Introduction to Macroeconomics

Chapter 6. Unemployment and the Labor Market


  1. Employment - Unemployment
    1. Measurement
      1. Employment Surveys
      2. Demographics of Unemployment
      3. Criticisms of the Unemployment Rate
    2. Types of Unemployment
    3. Natural Rate of Unemployment
    4. Government Policy and Unemployment
  2. Labor Market Model
    1. Labor Market Supply and Demand
    2. Labor Market Puzzle
    3. Minimum Wage Laws
    4. Wage Contracts
    5. Efficiency Wages

1. Employment - Unemployment

A low unemployment rate is one of the primary goals of macroeconomic policy. While unemployment can be disastrous for individuals, the unemployment rate is also a key indicator of overall economic performance. An economy with a high unemployment rate is not operating on its production possibilities curve. The economy's resources are being underutilized and the economy is operating below its potential.

In this chapter we will review how unemployment is measured and how we can relate that measurement to the performance of the macroeconomy.

  1. Measurement
    1. Employment Surveys
    2. Collection of U.S. unemployment statistics began during World War II to identify areas where labor market imbalance was created as a result of an inadequate labor supply, materials shortages, and transportation difficulties. After the war, emphasis was placed on identifying areas of labor surplus (high unemployment).

      Labor force and unemployment statistics are obtained from the Current Population Survey (CPS). The CPS is a monthly survey, conducted by the Bureau of the Census, of about 50,000 households representing the civilian noninstitutional population. Respondents are interviewed to obtain information about the employment status of each member of the household 16 years of age and over. Each person is classified into one of three categories based on their status during the calendar week, Sunday through Saturday, which includes the 12th day of the month (the "reference week"):

      The CPS provides comprehensive data on the labor force, the employed, and the unemployed, classified by such characteristics as age, sex, race, family relationship, marital status, occupation, and industry attachment. The survey also provides data on the characteristics and past work experience of those not in the labor force.

      Average annual U.S. unemployment rates Figure 6-1. Average annual U.S. unemployment rates.

      Data Source: U.S. Dept. of Labor, Bureau of Labor Statistics (

      Additional unemployment data is obtained from state unemployment insurance programs and the monthly Current Employment Statistics (CES) Survey. The CES survey is designed to provide industry information on nonfarm wage and salary employment, average weekly hours, average hourly earnings, and average weekly earnings. The employment, hours, and earnings data are based on payroll reports from a sample of over 390,000 establishments employing over 47 million nonfarm wage and salary workers.

      Civilian Noninstitutional Population - persons 16 years of age and older who are not inmates of institutions (e.g., penal and mental facilities, homes for the aged) and who are not on active duty in the Armed Forces.

      Employed Persons - persons 16 years and over in the civilian noninstitutional population who, during the reference week, (a) did any work at all (at least 1 hour) as paid employees, worked in their own business, profession, or on their own farm, or worked 15 hours or more as unpaid workers in an enterprise operated by a member of the family, and (b) all those who were not working but who had jobs or businesses from which they were temporarily absent because of vacation, illness, bad weather, childcare problems, maternity or paternity leave, labor-management dispute, job training, or other family or personal reasons, whether or not they were paid for the time off or were seeking other jobs. Each employed person is counted only once, even if he or she holds more than one job. Excluded are persons whose only activity consisted of work around their own house (painting, repairing, or own home housework) or volunteer work for religious, charitable, and other organizations.

      Unemployed Persons - persons 16 years and over who had no employment during the reference week, were available for work, except for temporary illness, and had made specific efforts to find employment sometime during the 4-week period ending with the reference week. Persons who were waiting to be recalled to a job from which they had been laid off need not have been looking for work to be classified as unemployed.

      Labor Force - Total employed + total unemployed.

      Unemployment Rate - The total number unemployed as a percentage of the labor force.

           Unemployment Rate = (Number Unemployed / Labor Force) * 100

      Not in the Labor Force - All persons in the civilian noninstitutional population who are neither employed nor unemployed. Information is collected on their desire for and availability to take a job, job search activity in the prior year, and reason for not looking in the 4 week period prior to the survey week. This group includes discouraged workers, defined as persons not in the labor force who want and are available for a job and who have looked for work sometime in the past 12 months, but are not currently looking because they believe there are no jobs available or there are none for which they would qualify.

