Answers to Textbook Questions and Problems

CHAPTER 7 Unemployment and the Labour Market

Questions for Review

1. The rates of job separation and job finding determine the natural rate of unemployment. The rate of job

separation is the fraction of people who lose their job each month. The higher the rate of job

separation, the higher the natural rate of unemployment. The rate of job finding is the fraction of

unemployed people who find a job each month. The higher the rate of job finding, the lower the natural

rate of unemployment.

2. Frictional unemployment is unemployment caused by the time it takes to match workers and jobs.

Finding an appropriate job takes time because the flow of information about job candidates and job

vacancies is not instantaneous. Since different jobs require different skills and pay different wages,

unemployed workers may not accept the first job offer they receive.

In contrast, structural unemployment is unemployment resulting from wage rigidity and job

rationing. These workers are unemployed not because they are actively searching for a job that best

suits their skills (as in the case of frictional unemployment) but because at the prevailing real wage, the

quantity of labour supplied exceeds the quantity of labour demanded. If the wage does not adjust to

clear the labour market, then these workers must wait for jobs to become available. Structural

unemployment thus arises because firms fail to reduce wages despite an excess supply of labour.

3. The real wage may remain above the level that equilibrates labour supply and demand because of

minimum-wage laws, the monopoly power of unions, and efficiency wages.

Minimum-wage laws cause wage rigidity when they prevent wages from falling to equilibrium

levels. Although most workers are paid a wage above the minimum, for some workers, especially those

Chapter 7—Unemployment and the Labour Market 53

 who are unskilled and inexperienced, the minimum wage raises their wage above the equilibrium level.

It therefore reduces the quantity of their labour that firms demand. This creates an excess supply of

workers, which increases unemployment.

The monopoly power of unions causes wage rigidity because the wages of unionized workers are

determined not by market supply and demand but by collective bargaining between union leaders and

firm management. The wage agreement often raises the wage above the equilibrium level, which

causes firms to hire fewer workers than they would have at the market-clearing wage, so structural

unemployment increases.

Efficiency-wage theories suggest that higher wages make workers more productive. The influence

of wages on worker efficiency may explain why firms often do not cut wages when there is an excess

supply of labour. Although a wage cut would decrease a firm’s wage bill, it could also lower worker

productivity and firm profits.

4. Depending on how one looks at the data, most unemployment can appear to be either short-term or

long-term. On the one hand, most spells of unemployment are short; that is, most of those who become

unemployed find jobs quickly. On the other hand, most weeks of unemployment are attributable to the

small number of long-term unemployed individuals. By definition, the long-term unemployed do not

find jobs quickly, so they appear on unemployment rolls for many weeks or months.

5. Europeans work fewer hours than North Americans. One explanation is that higher tax rates in Europe

reduce the incentive to work. Higher tax rates may also lead to a larger underground economy in

Europe as a result of tax evasion, and it is more difficult to measure hours worked in the underground

economy. A second explanation is the greater importance of unions in Europe since they can employ

collective bargaining to reduce work hours. A third explanation is based on preferences and argues that

Europeans value leisure more than Americans and therefore elect to work fewer hours.

Chapter 7—Unemployment and the Labour Market 54

Problems and Applications

1. a. In the example that follows, we assume that a college student typically takes 2 weeks to find a job

and that a job typically lasts 12 weeks.

b. If it takes 2 weeks to find a job, then the rate of job finding is

f = 1 job/2 weeks = 0.5 jobs/week.

If the job lasts 12 weeks, then the rate of job separation is

s = 1 job/12 weeks = 0.083 jobs/week.

c. From the text, we know that the formula for the natural rate of unemployment is

U/L = s/(s + f ),

where U is the number of people unemployed and L is the number of people in the labour force.

Plugging in the values of f and s that we calculated in part (b), we find that the natural rate of

unemployment is

U/L = 0.083/(0.083 + 0.5) = 0.14.

Thus, if college students typically take 2 weeks to find a job and the job typically lasts 12 weeks,

the natural rate of unemployment for college students is 14 percent.

2. We can reinterpret the formula for the natural rate of unemployment: U/L = s/(s + f ). Let U/L be the

steady-state fraction of residents who are uninvolved, let s = 0.1 be the rate at which involved residents

Chapter 7—Unemployment and the Labour Market 55

 break up, and let f = 0.05 be the rate at which uninvolved residents enter into relationships. The steady-

state fraction of residents who are uninvolved is then U/L = s/(s + f ) = 0.1/(0.1 + 0.05) = 2/3.

3. To show that the unemployment rate converges to the natural rate over time, we begin by showing how

the number of unemployed people changes over time. The change in the number of unemployed equals

the number of people losing jobs (sE) minus the number finding jobs (fU). That is,

ΔU = sE – fU.

By definition, L = E + U, so the equation becomes

ΔU = s(L – U) – fU

= sL – (s + f)U.

