CHAPTER 20

The Labor Market: Workers, Wages, and Unemployment

How do globalization and technological change affect wages and employment?©Rob Crandall/The Image Works

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

1. LO1Discuss five important trends that have characterized labor markets in the industrialized world in the past few decades.

2. LO2Apply a supply and demand model to understand the labor market.

3. LO3Explain how changes in the supply of and demand for labor explain trends in real wages and employment in the past few decades.

4. LO4Differentiate among the three types of unemployment defined by economists and the costs associated with each.

Why are you reading this book?

Some readers, thinking about this question in broad terms, may answer: “To better understand the economy” or even “To better understand the world around me.” Others, focusing more on the here and now, may answer: “Because it is required reading for my economics class,” or even just “To pass the final exam!” Still other readers would offer other answers, or more than one answer.

For an economist, by reading this book (and, more generally, by taking a course or studying for a degree) you are increasing your human capital. The concept of human capital was introduced in Chapter 19, Economic Growth, Productivity, and Living Standards. We described it as comprising one’s talents, education, training, and skills, and said that it is acquired primarily through the investment of time, energy, and money. We also said that workers with more human capital are more productive than those with less human capital. How have these productivity gaps changed over time? Have they translated to income gaps between workers who managed to “keep up” with a modern labor market by acquiring the right skills and those unwilling or unable to do so?

We also examined the remarkable economic growth and increased productivity that have occurred in the industrialized world over the past two centuries. These developments have greatly increased the quantity of goods and services that the economy can produce. But we have not yet discussed how the fruits of economic growth are distributed. Has everyone benefited equally from economic growth and increased productivity? Or, as some writers suggest, is the population divided between those who have caught the “train” of economic modernization, enriching themselves in the process, and those who have been left at the station?¹

To understand how economic growth and change affect different groups, we must turn to the labor market. Except for retirees and others receiving government support, most people rely almost entirely on wages and salaries to pay their bills and put something away for the future. Hence, it is in the labor market that most people will see the benefits of the economic growth and increasing productivity. This chapter describes and explains some important trends in the labor markets of industrial countries. Using a supply and demand model of the labor market, we focus first on several important trends in real wages and employment. In the second part of the chapter, we turn to the problem of unemployment, especially long-term unemployment. We will see that two key factors contributing to recent trends in wages, employment, and unemployment are the globalization of the economy, as reflected in the increasing importance of international trade, and ongoing technological change. By the end of the chapter, you will better understand the connection between these macroeconomic developments and the economic fortunes of workers and their families.

FIVE IMPORTANT LABOR MARKET TRENDS

In recent decades, at least five trends have characterized the labor markets of the industrialized world. We divide these trends into two groups: those affecting real wages and those affecting employment and unemployment.

TRENDS IN REAL WAGES

1. Over the twentieth century, all industrial countries have enjoyed substantial growth in real wages.

In the United States in 2016, the average worker’s yearly earnings could command more than twice as many goods and services as in 1960 and more than five times as much as in 1929, just prior to the Great Depression. Similar trends have prevailed in other industrialized countries.

2. Since the early 1970s, however, the rate of real wage growth has slowed.

Though the post–World War II period has seen impressive increases in real wages, the fastest rates of increase occurred during the 1960s and early 1970s. In the 13 years between 1960 and 1973, the buying power of workers’ incomes rose at a rate of about 2.5 percent per year, a strong rate of increase. But from 1973 to 1995, real yearly earnings grew at only 0.9 percent per year. The good news is that from 1995 to 2007, the eve of the 2007–2009 recession, real earnings grew at 1.8 percent per year, despite a recession in 2001. However, since then earnings growth slowed again: from 2007 to 2016, real earnings grew at only 0.7 percent per year, and for the whole 1973–2016 period, earnings grew at 1.1 percent a year. It remains to be seen whether a steeper upward trend in earnings resumes in the next few years.

3. Furthermore, recent decades have brought a pronounced increase in wage inequality in the United States.

A growing gap in real wages between skilled and unskilled workers has been of particular concern. Indeed, the real wages of the least-skilled, least-educated workers have actually declined since the early 1970s, by as much as 25 to 30 percent according to some studies. At the same time, the best-educated, highest-skilled workers have enjoyed continuing gains in real wages. Data for a recent year showed that, in the United States, the typical worker with a master’s degree earned almost three times the income of a high school graduate and four times the income of a worker with less than a high school degree. Many observers worry that the United States is developing a “two-tier” labor market: plenty of good jobs at good wages for the well-educated and highly skilled, but less and less opportunity for those without schooling or skills.

Outside the United States, particularly in western Europe, the trend toward wage inequality has been much less pronounced. But, as we will see, employment trends in Europe have not been as encouraging as in the United States. Let’s turn now to the trends in employment and unemployment.

TRENDS IN EMPLOYMENT AND UNEMPLOYMENT

4. In the United States, the number of people with jobs has grown substantially in the past 50 years. The rate of job growth has slowed recently.

In 1970, about 57 percent of the over-16 population in the United States had jobs. By 2000, total U.S. employment exceeded 135 million people, more than 64 percent of the over-16 population. Between 1980 and 2000, the U.S. economy created more than 35 million new jobs—an increase in total employment of 36 percent—while the over-16 population grew only 25 percent. The pace of new job creation has slowed since, dropping below the growth rate of the over-16 population: by late 2017, about 153 million people in the U.S. had jobs, about 60 percent of the over-16 population.

Similar job growth has not occurred in most other industrialized countries, however. In addition:

5. Compared with the U.S., western European countries have, in general, been suffering higher rates of unemployment during much of the past three decades.

In France, for example, an average of 10.9 percent of the workforce was unemployed over the period 1990–2001, compared to just 5.5 percent in the United States. This unemployment gap shrank somewhat in the following decade, and it briefly reversed in the aftermath of the 2008 global financial crisis as the unemployment rate in the U.S. increased faster than that in many other industrialized countries. Since 2010, however, the unemployment rate in the U.S. has come back down, and by late 2017, it was back at around 4.4 percent (compared with around 9.8 percent in France). Figure 20.8, presented later in the chapter, shows recent unemployment rates in five western European countries. Consistent with the high rates of unemployment, rates of job creation in western Europe have been exceptionally weak.

Given the trend toward increasing wage inequality in the United States and the persistence of high unemployment in Europe, we may conclude that a significant fraction of the industrial world’s labor force has not been sharing in the recent economic growth and prosperity.

What explains these trends in employment and wages? In the remainder of the chapter, we will show that a supply and demand analysis of the labor market can help to explain these important developments.

RECAP

FIVE IMPORTANT LABOR MARKET TRENDS

1. Over a long period, average real wages have risen substantially both in the United States and in other industrialized countries.

2. Despite the long-term upward trend in real wages, real wage growth has slowed significantly in the United States since the early 1970s.

3. In the United States, wage inequality has increased dramatically in recent decades. The real wages of most unskilled workers have actually declined, while the real wages of skilled and educated workers have continued to rise.

4. Employment has grown substantially in the United States in recent decades. However, the rate of growth has slowed since 2000.

5. Since about 1980, western European nations have experienced very high rates of unemployment and low rates of job creation.

SUPPLY AND DEMAND IN THE LABOR MARKET

We have seen how supply and demand analysis can be used to determine equilibrium prices and quantities for individual goods and services. The same approach is equally useful for studying labor market conditions. In the market for labor, the “price” is the wage paid to workers in exchange for their services. The wage is expressed per unit of time—for example, per hour or per year. The “quantity” is the amount of labor firms use, which in this book we will generally measure by number of workers employed. Alternatively, we could state the quantity of labor in terms of the number of hours worked; the choice of units is a matter of convenience.

Who are the demanders and suppliers in the labor market? Firms and other employers demand labor in order to produce goods and services. Virtually all of us supply labor during some phase of our lives. Whenever people work for pay, they are supplying labor services at a price equal to the wage they receive. In this chapter, we will discuss both the supply of and demand for labor, with an emphasis on the demand side of the labor market. Changes in the demand for labor turn out to be key in explaining the aggregate trends in wages and employment described in the preceding section.

