Unemployment is
one of the most visible indicators of economic activity. The rate of
unemployment typically rises considerably during recessions then falls as the
economic recovers. People commonly view the typical unemployed worker as
suffering long-lasting despair and destitution, so the media publicize high
unemployment as a great social problem. We shall see that this view of the
unemployed worker is not an accurate depiction of the vast majority of those
out of work in the United States. In contrast, most of the unemployed find work
relatively quickly. While their income loss is significant, it is not
catastrophic for most workers who suffer an unemployment spell.
degree of unemployment is socially and perhaps personally desirable. Much of
unemployment in the United States consists of new entrants to the labor market
seeking their first job, individuals who are voluntarily changing jobs or
occupations, and people in jobs for which periodic or seasonal layoffs are normal,
expected, and compensated for by higher wages during periods of employment. For
these individuals, unemployment is not a problem at all. It is merely part of
the natural functioning of a flexible and efficient labor market.
often view unemployment as one facet of an inevitable process of search in the
labor market. Jobs and workers are heterogeneous along many dimensions. Workers
differ (among other ways) by intelligence, creativity, education, training,
experience, physical size and strength, manual dexterity, ability to sustain
repetitive tasks, and preferences about their work environment. Jobs vary in
the abilities, education, and experience that are required to perform them, as
well as in working conditions, location, opportunities for advancement, and
many other characteristics. Since workers and jobs are so heterogeneous, the
process of matching the characteristics of a particular unemployed worker with
the most suitable vacant job often cannot be accomplished quickly. Instead
unemployed workers and employers having vacant jobs engage in a two-sided
search, seeking to achieve a good match as quickly as possible. The length of
this search process for a typical unemployed worker is a major factor in
determining the unemployment rate.
can imagine an economy in which this matching problem could be solved
trivially. If all workers and jobs were identical, for example, there would be
no gain to searching for a better match. Or if everyone had instantaneous and
perfect information about the characteristics of all workers and jobs, searches
could be accomplished in just a moment. However, in an economy in which the
matching problem cannot be solved trivially it is generally desirable to have
both a positive unemployment rate and a positive job vacancy rate. Successful
matching requires a pool of searching workers on one side of the market and a
pool of available jobs on the other. The socially optimal unemployment rate
depends on the size of the pool that is required in order for optimal matching
to occur. The optimal pool size, in turn, depends on the efficiency of the
“matching technology” in the economy as well as on a variety of social and
policy variables.
the costs and benefits of search are largely internal to the workers and firms
doing the searching, we might expect that a competitive market economy would
gravitate toward the socially optimal amount of search. However, the labor
markets of modern economies contain many distortions that might cause the long-run
equilibrium unemployment rate (the so-called natural rate of unemployment) to
be higher or lower than the optimal rate. In particular, a wide variety of
government policies influence the incentives of workers and employers to
continue searching, including unemployment insurance programs, job-protection
legislation, and “active” labormarket policies such as job-placement assistance
and training. 
analysis of unemployment has focused intensely on one particular empirical
problem: extremely high unemployment in continental Europe since 1980. From
1950 until 1970, the unemployment rate in most European countries averaged
about 2%, roughly half of the rate in the United States during that period.
Since 1980, Europe has suffered unemployment rates in the 8 to 12 percent
range, about twice the U.S. rate. Moreover, long-term unemployment (of more
than one year) is far more common in Europe than in America. Theories of
unemployment are able to explain some, but not all, aspects of the divergence
of unemployment behavior between Europe and America.
most interesting new tools that we employ in our analysis of unemployment is
dynamic programming, which is a common method of analysis of models involving
transition in continuous time between alternative discrete states. In the case
of unemployment models, the main states are employed and unemployed, with some
variations in selected models. Dynamic programming has a complicated side and a
simple intuition. We’ll focus on the latter here.