      Participation Rate - The labor force as a percentage of the civilian noninstitutional population.

           Participation Rate =             Labor Force              * 100
                                Civilian Noninstitutional Population

      U.S. Labor Force: Employment, Unemployment, and Unemployment Rate, 1998

      Figure 6-2. U.S. Labor Force: Employment, Unemployment, and Unemployment Rate, 2002.
      Data Source: U.S. Dept. of Labor, Bureau of Labor Statistics (

      2002 Total labor force = 8,378,000 + 136,485,000 = 144,863,000
      2002 Participation rate = ( 144,863,000 / 217,570,000 ) * 100 = 66.6%
      2002 Unemployment rate = ( 8,378,000 / 144,863,000 ) * 100 = 5.8%

      The share of the population participating in the labor force (participation rate) is an important statistic when examining unemployment over time and across countries. For example, the participation rate of women in the U.S. labor force has increased dramatically over the last three decades, while the participation rate of men has declined slightly.

      Average annual U.S. labor force particpation rates by gender Figure 6-3. Average annual U.S. labor force participation rates by gender.

      Data Source: U.S. Dept. of Labor, Bureau of Labor Statistics (

    3. Demographics of Unemployment
    4. The unemployment rate can vary widely between demographic groups. Unemployment tends to be greater among minorities (Figure 6-4), females (Figure 6-5), and teenagers (Figure 6-6). In addition, unemployment is generally lower for skilled workers and college graduates.

      Average annual U.S. unemployment rates by race Figure 6-4. Average annual U.S. unemployment rates by race.

      Data Source: U.S. Dept. of Labor, Bureau of Labor Statistics (

      Average annual U.S. unemployment rates by gender Figure 6-5. Average annual U.S. unemployment rates by gender.

      Data Source: U.S. Dept. of Labor, Bureau of Labor Statistics (

      Average annual U.S. unemployment rates by age Figure 6-6. Average annual U.S. unemployment rates by age.

      Data Source: U.S. Dept. of Labor, Bureau of Labor Statistics (

      The difference in unemployment rates between males and females does have some interesting twists. First, the labor survey has not been completely unbiased. When the survey was started the "Are you working?" question was put differently to men and women. Men were asked, "Last week, did you do any work for pay or profit?" Women were asked, "What were you doing last week, keeping house or something else?" Women who may have been looking for work may still have answered, "keeping house," and were not counted as unemployed. It wasn't until 1994 that the labor survey was changed to ask men and women the same question.

      Second, the difference in unemployment rates between men and women was the greatest from the early 1960s to the late 1970s. This period corresponds to the dramatic growth in the labor force participation rate by women shown in Figure 6-3. New entrants to the labor force have a higher unemployment rate and this shows up in the gender gap.

    5. Criticisms of the Unemployment Rate
    6. Unfortunately the unemployment rate is not a perfect indicator of economic activity or inactivity. There are three areas of criticisms regarding the measurement of the unemployment rate:

      1. Survey accuracy.
      2. Discouraged workers
      3. Underemployed workers

      First, all surveys are subject to difficulties that may affect survey accuracy. For example, telephone surveys will exclude people who don't have phones. If the unemployed are more likely not to have phone service then the unemployment rate could be understated. Perhaps a greater problem is that to be counted as unemployed the individual being surveyed must admit that he or she is out of work. This is embarrassing and can motivate a person to lie. Offsetting this tendency to understate the unemployment rate are survey respondents who say they are actively looking for work when they are not. For example, individuals who are receiving unemployment benefits or other income assistance must report they are actively seeking work to keep getting benefits. These persons may say they are looking for a job when they actually are not. Survey organizations must invest great effort to minimize or correct for these possible survey distortions.

      Second, the unemployment rate only counts those who are actively looking for work. It does not count those who would like to work but have given up finding suitable employment. The CPS was redesigned in 1994 to include a separate category for discouraged workers. Discouraged workers are those who would like a job, have looked for work in the last 12 months, are available for work, but are not currently looking for work because they don't believe they can find anything suitable for their skills, don't have the necessary skills or training, are too young or too old, or have faced other forms of discrimination. Discouraged workers are not counted as part of the labor force and are not counted as unemployed. Consequently, the unemployment rate may understate actual unemployment.