The labor market is studied by microeconomists as well as macroeconomists, and both use the tools of supply and demand. However, microeconomists focus on issues such as the determination of wages for specific types of jobs or workers. In this chapter, we take the macroeconomic approach and examine factors that affect aggregate, or economywide, trends in employment and wages.

WAGES AND THE DEMAND FOR LABOR

Let’s start by thinking about what determines the number of workers employers want to hire at any given wage—that is, the demand for labor. As we will see, the demand for labor depends both on the productivity of labor and the price that the market sets on workers’ output. The more productive workers are, or the more valuable the goods and services they produce, the greater the number of workers an employer will want to hire at any given wage.

Table 20.1 shows the relationship between output and the number of workers employed at the Banana Computer Company (BCC), which builds and sells computers. Column 1 of the table shows some different possibilities for the number of technicians BCC could employ in its plant. Column 2 shows how many computers the company can produce each year, depending on the number of workers employed. The more workers, the greater the number of computers BCC can produce. For the sake of simplicity, we assume that the plant, equipment, and materials the workers use to build computers are fixed quantities.

Column 3 of Table 20.1 shows the marginal product of each worker, the extra production that is gained by adding one more worker. Note that each additional worker adds less to total production than the previous worker did. The tendency for marginal product to decline as more and more workers are added is called diminishing returns to labor. The principle of diminishing returns to labor states that if the amount of capital and other inputs in use is held constant, then the greater the quantity of labor already employed, the less each additional worker adds to production.

The principle of diminishing returns to labor is analogous to the principle of diminishing returns to capital discussed in Chapter 19, Economic Growth, Productivity, and Living Standards. The economic basis for diminishing returns to labor is the Principle of Increasing Opportunity Cost, also known as the Low-Hanging Fruit Principle. A firm’s managers want to use their available inputs in the most productive way possible. Hence, an employer who has one worker will assign that worker to the most productive job. If she hires a second worker, she will assign that worker to the second most productive job. The third worker will be given the third most productive job available, and so on. The greater the number of workers already employed, the lower the marginal product of adding another worker, as shown in Table 20.1.

Increasing Opportunity Cost

If BCC computers sell for $3,000 each, then column 4 of Table 20.1 shows the value of the marginal product of each worker. The value of a worker’s marginal product is the amount of extra revenue that the worker generates for the firm. Specifically, the value of the marginal product of each BCC worker is that worker’s marginal product, stated in terms of the number of additional computers produced, multiplied by the price of output (here, $3,000 per computer). We now have all the information necessary to find BCC’s demand for workers.

EXAMPLE 20.1BCC’s Demand for Labor

How many workers should BCC hire?

Suppose that the going wage for computer technicians is $60,000 per year. BCC managers know that this is the wage being offered by all their competitors, so they cannot hire qualified workers for less. How many technicians will BCC hire? What would the answer be if the wage were $50,000 per year?

BCC will hire an extra worker if and only if the value of that worker’s marginal product (which equals the extra revenue the worker creates for the firm) exceeds the wage BCC must pay. The going wage for computer technicians, which BCC takes as given, is $60,000 per year. Table 20.1 shows that the value of the marginal product of the first, second, and third workers each exceeds $60,000. Hiring these workers will be profitable for BCC because the extra revenue each generates exceeds the wage that BCC must pay. However, the fourth worker’s marginal product is worth only $57,000. If BCC’s managers hired a fourth worker, they would be paying $60,000 in extra wages for additional output that is worth only $57,000. Since hiring the fourth worker is a money-losing proposition, BCC will hire only three workers. Thus the quantity of labor BCC demands when the going wage is $60,000 per year is three technicians.

If the market wage for computer technicians were $50,000 per year instead of $60,000, the fourth technician would be worth hiring since the value of the fourth technician’s marginal product, $57,000, would be $7,000 more than the fourth technician’s wages. The fifth technician would also be worth hiring since the fifth worker’s marginal product is worth $51,000—$1,000 more than the going wage. The value of the marginal product of a sixth technician, however, is only $45,000, so hiring a sixth worker would not be profitable. When wages are $50,000 per year then, BCC’s labor demand is five technicians.

CONCEPT CHECK 20.1

Continuing with Example 20.1, how many workers will BCC hire if the going wage for technicians is $35,000 per year?

The lower the wage a firm must pay, the more workers it will hire. Thus the demand for labor is like the demand for other goods or services in that the quantity demanded rises as the price (in this case, the wage) falls. Figure 20.1 shows a hypothetical labor demand curve for a firm or industry, with the wage on the vertical axis and employment on the horizontal axis. All else being equal, the higher the wage, the fewer workers a firm or industry will demand.

FIGURE 20.1 The Demand Curve for Labor.The demand curve for labor is downward-sloping. The higher the wage, the fewer workers employers will hire.

In our example thus far, we have discussed how labor demand depends on the nominal, or dollar, wage and the nominal price of workers’ output. Equivalently, we could have expressed the wage and the price of output in real terms—that is, measured relative to the average price of goods and services. The wage measured relative to the general price level is the real wage; as we saw in Chapter 18, Measuring the Price Level and Inflation, the real wage expresses the wage in terms of its purchasing power. The price of a specific good or service measured relative to the general price level is called the relative price of that good or service. Because our main interest is in real rather than nominal wages, from this point on we will analyze the demand for labor in terms of the real wage and the relative price of workers’ output, rather than in terms of nominal variables.

SHIFTS IN THE DEMAND FOR LABOR

The number of workers that BCC will employ at any given real wage depends on the value of their marginal product, as shown in column 4 of Table 20.1. Changes in the economy that increase the value of workers’ marginal product will increase the value of extra workers to BCC, and thus BCC’s demand for labor at any given real wage. In other words, any factor that raises the value of the marginal product of BCC’s workers will shift BCC’s labor demand curve to the right.

Two main factors could increase BCC’s labor demand:

1. An increase in the relative price of the company’s output (computers).

2. An increase in the productivity of BCC’s workers.

The next two examples illustrate both of these possibilities.

EXAMPLE 20.2Real Wage and an Increase in Demand

Will BCC hire more workers if the price of computers rises?

Suppose an increase in the demand for BCC’s computers raises the relative price of its computers to $5,000 each. How many technicians will BCC hire now, if the real wage is $60,000 per year? If the real wage is $50,000?

The effect of the increase in computer prices is shown in Table 20.2. Columns 1 to 3 of the table are the same as in Table 20.1. The number of computers a given number of technicians can build (column 2) has not changed; hence, the marginal product of particular technicians (column 3) is the same. But because computers can now be sold for $5,000 each instead of $3,000, the value of each worker’s marginal product has increased by two-thirds (compare column 4 of Table 20.2 with column 4 of Table 20.1).

How does the increase in the relative price of computers affect BCC’s demand for labor? Recall from Example 20.1 that when the price of computers was $3,000 and the going wage for technicians was $60,000, BCC’s demand for labor was three workers. But now, with computers selling for $5,000 each, the value of the marginal product of each of the first seven workers exceeds $60,000 (Table 20.2). So if the real wage of computer technicians is still $60,000, BCC would increase its demand from three workers to seven.

Suppose instead that the going real wage for technicians is $50,000. In the previous example, when the price of computers was $3,000 and the wage was $50,000, BCC demanded five workers. But if computers sell for $5,000, we can see from column 4 of Table 20.2 that the value of the marginal product of even the eighth worker exceeds the wage of $50,000. So if the real wage is $50,000, the increase in computer prices raises BCC’s demand for labor from five workers to eight.

CONCEPT CHECK 20.2

Refer to Example 20.2. How many workers will BCC hire if the going real wage for technicians is $100,000 per year and the relative price of computers is $5,000? Compare your answer to the demand for technicians at a wage of $100,000 when the price of computers is $3,000.

The general conclusion to be drawn from Example 20.2 is that an increase in the relative price of workers’ output increases the demand for labor, shifting the labor demand curve to the right, as shown in Figure 20.2. A higher relative price for workers’ output makes workers more valuable, leading employers to demand more workers at any given real wage.

FIGURE 20.2 A Higher Relative Price of Output Increases the Demand for Labor.An increase in the relative price of workers’ output increases the value of their marginal product, shifting the labor demand curve to the right.

