Understanding Unemployment

Understanding Unemployment - October 15, 2006 Federal...

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October 15, 2006 Federal Reserve Bank of Cleveland Understanding Unemployment by Guillaume Rocheteau ISSN 0428-1276 Modern economists have built models of the labor market, which isolate the market’s key drivers and describe the way these interact to produce particular levels of unemployment. One of the most popular models used by macroeconomists today is the search-matching model of equilibrium unemployment. We explain this model, and show how it can be applied to understand the way various policies, such as unemployment benefits, taxes, or technological changes, can affect the unemployment rate. A disturbing feature of the labor mar- ket is its seeming inability to clear. At each instant in time, there are both workers without jobs and jobs without workers. How can it be that productive resources are left unemployed in a well- functioning market economy? Economists attribute the failure of the labor market to instantly allocate work- ers to jobs to various “frictions.” These frictions arise because labor, unlike gold or oil, is not a homogenous commodity. The services provided by a plumber are different from those provided by a lawyer—and even lawyers differ in the services they offer; some specialize in constitutional law, others in private law. To match jobs and workers is far from a trivial problem. The heterogeneity of labor services also makes it hard for employers to distinguish productive from unproductive workers. And to complicate things even more, the mere process of moving labor services from one job to another is not costless. Over the past 25 years, economists have developed a theory of the labor market that takes into account the heterogeneity of labor services and that describes the matching process of workers and firms. The theory, sometimes called the search- matching theory of unemployment, is the description that most economists have in the back of their mind when thinking about the labor market. In this Commen- tary , we review this theory and show how it can be applied to address several issues related to unemployment. Three Building Blocks for a Theory of Unemployment The search model of unemployment contains three elements. Each element characterizes a different aspect of the labor market, and the three elements together determine the behavior of the overall labor market. The first element describes how wages are set. The second determines the number of vacancies that firms decide to open, and the third describes the process through which unemployed workers and vacancies are brought together, that is, the process of creating jobs. Setting Wages Not all labor markets work the same, but in many, wages are determined through a bargaining process between workers and their employers. The outcome of the bar- gaining process depends on two things: the bargaining power of each party and the outside options of each. The party with the most bargaining power—the worker or the firm—is the one that can extract a larger fraction of the surplus
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This note was uploaded on 11/04/2009 for the course ECON 62200 taught by Professor Brueckner during the Fall '09 term at UC Irvine.

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Understanding Unemployment - October 15, 2006 Federal...

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