15.2 Unemployment Fluctuations

Question 1

What are the two sets of theories that attempt to describe unemployment fluctuations?

Answer 1

The first set of theories are called market-clearing theories and are based on the central assumption that real wages adjust instantly to clear the labour market after any AD or AS shock occurs.

The second set of theories are called non-market-clearing theories and are based on a different view of how the labour market functions. These theories emphasize the distinction between the unemployment that exists when real GDP is equal to Potential, and unemployment that is due to deviations of real GDP from Potential.

Question 2

What is Cyclical unemployment?

Answer 2

Cyclical unemployment

Unemployment not due to frictional or structural factors; it is due to deviations of GDP from Y*

Question 3

What are two major characteristics of the market-clearing theories of the labour market?

Answer 3

Two major characteristics of the market-clearing theories of the labour market are that firms and workers continuously optimize and markets continuously clear.

In such models, there can be no involuntary unemployment.

Question 4

What do market clearing theories seek to explain?

Answer 4

These theories then seek to explain unemployment as the outcome of voluntary decisions made by individuals who are choosing to do what they do, including spending some time out of employment.

Question 5

Market-clearing theories explain fluctuations in employment and real wages as having one of two causes…

Answer 5

• Changes in technology that affect the productivity of labour will lead to changes in the demand for labour. If these technological shocks are sometimes positive and sometimes negative, they will lead to fluctuations in the level of employment and real wages.
• Changes in the willingness of individuals to work will lead to changes in the supply of labour and thus to fluctuations in the level of employment and real wages.

Question 6

Market-clearing theories explain fluctuations in employment and real wages as having one of two causes. What do they have in common?

Answer 6

In both cases, however, note that the flexibility of real wages results in a clearing of the labour market. In this setting, there is no involuntary unemployment. The unemployment that does exist is either frictional or structural.

Question 7

Graphs depicting employment and wages when labour markets clear.

Answer 7

Question 8

In market-clearing theories, how quickly do wages adjust after a shock?

Answer 8

In market-clearing theories of the labour market, real wages adjust quickly and so there is no involuntary unemployment.

Question 9

What to market clearing theories of the labour market assume?

Answer 9

Market-clearing theories of the labour market assume that real wages quickly adjust to clear the labour market. People who are not working are assumed to have voluntarily withdrawn from the labour market for one reason or another. There is no involuntary unemployment.

Question 10

What is the first major problem with Market-clearing theories?

Answer 10

Empirical observation is not consistent with the predicted fluctuations in real wages.

In Canada and other developed economies, employment tends to be quite volatile over the business cycle, whereas real wages tend to be relatively stable—they do not show the cyclical variation depicted

Question 11

What is the first major problem with Market-clearing theories?

Answer 11

market-clearing theories predict no involuntary unemployment whatsoever, a prediction that many economists argue is unsupported by empirical observation.

In Canada and other countries, a large fraction of unemployed workers are eligible for and collect employment insurance. In order to collect the insurance benefits, they are required to be actively searching for a job.

For those who are truly engaged in an active job search, it is difficult to describe them as voluntarily unemployed.

Question 12

What do the eonomists who reject the market-clearing theories emphasize?

Answer 12

The many economists who reject the market-clearing theories of unemployment fluctuations emphasize that labour markets do not operate in the extreme manner shown

Question 13

To economits who reject market-clearing theories, what plays a central role in explaining unemployment fluctuations?

Answer 13

These economists use non-market-clearing theories of the labour market in which “wage stickiness” plays a central role in explaining unemployment fluctuations.

Question 14

Why do many people become involuntarily employed when the demand for labor falls during a recession?

Answer 14

As a result of this wage stickiness, many people become involuntarily unemployed when the demand for labour falls during a recession. Their unemployment is involuntary in the sense that they would accept an offer of work in jobs for which they are trained, at the going wage rate, if such an offer were made.

Question 15

Employment and Sticky Wages When Labour Markets Do Not Clear (Graph)

Answer 15

Question 16

What happens when the wage rate does not change enough to equate quantity demanded with quantity suppplied?

Answer 16

When the wage rate does not change enough to equate quantity demanded with quantity supplied, there will be unemployment in slumps and labour shortages in booms.

Question 17

What is the main challenge for non-market clearing theories?

