Lesson 9 – Unemployment

Definitions & Measurement

Unemployment can be expressed either as a number (e.g. 8,000) or as a percentage (e.g. 6 %).

Who should be included in the statistics? Should it include everyone without a job? The answer is
clearly no, since we would not want to include children and pensioners. We would probably also
want to exclude those who were not looking for work, such as parents choosing to stay at home
to look after their children.

With this in mind, the most usual definition that economists use for the number unemployed is:
those of working age who are without work, but who are available for work at current wage rates.

Rate of Unemployment = Registered Unemployment X 100

Labour Supply

Labour Supply (Labour Force) is the number of employed plus the number of unemployed.

Therefore:
Labour Supply = gainfully occupied + registered unemployed

The Costs of Unemployment

• The most obvious cost of unemployment is to the unemployed themselves.

o There is a direct financial cost of the loss in their earnings.
o There are the personal costs of being unemployed. The longer people are
unemployed, their self-esteem is likely to fall, and they are more likely to succumb to
stress-related illness.
o There are also the costs to the family and friends of the unemployed. Personal
relations can become strained and there may be an increase in social problems such
as domestic violence and crime.

• The government loses tax revenues, since the unemployed pay no income tax and national
insurance and given that the unemployed spend less, they pay less VAT. Moreover,
government will also have to pay unemployment benefits, thus increasing its expenditure.

• Opportunity cost of lost production – unemployment will reduce production.

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
Causes of Unemployment

The causes of unemployment fall into two broad categories: equilibrium unemployment and
disequilibrium unemployment.

• Disequilibrium Unemployment

The labour market is in equilibrium at a wage of We – where the demand for labour equals the
supply. If the wage rate were above We the labour market would be in a state of disequilibrium.
At a wage rate of W1 there is an excess supply of labour. This is called disequilibrium
unemployment.

For disequilibrium unemployment to occur, two conditions must hold:

▪ The aggregate supply of labour must exceed the aggregate demand.

▪ There must be a ‘stickiness’ in wages. In other words, the wage rate must not immediately fall
to We.

Theoretically, if wage rates are below the equilibrium level, the demand for labour is
relatively high, and the supply would be relatively low, as workers are not as keen to enter
the labour force. As a result, the market would be characterized by unfilled vacancies, and so
prices (in this case the wages) would have to increase.

On the other hand, if the wage rates where too high, i.e. the market is above the equilibrium
level, the supply of labour would be high due to the fact that is it very favourable for workers

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
 to enter the market, however the demand would be low. This would result in unemployment,
in the economy and therefore wages would have to decrease in order to move towards the
equilibrium.

This, however, is not a realistic situation. Wages are said to be sticky in the downwards
direction, which means that it is very difficult to reduce wages. This problem is mainly due to
unions, who would create great uneasiness and discomfort within the country if wages where
to deflate. Consequently, the labour market disequilibrium (unemployment) will persist.

There are three possible causes of disequilibrium unemployment:

1. Real-wage unemployment (the classical view)

This type of unemployment occurs when trade unions use their monopoly power to drive wages
above the market-clearing level. It could also be caused by governments introducing minimum
wage legislation.

2. Demand-deficient or cyclical unemployment (the Keynesian view)

Demand-deficient unemployment is associated with economic recessions. As the economy

moves into recession, consumer demand falls. Firms find that they are unable to sell their current
level of output and therefore cut back on production and the amount of labour they employ. The
deeper the recession becomes and the longer it lasts, the higher will demand-deficient
unemployment become.

Demand deficient unemployment is illustrated is the diagram below. Assume initially that the
economy is at the peak of the trade cycle, and aggregate demand for and supply of labour are
equal at the current wage rate W1. Therefore, there is no disequilibrium unemployment. Now
assume that the economy moves into recession. Consumer demand falls and as a result firms will
demand less labour, shifting AD downward. Provided wages are ‘sticky’ in the downward
direction, i.e. wages rarely fall, the real wage rate remains fixed at W1 and there will now be
disequilibrium unemployment of Q1 – Qd. Put it differently, firms will reduce their wage bill by
reducing labour demand instead of the wage rate.

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
3. Growth in the labour supply

If labour supply rises with no corresponding increase in the demand for labour, the equilibrium
real wage rate will fall. If the real wage rate is ‘sticky’ downwards, disequilibrium unemployment
will occur.