The second factor that affects the demand for labor is worker productivity. Since an increase in productivity increases the value of a worker’s marginal product, it also increases the demand for labor, as Example 20.3 shows.

EXAMPLE 20.3Worker Productivity and Demand for Labor

Do productivity improvements hurt workers?

Suppose BCC adopts a new technology that reduces the number of components to be assembled, permitting each technician to build 50 percent more machines per year. Assume that the relative price of computers is $3,000 per machine. How many technicians will BCC hire if the real wage is $60,000 per year?

Table 20.3 shows workers’ marginal products and the value of their marginal products after the 50 percent increase in productivity, assuming that computers sell for $3,000 each.

Before the productivity increase, BCC would have demanded three workers at a wage of $60,000 (Table 20.1). After the productivity increase, however, the value of the marginal product of the first six workers exceeds $60,000 (see Table 20.3, column 4). So at a wage of $60,000, BCC’s demand for labor increases from three workers to six.

CONCEPT CHECK 20.3

Refer to Example 20.3. How many workers will BCC hire after the 50 percent increase in productivity if the going real wage for technicians is $50,000 per year? Compare this figure to the demand for workers at a $50,000 wage before the increase in productivity.

In general, an increase in worker productivity increases the demand for labor, shifting the labor demand curve to the right, as in Figure 20.3.

FIGURE 20.3 Higher Productivity Increases the Demand for Labor.An increase in productivity raises workers’ marginal product and—assuming no change in the price of output—the value of their marginal product. Since a productivity increase raises the value of marginal product, employers will hire more workers at any given real wage, shifting the labor demand curve to the right.

THE SUPPLY OF LABOR

We have discussed the demand for labor by employers; to complete the story we need to consider the supply of labor. The suppliers of labor are workers and potential workers. At any given real wage, potential suppliers of labor must decide if they are willing to work. The total number of people who are willing to work at each real wage is the supply of labor.²

EXAMPLE 20.4Reservation Price for Labor

Will you clean your neighbor’s basement or go to the beach?

You were planning to go to the beach today, but your neighbor asks you to clean out his basement. You like the beach a lot more than fighting cobwebs. Do you take the job?

Unless you are motivated primarily by neighborliness, your answer to this job offer would probably be “It depends on how much my neighbor will pay.” You probably would not be willing to take the job for $10 or $20 unless you have a severe and immediate need for cash. But if your neighbor were wealthy and eccentric enough to offer you $500 (to take an extreme example), you would very likely say yes. Somewhere between $20 and the unrealistic figure of $500 is the minimum payment you would be willing to accept to tackle the dirty basement. This minimum payment, the reservation price you set for your labor, is the compensation level that leaves you just indifferent between working and not working.

In economic terms, deciding whether to work at any given wage is a straightforward application of the Cost-Benefit Principle. The cost to you of cleaning out the basement is the opportunity cost of your time (you would rather be surfing) plus the cost you place on having to work in unpleasant conditions. You can measure this total cost in dollars simply by asking yourself, “What is the minimum amount of money I would take to clean out the basement instead of going to the beach?” The minimum payment that you would accept is the same as your reservation price. The benefit of taking the job is measured by the pay you receive, which will go toward that new smartphone you want. You should take the job only if the promised pay (the benefit of working) exceeds your reservation price (the cost of working).

Cost-Benefit

In this example, your willingness to supply labor is greater the higher the wage. In general, the same is true for the population as a whole. Certainly people work for many reasons, including personal satisfaction, the opportunity to develop skills and talents, and the chance to socialize with coworkers. Still, for most people, income is one of the principal benefits of working, so the higher the real wage, the more willing they are to sacrifice other possible uses of their time. The fact that people are more willing to work when the wage they are offered is higher is captured in the upward slope of the supply curve of labor (see Figure 20.4).

FIGURE 20.4 The Supply of Labor.The labor supply curve is upward-sloping because, in general, the higher the real wage, the more people are willing to work.Might accepting a job that pays no salary ever be a good career move?

CONCEPT CHECK 20.4

You want to make a career in broadcasting. The local radio station is offering an unpaid summer internship that would give you valuable experience. Your alternative to the internship is to earn $3,000 working in a car wash. How would you decide which job to take? Would a decision to take the internship contradict the conclusion that the labor supply curve is upward-sloping?

SHIFTS IN THE SUPPLY OF LABOR

Any factor that affects the quantity of labor offered at a given real wage will shift the labor supply curve. At the macroeconomic level, the most important factor affecting the supply of labor is the size of the working-age population, which is influenced by factors such as the domestic birthrate, immigration and emigration rates, and the ages at which people normally first enter the workforce and retire. All else being equal, an increase in the working-age population raises the quantity of labor supplied at each real wage, shifting the labor supply curve to the right. Changes in the percentage of people of working age who seek employment—for example, as a result of social changes that encourage women to work outside the home—can also affect the supply of labor.

Now that we have discussed both the demand for and supply of labor, we are ready to apply supply and demand analysis to real-world labor markets. But first, try your hand at using supply and demand analysis to answer the following question.

CONCEPT CHECK 20.5

Labor unions typically favor tough restrictions on immigration, while employers tend to favor more liberal rules. Why? (Hint: How is an influx of potential workers likely to affect real wages?)

RECAP

SUPPLY AND DEMAND IN THE LABOR MARKET

The Demand for Labor

The extra production gained by adding one more worker is the marginal product of that worker. The value of the marginal product of a worker is that worker’s marginal product times the relative price of the firm’s output. A firm will employ a worker only if the worker’s value of marginal product, which is the same as the extra revenue the worker generates for the firm, exceeds the real wage that the firm must pay. The lower the real wage, the more workers the firm will find it profitable to employ. Thus the labor demand curve, like most demand curves, is downward-sloping.

For a given real wage, any change that increases the value of workers’ marginal products will increase the demand for labor and shift the labor demand curve to the right. Examples of factors that increase labor demand are an increase in the relative price of workers’ output and an increase in productivity.

The Supply of Labor

An individual is willing to supply labor if the real wage that is offered is greater than the opportunity cost of the individual’s time. Generally, the higher the real wage, the more people are willing to work. Thus the labor supply curve, like most supply curves, is upward-sloping.

For a given real wage, any factor that increases the number of people available and willing to work increases the supply of labor and shifts the labor supply curve to the right. Examples of factors that increase labor supply include an increase in the working-age population or an increase in the share of the working-age population seeking employment.

EXPLAINING THE TRENDS IN REAL WAGES AND EMPLOYMENT

We are now ready to analyze the important trends in real wages and employment discussed earlier in the chapter.

LARGE INCREASES IN REAL WAGES IN INDUSTRIALIZED COUNTRIES

As we discussed, real annual earnings in the United States have increased more than fivefold since 1929, and other industrialized countries have experienced similar gains. These increases have greatly improved the standard of living of workers in these countries. Why have real wages increased by so much in the United States and other industrialized countries?

The large increase in real wages results from the sustained growth in productivity experienced by the industrialized countries during the twentieth century. (We mentioned this growth in productivity in Chapter 16, Macroeconomics: The Bird’s-Eye View of the Economy, and discussed its determinants and consequences in Chapter 19, Economic Growth, Productivity, and Living Standards.) As illustrated by Figure 20.5, increased productivity raises the demand for labor, increasing employment and the real wage.

FIGURE 20.5 An Increase in Productivity Raises the Real Wage.An increase in productivity raises the demand for labor, shifting the labor demand curve from D to D′. The real wage rises from w to w′, and employment rises from N to N′.

Of the factors contributing to productivity growth in the industrialized countries, two of the most important were (1) the dramatic technological progress that occurred during the twentieth century and (2) large increases in capital stocks, which provided workers with more and better tools with which to work. Labor supply increased during the century as well, of course (not shown in the diagram). However, the increases in labor demand, driven by rapidly expanding productivity, have been so great as to overwhelm the depressing effect on real wages of increased labor supply.

REAL WAGE GROWTH IN THE UNITED STATES HAS STAGNATED SINCE THE EARLY 1970S, WHILE EMPLOYMENT GROWTH HAS BEEN RAPID

With the exception of the late 1990s, rates of real wage growth after 1973 in the United States have been significantly lower than in previous decades. But over much of the period, the economy has created new jobs at a record rate. What accounts for these trends?