The statistical definition

order to measure unemployment, economists have adopted a statistical definition
that is only partially understood by the general public. Also, optimal matching
does not generally mean making the best matches that are conceivably possible.
Better matches involve costs (longer unemployment spells) as well as benefits
(better fit between jobs and workers). The optimal amount of matching balances
these marginal costs and benefits.
the United States are compiled by the Bureau of Labor Statistics (BLS) from the
monthly Current Population Survey (CPS) conducted by the Bureau of the Census.
This survey of approximately 64,000 households asks general questions about the
labor-market status of adult members of the household during the week prior to
the week in which the survey is taken.
on the responses to the CPS questions, every adult is placed into one of three
categories: employed, unemployed, or not in the labor force.
Anyone who worked for pay at all during the reference week is considered to be
employed, including part time workers. Among those not employed, those who were
both actively seeking work and immediately available for work, plus those who
were awaiting recall from a temporary layoff from their previous job, are
classified as unemployed. Anyone else, i.e., those who did not work, were not
on layoff, and either were not actively seeking work or were not available for
work, are considered to be out of the labor force.
the United States, the extent of unemployment is commonly expressed as the unemployment
, which is the number unemployed divided by the total labor force,
which consists of the sum of employment and unemployment. (In Europe, the
“headline number” is more likely to be the number of unemployed rather than the
rate.) The unemployment rate ignores completely those who are classified as out
of the labor force—they enter neither the numerator nor the denominator. To the
extent that it is difficult to distinguish between people who are unemployed
and those out of the labor force, this may cause ambiguity in the meaning of
the unemployment rate. To account for this potential problem, economists
sometimes use the employment/population ratio instead of the unemployment rate.
This ratio measures the share of the adult population that is employed and
treats unemployment and out of the labor force as equivalent states.

Problems with
the statistical measures

from the usual difficulties associated with surveys, such as inaccuracy in
responses, the categorization of the population by labor-market status poses
some particular difficulties. There are some “gray areas” between the three
categories that have led some economists (and politicians) to question the
relevance of published measures.
may seem like the least controversial boundary would be that between employment
and the other categories. There is an obvious benefit to basing unemployment
statistics on a survey such as the CPS rather than using such measures as
applications for unemployment insurance benefits. If eligibility for benefits
depends on their answer, then those out of work have a strong incentive to lie
about whether they are actively seeking work. The CPS approach is likely to
elicit more honest answers from respondents.
seems easy. However, if there are individuals who are working part-time because
they have not been able to find a full-time job, then some degree of “problem
underemployment” is masked in the statistics. Part-time work accounts for a
large and growing share of employment in some OECD countries. Among countries
of the European Union, over 15 percent of workers in the Netherlands, Belgium,
the United Kingdom, Germany, Denmark, and Spain now work part-time, while less
than 10 percent of those in Greece, Portugal, Italy, Ireland, and France do. In
many cases, laws that treat part-time workers differently than full-time
workers help to explain these differences in rates.
a study of the working-hour preferences of EU workers in 1989, a large majority
in most countries indicated satisfaction with their working status. Among those
working full-time, 21 percent indicated that they would rather be working
part-time while 77 percent were happier with full-time work. (The remainder
responded “no reply.”) Among part-time workers, 66 percent were content with
part-time work while 30 percent would have preferred full-time employment.
Thus, it appears that for European countries about one-third of part-time
employment is involuntary, while about one-fifth of full-time workers would
prefer to work part-time.
result suggests that defining employment to include both part-time and fulltime
workers masks problems in both directions: workers working more hours than they
wish and workers working fewer hours than they want. Since there are somewhat
more workers who work less than their desired amount, there is probably on net
some degree of hidden underemployment in part-time employees. However, this may
be less than one might have expected from the raucous reactions of union
leaders and some politicians to the rise of part-time employment in recent
difficult boundary is that between unemployed and out of the labor force. Many
countries have begun to collect data on discouraged workers, who are
officially classified as out of the labor force. Discouraged workers have given
up job search because they do not believe they can find a job. They are clearly
part of the unemployment problem if their
assumption is correct
. However, since they are not actively seeking work,
it is impossible to tell whether they would have, in fact, been able to find a
job had they continued their searches. As of 1991, the number of discouraged
workers as a percentage of the labor force ranged from virtually nil in number
was around one percent. The presence of discouraged workers suggests that the
measured unemployment rate may understate the true magnitude of unemployment.
However, there may be a counterbalancing bias due to “low-intensity searchers.”
Anyone without a job who answers affirmatively to the question “Are you looking
for work?” is classified as unemployed. Some individuals may answer yes to this
question even if their job search consists of sitting at home and waiting for
the phone to ring. (Or, in some countries, working at an unreported,
black-market job.) If some of the people counted as unemployed are actually, in
effect, either employed or out of the labor force, then unemployment may be
these problems may compromise the accuracy of unemployment statistics, it is
unlikely that the biases in the statistics change systematically from month to
month. Moreover, information about discouraged workers and involuntary
part-time workers are collected periodically to allow analysts to assess
whether the biases are changing over time. Interpreted with caution,
survey-based measures of unemployment are useful in measuring changes in
labor-market conditions over time.