      Discouraged workers are of interest because they, like the unemployed, represent unused human resources in the economy. Table 6-1 shows that an average of 4.68 million persons reported that they would like to work in 2002, representing about 6.4 percent of all persons outside the labor force. If these discouraged workers counted as unemployed the average 2002 unemployment rate would have increased from 5.8 to as much as 9.0 percent

      Table 6-1. Discouraged Workers
      (thousand of persons, annual averages)

        2000 2001 2002

      Total not in the labor force 69,994    71,359    72,707
          Persons who currently want a job 4,413 4,590 4,677
              Searched for work and available for work now (1)    1,157 1,266 1,439
              Reason for not looking:    
                    Discouragement over job prospects (2) 262 321 369
                    Reasons other than discouragement (3) 895 945 1,070

      (1) persons who have searched for work during the prior 12 months and were available to take a job during the reference week.
      (2) includes thinks no work available, could not find work, lacks schooling or training, employer thinks too young or old, and other types of discrimination.
      (3) includes those who did not actively look for work in the prior 4 weeks for such reasons as child-care and transportation problems, as well as a small number for which reason non-participation was not determined.
      Source: Bureau of Labor Statistics, U.S. Department of Labor (

      A third problem with the unemployment rate as a measure of overall labor activity is that the employed may not be working as much as they would like. The underemployed may be working part-time but would prefer a full-time job, may be employed full-time but working at less than capacity, or may be overqualified for their current positions. For example, Figure 6-7 shows that the average hours worked per week in manufacturing generally declines during recessions. Again, the unemployment rate alone may understate actual unemployment or the slack in the economy.

      Average Hours Worked per Week in Manufacturing

      Figure 6-7. Average Hours Worked per Week in Manufacturing.

      Discouraged Workers - persons not in the labor force who want and are available for a job and who have looked for work sometime in the past 12 months, but who are not currently looking because they believe there are no jobs available or there are none for which they would qualify.

      Underemployment - persons in the labor who are working but are not working all the hours they are willing and able to.

  2. Types of Unemployment
  3. Unemployment may be characterized according to its causes. We generally classify unemployment into four basic types:

    Frictional Unemployment is associated with a dynamic labor force in a stable economy with imperfect information about available jobs. People are just entering the labor force or moving between careers and locations (dynamic labor force) and while there are job openings (stable economy) it takes time to find a new job (imperfect information). We should expect with the Internet as a growing new source of job information that job search time and frictional unemployment should decline. However, the process of applying and interviewing for a new job remains costly in terms of time required.

    Structural Unemployment is associated with a stable labor force in a dynamic economy. There may exist a mismatch between workers' skills and the skills required for available jobs. For example, as technology progresses new industries arise and mature ones decline. Badly managed firms go bankrupt and new firms are formed. Structural unemployment results when the location and/or skills of the labor force do not match the available jobs. It takes time for displaced workers in one region of the country to find comparable work elsewhere, or receive retraining for the skills required with different or new technologies.

    Seasonal unemployment is associated with the seasons of the year. Some businesses and industries experience a peak in consumer demand during the last half of the year leading up to Christmas. Snow skiing and Florida beach resorts are busiest during the winter. Many other resorts have customers only during the summer.

    The published unemployment statistics are often reported as "seasonally adjusted" numbers in order to eliminate the normal seasonal changes. For example, if the unemployment rate increases from 5 percent in December to 5.5 percent one month later in January, should we be surprised and suspect the economy is slipping into a recession? Probably not, especially if we normally see such increases in the unemployment rate from December to January. The seasonally adjusted unemployment rate provides a measure that lets us more easily recognize unusual or unexpected month-to-month changes.

    Seasonal adjustment essentially asks the question, if we have a 5.5 percent unemployment rate in January, what would we expect the annual average unemployment rate will be? Consider the trend in unemployment for 2001 as shown in Table 6-2. From January to December the raw (unadjusted) unemployment rate increased from 4.7 percent to 5.4 percent. That does not appear to be a particularly large increase. The seasonally adjusted numbers, however, reveal a more dramatic increase, from 4.2 to 5.8 percent. A 4.7 percent January unemployment rate is usually consistent with an annual average unemployment rate of 4.2 percent. The 5.4 percent December unemployment rate is usually consistent with an annual average unemployment rate of 5.8 percent.

