Unemployment is making the headlines every day, in some part of the world. Yet, not many people fully understand the mechanics of unemployment, its many types or many causes. For good reason though, because the economics of unemployment can be rather complex, if not abstruse.
Firstly, it is important to distinguish between involuntary unemployment and voluntary unemployment. Involuntary unemployment is when a person is willing to work, but cannot be employed in the given economic conditions, and their current capacity for work. Voluntary unemployment is when a person is not willing to work in the given economic conditions (for n number of their own reasons). It is the former that is a bigger concern for economists and policy makers alike.
A more well rounded definition for an involuntarily unemployed worker is given by Orley Ashenfelter1 thus:
"A worker is then defined as involuntarily unemployed if the number of hours he would otherwise choose to sell is greater than the number of hours he can sell. By this definition, a worker who is involuntarily employed is forced to consume more non market time than he would prefer, and consequently, a smaller bundle of commodities. Alternatively, a worker who is involuntarily unemployed cannot work as much as he would prefer and thus cannot purchase as large a bundle of commodities as he would like."
Ashenfelter, Orley. “What Is Involuntary Unemployment?” Proceedings of the American Philosophical Society, vol. 122, no. 3, 1978, pp. 135–138. JSTOR, www.jstor.org/stable/986547. Accessed 12 Feb. 2020.
It is important to note that the definition directly relates the worker's work hours and his/her consumption. The consumption of workers, which depends on their "market time," directly affects the overall economy of a country, and the world, so unemployment is a very serious problem and requires rigorous policy measures to solve it.
Labour Market Equilibrium & Voluntary Unemployment
A simple understanding of labour markets will reveal the top reason for unemployment. Figure 1 shows a typical labour market diagram, where Qs is labour supply & Qd is the demand for labour. W is the wage. Qt is the total labour available. Equilibrium is (Qo, Wo) where Qo is the equilibrium amount of labour and Wo is the equilibrium wage. In this figure, (Qt-Qo) is the voluntary unemployment, and there is no involuntary unemployment. All the people who want to work at the wage of Wo, get jobs and are employed. The remaining people, for their own reasons, do not want to work at wage Wo, and choose to not work.
There could be reasons for choosing not to work, like switching jobs, taking a sabbatical, taking a maternity leave, and such. It could be that a freelancer would prefer to remain unemployed at wage Wo in the current period, because s/he has some savings from a previous work assignments, and choose to wait for another work assignment which pays them higher than Wo wage. So, in this period they would rather not lower their rates and remain unemployed out of choice. Their "reservation wage"--the lowest wage that can entice them to work--is higher than the current wage.
Trade Unions & Minimum Wage
In this scenario, enter trade unions. The unionists' view of labour markets is that "everyone" should get a basic minimum wage, which helps them cover their basic needs and live respectably. The idea is nobly presented, but unfortunately, it doesn't end there when it comes to labour markets.
In the market equilibrium of Figure 1, when you impose a "wage floor" or minimum wage of WM, as shown in Figure 2, the market responds differently. At this wage WM, Q1 number of people want to work, whereas there is demand only for QM number of people. There are only QM jobs available at wage WM. Companies have their own costs to take care of, and increasing the wage means they will want fewer workers.
What does this lead to? An involuntary unemployment of (Q1-QM). These are the number of people who would like to work at the given wage WM, but do not get the jobs. In this scenario, the voluntary unemployment is now (QT - Q1). As we can see from the figure, in this scenario, the employment has reduced from Qo to QM. And instead, it has introduced an involuntary unemployment into the market. This is also less equitable, as a few workers earn higher, but a bigger number of workers earns nothing. So wealth distribution is even less fair than it was before--which was the original idea behind a minimum wage.
The trade unions also work by conglomerating the worker force. Which means that anyone who is not a part of the trade union, cannot work for a lower wage either. So there is further disincentive to lower wages.
All of these factors combined lead to certain "black markets" for labour, where people work "off the record." They evade paperwork and unions, companies pay them lower wages without any paper trail, and a lot of the work force goes unaccounted for.
Different countries have different laws around minimum wage. India has a complex structure of minimum wages, which vary from one state to another, and one industry to another (for some states). Although this allows for accommodating the market structure and cost of living variation from one state to another, it is also rather complex, and hence, a worker may not even be aware of the real minimum wage for his job. Moreover, in some cases the work is on a piece wage, rather than monthly wages, and the current model of minimum wage setup does not account for that.
The Efficiency Wage
There is yet another reason why we might see a similar phenomenon, although for very different reasons: the "efficiency wage" model by Carl Shapiro & Joseph Stiglitz.2
The model argues that employers face high attrition from workers quitting jobs regularly, and their method to check this attrition is to increase the wage to a point where losing the job increases the opportunity cost to the worker manifold. They argue, that at lower wages, people tend to shirk their responsibilities, and hence a significant amount is spent in monitoring costs, where the employer needs to constantly monitor the performance of the employees. When the wage is increased to W*, much higher than going market rate Wo, the job becomes that much more desirable, and losing it, that much more costly.
After some time, the market re-adjusts and other employers increase their wages to match the highest wage W*. This process involves sacking many people to justify the salary and cost. Now, in this new scenario, there are fewer jobs (Q*) available, and hence, if one gets sacked for non performance, they find it quite tough to find a new job as well. This de-incentivises shirking responsibilities & lowers attrition rates & monitoring costs. In this scenario, there is, once again, a gap in the number of people willing to work, and the number of people who are actually employed -- this is yet another form of involuntary unemployment. This model suggests that there is some "job rationing" done by firms, in order to incentivise work performance.
