Macroeconomics

Sixth Canadian Edition

Chapter 6
Search and Unemployment

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Chapter 6 Topics
• Labour market facts.
• One-sided search model of unemployment.
• Working with the one-sided model: reservation wage,
employment insurance, job offers, unemployment rate.
• Two-sided search model of search and unemployment.
• Working with the two-sided search model: employment
insurance, productivity, matching efficiency.

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Key Labour Market Variables
N = working age population
Q = labour force (employed plus unemployed)
U = unemployed
Unemployment rate
Participation rate
Employment/population ratio

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Figure 6.1
The Canadian Unemployment Rate, 1946–2017

The unemployment rate shows considerable cyclical volatility. In Canada, there was also a trend increase
in the unemployment rate from the late 1960s until the mid-1980s and a small trend decrease from the
mid-1980s through the 1990s.

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Figure 6.2
Deviations from Trend in the Unemployment Rate and Percentage
Deviations from Trend in Real GDP for 1976–2017

The unemployment rate is countercyclical, as it tends to be above (below) trend when real GDP is below
(above) trend.

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Figure 6.3
The Canadian Participation Rate, 1946–2017

The participation rate has increased in Canada from about 55% in 1946 to close to 67% in 2008.

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Figure 6.4
Labour Force Participation of Women and Men

Although the labour force participation rate of women has increased by a factor of more than 2 since
1946, the participation rate of men has decreased.

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Figure 6.5
Deviations from Trend in the Participation Rate and GDP

The participation rate is procyclical: an increase (decrease) in aggregate economic activity tends to cause
an increase (decrease) in labour force participation.

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Figure 6.6
The Employment/Population Ratio and the Participation Rate,
1976–2018

Both series have increased on trend, but there is more cyclical variability in the employment/population
ratio.

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The One-Sided Search Model
• Focuses on the behavior of an unemployed worker.
• Unemployed worker receives wage offer with probability p.
• Wage offer w either accepted, or unemployed worker turns
down the offer and continues to search.
• All workers are either employed or unemployed. Not-in-
the-labour-force not modeled.

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Welfare of the Employed and Unemployed
• Welfare of an employed worker Ve (w) :
– Decreases with the separation rate s.
• Welfare of an unemployed worker Vu:
– Increases with the EI benefit, b.
– Increases with p, the frequency with which the unemployed
worker receives job offers.

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Figure 6.7
The Welfare of an Employed Worker

The worker’s welfare is increasing in the real wage, w, which he or she earns on the job, and the function
is concave because the marginal benefit from a higher real wage declines as the real wage increases.

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Reservation Wage
• Reservation Wage: the wage w* at which the unemployed
worker is just indifferent between accepting and declining a
job offer.
• The unemployed worker turns down jobs with w < w*, and
accepts jobs with w > w*.

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Figure 6.8
The Reservation Wage

The reservation wage, w*, is determined by the intersection of the Ve(w) curve (the welfare from
employment) and the Vu curve (the welfare from unemployment).

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Figure 6.9
An Increase in the Unemployment Insurance Benefit, b

1 2
The increase in benefits increases the welfare from unemployment from V to V . The reservation wage
𝑢 𝑢
∗ ∗
then increases from w to w .
1 2
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Determining the Unemployment Rate in the
One-Sided Search Model
• H(w) = Fraction of workers receiving a wage offer greater
than w.
• U = unemployment rate.
• Long-run equilibrium: flow of workers from employment to
unemployment equals the flow in reverse direction:

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Figure 6.12
The Determination of the Reservation Wage and the
Unemployment Rate in the One-Sided Search Model

The reservation wage, w*, is determined in panel (a) by the intersection of the curves Ve(w) and Vu. Then,
given the reservation wage, the long-run unemployment rate is determined in panel (b).

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Figure 6.13
An Increase in the Employment Insurance Benefit, b

1 2
The rise in EI benefit increases the value of unemployment from V to V in panel (a), causing the
𝑢 𝑢
reservation wage to increase. This decreases the flow of workers from unemployment to employment in
panel (b), and the unemployment rate rises in the long run.

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Figure 6.14
An Increase in the Job Offer Rate, p

When p increases, it increases the welfare of the unemployed, who are now more likely to find work, and
∗ ∗
the reservation wage increases from w to w in panel (a). In panel (b), there are two effects on pH(w*),
1 2
in that p has also increased, which increases the flow of workers from unemployment to employment, but
w* has also increased, which reduces this flow. It is not clear how the unemployment rate is affected, but
we show it as decreasing in the figure.

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A Two-Sided Search Model of Unemployment
• One-period model.
• N consumers who can all potentially work, so N is the
labour force.
• Number of firms is endogenous.

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Consumers in the Two-Sided Search Model
• Each of the N consumers chooses whether to work outside
the market (homework), or to search for work in the
market.
• Q = number of consumers who search for work.
• N-Q = not in the labour force.
• P(Q) = expected payoff to searching for work that would
induce Q workers to search. P(Q) is essentially the supply
curve for searching workers.