This tends not to be such a serious cause of unemployment as demand deficiency, since the
supply of labour changes relatively slowly. Nevertheless there is a problem of providing jobs for
school leavers each year with the sudden influx of new workers on to the labour market.
Increased female participation over the longer term may also be a factor for increased labour
supply.

• Equilibrium Unemployment

Even when there is no general disequilibrium in the economy at the current wage levels, i.e.
Aggregate Demand = Aggregate Supply. Even when there are as many job vacancies as people
unemployed – there will still be some unemployment. For various reasons, not all vacancies will
be filled. There may be excess demand for labour (vacancies) in some markets and excess supply
(unemployment) in others. For example, there may be vacancies for computer technicians and
unemployment in the textile industry, but unemployed textile workers cannot immediately
become computer technicians. This is when equilibrium unemployment will occur.

There are various types of equilibrium unemployment:

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
1. Frictional Unemployment

Some unemployment is not caused so much because there are not enough jobs, but because of
the friction in the labour market. This friction can be the result of any of the following causes:

▪ Labour Skills mismatch – unemployment could occur because of skill mismatches within the
labour market. The computer technician / textile industry example mentioned above is
perfectly suitable to describe this cause.

▪ Imperfect Information – Frictions could also be caused by a lack of knowledge available in the
market for job vacancies. Thus job seekers are misinformed regarding new job openings and
firms who would like to fill their job vacancies do not have the right means of conveying their
vacancy to job seekers to fill their vacancies.

▪ Search / Transitional Unemployment – unemployment that results during the transition

period between one job and another – search process, interviewing phase and the actual
commencement of the job.

2. Seasonal Unemployment

Occurs in industries, such as tourism and construction, where demand for labour fluctuates in
seasonal patterns throughout the year.

3. Structural Unemployment

This occurs where the structure of the economy changes. Employment in some industries may
expand while in others it contracts. There are two main reasons for this.

▪ A change in the pattern of demand – Some industries experience declining demand. This may
be due to a change in consumer tastes. Certain goods may go out of fashion. Or it may be due
to competition from other industries. For example, with the growing demand for airbnb
unemployment in the hotel industry may very well become a reality.

▪ A change in the methods of production – new techniques of production often allow the same
level of output to be produced with fewer workers. Unless output expands sufficiently to
absorb the surplus labour, people will be made redundant. This creates technological
unemployment.

Structural unemployment often occurs in particular regions of the country. When it does, it is
referred to as regional unemployment. Regional unemployment is due to the concentration of
particular industries in particular areas. For example, the decline in the South Wales coal-mining
industry led to high unemployment in the Welsh valleys.

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)
Policies to tackle Unemployment

If unemployment is the result of excess labour supply then the right approach would be to
stimulate labour demand with the main goal being to narrow the gap between labour demand
and labour supply; for example through aggregate demand expansions. However, such a policy
could harm the labour market if the government hap-hazardously decides to absorb the excess
labour supply through large-scale public sector employment, since this would lead to further
inefficiencies.

Policies to reduce unemployment would include:

1. Promote the enhancement of human capital within the workforce – so that more of the
unemployed have the skills to take up the available jobs. Policies normally concentrate on
improving the occupational mobility of labour. The pattern of employment in any modern
economy is always changing, so people need to have sufficient flexibility to adapt to
structural changes in industries over the years. Education, training and lifelong learning
are all ways that will increase the employability of the workforce.

2. Improve incentives for people to search and then accept paid work – this may require
reforms of the tax and benefits systems for example a reduction in the starting rate of
income tax (an incentive for people in lower paid jobs). One may also opt for a change in
welfare benefits such that people who find work will have the incentive to accept
employment since this would lead to a higher periodic wage when compared to the
benefits received whilst unemployed.

3. Allow a sustained period of economic growth – this requires that Aggregate Demand is
sufficiently high for businesses to be looking to expand their workforce.

4. Improve the institutional setup for job-seekers – this would entail the setting up of
specialized institutions whose main aim would be to provide and disseminate timely
information regarding job availability, training courses, labour market regulations,
employment incentive schemes (particularly for women, the long-term unemployed and
people with some form of disability), etc.

Further Reading:

• Phillips Curve: The relationship between inflation & unemployment

© 2023 Glenn Fenech B.Com. (Hons) (Econ.) (Melit.), M.A. (Econ.) (Melit.)