This is a common scenario in multinational companies today (although the paper was written in 1984), wherein, combined with the wage, firms offer other incentives like health insurance, housing allowance, maternity allowance, travel allowance and so on. If you get sacked, you lose it all, and suddenly life looks very tough. You are accustomed a certain "standard of living" which is no longer possible. Getting another job is no longer a cake walk. This is one of the key reasons why people stick to their jobs today, and how MNCs check attrition rates.
Keynesian Theory of Unemployment
John Maynard Keynes was a celebrated economist and visionary who had much to say on labour economics, specifically.3 He describes involuntary unemployment as follows:
"Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods relatively to the money-wage, both the aggregate supply of labour willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment."
John Maynard Keynes. The General Theory of Employment, Interest, and Money (Kindle Locations 212-214). Blurb. Kindle Edition.
Keynes explained unemployment arguing based on his concept of "effective demand," which, as per him, was based on the consumption and investment of the entire population. His argument was that what people earn, they either spend on goods & services, or on investments. The combination of the two decides the overall effective demand in a country, which in turn decides how much firms produce, and how many workers they employ.
So if the price of wage goods increases, the revenue of firms is more, and hence, they can employ more people. On the other hand, if the price of wage goods increases, workers are effectively poorer at the same wage (their income now buys them less of the same goods), and hence, more people will want to work to sustain themselves. Outcome is that there is an increase in demand as well as supply of jobs, when the price of goods increases by ΔW.
According to him, when the effective demand is low, there is a big number of workers willing to work, but they cannot be employed, as shown in figure 3. The number of people willing to work is Q1, whereas only Qo can be employed. Here (Q1-Qo) is the involuntary unemployment.
Much of unemployment can happen due to the slowdown in one industry/sector or the entire country as a whole. Keynes' theory explains this phenomenon. For example, there is an ongoing slowdown in the automobile industry worldwide, and hence, a reduction in the number of jobs available in the industry. In this case, a figure similar to Figure 4 can explain the existing involuntary unemployment.
As another example, recollect the service job situation shown in the popular TV series Downton Abbey. Mr Molesely, Thomas Barrow, and many others like them, once sacked or who lost their jobs for other reasons, find it difficult to find another job in the same type of work. There is an influx of wounded soldiers after WW1, all desperate for work & to sustain themselves, but not enough jobs as the size of households is dwindling, due to overall economic slowdown. At the same time, there are new industries coming up, and slowly, the labour force is moving from one industry to another, but over a longer period of time.
Capacity Curve & Developmental Economists' View of Unemployment in the Poor
When we look at unemployment in the poor, there is the additional factor of "work capacity" that needs to be factored in, since not everyone can even consume enough food to survive.4
When it comes to the poor (especially those below the poverty line, based on PPP), they will be forced to consume everything they earn, just to meet the calorific requirement to survive, and hence, have a lower work capacity than they would when their nutritional requirements are met.5 This is shown in Figure 5. When they reach the critical nutritional intake, additional food intake increases their work capacity dramatically, leading to a sudden jump in the labour supply in the market. Beyond a certain point, increasing food intake does not increase work capacity anymore, which is where the work capacity flattens out. The labour supply curve in this scenario will be similar to Figure 4, where the flat portion of the curve is explained by low work capacity of workers. In Figure 5, V1 is the piece wage which is too low to give any work capacity to workers. V* wage is just enough to give enough income, hence enough food & work capacity to start working and be "on the labour market."
Although this concept is explained in the context of nutrition, similar poverty trap like scenarios exist for other constraints to work capacity like health, education, capital etc. All of these can cause a person to be willing to work, yet not able to work, and hence not be employable at the going wage rate, leading to involuntary unemployment.
It is important to understand the causes of involuntary unemployment to be able to identify the right policy or solution to address it. In volatile times like economic slowdowns, multiple factors may be at work, and would require a multi pronged approach, keeping the different strata of the economy in mind.
- Ashenfelter, Orley. “What Is Involuntary Unemployment?” Proceedings of the American Philosophical Society, vol. 122, no. 3, 1978, pp. 135–138. JSTOR, www.jstor.org/stable/986547. Accessed 12 Feb. 2020.
- Shapiro, Carl, and Joseph E. Stiglitz. “Equilibrium Unemployment as a Worker Discipline Device.” The American Economic Review, vol. 74, no. 3, 1984, pp. 433–444. JSTOR, www.jstor.org/stable/1804018. Accessed 12 Feb. 2020.
- John Maynard Keynes. The General Theory of Employment, Interest, and Money (Kindle Location 9). Blurb. Kindle Edition.
- Esther Duflo. 14.74 Foundations of Development Policy. Spring 2009. Massachusetts Institute of Technology: MIT OpenCourseWare, https://ocw.mit.edu
- Dasgupta, Partha, and Debraj Ray. “Inequality as a Determinant of Malnutrition and Unemployment: Theory.” The Economic Journal, vol. 96, no. 384, 1986, pp. 1011–1034. JSTOR, www.jstor.org/stable/2233171. Accessed 12 Feb. 2020.