for UI Layoffs UI raises workers reservation wages According to Implicit Contract Theory this increases the probability that a layoff will occur Illustrated as an upward shift in the supply curve Professor Schuetze - Econ

12 Labour Market Impacts of UI In addition, firms that experience fluctuations in demand may incorporate the EI system into compensation Seasonal employers can lower compensating wage and coordinate length of employment to EI parameters Results in higher employment fluctuation Labour Supply We have previously examined the impact of EI on labour supply using the Income-Leisure model Results suggest increased generosity will reduce weeks worked by those who qualify and increase weeks worked by those who do not Professor Schuetze - Econ Labour Market Impacts of UI Thus, the effect on total employment is ambiguous However, labour force participation and unemployment will unambiguously rise A number of studies have tested these results with somewhat mixed results Interregional Mobility Regional extended benefits likely reduce interregional mobility Provide benefits for a longer period of time in regions with high unemployment A number of studies find evidence of this Professor Schuetze - Econ