Information on employment is usually provided by citing the unemployment rate which, in turn, is expressed in percentage terms. The unemployment rate itself is defined as the percentage of labor force unemployed. The labor force is composed of individuals unemployed and employed. A person is considered unemployed if the person is out of work, but is actively seeking work. If a person is not working and is also not seeking work, then the person is voluntarily unemployed. A voluntarily unemployed person is not considered by the government as part of the labor force and is thus not counted as being truly unemployed. The division of the labor force into employed and unemployed individuals provides the direct and clear linkage between employment and unemployment rates, even though information is often provided in terms of the unemployment rate—an 8 percent rate of unemployment implies that the remaining 92 percent of the labor force is gainfully employed. The sum of unemployment rate and the associated employment rate must always, by definition, be equal to 100. Thus, the traditional use of the unemployment rate to describe the state of employment in an economy should not cause any confusion.
The concept can be illustrated with the help of recent statistics. In May 1999, a total of 139 million people were in the U.S. civilian labor force, of which 5.8 million people were unemployed. These two numbers yielded the unemployment rate of 4.2 percent for all workers. It is customary to make a distinction between civilian workers and the total labor force. The total labor force is made up of civilian workers and those in the U.S. armed forces. It is often considered that the civilian unemployment rate provides the truer picture of the underlying strength of the economy, as it captures the employment provided by the market forces. As a result, the unemployment rate quoted in the popular and financial media is almost invariably the civilian unemployment rate. The difference between the unemployment rates for the total labor force and civilian workers is extremely small.
On the surface, full employment may appear to be equivalent to a zero unemployment rate. Official statistics, however, do not treat the full employment level in this manner. Full employment is officially defined as a mere 6 percent unemployment rate. Six percent is currently considered to be the "full employment rate of unemployment." The use of the 6 percent benchmark is based on the fact that it is not realistic to expect the unemployment rate to drop to zero even under best of circumstances—there will be some unemployed people seeking jobs at any point of time. One may appreciate this seemingly odd convention if one understands the different kinds of unemployment that may be prevalent at different times. There are mainly four kinds of unemployment: seasonal, frictional, structural, and cyclical.
Seasonal unemployment results due to a variation in employment pattern as seasons change during a year. Thus, certain industries witness higher levels of unemployment during slack seasons whereas they may even experience a labor shortage during the peak seasons. For example, during harvesting season, employment in the agricultural sector increases drastically. Similarly, the construction industry experiences higher unemployment during winter and increased employment during summer months. In cold weather regions, construction workers may be laid off for months at a time. So, why are these workers in such a high risk industry? While the average unemployment rate in the construction industry is quite high, the industry attracts workers because the average wage rate is also high. Agricultural workers are not so lucky. Wage rates for workers harvesting crops quite low. As a result, migrant workers from Latin America, who are enthusiastic about raising funds to take back home, often end up with the lowest paying agricultural jobs.
It may, however, be noted that seasonal variations in unemployment can happen only if a region experiences a change in season. Thus, employment in the construction industry in California may not vary much across the year due to seasonal factors. While a particular region of the economy may be unaffected by seasonal factors, for the nation as a whole, seasonal variations in employment pattern are easily detectable.
In May 1999 the U.S. civilian labor market comprised about 139 million individuals. The labor market is in a constant state of flux, even when the economy is in equilibrium. Millions of people are entering the workforce or leaving it at any time. Moreover, millions are seeking gainful employment at any point in time.
The very complexity of the labor force itself becomes a cause for a temporary unemployment, called frictional unemployment. For example, if a housewife notes that the economy is doing quite well and speculates that there may be a good chance of getting a decent job, she might start actively searching for a job, thereby entering the labor force for the first time. Once part of the labor force but not yet employed, she will be counted in government statistics as being involuntarily unemployed. Let us assume that she finds an acceptable job after three months of being in the labor force. For these three months, she is a part of what is known as the frictionally unemployed labor force. Similarly, if a software programmer quits his current job due to inadequate pay or unsatisfactory work conditions, for example, and starts searching for a better job, he is also part of the frictionally unemployed labor force. Similar norms apply to a worker who reenters the labor force. A new mother, for example, may leave her job to take care of her child for a few years and come back to look for a job when the child can go to preschool. When she reenters the labor force, she joins the group of frictionally unemployed workers.
