Macroeconomics

Sixth Edition, Global Edition

Chapter 6
Search and
Unemployment

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Learning Objectives, Part I
6.1 List the key labor market facts concerning the unemployment
rate, the participation rate, and the employment/population
ratio.
6.2 Describe the Beveridge curve, and explain its importance.
6.3 In the one-sided search model, explain how the reservation
wage is determined.

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Learning Objectives, Part II
6.4 Show how the one-sided search model determines the
unemployment rate.
6.5 Use the one-sided search model to determine the effects of
changes in the labor market on the efficiency wage and the
unemployment rate.

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Learning Objectives, Part III
6.6 Construct an equilibrium in the two-sided search model.
6.7 Use the two-sided search model to explain how shocks to the
labor market change labor force participation, unemployment,
vacancies, aggregate output, and labor market tightness.

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Labor Market Friction
▪ “Search”
▪ it takes time for an individual who wants to work to find a suitable
job with a firm that wishes to hire.
▪ it takes time for a firm to fill a vacancy.
▪ How government policy affect search behavior? Will
unemployment be inefficiently high or low?
▪ Search models:
▪ One-sided: focus on the behavior of one person searching for
work—the behavior of firm is left out.
▪ Two-sided: incorporate the behavior of firms (the demand side of
the labor market), and also consider the labor force participation
decisions of would-be workers.

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Key Labor Market Variables
𝑁: working age population
𝑄: labor force (employed plus unemployed)
𝑈: unemployed
U
Unemployment rate:
Q
Q
Participation rate:
N
Q−U
Employment/population ratio:
N

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Figure 6.1 The Unemployment Rate

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Figure 6.2 Deviations From Trend in the
Unemployment Rate and Real GDP

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Figure 6.3 Labor Force Participation Rate

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Figure 6.4 Labor Force Participation Rates
of Men and Women

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Figure 6.5 Percentage Deviations From Trend:
Labor Force Participation Rate and Real GDP

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Figure 6.6 Labor Force Participation Rate and
Employment/Population Ratio

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Vacancies and Unemployment
▪ 𝐴: aggregate number of vacancies listed by firms.
A
▪ Vacancy rate: A+Q − U

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Figure 6.7 The Vacancy Rate and Unemployment
Rate

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Figure 6.8 Beveridge Curve

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Key Labor Market Observations
1. The unemployment rate is countercyclical and the
vacancy rate is procyclical.
2. The unemployment rate and the vacancy rate are
negatively correlated (the Beveridge curve).
3. The Beveridge curve shifted out during the last
recession.

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The One-Sided Search Model
▪ A “partial equilibrium” model—treats demand side of the labor
market as exogenous.
▪ Focuses on the behavior of an unemployed worker
▪ He/she (1) searches for work, (2) receives job offers that pay
particular wages and should (3) decide when to accept job and
stop searching.
▪ 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-
labor-force not modeled.
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Welfare of the Employed and Unemployed
▪ Welfare of an employed worker 𝑉𝑒 (𝑤), or the value of being
employed:
▪ Decreases with the separation rate 𝑠—the fraction of
employed workers become randomly separated from their
jobs every period.
▪ Welfare of an unemployed worker 𝑉𝑢 :
▪ Increases with the UI benefit, 𝑏.
▪ Increases with 𝑝, the frequency with which the unemployed
worker receives job offers.

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Reservation Wage (1 of 2)
▪ If a bad job is turned down, this involves a trade-off
between the short-run losses from unemployment and the
uncertain long-run benefits from a good job.
▪ 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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Reservation Wage (2 of 2)

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An Increase in the Unemployment Insurance
Benefit

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Determining the Unemployment Rate in
the One-Sided Search Model
▪ Long-run equilibrium:
▪ Flow of workers from employment to
unemployment equals the flow in reverse direction:

𝑠 1 − 𝑈 = 𝑈𝑝𝐻(𝑤 ∗ )

𝐻(𝑤): fraction of workers receiving a wage offer greater

than 𝑤.
𝑈: unemployment rate.
𝑝: the fraction who receive a job offer.
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Determining the Reservation Wage and
Unemployment Rate

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An Increase in the UI Benefit

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An Increase in the Job Offer Rate

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A Two-Sided Search Model of Unemployment

▪ One-period model.
▪ Take account of both sides of labor market.
▪ N consumers who can all potentially work, so N is the
working age population.
▪ 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 labor 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 6.17 The Supply Curve of Consumers
Searching for Work
If the expected payoff from searching is
higher, this induces more consumers to
forego home production to search for
market work.