Let’s begin with the slowdown in real wage growth since the early 1970s. Supply and demand analysis tells us that a slowdown in real wage growth must result from slower growth in the demand for labor, more rapid growth in the supply of labor, or both. On the demand side, since the early 1970s the United States and other industrialized nations have experienced a slowdown in productivity growth. Thus, one possible explanation for the slowdown in the growth of real wages since the early 1970s is the decline in the pace of productivity gains.

Some evidence for a relationship between productivity and real wages is given in Table 20.4, which shows the average annual growth rates in labor productivity and real annual earnings for each decade since 1960. You can see that the growth in productivity decade by decade corresponds closely to the growth in real earnings. Particularly striking is the rapid growth of both productivity and wages during the 1960s. Since the 1970s, growth in both productivity and real wages has been significantly slower, although some improvement was apparent in the 1990s.

While the effects of the slowdown in productivity on the demand for labor are an important reason for declining real wage growth, they can’t be the whole story. We know this because, with labor supply held constant, slower growth in labor demand would lead to reduced rates of employment growth, as well as reduced growth in real wages. But job growth in the United States has been rapid in recent decades. Large increases in employment in the face of slow growth of labor demand can be explained only by simultaneous increases in the supply of labor (see Concept Check 20.6).

Labor supply in the United States does appear to have grown rapidly until recently. In particular, increased participation in the labor market by women increased the U.S. supply of labor from the mid-1970s to the late 1990s. Other factors, including the coming of age of the baby boomers and high rates of immigration, also help to explain the increase in the supply of labor during those years. The combination of slower growth in labor demand (the result of the productivity slowdown) and accelerated growth in labor supply (the result of increased participation by women in the workforce, together with other factors) helps to explain why real wage growth was sluggish for many years in the United States, even as employment grew rapidly.

What about the 2000s? Here the story is different. On the supply side, the participation rate of women in the workforce leveled off and then started slowly declining in the 2000s. This trend reversal, together with the aging population and other factors, slowed down the growth of labor supply. With tightening supply, why was earnings growth so disappointing? Part of the answer is slowing productivity gains. But again, productivity alone cannot be the whole story: As Table 20.4 shows, while increasing more slowly than in the 1990s, on average productivity still grew during the 2000s almost twice as fast as real earnings, before slowing further in recent years. So another part of the answer must be that the demand for labor slowed more than the supply of labor for reasons other than productivity. One reason could be weak demand for the products of labor—namely, for goods and services. Consistent with this explanation, the 2000s started with a mild recession and ended with a severe one. (Recessions are periods of particularly weak demand, as we will see in later chapters.)

What about the future? As we have seen, labor supply growth is likely to continue slowing as the baby boomers retire. If productivity starts accelerating again, perhaps reflecting the benefits of new technologies, among other factors, there seems a good chance that the more rapid increases in real wages that began around 1996 will return in years to come.

CONCEPT CHECK 20.6

As we have just discussed, relatively weak growth in productivity and relatively strong growth in labor supply after about 1973 can explain (1) the slowdown in real wage growth and (2) the more rapid expansion in employment after about 1973. Show this point graphically by drawing two supply and demand diagrams of the labor market, one corresponding to the period 1960–1973 and the other to 1973–1995. Assuming that productivity growth was strong but labor supply growth was modest during 1960–1973, show that we would expect to see rapid real wage growth but only moderate growth in employment in that period. Now apply the same analysis to 1973–1995, assuming that productivity growth is weaker but labor supply growth stronger than in 1960–1973. What do you predict for growth in the real wage and employment in 1973–1995 relative to the earlier period? What could account for increased real wage growth in the late 1990s?

INCREASING WAGE INEQUALITY: THE EFFECTS OF GLOBALIZATION AND TECHNOLOGICAL CHANGE

Another important trend in U.S. labor markets is increasing inequality in wages, especially the tendency for the wages of the less-skilled and less-educated to fall further and further behind those of better-trained workers. We next discuss two reasons for this increasing inequality: (1) globalization and (2) technological change.

Globalization

Many commentators have blamed the increasing divergence between the wages of skilled and unskilled workers on the phenomenon of “globalization.” This popular term refers to the fact that to an increasing extent, the markets for many goods and services are becoming international, rather than national or local, in scope. While Americans have long been able to buy products from all over the world, the ease with which goods and services can cross borders is increasing rapidly. In part, this trend is the result of international trade agreements, which reduced taxes on goods and services traded across countries. However, technological advances such as the Internet have also promoted globalization.

The main economic benefit of globalization is increased specialization and the efficiency that it brings. Instead of each country trying to produce everything its citizens consume, each can concentrate on producing those goods and services at which it is relatively most efficient. As implied by the Principle of Comparative Advantage, the result is that consumers of all countries enjoy a greater variety of goods and services, of better quality and at lower prices, than they would without international trade.

Comparative Advantage

The effects of globalization on the labor market are mixed, however, which explains why many politicians oppose free trade agreements. Expanded trade means that consumers stop buying certain goods and services from domestic producers and switch to foreign-made products. Consumers would not make this switch unless the foreign products were better, cheaper, or both, so expanded trade clearly makes them better off. But the workers and firm owners in the domestic industries that lose business may well suffer from the increase in foreign competition.

The effects of increasing trade on the labor market can be analyzed using Figure 20.6. The figure contrasts the supply and demand for labor in two different industries, (a) textiles and (b) computer software. Imagine that, initially, there is little or no international trade in these two goods. Without trade, the demand for workers in each industry is indicated by the curves marked D_textiles and D_software, respectively. Wages and employment in each industry are determined by the intersection of the demand curves and the labor supply curves in each industry. As we have drawn the figure, initially, the real wage is the same in both industries, equal to w. Employment is N_textiles in textiles and N_software in software.

FIGURE 20.6 The Effect of Globalization on the Demand for Workers in Two Industries.Initially, real wages in the two industries are equal at w. After an increase in trade, (a) demand for workers in the importing industry (textiles) declines, lowering real wages and employment, while (b) demand for workers in the exporting industry (software) increases, raising real wages and employment in that industry.

What will happen when this economy is opened up to trade, perhaps because of a free trade agreement? Under the agreement, countries will begin to produce for export those goods or services at which they are relatively more efficient and to import goods or services that they are relatively less efficient at producing. Suppose the country in this example is relatively more efficient at producing software than manufacturing textiles. With the opening of trade, the country gains new foreign markets for its software and begins to produce for export as well as for domestic use. Meanwhile, because the country is relatively less efficient at producing textiles, consumers begin to purchase foreign-made textiles, which are cheaper or of higher quality, instead of the domestic product. In short, software becomes an exporting industry and textiles an importing industry.

These changes in the demand for domestic products are translated into changes in the demand for labor. The opening of export markets increases the demand for domestic software, raising its relative price. The higher price for domestic software, in turn, raises the value of the marginal products of software workers, shifting the labor demand curve in the software industry to the right, from D_software to D′_software in Figure 20.6 (b). Wages in the software industry rise, from w to w′_software, and employment in the industry rises as well. In the textile industry the opposite happens. Demand for domestic textiles falls as consumers switch to imports. The relative price of domestic textiles falls with demand, reducing the value of the marginal product of textile workers and hence the demand for their labor, to D′_textiles in Figure 20.6(a). Employment in the textile industry falls, and the real wage falls as well, from w to w′_textiles.

In sum, Figure 20.6 shows how globalization can contribute to increasing wage inequality. Initially, we assumed that software workers and textile workers received the same wage. However, the opening up of trade raised the wages of workers in the “winning” industry (software) and lowered the wages of workers in the “losing” industry (textiles), increasing inequality.

In practice, the tendency of trade to increase wage inequality may be even worse than depicted in the example, because the great majority of the world’s workers, particularly those in developing countries, have relatively low skill levels. Thus, when industrialized countries like the United States open up trade with developing countries, the domestic industries that are likely to face the toughest international competition are those that use mostly low-skilled labor. Conversely, the domestic industries that are likely to do the best in international competition are those that employ mostly skilled workers. Thus increased trade may lower the wages of those workers in the industrialized country who are already poorly paid and increase the wages of those who are well paid.