One can thus summarize that the frictional unemployment occurs during the normal job search process by individual workers. Since frictional unemployment occurs in the normal process of employee turnover in the labor market, it is also called "turnover unemployment." While the frictional unemployment for any one individual is a temporary phenomenon, for the economy as whole there are always a good number of people that are frictionally unemployed. Any economy is expected to have a modest amount of frictional unemployment. For a number of reasons, the United States seems to have a higher level of frictional unemployment than some other developed countries. The system of unemployment compensation in the United States is considered one of the factors leading to higher than necessary frictional unemployment. It is argued by critics of the unemployment compensation policy that the system induces higher overall unemployment.
Structural unemployment occurs in the economy when it undergoes structural changes. The structural changes lead to a mismatch: skill requirements and/or the geographical location of existing jobs do not match the present skills of workers seeking jobs or the geographical location of unemployed workers. Since the structural unemployment involves this mismatch between skills and/or locations, it is also called "mismatch unemployment." There are a number of factors that account for the mismatch between skills, locations, or both.
Mismatches between current skills of workers and skill requirements of available jobs arise when workers fail to meet specific skill requirements of vacant jobs. If an office wants to hire a secretary who knows the filing system employed in that office, having general skills such as typing will not suffice. Sometimes, the skill gap may be due to much higher technical skills required at emerging jobs (job openings for computer programmers, for example). These vacancies cannot be filled with workers who know only word processing.
Structural changes, often triggered by technological changes, lead to job losses in some industries. For example, with a rise in wages and advancements in technology, the U.S. economy no longer has a comparative advantage in producing labor intensive products. One such example is the decline of the U.S. shoe industry. The American shoe industry could not compete with workers in developing countries because workers in those countries possess the skills needed in shoe manufacturing and their wage rates are much lower. As a result, the American shoe industry is fighting a losing battle. A similar situation has already occurred in the textile industry. American textile jobs have been lost to developing countries. This phenomenon is by no means unique to the United States—the Japanese textile industry suffered a similar fate.
The steel industry is also having a difficult time. The reason again is technological change, but of a slightly different sort. The U.S. steel industry is quite old and thus while it embodies the best technology available at the time these steel plants were built, they have been made obsolete by later developments in steel manufacturing technology. Thus, the late-starting less-developed countries (LDCs) possess a technological edge and are thus able to out-compete the U.S. steel manufacturers. Now, suppose a worker who has lost his or her job in the steel industry goes looking for a job. Clearly, it is most unlikely that the worker would find many steel industry jobs waiting—he or she would have to find a job in another industry. This is a classic case of structural unemployment. Retraining to acquire new skills is the only remedy available for this worker.
A mismatch of locations occurs when job vacancies and unemployed workers are distributed unequally across geographical regions. During the 1980s, when the New England economy was booming, the Texas economy went bust. The bursting of the economic bubble in the Texas economy was due to a collapse in oil prices. A lot of oil industry and related jobs were lost. The New England economy, on the other hand, was booming due to an increased demand for computer and financial services. Thus there were unemployed workers in Texas and a surplus of jobs in New England. Why didn't the unemployed workers move to New England? There are at least three factors that accounted for the reluctance of Texas workers to move to New England. First, job requirements for the two kinds of jobs were probably very different. Second, a preponderance of two-worker families implied that each family would need to find two jobs, not one, to make moving feasible. Finally, most people are reluctant to move across country in search of work—they would rather stay near friends and family.