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Figure 6.15
The Supply Curve of Consumers Searching for Work

The curve v(Q) defines the expected payoff required to induce Q consumers to search for work. The
supply curve is upward-sloping because different consumers have different payoffs to working in the
home.

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Firms
• A firm must post a vacancy in order to have a chance of
matching with a worker.
• k = cost of posting a vacancy, in units of consumption
goods.
• A = number of active firms (firms posting vacancies).

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Matching
• A successful match in the model is between one worker
and one firm.
• M = aggregate number of matches.
• e = matching efficiency.
• Matching function:

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Properties of the Matching Function
• The matching function has properties like a production
function.
• The “inputs,” Q and A, produce the “output” M, and e plays
the same role as total factor productivity in the production
function.
• The matching function has constant returns to scale,
positive marginal products, and diminishing marginal
products.

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Supply Side of the Labour Market:
Optimization by Consumers
• Each consumer chooses between home production and
searching for work.
• If the consumer chooses to search for work, then he or she
finds a match with a firm with probability
• If the consumer searches for work and is matched he/she
receives wage w.
• If the consumer searches and is not matched, then he/she
is unemployed and receives the EI benefit b.

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Marginal Consumer
• For the consumer who is indifferent between home
production and searching for work,

• Here, j is labour market tightness,

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Figure 6.16
Determination of the Labour Force

The market wage, the EI benefit, and labour market tightness determine the expected payoff to searching
for work for a consumer. Then, given this expected payoff, the supply curve for searching consumers
determines the labour force.

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Demand Side of the Labour Market
• A firm entering the labour market bears the cost k to post a
vacancy.
• The probability that a firm with a vacancy finds a worker to
fill the job is

• When matched, a worker and firm produce z, so the payoff

to the firm is profit = z – w.

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Expected Net Payoff for a Firm Posting a
Vacancy is Zero in Equilibrium
• In equilibrium, k must be equal to the expected payoff for
the firm from posting the vacancy, which implies

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Figure 6.17
Determination of Labour Market Tightness

Firms post vacancies up to the point where the probability for a firm of matching with a worker is equal
to the ratio of the cost of posting a vacancy to the profit the firm receives from a successful match.

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Nash Bargaining
• Use Nash bargaining theory to determine how a matched
firm and worker split the total revenue from production.
• Worker’s surplus = w – b (wage minus EI benefit)
• Firm’s surplus = z – w (profit)
• Total surplus = z – b
• a = worker’s share of total surplus (“bargaining power”)

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Equilibrium
• Two equations determining Q and j (from supply side,
demand side, and Nash bargaining):

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Equilibrium Unemployment Rate, Vacancy
Rate, and Aggregate Output
• In equilibrium, as functions of j and Q, the unemployment
rate, vacancy rate, and level of aggregate output,
respectively, are:

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Figure 6.18
Equilibrium in the Two-Sided Search Model

In panel (b), the ratio of the cost of posting a vacancy to the firm’s surplus from a successful match
determines labour market tightness. Then, in panel (a), labour market tightness determines the size of
the labour force.

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Working with the Two-Sided Search Model:
3 Experiments
• Increase in the EI benefit b.
• Increase in productivity z.
• Decrease in matching efficiency e.

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Increase in the EI Benefit, b
• Reduces total surplus from a match, z – b
• Increases the wage, w, as the alternative to working
becomes more tempting for a searching consumer.
• Posting vacancies becomes less attractive for firms, so
labour market tightness, j, falls.
• For consumers, searching for work becomes more
attractive, as the wage is higher. But searching for work is
also less attractive, as the chances of finding a job are
lower (j is lower).
• Q may rise or fall given these two opposing effects.
• u rises and v falls.

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Figure 6.19
An Increase in the EI Benefit, b

An increase in b reduces the surplus the firm receives from a match, which reduces labour market
tightness in panel (b). Then, in panel (a), the increase in b acts to shift the curve up. The labour force
could increase or decrease.

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An Increase in Productivity
• Increases the total surplus from a match, z – b.
• Increases the wage, w, as the worker gets the same share
of a larger pie.
• As profit is higher, posting vacancies becomes more
attractive for firms, so labour market tightness, j, rises.
• For consumers, searching for work becomes more
attractive, as the wage is higher, and the chances of
finding work are better.
• Q rises, u falls, v rises, Y rises.

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Figure 6.20
An Increase in Productivity, z

An increase in productivity acts to increase the surplus from a match for both workers and firms. In panel
(b), labour market tightness increases, and the curve shifts up in panel (a) so that the labour force must
increase.

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A Decrease in Matching Efficiency
• No change in total surplus, or in the wage.
• Chances of finding a worker are lower, so fewer firms post
vacancies and j falls.
• For consumers searching is less attractive – the wage is
the same, but the chances of finding a job are lower, so Q
falls.
• u rises, but vacancy rate stays the same, and Y falls.
• Potential explanation for the shifting Beveridge curve.

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Figure 6.21
A Decrease in Matching Efficiency, e

This acts to shift the curves down in panels (a) and (b). Labour market tightness and the labour force
must both decrease.

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