    Table 6-2. Unadjusted Versus Seasonally Adjusted Unemployment Rates

    Month Not Seasonally

    January, 2001 4.7 4.2
    February 4.6 4.2
    March 4.6 4.3
    April 4.2 4.5
    May 4.1 4.4
    June 4.7 4.6
    July 4.7 4.6
    August 4.9 4.9
    September 4.7 5.0
    October 5.0 5.4
    November 5.3 5.6
    December, 2001 5.4 5.8

    Source: Bureau of Labor Statistics, U.S. Department of Labor (

    Cyclical Unemployment is associated with business cycles and, more particularly, with temporary downturns in the economy. During recessions the demand for products and services declines, workers are laid off, and (cyclical) unemployment increases. The demand for labor is derived from the demand for goods and services. When the demand for goods and services declines then the demand for labor drops as well.

    Frictional Unemployment - unemployment that results from people entering the labor force or voluntarily moving between careers or locations. Information about available jobs and available workers is imperfect and therefore job search takes time.

    Structural Unemployment - unemployment that results from a mismatch between workers' skills and the skills required for available jobs.

    Seasonal Unemployment - unemployment that results from the normal seasonal change in aggregate economic activity.

    Cyclical Unemployment - unemployment that results from a decline in aggregate economic activity that occurs during business cycle contractions (e.g., recessions).

    You should recognize that we have not really drawn sharp distinctions between these types of unemployment. A worker may quit one job because it is in a declining industry to look for a better job in a growing industry. Is this frictional or structural unemployment? We suggested that new entrants into the labor force represented frictional unemployment, but during recessions it becomes much harder for new entrants to find jobs. Is this frictional or cyclical unemployment?

    What is important to realize is that there will always be some level of unemployment that no force in heaven or in Congress can eliminate. Frictional, structural, and seasonal unemployment are three types of unemployment that always exist in an economy and thus prevent the unemployment rate from ever reaching zero.

    Cyclical unemployment is generally considered the most important and the one on which our macroeconomic models are focused. Congress may act aggressively to stimulate the economy during recessions and lower cyclical unemployment such as through tax cuts or increased government spending. This will be a primary topic of following chapters in this course.

  4. Natural Rate of Unemployment
  5. Full employment represents the complete utilization of available resources. At full employment an economy would be on its production possibilities frontier. But, because of the existence of frictional, structural, and seasonal unemployment, an economy's unemployment rate is never zero, even when the economy is at its "full-employment" level. The rate of unemployment that prevails when the economy is at its full-employment level of output is called the natural rate of unemployment.

    It is very difficult to say exactly what the natural rate of unemployment is. During the 1950s, most economists believed the natural rate was in the 4 to 5 percent range. The natural rate grew to about 6 percent in the 1970s because of the surge of teenagers from the baby boom generation entering the labor market, and has fallen back to less than 5 percent in the 1990s (if you are unfamiliar with the term "baby boom" let's just say that the men and women who returned home from World War II caught up on unfinished business, which significantly impacted the labor market some 16 years and 9 months later). The reason for changes in frictional and structural unemployment rates over time include changing demographics as mentioned above and changes in minimum wages, racial and sex discrimination, and unemployment benefits among other factors.

    Because frictional and structural unemployment cannot be directly measured, the natural rate of unemployment is a theoretical concept that is often defined as the rate at which increases in aggregate demand for output lead mostly to higher prices and wages rather than output and employment. In other words, let's say the economy is at full employment output and unemployment is at the natural rate. Experienced available labor becomes hard to find. If there is an increase in demand for products and services then firms will start to raid labor from other firms by offering higher wages. When paying higher wages firms must increase the price of their product or service. The result is no actual increase in the level of employment or total output but an increase in prices. But we do not have the situation in a microeconomic supply-demand model where an increase in price reduces the quantity demanded. In a macroeconomic model there may be no reason to expect a reduction in demand because wages are rising at the same rate as prices. Therefore, as long as demand remains above the level that can be satisfied at full employment output we can have a sustained period of rising prices, i.e., high inflation.

    Full Employment Output - the level of output at which the labor market is at its natural rate of unemployment.

    Natural Rate of Unemployment - unemployment arising from frictional, structural, and seasonal unemployment. Also described as the unemployment rate that coexists with macroeconomic stability.