The fact that increasing trade may exacerbate wage inequality explains some of the political resistance to globalization. Such resistance is seen in recent years in the U.S., Europe, and other countries around the world, where voters show strong support for political candidates who promise to reverse the trend. Perhaps most consequential, in the “Brexit” (short for British exit) referendum of 2016, voters in the United Kingdom voted for withdrawal from the European Union. While the vote had many different reasons that are still being studied, it clearly expressed an anti-globalization sentiment—for example, in the form of anti-immigration positions, often in the context of labor-market concerns.

But attempts to reverse the trend of globalization, if they succeed, would come with their own costs to society because increasing trade and specialization is a major source of improvement in living standards in the United States, Europe, the United Kingdom, and other countries. Indeed, the economic forces behind globalization—primarily, the desire of consumers for better and cheaper products and of producers for new markets—are so powerful that the process would be hard to stop even if government officials were determined to do so.

Rather than trying to stop globalization, helping the labor market to adjust to the effects of globalization may be a better course. Indeed, our analysis of supply and demand in the labor market suggests that to a certain extent, at least in theory, the economy will adjust on its own. Figure 20.6 showed that, following the opening to trade, real wages and employment fall in (a) textiles and rise in (b) software. At that point, wages and job opportunities are much more attractive in the software industry than in textiles. Will this situation persist? Clearly, there is a strong incentive for workers who are able to do so to leave the textile industry and seek employment in the software industry.

The movement of workers between jobs, firms, and industries is called worker mobility. In our example, worker mobility will tend to reduce labor supply in textiles and increase it in software, as workers move from the contracting industry to the growing one. This process will reverse some of the increase in wage inequality by raising wages in textiles and lowering them in software. It will also shift workers from a less competitive sector to a more competitive sector. To some extent, then, in theory, the labor market can adjust on its own to the effects of globalization.

Of course, in practice, the adjustment process is never quick, easy, or painless. While left outside our simple supply-and-demand model, in reality there are many barriers to a textile worker becoming a software engineer. Indeed, as reported in The Economic Naturalist 15.1, empirical evidence suggests that the reallocation of U.S. workers from less competitive sectors to more competitive ones can be painfully slow. In the case of opening up to trade with an economy like China, which has a large supply of low-skill workers, the adjustment of many U.S. workers could be difficult and could take many years.

As we discussed in Chapter 15, International Trade and Trade Policy, then, there may also be a need for transition aid to workers in the affected sectors. Ideally, such aid helps workers train for and find new jobs. If that is not possible or desirable—say, because a worker is nearing retirement—transition aid can take the form of government payments to help the worker maintain his or her standard of living. In addition, redevelopment aid may be needed in affected communities, as the slow adjustment process of affected workers may come with both economic and social problems. The Efficiency Principle reminds us that transition aid and similar programs are useful because trade and specialization increase the total economic pie. The “winners” from globalization can afford the taxes necessary to finance aid and still enjoy a net benefit from increased trade. Developing effective aid programs is thus a priority.

Efficiency

Technological Change

A second source of increasing wage inequality is ongoing technological change that favors more highly skilled or educated workers. As we have seen, new scientific knowledge and the technological advances associated with it are a major source of improved productivity and economic growth. Increases in worker productivity are in turn a driving force behind wage increases and higher average living standards. In the long run and on average, technological progress is undoubtedly the worker’s friend.

This sweeping statement is not true at all times and in all places, however. Whether a particular technological development is good for a particular worker depends on the effect of that innovation on the worker’s value of marginal product and, hence, on his or her wage. For example, at one time the ability to add numbers rapidly and accurately was a valuable skill; a clerk with that skill could expect advancement and higher wages. However, the invention and mass production of the electronic calculator has rendered human calculating skills less valuable, to the detriment of those who have that skill.

History is replete with examples of workers who opposed new technologies out of fear that their skills would become less valuable. In England in the early nineteenth century, rioting workmen destroyed newly introduced labor-saving machinery. The name of the workers’ reputed leader, Ned Ludd, has been preserved in the term Luddite, meaning a person who is opposed to the introduction of new technologies. The same theme appears in American folk history in the tale of John Henry, the mighty pile-driving man who died in an attempt to show that a human could tunnel into a rock face more quickly than a steam-powered machine.

How do these observations bear on wage inequality? According to some economists, many recent technological advances have taken the form of skill-biased technological change—that is, technological change that affects the marginal product of higher-skilled workers differently from that of lower-skilled workers. Specifically, technological developments in recent decades appear to have favored more-skilled and educated workers.

Developments in automobile production are a case in point. The advent of mass production techniques in the 1920s provided highly paid work for several generations of relatively low-skilled autoworkers. But in recent years automobile production, like the automobiles themselves, has become considerably more sophisticated. The simplest production jobs have been taken over by robots and computer-controlled machinery, which require skilled operatives who know how to use and maintain the new equipment. Consumer demand for luxury features and customized options has also raised the automakers’ demand for highly skilled craftsmen. Thus, in general, the skill requirements for jobs in automobile production have risen.

Figure 20.7 illustrates the effects of technological change that favors skilled workers. Figure 20.7(a) shows the market for unskilled workers; Figure 20.7(b) shows the market for skilled workers. The demand curves labeled D_unskilled and D_skilled show the demand for each type of worker before a skill-biased technological change. Wages and employment for each type of worker are determined by the intersection of the demand and supply curves in each market. Figure 20.7 shows that, even before the technological change, unskilled workers received lower real wages than skilled workers (w_unskilled < w_skilled), reflecting the lower marginal products of the unskilled.

FIGURE 20.7 The Effect of Skill-Biased Technological Change on Wage Inequality.The figure shows the effects of a skill-biased technological change that increases the marginal product of skilled workers and reduces the marginal product of unskilled workers. The resulting increase in the demand for skilled workers raises their wages (b), while the decline in demand for unskilled workers reduces their wages (a). Wage inequality increases.

Now suppose that a new technology—computer-controlled machinery, for example—is introduced. This technological change is biased toward skilled workers, which means that it raises their marginal productivity relative to unskilled workers. We will assume in this example that the new technology also lowers the marginal productivity of unskilled workers, perhaps because they are unable to use the new technology, but all that is necessary for our conclusions is that they benefit less than skilled workers. Figure 20.7 shows the effect of this change in marginal products. In part (b) the increase in the marginal productivity of skilled workers raises the demand for those workers; the demand curve shifts rightward to D′_skilled. Accordingly, the real wages and employment of skilled workers also rise. In contrast, because they have been made less productive by the technological change, the demand for unskilled workers shifts leftward to D′_unskilled [Figure 20.7(a)]. Lower demand for unskilled workers reduces their real wages and employment.

In summary, this analysis supports the conclusion that technological change that is biased in favor of skilled workers will tend to increase the wage gap between the skilled and unskilled. Empirical studies have confirmed the role of skill-biased technological change in recent increases in wage inequality.

Because new technologies that favor skilled workers increase wage inequality, should government regulators act to block them? As in the case of globalization, most economists would argue against trying to block new technologies since technological advances are necessary for economic growth and improved living standards. If the Luddites had somehow succeeded in preventing the introduction of labor-saving machinery in Great Britain, economic growth and development over the past few centuries might have been greatly reduced.

The remedies for the problem of wage inequalities caused by technological change are similar to those for wage inequalities caused by globalization. First among them is worker mobility. As the pay differential between skilled and unskilled work increases, unskilled workers will have a stronger incentive to acquire education and skills, to everyone’s benefit. A second remedy is transition aid. Government policymakers should consider programs that will help workers to retrain if they are able, or provide income support if they are not.

Unimpressed by new technology

RECAP

EXPLAINING THE TRENDS IN REAL WAGES AND EMPLOYMENT

· The long-term increase in real wages enjoyed by workers in industrial countries results primarily from large productivity gains, which have raised the demand for labor. Technological progress and an expanded and modernized capital stock are two important reasons for these long-term increases in productivity.