Suppose that the number of unemployed is above the natural rate, so U > sL/(s + f ). Then (s + f)U > sL

and ΔU < 0. Now suppose that the number of unemployed is below the natural rate, so U < sL/(s + f ).

Then (s + f)U < sL and ΔU > 0. If the number of unemployed is above the natural rate, the natural rate

falls; if the number of unemployed is below the natural rate, the natural rate rises. The unemployment

rate therefore converges to the natural rate over time.

4. Consider the formula for the natural rate of unemployment: U/L = s/(s + f ). If the new law lowers the

rate of job separation s but has no effect on the rate of job finding f, then the natural rate of

unemployment falls.

The new law is also likely to lower f for two main reasons. First, raising the cost of firing might

make firms more careful about hiring workers since it will be more costly to fire a worker who turns

out to be a poor match. Second, if job searchers think that the new legislation will lead them to spend a

longer period of time at a particular job, they might weigh more carefully whether to accept a job offer.

If the reduction in f is large enough, then the new policy could even increase the natural rate of

unemployment.

Chapter 7—Unemployment and the Labour Market 56

5. a. The demand for labour is determined by the amount of labour that a profit-maximizing firm wants

to hire at a given real wage. The firm will hire labour until the marginal product of labour equals

the real wage:

W
MPL =
P.

The marginal product of labour is found by taking the partial derivative of the production function

with respect to labour (see Chapter 3 for more discussion):

Y
MPL 
L
 (5 K 1/ 3 L2/3 )

L
10 1/ 3 1/3
 K L .
3

To solve for labour demand, we set the marginal product of labour equal to the real wage and

solve for L:

10 1/3 1/ 3 W
K L 
3 P
3
1, 000  W 
L K  .
27 P

This expression has the intuitively desirable feature that an increase in the real wage reduces the

demand for labour.

b. Given a labour supply of 1,000 workers and a capital stock of 27,000 units, we can use the

equilibrium condition that labour supply equals labour demand to solve for W/P:

Chapter 7—Unemployment and the Labour Market 57

 3
1, 000 W 
1, 000   27, 000   
27 P
W
 10.
P

In equilibrium, firms hire 1,000 workers at a real wage of 10 units of output for total employment

compensation of 10,000 units of output. Total output is given by the production function:

Y  5 K 1/ 3 L2/ 3
 5  27,0001/3 1, 0002/3
 15, 000.

Notice that workers get two-thirds of output, which is consistent with what we know about the

Cobb–Douglas production function from Chapter 3.

c. The real wage is now 10 × 1.1 = 11 units of output. Firms’ labour demand is then given by

3
1, 000  W 
L K 
27 P
1, 000
  27, 000  113
27
 751.3.

Thus, firms hire 751.3 workers at a wage of 11 units of output, for total compensation of 8,264

units of output. Aggregate output is

Y  5 K 1/3 L2/ 3
 5  27, 0001/ 3  751.32/3
 12,397.

Chapter 7—Unemployment and the Labour Market 58

 d. The 751.3 workers who are employed earn 1 more unit of output, but 248.7 workers become

involuntarily unemployed. Workers are worse off in terms of total compensation, which falls from

10,000 to 8,264 units of output.

e. This analysis shows the main effects of minimum-wage laws: they raise wages for some workers

but lead to structural unemployment. In this example, workers are worse off in terms of total

compensation. If, however, labour demand is less elastic, then the loss of employment may be

small enough that total compensation increases.

6. a. The labour demand curve is given by the marginal product of labour. If a country experiences a

reduction in productivity, then the labour demand curve shifts inward, as in Figure 7-1. Thus, for

any given real wage, firms demand less labour.

b. If the labour market is always in equilibrium, then, assuming a fixed labour supply, an adverse

productivity shock causes a decrease in the real wage but has no effect on employment, as in

Figure 7-2.

Chapter 7—Unemployment and the Labour Market 59

 c. If unions prevent the real wage from falling, then, as illustrated in Figure 7-3, employment falls to

L1 and unemployment equals L – L1.

7. a. If workers are free to move between sectors, then the wages in the sectors must be equal. If the

wages were not equal, then workers would have an incentive to move to the sector with the higher

wage. This would cause the higher wage to fall and the lower wage to rise until they became

Chapter 7—Unemployment and the Labour Market 60

 equal.

b. Since there are 100 workers in total, Ls = 100 – Lm. Substituting this in and setting the wages equal

to W, the labour demand equations become

Lm = 200 – 6W

100 – Lm = 100 – 4W.

The second equation implies that

Lm = 4W.

Substituting this into the first equation, we have

4W = 200 – 6W

10W = 200

W = 20.

Finally, we substitute the equilibrium wage into the labour demand equations to find that Lm = 80

and Ls = 20.

c. If Wm =25, then

Lm = 200 – 6 × 25

= 50.

d. There are now 50 workers employed in the service sector. Labour demand in services implies that

Chapter 7—Unemployment and the Labour Market 61

 50 = 100 – 4Ws

4Ws = 50

Ws = 12.5.

e. The wage in manufacturing remains $25, and employment remains 50. At a reservation wage of

$15, demand for labour in services is

Ls = 100 – 4 × 15

= 40.