Answer 17

The main challenge for these non-market-clearing theories is to explain why wages do not quickly adjust to eliminate involuntary unemployment. This issue has been debated among economists for years, and several compelling reasons have been presented.

Question 18

What is the most obvious reason for wage stickiness over the business cycle?

Answer 18

The most obvious reason for wage stickiness over the business cycle is that many workers and their employers have long-term relationships in which the wages and conditions of work are determined for extended periods of time, often for one or more years.

Question 19

To see why long-term employment relationships usually involve sticky wages, imagine a worker being faced with a choice between two employment arrangements…

Answer 19

A high average wage but one that fluctuates over the business cycle, and the chance of job loss during a recession.

A somewhat lower wage that is stable over the business cycle, and a reduced chance of job loss during a recession.

Question 20

Why would employees prefer a lower, stable wage over a higer instable one?

Answer 20

Most workers would prefer the second employment arrangement because they value the security that allows them to make long-term financial plans. For example, taking on a home mortgage or car loan is more manageable with a relatively secure job and income. The lower wage in the second employment arrangement can be seen as the price the worker pays for greater employment and income security.

Question 21

Why do employers also prefer such long-term employment arrangements with sticky wages?

Answer 21

Employers want to retain workers who have the knowledge required for a particular job—knowledge of the firm’s organization, production techniques, operating procedures, and marketing plans.

What the worker learns through on-the-job experience is valuable to the firm and makes each individual a unique asset. If a firm laid off one worker and then later hired another worker for the same job, it would lose all the knowledge that the first worker had acquired on the job and would lose efficiency until the new worker acquired similar experience.

Question 22

In short, why are wages in many labour markets not adjusted frequently?

Answer 22

Long-term relationships between firms and workers are important in most labour markets, and wages in such labour markets do not adjust frequently to eliminate involuntary unemployment.

Question 23

What is “Gig economy”?

Answer 23

Though long-term relationships between employers and workers have been the norm in most parts of the Canadian economy for many years, there is now an emerging trend toward workers being less connected to a single employer and more involved in short-term contract work—what is often referred to as the “gig economy.”

Question 24

Workers in this gig economy are characterized as

Answer 24

(1) Having their independence
(2) Receiving payment for specific tasks
(3) Having short-term relationships with their clients.

Question 25

What are characteristics of workers in the Gig economy?

Answer 25

Question 26

What is Menu costs and what is its connection to sticky wages?

Answer 26

A second reason for wage (and price) stickiness relates to the costs associated with their changes. A typical large firm sells dozens of differentiated products and employs many different types of labour. Changing wages and prices in response to every fluctuation in demand is a costly and time-consuming activity. Many firms therefore find it optimal to keep their wage structures and price lists (menus) constant for significant periods of time.

Question 27

What would happen if firms did alter their prices dramatically over the business cycle?

Answer 27

If firms did alter their prices dramatically over the business cycle, they would be more or less forced to alter wages correspondingly or else suffer losses that could threaten their existence during recessions.

As it is, the presence of relatively sticky prices allows firms to keep wages relatively sticky over the cycle for all of the reasons we discussed when examining long-term employment relationships.

Question 28

What are efficiency wages and what is their connection to wage stickiness?

Answer 28

A third reason for wage stickiness is that firms may find it profitable to pay workers a higher rather than a lower wage. Employers may find that they get more output per dollar of wages paid—that is, a more efficient workforce—when they pay labour somewhat more than the minimum amount that would induce people to work for them.

Question 29

What is the connection between wage stickiness and Union bargaining?

Answer 29

A final important reason for wage stickiness comes from existing institutions in the labour market. In many employment situations, those already working (“insiders”) have more say in wage bargaining than those currently not employed (“outsiders”). Employed workers are often represented by a union, which negotiates the wage rate with firms.

Question 30

What is wage stickiness an important explanation for?

Answer 30

There are several reasons why wages do not adjust quickly to clear excess demands or supplies in labour markets. Such wage stickiness is an important explanation for the existence of cyclical unemployment, which rises and falls as real GDP fluctuates.

Question 31

What kind of unemployment exisits when real GDP is greater then potential?

Answer 31

Cyclical unemployment is associated with gaps between real GDP and potential GDP. If the real GDP is greater than potential​ GDP, there is negative cyclical unemployment since the unemployment rate is below the NAIRU.