· The slowdown in real wage growth that began in the 1970s resulted in part from the slowdown in productivity growth (and, hence, the slower growth in labor demand) that occurred at about the same time. Increased labor supply, arising from such factors as the increased participation of women and the coming of age of the baby boom generation, depressed real wages further while also expanding employment. In the latter part of the 1990s, resurgence in productivity growth was accompanied by an increase in real wage growth. If such productivity growth returns in years to come, real wages are expected to resume their faster growth. The slower growth in labor supply in recent years, resulting from a reversal in the earlier participation trends, is expected to further strengthen real wage growth.

· Both globalization and skill-biased technological change contribute to wage inequality. Globalization raises the wages of workers in exporting industries by raising the demand for those workers, while reducing the wages of workers in importing industries. Technological change that favors more-skilled workers increases the demand for such workers, and hence their wages, relative to the wages of less-skilled workers.

· Attempting to block either globalization or technological change is not the best response to the problem of wage inequality. To some extent, worker mobility (movement of workers from low-wage to high-wage industries) will offset the inequality created by these forces. Where mobility is not practical, or, as is often the case, is slow, transition aid—government assistance to workers whose employment prospects have worsened—may be the best solution. Developing effective assistance programs is thus a priority.

UNEMPLOYMENT

The concept of the unemployment rate was introduced in Chapter 17, Measuring Economic Activity: GDP and Unemployment. To review, government survey takers classify adults as employed (holding a job), unemployed (not holding a job, but looking for one), or not in the labor force (not holding a job and not looking for one—retirees, for example). The labor force consists of the employed and the unemployed. The unemployment rate is the percentage of the labor force that is unemployed.

Unemployment rates differ markedly from country to country. (Different countries measure their unemployment rates in slightly different ways; one should be careful to only compare unemployment rates that are either measured similarly or adjusted to be comparable.) Unemployment rates also vary with time. In the United States, unemployment rates reached historic lows in 2000—4 percent of the labor force—but were almost 2.5 times higher a decade later—reaching 9.6 percent in 2010—before gradually declining below 4.5 percent in 2017. In many western European countries, unemployment rates for many years have been two to three times the U.S. rate (the years following the 2007–2009 recession were an exception). In Europe, unemployment is exceptionally high among young people.

A high unemployment rate has serious economic, psychological, and social costs. Understanding the causes of unemployment and finding ways to reduce it are therefore major concerns of macroeconomists. In the remainder of this chapter we discuss the causes and costs of three types of unemployment, and we will also consider some features of labor markets that may exacerbate the problem.

TYPES OF UNEMPLOYMENT AND THEIR COSTS

Economists have found it useful to think of unemployment as being of three broad types: frictional unemployment, structural unemployment, and cyclical unemployment. Each type of unemployment has different causes and imposes different economic and social costs.

Frictional Unemployment

The function of the labor market is to match available jobs with available workers. If all jobs and workers were the same, or if the set of jobs and workers were static and unchanging, this matching process would be quick and easy. But the real world is more complicated. In practice, both jobs and workers are highly heterogeneous. Jobs differ in their location, in the skills they require, in their working conditions and hours, and in many other ways. Workers differ in their career aspirations, their skills and experience, their preferred working hours, their willingness to travel, and so on.

The real labor market is also dynamic, or constantly changing and evolving. On the demand side of the labor market, technological advances, globalization, and changing consumer tastes spur the creation of new products, new firms, and even new industries, while outmoded products, firms, and industries disappear. Thus CD players replaced record players and then were replaced by media-playing apps. As a result of this upheaval, new jobs are constantly being created, while some old jobs cease to be viable. The workforce in a modern economy is equally dynamic. People move, gain new skills, leave the labor force for a time to rear children or go back to school, and even change careers.

Because the labor market is heterogeneous and dynamic, the process of matching jobs with workers often takes time. For example, a software engineer who loses or quits her job in Silicon Valley may take weeks or even months to find an appropriate new job. In her search, she will probably consider alternative areas of software development or even totally new challenges. She may also want to think about different regions of the country in which software companies are located, such as North Carolina’s Research Triangle or New York City’s Silicon Alley. During the period in which she is searching for a new job, she is counted as unemployed.

Short-term unemployment that is associated with the process of matching workers with jobs is called frictional unemployment. The costs of frictional unemployment are low and may even be negative; that is, frictional unemployment may be economically beneficial. First, frictional unemployment is short-term, so its psychological effects and direct economic losses are minimal. Second, to the extent that the search process leads to a better match between worker and job, a period of frictional unemployment is actually productive, in the sense that it leads to higher output over the long run. Indeed, a certain amount of frictional unemployment seems essential to the smooth functioning of a rapidly changing, dynamic economy.

Structural Unemployment

A second major type of unemployment is structural unemployment, or the long-term and chronic unemployment that exists even when the economy is producing at a normal rate. Several factors contribute to structural unemployment. First, a lack of skills, language barriers, or discrimination keeps some workers from finding stable, long-term jobs. Migrant farmworkers and unskilled construction workers who find short-term or temporary jobs from time to time, but never stay in one job for very long, fit the definition of chronically unemployed.

Second, economic changes sometimes create a long-term mismatch between the skills some workers have and the available jobs. The U.S. steel industry, for example, has declined over the years, while the computer software industry has grown rapidly. Ideally, steelworkers who lose their jobs would be able to find new jobs in software firms (worker mobility), so their unemployment would only be frictional in nature. In practice, of course, many ex-steelworkers lack the education, ability, or interest necessary to work in the software industry. Since their skills are no longer in demand, these workers may drift into chronic or long-term unemployment.

Finally, structural unemployment can result from structural features of the labor market that act as barriers to employment. Examples of such barriers include laws that limit certain types of government help to people without jobs, thus discouraging people from taking a job (and losing their benefits as a result).

The costs of structural unemployment are much higher than those of frictional unemployment. Because structurally unemployed workers do little productive work over long periods, their idleness causes substantial economic losses both to the unemployed workers and to society. Structurally unemployed workers also lose out on the opportunity to develop new skills on the job, and their existing skills wither from disuse. Long spells of unemployment are also much more difficult for workers to handle psychologically than the relatively brief spells associated with frictional unemployment.

Cyclical Unemployment

The third type of unemployment occurs during periods of recession (that is, periods of unusually low production) and is called cyclical unemployment. Sharp peaks in unemployment reflect the cyclical unemployment that occurs during recessions. Increases in cyclical unemployment, although they are relatively short-lived, are associated with significant declines in real GDP and are therefore quite costly economically. We will study cyclical unemployment in more detail later in the chapters dealing with booms and recessions.

In principle, frictional, structural, and cyclical unemployment add up to the total unemployment rate. In practice, sharp distinctions often cannot be made between the different categories, so any breakdown of the total unemployment rate into the three types of unemployment is necessarily subjective and approximate.

IMPEDIMENTS TO FULL EMPLOYMENT

In discussing structural unemployment, we mentioned that structural features of the labor market may contribute to long-term and chronic unemployment. One such structural feature is the availability of unemployment insurance, or government transfer payments to unemployed workers. Unemployment insurance provides an important social benefit in that it helps the unemployed to maintain a decent standard of living while they are looking for a job. But because its availability allows the unemployed to search longer or less intensively for a job, it may lengthen the average amount of time the typical unemployed worker is without a job.

Most economists would argue that unemployment insurance should be generous enough to provide basic support to the unemployed but not so generous as to remove the incentive to actively seek work. Thus, unemployment insurance should last for only a limited time, and its benefits should not be as high as the income a worker receives when working.

Many other government regulations bear on the labor market. They include health and safety regulations, which establish the safety standards employers must follow, and rules that prohibit racial or gender-based discrimination in hiring. Many of these regulations are beneficial. In some cases, however, the costs of complying with regulations may exceed the benefits they provide. Further, to the extent that regulations increase employer costs and reduce productivity, they depress the demand for labor, lowering real wages and contributing to unemployment. For maximum economic efficiency, legislators should use cost-benefit criterion when deciding what regulations to impose on the labor market.