There are then 10 unemployed individuals, so the unemployment rate is 10 percent.

8. Real wages have risen over time in both the United States and Europe, increasing the reward for

working (the substitution effect) but also increasing the desire to consume more leisure (the income

effect). If the income effect dominates, then people work less as real wages rise. This could help to

explain the European experience, since the number of hours a typical person works has fallen since the

1970s. If the income and substitution effects cancel, then people work the same amount as real wages

rise. This could help to explain the U.S. experience, since the number of hours a typical person works

has remained about constant since the 1970s. Though tastes for leisure might vary by geography for

cultural reasons, there is substantial debate over this among economists.

9. The vacant office space problem is similar to the unemployment problem, so we can apply the same

concepts we used in analyzing unemployment to analyze office vacancies. There is a rate of office

separation: firms that occupy offices leave, either to move to different offices or because they go out of

business. There is a rate of office finding: firms that need office space (either to start up or expand)

find empty offices. Different types of firms want spaces with different attributes, so it takes time to

match firms with available office space. This is analogous to frictional unemployment.

Chapter 7—Unemployment and the Labour Market 62

More Problems and Applications Chapter 7

1. The Employment Insurance (EI) program was created to provide temporary financial assistance to

workers who lost their jobs or who are upgrading their skills. As of January 2017, an eligible worker

can receive up to 55 percent of his or her former wage up to a maximum of $543 per week. Workers

are eligible to receive EI for a period ranging from 14 weeks up to a maximum of 45 weeks. The

region where the workers lives and the amount of contribution the worker made to EI determine the

amount and length he or she is entitled for. The EI program allows workers to transition out of the

labour force and back in the labour force while reducing the pain and hardship usually associated with

loss of revenue. Moreover, the EI program allows workers to take more time to find the best possible

job and in doing so, the program encourages a better matching between workers and jobs.

However, the program is not without drawbacks and may have an adverse effect on the

unemployment rate and on the natural rate of unemployment. Workers that receive EI benefits may

have less incentives to search actively and rapidly for a job and may even turn down unattractive job

offers. This type of behaviour would increase the frictional unemployment rate and the rate of job

finding. In the model in Section 6.1, this would amount to a decrease in the parameter f, the rate of job

finding. EI has also an effect on the rate of job separation. Since workers know that they can receive

financial assistance through EI if they lose their job, they may have less incentives to search for jobs

with stable employment prospects and may attach less importance to job security. As a result, the job

separation rate may be higher because of the EI program.

A higher job separation rate and a lower job finding rate lead to a higher unemployment rate and a

higher natural rate of unemployment. Because the EI program has a negative effect on both the rate of

job separation and the rate of job finding, countries with very generous EI programs such as Canada in

the 1980s tend to have high unemployment rates.

2. Antiglobalization protesters are mostly concerned about income inequality, that is the growing income

gap between owners of capital and labour. They want the government to address this issue of growing

income inequality and want income to be redistributed from owners of capital to labour. Essentially,

they want governments around the world to tax capital and take the proceeds of the tax and redistribute

it to labour. However, if capital can be taxed, owners of capital can move their capital from a high tax

Chapter 7—Unemployment and the Labour Market 63

 jurisdiction to a low tax jurisdiction. The protesters argue that this can be prevented if governments

around the world restrict the movement of capital. However, the solution is not that simple and can

lead to unintended consequences on labour income.

The problem with that argument is that by limiting the movement of capital, this will reduce

globalization, trade volumes and as shown in the appendix, the overall production of goods and

services. Essentially what happens is that the imposition of a tax on capital pushes the owners of

capital to demand a higher pretax rate of return to compensate for the tax. If the pretax rate of return

does not increase enough to compensate the owners of capital, then the latter will transfer his or her

capital to another jurisdiction with a lower tax rate. It is not farfetched to assume that some capital will

leave the country once a tax is imposed. With the fall in the amount of capital and hence capital per

worker, the owners of capital are as well off as before since they can make up for the loss in return

elsewhere. However, workers are worse off as GDP falls and the share of the pie that goes to the

workers fall. Clearly, in this case, workers do not help their cause by demanding a tax on capital.

Owners of capital can always shift their capital from one jurisdiction to another leaving them

unaffected but leaving workers worse off.

However, if the tax on capital is accompanied by a cut in payroll tax, it is shown in the appendix

that this leads to an increase in GDP. The share that goes to workers increase and labourers in this case

can be better off. The payroll tax leads to a fall in the unemployment rate and to an increase in the

productivity of capital since capital now has more labour to work with. Although owners of capital are

better off in this scenario, workers are also better off since the level of GDP and hence the size of the

pie that is distributed between owners of capital and labour increases.

Chapter 7—Unemployment and the Labour Market 64