Question

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) Frictional Unemployment

It occurs when people temporarily switch between jobs. they may have quit one job to find another, or they could be trying to find the best opportunity after graduation.It is called search and wait employment. An employer may be dissatisfied with his current job due to factors like low salary, bad working conditions, work not matching his skill set. He may leave the job to find a new suitable one. There may be a possibility that an organization may terminate employee, rendering him unemployed and thus looking for new one.

Search theory explains how buyers and sellers decide when to accept a matching offer for a transaction.Search theory helps explain why frictional unemployment occurs as workers search for jobs and businesses search for new employees. There may be search frictions between employer and job seeker.These frictions can take the form of mismatched geographies, price expectations, and specification requirements, as well as slow response and negotiation times by one of the parties involved in the process.Government or corporate policy may further interfere with an efficient search process. This will distort the equilibrium as jobs are available but job seekers are not willing to take them.

b) Structural Unemployment

Structural unemployment arises as the unemployed needs to learn new skill sets in the new industries or need to relocate to a different areas for the new industries. It arises from a change in the structure of the economy.Example: decline of one industry and the rise of another. Another example can be with the use of data science and Artificial Intelligence people into business reporting and analysis will become obsolete until they do not learn new skills like R, Python, VBA, SQL etc.

Frictional unemployment is not a direct result of economic factors and occurs when workers search for jobs. Conversely, structural unemployment is caused by shifts in the economy that make it difficult for workers to find employment. Frictional unemployment is typically a temporary phenomenon, while structural unemployment can last for years. Structural unemployment is very concerning to economists, while frictional unemployment is considered inevitable and not factored into unemployment rate.

c) Some effects of Unemployment benefits in imperfect market are as follows:

Job search effect

It increases reservation wage.Job seekers become choosy. Longer duration of unemployment among recipients is harmful.They only accept job offers involving a higher wage. This higher dynamic reservation wage discriminates between unemployment and employment (Not the reservation wage that separates employment and inactivity)

Wage effect

Increase in wages through improvement of bargaining position or through an increase in the efficiency wage. Higher option of workers at the bargaining table (bargaining effect). Higher wage is required to deter shirking ("efficiency wage effect)

Entitlement effect

Increase in participation of those not receiving unemployment benefits.Unemployment benefits increase the value of employment.More participation in the labor market (shifts across participation margins). Lower reservation wage of job seekers not receiving these benefits. Higher job finding rates of unemployed not eligible to unemployment benefits.

Let's have look at the effects in perfect market.

Labor/leisure choice affected by non-work income. Budget constraint with spike in correspondence to 0 earnings. Substitution effect discourages work
Increase in the reservation wage of unemployed benefit recipients. It leads to a reduced labor supply, but its slope is decreasing as more are willing to work at higher wage levels.

To conclude the more generous the benefits the less the people will be willing to find a job as they will become choosy and lazy. People will be interested in doing only the job matching as per their requirements thus increasing the period of unemployment. Also, they will not be ready to accept the job at low wages. This may also lengthen the period of Unemployment.