The meaning and general effects of unemployment

Unemployment occurs when the supply of labour exceeds the demand for it in an economy.

Why some unemployment always exists

Unemployment represents a waste of scarce resources, as an economy fails to utilise its full productive potential when workers are idle. However, a certain level of unemployment is inevitable in any economy.

Benefits of some unemployment:

• Unemployment helps control wage levels by creating competition among workers.
• If every worker were employed, firms seeking new hires would need to offer higher wages or improved non-financial benefits, increasing overall costs.

Unemployment only becomes a major economic issue when it reaches high levels and lasts for an extended time.

Causes of unemployment including benefits and real wages

Various factors can lead to unemployment, including government policies on benefits and pressures that push wages above market-clearing levels.

High unemployment benefits

If unemployment benefits are set too high, they can discourage people from seeking work, resulting in voluntary unemployment. The replacement ratio measures the proportion of income received while unemployed compared to potential earnings from employment. This creates an unemployment trap, where individuals prefer claiming benefits over accepting available employment opportunities.

Real wage unemployment

Real wage unemployment arises when wages are forced above the equilibrium point where labour supply equals demand. This is usually caused by trade unions negotiating for higher wages or the introduction of a national minimum wage.

Effects of introducing a national minimum wage above equilibrium:

• An increase in labour supply.
• A decrease in labour demand.
• Overall unemployment due to the resulting excess supply of workers.

Factors like rising productivity or increased consumer spending can mitigate this by shifting the labour demand curve rightwards, reducing the extent of unemployment.

The natural rate of unemployment

The natural rate of unemployment (NRU) represents the baseline level of unemployment in a balanced labour market.

Features of the natural rate of unemployment

The NRU occurs when the labour market is in equilibrium, with labour demand matching supply. At this point, sufficient jobs exist for the workforce, but not every individual will be employed due to ongoing transitions.

Types of unemployment contributing to the NRU:

• Frictional unemployment - Workers are temporarily between jobs while searching for new ones.
• Structural unemployment - Arising from mismatches between workers' skills and available jobs.

The NRU aligns with full employment, as achieving zero unemployment is impossible in practice.

The short-run Phillips curve and inflation-unemployment trade-off

The short-run Phillips curve illustrates a key economic relationship between inflation and unemployment rates.

Characteristics of the short-run Phillips curve

This curve demonstrates a trade-off: lower unemployment often comes with higher inflation, and vice versa. Based on historical data analysed by economist A.W. Phillips, it shows that falling inflation tends to coincide with rising unemployment.

Key features:

• Governments can reduce unemployment by boosting aggregate demand, but this typically leads to increased inflation.
• Adaptive expectations play a role: if inflation rises, people anticipate it will stay high, potentially embedding elevated inflation in the economy.

The Keynesian view of the Phillips curve

Keynesian economists argue that the Phillips curve relationship holds true, mirroring patterns in the Keynesian long-run aggregate supply (LRAS) curve.

How the relationship works:

• At low output levels with high unemployment, workers accept jobs at modest wages, allowing output to rise without much inflationary pressure.
• As output increases and unemployment drops, prices begin to rise, creating inflation.

The economic costs of unemployment

High unemployment imposes significant burdens on the entire economy, affecting individuals, businesses, and governments.

Why governments monitor unemployment closely

• A high unemployment rate signals poor economic performance overall.
• Unemployed individuals have lower incomes, leading to reduced spending in the economy.

Impacts on businesses and production

• With less consumer spending, firms sell fewer goods and services, which may force them to lower prices and accept reduced profits.
• Unused labour means the economy produces fewer goods and services than its potential.

Financial implications for governments

• Governments incur higher costs through increased welfare payments to the unemployed.
• Revenue falls as fewer people pay income taxes and spending-related taxes decline.