Structural unemployment tends to last much longer than frictional unemployment, as it takes much longer to acquire new skills or to move to a new location to begin a job search. Several solutions have been suggested to deal with structural unemployment. Economists have suggested that the government should provide better public education, provide subsidies to firms that train workers, and initiate government-financed training programs to solve the problem of low skills. One of the suggestions to deal with the mismatch in locations is for the government to subsidize the cost of relocation. Another suggestion to deal with the problem calls for the establishment of tax-incentive-based enterprise zones.
As mentioned in the beginning, at the 6 percent rate of unemployment, the economy is considered as good as being fully employed. The 6 percent level is called the benchmark unemployment, full employment rate of unemployment, or the natural rate of unemployment. This number is arrived at by adding the three components of unemployment discussed above—seasonal, frictional, and structural unemployment. The 6 percent level is the current estimate of these three components. With the increasing complexity in the U.S. labor market, this benchmark unemployment rate has been steadily revised upward over time—it was 4 percent during 1952-58, 4.5 percent in 1970 and 4.9 percent in 1977, and it is 6 percent at the current time.
Cyclical unemployment can be considered to be determined residually as the difference between the actual and natural rates of unemployment. Thus, if we assume that the current rate of unemployment is 7.5 percent, 1.5 percent is attributable to cyclical unemployment. Fortunately, the actual unemployment rate has remained under 4.5 percent since November 1998. The booming economy has not only eliminated the cyclical unemployment, it has led to more-than-full employment of the labor force. What causes cyclical unemployment?
Cyclical unemployment is the result of variations in the level of aggregate demand in the economy. If the aggregate demand level falls short of that necessary to maintain full employment, cyclical unemployment is the result and the unemployment rate goes above the 6 percent benchmark level. The higher the deficiency in aggregate demand, the higher the unemployment rate climbs above the 6 percent mark. As fluctuations in the aggregate demand are considered to be cyclical, the unemployment caused by demand deficiency (i.e., those not attributable to natural factors) is called cyclical unemployment. It is the cyclical unemployment that is the focus of government macroeconomic policies.
Unemployment (especially cyclical unemployment) is the focus of government policies. Thus, collection of unemployment data by the government on a continuous basis is of great importance for policy purposes and is collected every month. The government needs to know not only the prevailing unemployment rate at the national level, but also its geographical and demographic break. Of course, collecting unemployment data every month by contacting everyone in the labor force would be a very time consuming and costly affair, as there are about 139 million people in the civilian labor force. As a result, the government uses a cost-efficient, but scientifically designed, alternative known as the survey method. Each month the U.S. Census Bureau workers interview about 66,000 households regarding their employment status. In particular, they are asked if they are working for pay (full or part-time), are actively looking for jobs, are temporarily absent from work or are on layoffs. Each month one-fourth of the households in the sample are replaced by new households in order to gradually update the sample. While the data obtained from the survey are not as good as those based on contacting all workers in the labor force, they are pretty close.
The official unemployment rate data do not represent the true extent of unemployment in the economy. They suffer from several flaws that undermine the use of the unemployment rate as guide of labor market conditions. These will be briefly discussed to warn the readers of the shortcomings of the official unemployment rate statistic. First, the unemployment rate does not capture the effects of discouraged workers dropping out of the labor force. For example, say a female worker keeps looking for a job for about a year and does not find one. She is so discouraged about the prospect of landing a job that she quits searching. The moment she quits actively searching for a job, she is no longer considered a part of the labor force and is thus not counted among unemployed in official statistics. As a result, if there is a poor job market from which a lot of workers drop out, the official unemployment rate may actually go down because those people aren't looking anymore. Suppose, for the purpose of illustration, that there are 100 persons in the labor force, 10 of whom are unemployed, yielding an unemployment rate of 10 percent. Assume now that 3 discouraged workers drop out of the labor force—the labor force declines to 97 and the number of unemployed reduces to 7. The official unemployment would drop from 10 percent to about 7 percent. One thus observes a rather backwards response of the unemployment rate statistic to a discouraging labor market condition. An opposite phenomenon occurs when the economy is doing very well and the labor market shows a lot of promise to aspiring workers. People who are not yet in the labor market feel encouraged to enter the job market. Even if they find jobs ultimately, they raise the number of unemployed temporarily. This can result in higher official unemployment rate even when the economy is doing better than before.