    Full employment output is also described as the maximum sustainable level of output. Over short periods the economy could be operating above this level and at times below this level. As output fluctuates around the full-employment level of output during a business cycle, the unemployment rate fluctuates around the natural rate. When the economy is in a recession and output is below full employment output, cyclical unemployment is positive. During the inflationary peak of a business cycle, output could be above the full-employment level and cyclical unemployment is negative.

  6. Government Policy and Unemployment
  7. While the focus of this course is on the impact government can have on cyclical unemployment, government policy can also influence on the rates of frictional or structural unemployment. For example, the monthly government reports on regional unemployment rates can help workers identify the areas of the country where labor is most needed and make job search more efficient. Publicly funded retraining programs are designed to help workers transition from one industry to another. Such programs hopefully reduce the time needed to find new jobs and thereby lower the frictional and structural unemployment rates.

    The government policy that is perhaps the most controversial with respect to its effect on structural and cyclical unemployment is unemployment insurance. Workers who are forced to leave their jobs through no fault of their own can collect a fraction of their wages for a certain period after losing their jobs. A typical unemployed worker can receive 50 percent of his or her former wages for 26 weeks. During recessions the government may extend the coverage period because of the greater difficulty in finding new jobs. Workers who voluntarily quit their jobs or who are fired for cause do not qualify.

    Unemployment benefits certainly reduce the hardship to the individual from being laid off, but they also raise the level of the natural rate of unemployment. Those who receive unemployment benefits may feel less pressure to find a new job. With the unemployment compensation cushion they may turn down some job offers while waiting for something better. Cross-section studies that compare unemployment rates across regions of the country or between different countries generally find that those with more generous unemployment compensation benefits have higher unemployment rates. This is one of many examples we will run across where what is good for the individual may not produce the most desirable measure of aggregate economic performance.

2. Labor Market Model

One of the natural starting points for understanding labor markets is the microeconomic model of supply and demand. Labor is a service that is supplied by individuals and demanded by firms. However, we will find that some characteristics of the labor market do not conform to the simple microeconomic model. In particular, the microeconomic equilibrium model does not explain why there can be cyclical unemployment in an economy. We will review a few of the interesting modifications that try to improve the validity of the simple microeconomic model of labor supply and demand.

  1. Labor Market Supply and Demand
  2. The simple microeconomic labor model balances the supply of labor by individuals against the demand for labor by firms. The trick is recognizing that labor supply and demand are a function of the real wage. The real wage is the nominal wage (a worker's take-home pay) corrected for the average price level. What should matter to a worker is not necessarily the size of the paycheck but what the paycheck can buy. If the nominal wage doubles but at the same time the prices of all the goods and services bought with that wage also double then nothing has really changed. For the firm the nominal wage rate is compared with the prices of the product it sells and the cost of other inputs to the production process. Again, if the wage rate doubles but the prices of the product and other inputs (i.e., the average price level) also double then the firm's rate of profit is unaffected.

    The real wage rate is represented by dividing the nominal wage rate (w) by a measure of the average price level (P), or w/P. As the nominal wage rises while the average price level remains steady, the real wage increases. With a constant paycheck but a rising average price level, the real wage declines. The average hourly nominal and real wage for all workers is shown in Figure 6-8. The real wage is calculated by dividing the nominal wage by the Consumer Price Index. While nominal wages have risen steadily over the last 55 years, the real wage actually declined over the a 20-year period starting in 1974. Only in the second half of the 1990s have we seen a recovery.

    Average Hourly Nominal and Real Wage

    Figure 6-8. Average Hourly Nominal and Real Wage.

    The supply of labor is determined by individuals. The supply curve for labor is based on the assumption that as the real wage rate (purchasing power) increases then individuals would be willing to work more hours and some who were not interested in working may now decide to enter the labor force. With a higher real wage rate individuals are more willing to substitute labor for leisure. The opportunity cost of leisure is higher with a higher real wage rate. The substitution effect of labor for leisure implies the supply curve for labor is upward sloping (Figure 6-9). The higher the real wage rate the more labor is supplied. But there is an offsetting factor. A higher real wage rate also means than an individual's real income is now greater. With more real income an individual may now be willing to work less and consume more leisure. With a higher real wage rate you can work fewer hours and still end up ahead. This income effect implies the labor supply curve could be very steep. A higher real wage increases the quantity of labor supplied through the substitution effect but also lowers the quantity of labor supplied through the income effect.