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Firms
▪ A firm must post a vacancy in order to have a chance of
matching with a worker.
▪ Firms that do not post a vacancy are inactive and
cannot produce.
▪ 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.
▪ Matching workers with firms is a time-consuming and
costly process.
▪ Suppose that 𝑀 denotes aggregate number of matches
and 𝑒 is the matching efficiency, difficulties in
matching is captured by a matching function:
𝑀 = 𝑒𝑚(𝑄, 𝐴).

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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
1. constant returns to scale 𝑒𝑚 𝑥𝑄, 𝑥𝐴 = 𝑥𝑒𝑚(𝑄, 𝐴),
2. positive marginal products 𝑚 0, 𝐴 = 𝑚 𝑄, 0 = 0, and
3. diminishing marginal products—the increase in matches
obtained for a one-unit increase in 𝑄 decreases as 𝑄
increases.
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Supply Side of the Labor Market:
Optimization by Consumers
▪ Each consumer chooses between home production and
searching for work.
▪ 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 UI benefit b.
▪ If the consumer chooses to search for work, then he or she
finds a match with a firm with probability
𝑒𝑚(𝑄,𝐴) 𝐴 𝐴
𝑝𝑐 = = 𝑒𝑚 1, = 𝑒𝑚 1, 𝑗 , where 𝑗 = .
𝑄 𝑄 𝑄

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Marginal Consumer
▪ For the consumer who is indifferent between home
production and searching for work,
𝑃 𝑄 = 𝑝𝑐 𝑤 + 1 − 𝑝𝑐 𝑏 = 𝑏 + 𝑒𝑚 1, 𝑗 𝑤 − 𝑏 .
▪ Here, 𝑗 is labor market tightness,
𝐴
𝑗= .
𝑄

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Figure 6.18 The Supply Side of the Labor Market

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Demand Side of the Labor Market
▪ A firm entering the labor 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
𝑀 𝑒𝑚(𝑄,𝐴) 𝑄 1
𝑝𝑓 = = = 𝑒𝑚 ,1 = 𝑒𝑚( , 1).
𝐴 𝐴 𝐴 𝑗

▪ 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
▪ Firms will enter the labor market, posting vacancies,
until the expected net payoff from doing so is zero,
𝑝𝑓 𝑧 − 𝑤 − 𝑘 = 0,
▪ In equilibrium, 𝑘 must be equal to the expected payoff
for the firm from posting the vacancy, which implies:
1 𝑘
𝑒𝑚 ,1 = .
𝑗 𝑧−𝑤

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Figure 6.19 Demand Side of the Labor Market

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Nash Bargaining (1 of 2)
▪ Use Nash bargaining theory to determine how a matched
firm and worker split the total revenue from production.
▪ Two individuals strike a bargain that depends on each
person faces as an alternative if the two cannot agree,
and on the relative bargaining power of the two people.
▪ Worker’s surplus: 𝑤 − 𝑏 (wage minus UI benefit)
▪ Firm’s surplus: 𝑧 − 𝑤 (profit)
▪ Total surplus: 𝑧 − 𝑏

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Nash Bargaining (2 of 2)
▪ Let 𝑎, where 0 < 𝑎 < 1, denotes the worker’s share of
total surplus (or bargaining power), the worker and firm
agree to a contract such that the worker’s surplus is a
fraction a of total surplus
𝑤 − 𝑏 = 𝑎(𝑧 − 𝑏) ⇔ 𝑤 = 𝑎𝑧 + 1 − 𝑎 𝑏.

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

𝑃 𝑄 = 𝑏 + 𝑒𝑚 1, 𝑗 𝑎 𝑧 − 𝑏
1 𝑘
𝑒𝑚 , 1 =
𝑗 (1 − 𝑎)(𝑧 − 𝑏)

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Figure 6.20 Equilibrium in the Two-Side Search Model

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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:

𝑄(1 − 𝑝𝑐 )
𝑈= = 1 − 𝑒𝑚 1, 𝑗
𝑄
𝐴(1 − 𝑝𝑓 ) 1
𝑣= = 1 − 𝑒𝑚 , 1
𝐴 𝑗
𝑌 = 𝑒𝑚 𝑄, 𝐴 𝑧 = 𝑄𝑒𝑚 1, 𝑗 𝑧

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

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Increase in the UI 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 labor
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 6.21 An Increase in the UI Benefit (b)

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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 labor 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 6.22 An Increase in Productivity

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A Decrease in Matching Efficiency (1 of 2)
▪ 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 6.8 Beveridge Curve

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A Decrease in Matching Efficiency (2 of 2)

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