Another drawback of the unemployment statistic is that it does not distinguish between part-time and full-time employment. While working the 2:00 A.M. to 4:00 A.M. shift at a convenience store is not a dream job, the government statistics would count that person as being employed. This naturally inflates the extent of true employment in the economy.
Even if somebody is employed full-time, that person might be working a minimum-wage job with no fringe benefits or job security. Such a job may be unable to provide the worker with enough income to support a family. Workers employed in this manner are often called the working poor.
The above-mentioned drawbacks of the official unemployment statistics provide adequate warning not to take the unemployment rate literally without asking additional questions. While the unemployment rate data are not without flaws, the government relies on them to a large degree to gauge the labor market.
Unemployment of labor essentially amounts to a waste of productive labor resources. It also leads to a number of undesirable outcomes, such as lower incomes, lower standards of living, greater social tension, and greater welfare expenditures. Thus, we need to consider not only the economic costs (billions of dollars in lost output) but also the human costs associated with increased unemployment. With respect to economic costs, researchers have estimated that every percentage point increase in the unemployment rate above the natural rate leads to a loss in output equivalent to 2.5 percent of the year's gross domestic product (the main gauge of the nation's economic activity). This implies that if the unemployment rate was 7 percent in 1993, it was equivalent to an output loss of about $625 billion in 1993 prices.
Researchers have also found that the human costs of unemployment are quite tragic. Estimates by two economists (Barry Bluestone and Bennett Harrison in The Deindustrialization of America) suggest that for every I percent increase in the unemployment rate, 920 more people commit suicide, 650 more commit homicide, 500 more die from heart and kidney disease, 4,000 more are admitted to state mental hospitals, and an additional 3,300 individuals are sent to state prisons.
Both economic and human costs, in addition to probably the political motivations, are the reasons behind the use of active government policies to reduce the unemployment rate to the full employment level. The government uses two sets of macroeconomic policies to reduce the unemployment rate—monetary and fiscal policies. These policies attempt to reduce unemployment by increasing aggregate demand for goods and services in the economy. Greater demand for goods and services leads to higher production, requires a larger number of workers to be employed in the production process. This, generally, reduces the unemployment rate.
While reducing the unemployment rate sounds desirable, the process is not without complications. A lowering of the unemployment rate leads to higher inflation, especially when the economy is at or near the full employment level. So, the macroeconomic policies have to strike a balance between acceptable unemployment and inflation rates. Normally, fiscal policy, conducted by the U.S. Congress and the White House in the United States, tends to have proemployment bias. Monetary policy, conducted by an independent central bank (called the Federal Reserve System in the United States), on the other hand, tends to have anti-inflation bias. In general, the purpose of both monetary and fiscal policies is to strive to achieve high employment consistent with low and stable inflation. Fortunately, the late 1990s were great years for the policy makers—the economy experienced much lower than the 6 percent unemployment rate, and virtually no inflation. This unlikely combination (dubbed as the "Goldilocks economy") has sent economists searching for the causes of the noninflationary growth.
[ Anandi P Sahu Ph.D. ]
Bluestone, Barry, and Bennett Harrison. The Deindustrialization of America: Plant Closings, Community Abandonment, and the Dismantling of Basic Industry. New York: Basic Books, 1982.
Froyen, Richard T. Macroeconomics: Theories and Policies. 6th ed. Upper Saddle River, NJ: Prentice Hall, 1998.
Gordon, Robert J. Macroeconomics. 7th ed. Reading, MA: Addison-Wesley, 1998.
Hall, Robert E. "Why Is the Unemployment Rate So High at Full Employment?" Brookings Papers on Economic Activity 3 (1970).
Sommers, Albert T. The U.S. Economy Demystified. Lexington, MA: Lexington Books, 1988.
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