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Q. In a competitive equilibrium, the equilibrium wage clears the market and everybody that is looking for a job can find one. But in reality, we observe quite widespread involuntary unemployment.

a) Describe how search frictions can generate unemployment in equilibrium.

b) Define structural unemployment and discuss how structural unemployment differs from frictional unemployment.

c) How can the generosity of the unemployment insurance benefit effect the length of the unemployment spell and the accepted wage offer? Use your own words and carefully describe the mechanisms.

Answer 1

A. Despite equilibrium wge clearing, in real life there still is some involuntary unemployment because of 'search frictions' These frictions are basically difficulties and issues in the search stage of the job. Market information is not perfect. Sometimes it is difficult to match the right job with the right talent. I am looking for a job and there might be a job which suits me prefectly, but I am not aware about the job. Similarly the employer might not be aware about the job seeker or may not be able to contact him/her. This difficulty in pairing the right person with the right job is a friction which causes unemployment.

B. Structural unemployment is a longer-lasting form of unemployment caused by fundamental shifts in an economy and exacerbated by extraneous factors such as technology, competition, and government policy. Structural unemployment occurs because workers lack the requisite job skills or live too far from regions where jobs are available and cannot move closer. Jobs are available, but there is a serious mismatch between what companies need and what workers can offer.

Frictional unemployment, on the other hand, is the result of voluntary employment transitions. Frictional unemployment naturally occurs in all economies- including growing or stable economies. Workers choosing to leave their jobs in search of new ones and workers entering the workforce for the first time constitute frictional unemployment.

So the main difference between these is that structural unemployment is involuntary while frictional unemployment is voluntary.

C. Generosity of unemployment benefit is directly proportional to the length of the unemployment spell and also to the minimum acceptable job offer. The higher the unemployment benefit, the longer the unemployment spell and bigger the minimum acceptable wage.

This is because, apart from other things, length of unemployment spell depends upon effort from the unemployment individual too. The effort would be higher when difficulties are higher and vice versa. The bigger the unemployment benefit, the lower the difficulties and the lower the difficulties the lower the effort put in searching for jobs. The lower the effort the longer the unemployment spell.

Similarly, the higher the unemployment benefit, the higher the requirement for minimum wage. The utility of unemployment benefit is very high as it is almost no effort utility. The net utility from a job is benefit-effort. A candidate will only accept a wage when the utility from the wage will be higher than the utility from unemployment benefit. Since unemployment benefit has no effort involved- the higher the eumployment benefit the higher its utility and the tougher it is for a wage to exceed that utility.