    The demand for labor is determined by firms. The demand curve for labor is downward sloping (Figure 6-9) for two reasons. First, as nominal wages fall labor becomes less expensive relative to the prices of goods the firm produces. Firms have an opportunity for greater profits (the value of its output minus the costs of production, including labor) by hiring more workers and increasing output. Second, as nominal wages fall relative to the cost of capital equipment, firms may substitute workers for capital. Firms may forego purchasing labor-saving automation when labor is less expensive. Thus, the demand curve for labor is downward sloping. As the real wage declines, firms hire more labor.

    Labor Supply and Demand Model

    Figure 6-9. Labor Supply and Demand Model.

    Equilibrium in the labor market occurs where the aggregate quantity of labor supplied equals the aggregate quantity of labor demanded, i.e. where the labor supply and demand curves cross. The equilibrium level of employment corresponds to full-employment output and any unemployment that exists corresponds to only frictional, structural, or seasonal unemployment.

    The labor market model, just like the product supply-demand model in Chapter 3, suggests that the real wage rate will change if a disequilibrium exists (i.e., the market wage is above or below the equilibrium wage). For example, if the real wage is above the equilibrium real wage there will be a surplus of labor. There are more willing workers than jobs to fill. Competition for jobs will lead to a lower real wage rate thereby returning the real wage rate to the equilibrium level. Similarly, if the real wage is lower than the equilibrium rate then firms will demand more labor than is being supplied by willing workers. Firms have an incentive to raise the real wage rate to attract labor from other firms, motivate their workers to put in more hours, or attract new entrants to the labor force. The real wage will rise until equilibrium is reached.

    Labor Supply Curve - the amount of labor supplied by individuals at a given real wage rate.

    Labor Demand Curve - the amount of labor demanded by firms at a given real wage rate.

    Real Wage - the nominal wage (e.g., take-home pay) corrected for the average level of prices.

  3. Labor Market Puzzle
  4. Two major shortcomings of this labor supply-demand model are revealed when we consider what happens during a recession. During a recession (a recession is explained in more detail in the next chapter) there is a reduction of output by firms, which implies a leftward shift of the labor demand curve (Figure 6-10). Firms reduce output and, according to the labor market model, also reduce their demand for workers and the real wage they pay.

    A Decline in Labor Demand

    Figure 6-10. A Decline in Labor Demand.

    The first problem we find is that while there is a reduction in employment during a recession the model suggests that there is no increase in unemployment. When the economy moves into a recession and firms reduce their output the demand curve for labor shifts to the left. The labor market model attains a new equilibrium and, by definition, the economy is at full employment when the labor market is in equilibrium. Those workers who lose their jobs are unwilling to work at the lower wage and leave the work force. Cyclical unemployment does not occur.

    The second problem is we don't always see a decline in the real wage during recessions. Firms reduce employment but don't lower real wage rates. In the Great Depression of the 1930s for example, the demand for labor fell drastically and the unemployment rate rose to about 25% while real wages in manufacturing actually rose. We saw a similar pattern of rising unemployment and rising real wages during most recessions up through the 1970s.

    The implication of these two problems is that there appears to be a wage floor, similar to the price floor we discussed in the section on disequilibrium in Chapter 3. As demand declines, the real wage remains fixed. The result as shown in Figure 6-11 is that the quantity of labor supplied is greater than the quantity of labor demanded and we have cyclical unemployment. Cyclical unemployment usually occurs when there is a shift in the aggregate demand for labor and real wages do not adjust to return the labor market to equiibrium.

    Disequilibrium in the Labor Market

    Figure 6-11. Disequilibrium in the Labor Market.

    Several theories have been offered to explain why real wages may be rigid even when there is an excess supply of labor and cyclical unemployment. We will review three of those theories here:

    1. Legal - minimum wage laws
    2. Institutional - union contracts
    3. Economic - efficiency wage theory

  5. Minimum Wage Laws
  6. The U.S. minimum wage law was passed in the Fair Labor Standards Act of 1938. In 2001, 1.7 percent of the U.S. labor force were paid an hourly rate that was at or below the Federal minimum wage level of $5.15 per hour. Most were young, female, part-time workers (Table 6-3). The minimum wage represents a price floor where the government prevents firms and workers from negotiating a lower wage. The minimum wage is about 1/3 that of the average hourly wage in manufacturing.