Cost-Benefit

The points raised in this section can help us to understand one of the important labor market trends discussed earlier in the chapter, namely, the persistence of high unemployment in western Europe. For more than two decades, unemployment has been exceptionally high in the major countries of western Europe, as Figure 20.8 shows. The figure shows “harmonized unemployment rates”—unemployment rates that are calculated by applying a uniform definition to data from different countries, facilitating comparisons. From 1995 to 2005, for example, the harmonized unemployment rate was roughly in the range 8–11 percent in Germany, 9–12 percent in France, 8–11 percent in Italy, and 9–21 percent in Spain, compared with 5–6 percent in the U.S. In the 1950s, 1960s, and 1970s, western Europe consistently enjoyed very low unemployment rates. Why has European unemployment been so stubbornly high for the past decades?

FIGURE 20.8 Unemployment Rates in Western Europe, 1991–2016.In the largest economies in continental western Europe, unemployment rates have been high in recent decades.Source: Harmonized unemployment rates, Federal Reserve of St. Louis Economic Data, https://fred. stlouisfed.org.

One explanation for the high unemployment in major western European countries is the existence of structural “rigidities” in their labor markets. Relative to the United States, European labor markets are highly regulated. European governments set rules in matters ranging from the number of weeks of vacation workers must receive to the reasons for which a worker can be dismissed. Minimum wages in Europe are high, and unemployment benefits are much more generous than in the United States. European unions are also far more powerful than those in the United States; their wage agreements are often extended by law to all firms in the industry, whether or not they are unionized. This lack of flexibility in labor markets causes higher frictional and structural unemployment.

If European labor markets are so dysfunctional, why has serious European unemployment emerged only in the past few decades? One explanation turns on the increasing pace of globalization and skill-biased technological change. As we saw, these two factors decrease the demand for less-skilled labor relative to the demand for skilled labor. In the United States, falling demand has depressed the wages of the less skilled, increasing wage inequality. But in western Europe, high minimum wages, union contracts, generous unemployment insurance, and other factors may have created a floor for the wage that firms could pay or that workers would accept. As the marginal productivity of the less skilled dropped below that floor, firms no longer found it profitable to employ those workers, swelling the ranks of the unemployed. Thus the combination of labor market rigidity and the declining marginal productivity of low-skilled workers may be responsible for the European unemployment problem.

Evidence for the idea that inflexible labor markets have contributed to European unemployment comes from the United Kingdom, where the government of Prime Minister Margaret Thatcher instituted a series of reforms beginning in the early 1980s. Britain has since largely deregulated its labor market so that it functions much more like that in the United States. Figure 20.8 shows that unemployment in Britain has gradually declined and is now lower than in other western European countries.

More recently, during 2003–2005, Germany enacted a series of labor market reforms (the “Hartz reforms”) under the government of Chancellor Gerhard Schröder. Aimed at increasing the flexibility of Germany’s labor markets, the reforms attempted, among other things, to make it easier for employers to hire for short periods and to make it harder for the unemployed to receive generous benefits for long periods. The reforms were controversial, and it is too early for a comprehensive assessment of their long-term impact. That said, as Figure 20.8 shows, the unemployment rate in Germany dropped sharply in the past 10 years—from above 11 percent in 2005 to just above 4 percent in 2016—setting Germany apart from the rest. Labor market reforms like those in Britain and Germany are examples of structural policies.

RECAP

UNEMPLOYMENT

Economists distinguish among three broad types of unemployment. Frictional unemployment is the short-term unemployment that is associated with the process of matching workers with jobs. Structural unemployment is the long-term or chronic unemployment that occurs even when the economy is producing at a normal rate. Cyclical unemployment is the extra unemployment that occurs during periods of recession. Frictional unemployment may be economically beneficial, as improved matching of workers and jobs may increase output in the long run. Structural and cyclical unemployment impose heavy economic costs on workers and society, as well as psychological costs on workers and their families.

Structural features of the labor market may cause structural unemployment. Examples of such features are unemployment insurance, which allows unemployed workers to search longer or less intensively for a job, and government regulations that impose extra costs on employers. Regulation of the labor market is not necessarily undesirable, but it should be subject to cost-benefit analysis. Heavy labor market regulation and high unionization rates in western Europe help to explain the persistence of high unemployment rates in some of those countries.

SUMMARY

· For the average person, the most tangible result of economic growth and increasing productivity is the availability of “good jobs at good wages.” Over the long run, the U.S. economy has, for the most part, delivered on this promise as both real wages and employment have grown strongly. But while growth in employment has generally been rapid, two worrisome trends dog the U.S. labor market: a slowdown since the early 1970s in the growth of real wages and increasing wage inequality. Western Europe has experienced less wage inequality but significantly higher rates of unemployment than the United States. (LO1)

· Trends in real wages and employment can be studied using a supply and demand model of the labor market. The productivity of labor and the relative price of workers’ output determine the demand for labor. Employers will hire workers only as long as the value of the marginal product of the last worker hired equals or exceeds the wage the firm must pay. Because of diminishing returns to labor, the more workers a firm employs, the less additional product will be obtained by adding yet another worker. The lower the going wage, the more workers will be hired; that is, the demand for labor curve slopes downward. Economic changes that increase the value of labor’s marginal product, such as an increase in the relative price of workers’ output or an increase in productivity, shift the labor demand curve to the right. Conversely, changes that reduce the value of labor’s marginal product shift the labor demand curve to the left. (LO2)

· The supply curve for labor shows the number of people willing to work at any given real wage. Since more people will work at a higher real wage, the supply curve is upward-sloping. An increase in the working-age population, or a social change that promotes labor market participation (like increased acceptance of women in the labor force) will raise labor supply and shift the labor supply curve to the right. (LO2)

· Improvements in productivity, which raise the demand for labor, account for the bulk of the increase in U.S. real wages over the last century. The slowdown in real wage growth that has occurred in recent decades is the result of slower growth in labor demand, which was caused in turn by a slowdown in the rate of productivity improvement, and of more rapid growth in labor supply. Rapid growth in labor supply, caused by such factors as immigration and increased labor force participation by women, has until recently also contributed to the continued expansion of employment. Recently, however, overall labor force participation, has been decreasing. (LO3)

· Two reasons for the increasing wage inequality in the United States are economic globalization and skill-biased technological change. Both have increased the demand for, and hence the real wages of, relatively skilled and educated workers. Attempting to block globalization and technological change is counterproductive, however, since both factors are essential to economic growth and increased productivity. To some extent, the movement of workers from lower-paying to higher-paying jobs or industries (worker mobility) will counteract the trend toward wage inequality. A policy of providing transition aid and training for workers with obsolete skills is a more useful response to the problem. (LO3)

· There are three broad types of unemployment: frictional, structural, and cyclical. Frictional unemployment is the short-term unemployment associated with the process of matching workers with jobs in a dynamic, heterogeneous labor market. Structural unemployment is the long-term and chronic unemployment that exists even when the economy is producing at a normal rate. It arises from a variety of factors, including language barriers, discrimination, structural features of the labor market, lack of skills, or long-term mismatches between the skills workers have and the available jobs. Cyclical unemployment is the extra unemployment that occurs during periods of recession. The costs of frictional unemployment are low, as it tends to be brief and to create more productive matches between workers and jobs. But structural unemployment, which is often long-term, and cyclical unemployment, which is associated with significant reductions in real GDP, are relatively more costly. (LO4)

· Structural features of the labor market that may contribute to unemployment include unemployment insurance, which reduces the incentives of the unemployed to find work quickly, and other government regulations, which—although possibly conferring benefits—increase the costs of employing workers. The labor market “rigidity” created by government regulations and union contracts is more of a problem in western Europe than in the United States, which may account for Europe’s high unemployment rates. (LO4)

KEY TERMS

cyclical unemployment

diminishing returns to labor

frictional unemployment

skill-biased technological change

structural unemployment

worker mobility

REVIEW QUESTIONS

1. List and discuss the five important labor market trends given in the first section of the chapter. How do these trends either support or qualify the proposition that increasing labor productivity leads to higher standards of living? (LO1)

2. Acme Corporation is considering hiring Jane Smith. Based on her other opportunities in the job market, Jane has told Acme that she will work for them for $40,000 per year. How should Acme determine whether to employ her? (LO2)