Natural and
cyclical unemployment

often make a distinction theoretically among several categories of
unemployment, although it is difficult or impossible to decompose our empirical
measure in a corresponding way. The most fundamental distinction is between natural
and cyclical unemployment. Milton
Friedman, in his famous presidential address to the American Economic
Association in 1967, coined the phrase “natural rate of unemployment” to refer
to the rate that results from the equilibrium operation of the microeconomy,
when macroeconomic conditions cause neither a general excess demand nor an
excess supply of labor.
any point in time, macroeconomic conditions can lead to a slack aggregate labor
market in which unemployment is above the natural rate or a tight labor market
with unemployment lower than the natural rate. The difference between the
actual rate and the natural rate of unemployment is often called cyclical
unemployment. Keynes emphasized the importance of cyclical unemployment during
the Great Depression, which he interpreted as a huge aggregate excess supply of
unemployment changes, there is often disagreement among economists about
whether the causes are microeconomic or macroeconomic, in other words, whether
it is a change in natural or cyclical unemployment. In the early postwar period,
the natural rate of unemployment was widely regarded as being stable at about 4
percent in the United States and about half of that in Europe. Fluctuations in
un-employment during the 1950s and 1960s were believed to be changes in
cyclical unemployment. 
in the labor market and in the general level of unemployment in the 1970s and
1980s convinced most macroeconomists that the natural rate can fluctuate
considerably due to changes in the microeconomic structure of the labor market.
The natural rate in the United States was reckoned to be 5.5 to 6.5 percent in
the 1980s, but may be somewhat lower now. The causes of the current high
unemployment in Europe are regarded almost universally as microeconomic, which
means that they should be viewed as increases in the natural rate.
and labor economists have recently begun reexamining the sharp distinction
between natural and cyclical unemployment. Despite the inconvenience it imposes
on our theories, the microeconomy and macroeconomy are highly interdependent. A
period of recession or depression caused by strictly macroeconomic factors will
affect the microeconomic structure of the labor market in several ways. The
demand for durable goods is usually more sensitive to business cycles than
other goods, so these industries will shrink more than others in recessions,
which will affect the industry, regional, and occupational structure of the
demand for labor. On the supply side, workers who have been unemployed for a
long time often lose job skills or job-finding skills, making them less likely
to find a job.
have used the term hysteresis to refer to situations where prolonged increases in
cyclical unemployment raise the natural rate of unemployment. If hysteresis
occurs, then the unemployment rate may never return all the way to its original
natural rate after rising in a large and prolonged recession.
the category of natural unemployment, economists sometimes distinguish frictional
and structural
unemployment. Frictional unemployment results from the natural frictions of the
labor-market matching process. You can think of the frictionally unemployed as
job searchers for whom suitable vacancies exist, but who have not yet found
these openings. Structural unemployment occurs when the skills and other
characteristics of the unemployed do not match the requirements of the
available jobs. Technological change and structural shifts in the economy often
cause changes in the skill composition of the job pool. If the labor force does
not keep up with these changes, then structural unemployment is likely to
There is no
single unified model of unemployment. The Walrasian paradigm based on the
market for a homogeneous good predicts that there should be no unemployment, so
this workhorse benchmark model of neoclassical economics is not informative.
Instead, one must move beyond the Walrasian model in one way or another. Since
there are many ways in which actual labor markets differ from a Walrasian
market, there are many possible approaches that can be followed.
Introduction to Theories of Unemployment
employment and unemployment are clearly connected in important ways, a theory
of employment alone is not sufficient to explain the behavior of unemployment.
One fallacy that is often committed by uninformed members of the public and the
media is to assume that a decline in employment of, say, 1000 workers
necessarily means that unemployment will rise by 1000. If a firm lays off 1000
workers, only a fraction will enter the ranks of the unemployed, and many of
those are unlikely to remain there very long. Some of the laidoff workers will
find jobs right away, moving from one employment position to another rather
than into unemployment. Others will leave the labor force for retirement,
education, child-bearing, or other nonlabor activity. Similarly, when a firm
hires 1000 new workers, some will have been previously unemployed but many
others will come from other jobs or from outside the labor force as, for
example, with new graduates finding their first jobs.
 Rather than simply viewing unemployment as the
counter-state to employment, we model it as a process of search. The success
that individuals seeking new jobs will have in finding them depends on two
broad kinds of circumstances: (1) the general balance of demand and supply in
the labor market, and (2) the match between the searchers’ characteristics and
those of the available jobs. There are two broad categories of approaches to
explaining movements in unemployment that correspond to these two kinds of
  One approach emphasizes the heterogeneity of
workers and jobs. Because every worker and every job has unique
characteristics, matching them up through a search process is time consuming.
Search models examine the propensity of employers and job searchers to achieve
matches and how that propensity varies over time. This approach models the
flows of workers and jobs between states: a job match that results in a hire
transforms an unemployed worker into an employed worker and a vacant job into
an occupied one. To complete the model, one must examine the other labormarket
flows: job creation and destruction, entry to and exit from the labor force,
and the flow of separations of existing workers from their jobs.
the search approach, natural unemployment fluctuates when there are changes in
the efficiency of matching in the economy or in the other flows between
labormarket states. For example, if structural shifts in the economy
make it more difficult to match the characteristics of unemployed workers with
those of vacant jobs, then matching will be less efficient and the natural rate
of unemployment will increase.
should be emphasized that the kind of unemployment described by the search
theories does not require a general excess supply of labor. It stresses the
fact that even when the number of unemployed is equal to the number of job
vacancies, neither number is likely to be zero.
other major approach emphasizes microeconomic imperfections that lead to
imbalance between demand and supply in the aggregate labor market, especially
to excess labor supply. These imperfections can be associated with government
interference such as minimum wages and unemployment benefits, or with
deviations in the behavior of firms or workers from the assumptions of
price-taking competitive markets such as the presence of unions or
noncompetitive behavior by employers. This approach often tends to maintain the
assumption that labor is a homogeneous good and emphasizes the possibility of a
lasting imbalance between demand and supply in the unified labor market.
popular model that takes that approach is the efficiency-wage model.
This model is based on the notion that firms pay higher wages than would
normally be necessary in order to attract workers. Different versions of
efficiency-wage models stress different reasons why firms may do this. One is
that higher wages may prevent shirking by employees; another is that a higher
wage offer may attract a more qualified pool of applicants. While each firm in
an efficiency-wage model wants to pay more than other firms, that obviously
cannot happen. If all firms offer an efficiency wage, then aggregate wages in
the economy are bid up above the market-clearing level and a general excess
supply of labor results.

