Employment and unemployment

Economics A2 · The macroeconomy. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Full employment does not mean zero unemployment. It is the level of employment at which everyone willing and able to work at the going wage has a job, apart from those between jobs or without the right skills. The unemployment that remains is the natural rate.

Equilibrium unemployment exists even when the demand for labour equals the supply of labour: it is frictional and structural. Disequilibrium unemployment exists when the real wage is above the market-clearing level, either because aggregate demand is too low (cyclical) or because wages are held too high (real-wage unemployment).

Hysteresis means that a long period of high unemployment raises the natural rate, because workers lose skills and motivation.

Rules to remember

Unemployment rate = unemployed ÷ labour force × 100. Labour force = employed + unemployed.
Natural rate of unemployment: the rate when the labour market is in equilibrium and inflation is stable; it consists of frictional and structural unemployment.
Disequilibrium unemployment = workers willing to accept jobs at the current real wage − workers demanded by firms.
Voluntary unemployment: a person chooses not to accept a job at the current wage. Involuntary unemployment: a person is willing to work at the current wage but cannot find a job.
Occupational mobility: ability to change job type (helped by training). Geographical mobility: ability to move to another area (limited by housing costs, family ties, lack of information).
Unemployment above the natural rate: use demand-side policies. Unemployment at the natural rate: use supply-side policies, because extra demand only raises inflation.
The natural rate falls with better training, better job information, lower benefits relative to wages and greater labour mobility.

Common mistake

Students choose expansionary fiscal or monetary policy to cut any unemployment. This works only for cyclical unemployment; at the natural rate it mainly causes inflation.

Worked example

A labour force is 40 million and 37.2 million are employed. The natural rate of unemployment is 5%. How many people are in disequilibrium (cyclical) unemployment?

Unemployed = 40 − 37.2 = 2.8 million, so the unemployment rate = 2.8 ÷ 40 × 100 = 7%.
Natural (equilibrium) unemployment = 5% of 40 million = 2.0 million.
Disequilibrium unemployment = 2.8 − 2.0 = 0.8 million.

Answer: 0.8 million (2 percentage points of the labour force), which higher aggregate demand could remove.

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