3. Why have real wages risen by so much in the United States in the past century? Why did real wage growth slow for 25 years beginning in the early 1970s? What has been happening to real wages recently? (LO3)

4. What are two major factors contributing to increased inequality in wages? Briefly, why do these factors raise wage inequality? Contrast possible policy responses to increasing inequality in terms of their effects on economic efficiency. (LO3)

5. List three types of unemployment and their causes. Which of these types is economically and socially the least costly? Explain. (LO4)

PROBLEMS

1. Data on the average earnings of people of different education levels are available from the Bureau of the Census (try online at www.census.gov/population/socdemo/education/tableA-3.txt). Using these data, prepare a table showing the earnings of college graduates relative to high school graduates and of college graduates relative to those with less than a high school degree. Show the data for the latest year available and for every fifth year going back to the earliest data available. What are the trends in relative earnings? (LO1)

2. Production data for Bob’s Bicycle Factory are as follows:

Other than wages, Bob has costs of $100 (for parts and so on) for each bike assembled. (LO2)

a. Bikes sell for $130 each. Find the marginal product and the value of the marginal product for each worker (don’t forget about Bob’s cost of parts).

b. Make a table showing Bob’s demand curve for labor.

c. Repeat part b for the case in which bikes sell for $140 each.

d. Repeat part b for the case in which worker productivity increases by 50 percent. Bikes sell for $130 each.

3. The following table lists the marginal product per hour of workers in a light bulb factory. Light bulbs sell for $2 each, and there are no costs to producing them other than labor costs. (LO2)

a. The going hourly wage for factory workers is $24 per hour. How many workers should the factory manager hire? What if the wage is $36 per hour?

b. Graph the factory’s demand for labor.

c. Repeat part b for the case in which light bulbs sell for $3 each.

d. Suppose the supply of factory workers in the town in which the light bulb factory is located is 8 workers (in other words, the labor supply curve is vertical at 8 workers). What will be the equilibrium real wage for factory workers in the town if light bulbs sell for $2 each? If they sell for $3 each?

4. How would each of the following factors be likely to affect the economywide supply of labor? (LO2)

a. The age at which people are eligible for Medicare is increased.

b. Increased productivity causes real wages to rise.

c. War preparations lead to the institution of a national draft, and many young people are called up.

d. More people decide to have children (consider both short-run and long-run effects).

e. Social Security benefits are made more generous,

5. How would each of the following likely affect the real wage and employment of unskilled workers on an automobile plant assembly line? (LO3)

a. Demand for the type of car made by the plant increases.

b. A sharp increase in the price of gas causes many commuters to switch to mass transit.

c. Because of alternative opportunities, people become less willing to do factory work.

6. Skilled or unskilled workers can be used to produce a small toy. Initially, assume that the wages paid to both types of workers are equal. (LO3)

a. Suppose that electronic equipment is introduced that increases the marginal product of skilled workers (who can use the equipment to produce more toys per hours worked). The marginal products of unskilled workers are unaffected. Explain, using words and graphs, what happens to the equilibrium wages are the equilibrium wages for the two groups?

b. Suppose that unskilled workers find it worthwhile to acquire skills when the wage differential between skilled and unskilled workers reaches a certain point. Explain what will happen to the supply of unskilled workers, the supply of skilled workers, and the equilibrium wage for the two groups. In particular, what are the equilibrium wages for skilled workers relative to unskilled workers after some unskilled workers acquire training?

7. For each of the following scenarios, state whether the unemployment is frictional, structural, or cyclical. Justify your answer. (LO4)

a. Ted lost his job when the steel mill closed down. He lacks the skills to work in another industry and so has been unemployed over a year.

b. Alice was laid off from her job at the auto plant because the recession reduced the demand for cars. She expects to get her job back when the economy picks up.

c. Gwen had a job as a clerk but quit when her husband was transferred to another state. She looked for a month before finding a new job that she liked.

ANSWERS TO CONCEPT CHECKS

20.1The value of the marginal product of the seventh worker is $39,000, and the value of the marginal product of the eighth worker is $33,000. So the seventh but not the eighth worker is profitable to hire at a wage of $35,000. (LO2)

20.2With the computer price at $5,000, it is profitable to hire three workers at a wage of $100,000 since the third worker’s value of marginal product ($105,000) exceeds $100,000 but the fourth worker’s value of marginal product ($95,000) is less than $100,000. At a computer price of $3,000, we can refer to Table 20.1 to find that not even the first worker has a value of marginal product as high as $100,000, so at that computer price BCC will hire no workers. In short, at a wage of $100,000, the increase in the computer price raises the demand for technicians from zero to three. (LO2)

20.3The seventh but not the eighth worker’s value of marginal product exceeds $50,000 (Table 20.3), so it is profitable to hire seven workers if the going wage is $50,000. From Table 20.1, before the increase in productivity, the first five workers have values of marginal product greater than $50,000, so the demand for labor at a given wage of $50,000 is five workers. Thus the increase in productivity raises the quantity of labor demanded at a wage of $50,000 from five workers to seven workers. (LO2)

20.4Even though you are receiving no pay, the valuable experience you gain as an intern is likely to raise the pay you will be able to earn in the future, so it is an investment in human capital. You also find working in the radio station more enjoyable than working in a car wash, presumably. To decide which job to take, you should ask yourself, “Taking into account both the likely increase in my future earnings and my greater enjoyment from working in the radio station, would I be willing to pay $3,000 to work in the radio station rather than earn $3,000 working in the car wash?” If the answer is yes, then you should work in the radio station; otherwise you should go to the car wash.

A decision to work in the radio station does not contradict the idea of an upward-sloping labor supply curve, if we are willing to think of the total compensation for that job as including not just cash wages but such factors as the value of the training that you receive. Your labor supply curve is still upward-sloping in the sense that the greater the value you place on the internship experience, the more likely you are to accept the job. (LO2)

20.5Immigration to a country raises labor supply—indeed, the search for work is one of the most powerful factors drawing immigrants in the first place. As shown in the accompanying figure, an increase in labor supply will tend to lower the wages that employers have to pay (from w to w′), while raising overall employment (from N to N′). Because of its tendency to reduce real wages, labor unions generally oppose large-scale immigration, while employers support it.

Although the figure shows the overall, or aggregate, supply of labor in the economy, the specific effects of immigration on wages depend on the skills and occupations of the immigrants. Current U.S. immigration policy makes the reunification of families the main reason for admitting immigrants, and for the most part immigrants are not screened for their education or skills. The U.S. also has a good deal of illegal immigration, made up largely of people looking for economic opportunity. These two factors create a tendency for new immigrants to the United States to be relatively low-skilled. Since immigration tends to increase the supply of unskilled labor by relatively more, it depresses wages of domestic low-skilled workers more than it does the wages of domestic high-skilled workers. Some economists, such as George Borjas of Harvard University, have argued that low-skilled immigration is another important factor reducing the wages of less-skilled workers relative to workers with greater skills and education. Borjas argues that the United States should adopt the approach used by Canada and give preference to potential immigrants with relatively higher levels of skills and education. (LO2)

20.6Part (a) of the accompanying figure shows the labor market in 1960–1973; part (b) shows the labor market in 1973–1995. For comparability, we set the initial labor supply (S) and demand (D) curves the same in both parts, implying the same initial values of the real wage (w) and employment (N). In part (a), we show the effects of a large increase in labor demand (from D to D′), the result of rapid productivity growth, and a relatively small increase in labor supply (from S to S′). The real wage rises to w′ and employment rises to N′. In part (b), we observe the effects of a somewhat smaller increase in labor demand (from D to D″) and a larger increase in labor supply (from S to S″). Part (b), corresponding to the 1973–1995 period, shows a smaller increase in the real wage and a larger increase in employment than part (a), corresponding to 1960–1973. These results are consistent with actual developments in the U.S. labor market over these two periods. Since 1995, more rapid productivity growth, which raises labor demand more quickly, accounts for faster growth in real wages. (LO3)

¹See, for example, Thomas L. Friedman, The Lexus and the Olive Tree (New York: Farrar, Straus, & Giroux, 1999).

²We are still holding the general price level constant, so any increase in the nominal wage also represents an increase in the real wage.