are based on the observation that labor contracts often forbid firms from
changing wages in the short run, but allow them to respond to variations in
their need for labor through layoffs and overtime. A rich literature exists
that examines the rationale for such contracts and their optimal structure.
model that follows this approach is the insider-outsider model, where a
sharp distinction is drawn between the bargaining status of individuals who are
currently working (insiders) and those who are unemployed or out of the labor
force (outsiders). This model has been advanced as a promising explanation for
the poor performance of labor markets in continental Europe in recent decades.
Minimum Wages and
lengthy empirical literature has examined the impact of minimum-wage laws on
both employment and unemployment. Although there is a considerable range of
results, the consensus seems to be that minimum wages have relatively minor employment/unemployment
effects. Nonetheless, minimum-wage laws may have significant impacts in certain
time periods and on certain groups of workers, especially teenagers and
unskilled workers.

A simple
minimum-wage model

most basic analysis of the minimum wage proceeds in the way that we would
analyze any price floor. In Figure 1, labor is assumed to be homogeneous; all
workers participate in the same market and earn the same wage. If the market is
Walrasian, then the wage will be w*
and the economy will operate with full employment at the level L*. If a minimum wage is imposed at a
level higher than the equilibrium wage, say at w1, then the market cannot reach equilibrium. Only L
workers are
hired at w1 and L
″−Lworkers are

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