    Congressional action to raise the minimum wage is always met with the criticism that the move will hurt the same people it is intended to help. The labor supply-demand model suggests that an increase in the minimum wage price floor will reduce the quantity of labor demanded by firms and unemployment among the least skilled would increase. The counter argument is that the increase in unemployment will be very small and the benefit of the higher wage to many will more than offset the cost of unemployment to a few. For example, Charles Brown ("Minimum Wage Laws Are They Overrated?" Journal of Economic Perspectives, Summer 1998, 133-146) estimated that a 10 percent increase in the minimum wage reduces teenage unemployment by 1 to 3 percent.

    Table 6-3. Employment At or Below the Minimum Wage, 2001

    Number (1)
    Percent of
    Labor Force

    Total 16 and Over 2,238 1.7%
    16 to 24 Years Old 1,206 6.0%
    25 Years and Over 1,032 0.9%
    Men 16 and Over   784 1.1%
    Women 16 and Over 1,454 2.3%
    Full-time Worker 16 and Over   853 0.7%
    Part-time worker 16 and Over 1,378 5.9%

    Notes: (1) The prevailing Federal minimum wage was $5.15 per hour in 2001
    (2) Percentages based on the labor force in each category. For example, the number of 16-to-24 year olds in the labor force in 2001 was 20,250,000.
    Source: Bureau of Labor Statistics, U.S. Department of Labor (

  7. Wage Contracts
  8. Another reason for inflexible wages is the wage contract. For example, union contracts may establish the wage level for the next several years. Salaries for non-union workers are also usually revised only once a year. The wages in these explicit (union) and implicit (non-union) labor contracts are often indexed to the rate of inflation through cost-of-living adjustments (COLAs). Thus the nominal wage rate follows the average price level and the real wage remains steady. We may have a recession and a decline in the demand for labor but the real wage level is prevented from immediately declining to the equilibrium level. The change in the average real wage is slow as contracts periodically expire and new ones are negotiated.

  9. Efficiency Wages
  10. Efficiency wage theory suggests that a worker's productivity depends on the wage paid by a firm. If better-paid workers are more productive then firms may prefer to pay a wage rate higher than the equilibrium wage rate. Because firms pay a wage that is higher than the equilibrium level we again have what is equivalent to a price floor. The supply of labor exceeds the demand for labor at the wage rate offered by the firm. The unemployed may be willing to work at a lower wage rate but firms are unwilling to employ them.

    Efficiency wage theory offers two reasons why the firm would prefer to maintain a wage rate above the equilibrium level:

    1. The wage rate affects the level of effort or productivity of workers (this is often referred to in economics as a "moral hazard" problem.) If the wage is at the equilibrium level a worker can leave one firm for another at the same wage rate. The cost to a worker from being fired for shirking on the job may be small because there would be no reduction in wage from the forced change in employer. Firms motivate workers by paying a wage higher than the entry-level wage at other firms so that being fired for shirking will be costly to the worker.

    2. The wage rate affects the quality of the applicant pool (often referred to in economics as an "adverse selection" problem.) A low wage may result in a lower quality of applicants for the firm's job openings.

    Efficiency wage theory proposes that the microeconomic labor-supply demand model is not one of simply workers, but the supply and demand of efficient workers. The model suggests that even at "full employment" there may be some unemployment apart from the frictional, structural, and seasonal unemployment described earlier. At the efficiency wage the quantity of labor supplied is greater than the quantity demanded.

    During a recession a firm may prefer to lay off workers rather than lower the real wage because the loss of output arising from lower productivity with a lower real wage may be greater than the reduction in output through layoffs. Consequently, during a recession the real wage remains unmoved while unemployment rises. The assumption of a fixed real wage during recessions can be relaxed somewhat by assuming workers may be more concerned about losing their jobs during a recession when finding another job is more difficult. With this assumption the real wage necessary to obtain the desired level of worker productivity may be lower during recessions, but not by as much as implied by equilibrium in the simple labor supply-demand model.

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