Measurement of unemployment and the unemployment rate
Unemployment
When people of working age (16-65) who are actively seeking and able to work, but are not employed.
Unemployment Rate
The number of unemployed people expressed as a percentage of the labor force.
The formula for calculating the unemployment rate is:
$$\text{Unemployment Rate} = \left(\frac{\text{Number of Unemployed People}}{\text{Labor Force}} \right) \times 100$$
NoteThe labor force consists of those who are employed plus those who are unemployed but actively seeking work.
ExampleCalculating the unemployment rate from a given data set
Imagine an economy, Econland, with the following statistics:
- Number of unemployed people: 2,500
- Total labor force: 50,000
Applying the formula for the unemployment rate:
$$\text{Unemployment Rate} = \left( \frac{2500}{50000} \right) \times 100$$
$$=5\%$$
Final Answer: There is a 5% unemployment rate in Econland.
Common MistakeStudents often incorrectly assume that part-time workers are counted as unemployed.
However, anyone who has any paid work, even if only for a few hours per week, is counted as employed in unemployment statistics.
Difficulties in measuring unemployment
Measuring unemployment has some underlying difficulties including:
- Accounting for hidden unemployment.
- Factoring the impact of underemployment.
- Measuring the informal sector employment.
Hidden unemployment
- The hidden unemployment in an economy is represented by the individuals who have stopped actively looking for work but are still willing to work.
- These individuals are not counted as unemployed in official statistics because they are no longer actively seeking jobs, despite being discouraged job seekers.
In the aftermath of the 2008 Global Financial Crisis, many job seekers in the U.S. gave up on finding work, temporarily leading to an underestimation of unemployment.
Underemployment
Underemployment occurs when workers:
- Are involuntarily working part-time but desire full-time jobs.
- Are overqualified for their current jobs, meaning their skills and education are underutilised.
- Therefore, the unemployment rate does not fully reflect the unemployment of human capital in an economy, since many part-time workers seeking full-time jobs are classified as employed, even though their resources are not fully utilised.
In many European countries post-COVID-19, skilled workers (like engineers) took up roles in retail or gig jobs due to limited opportunities in their fields
Informal sector employment
- The informal sector consists of workers engaged in unregulated, unregistered, or casual jobs without official contracts.
- Since these workers do not have formal employment records, they are often excluded from unemployment statistics, despite facing job insecurity and low wages.
- This may lead to overestimations of the unemployment rate.
In developing economies like India, a large proportion of workers in street vending or domestic services are part of the informal sector and uncounted in employment surveys.
Causes of unemployment
TipThis topic has been asked several times in IB exams. Read carefully!
There are 4 main causes of unemployment:
- Cyclical unemployment.
- Structural unemployment.
- Seasonal unemployment.
- Frictional unemployment.
Cyclical unemployment
Cyclical unemployment
Cyclical unemployment occurs during economic downturns when demand for goods and services falls, leading to job losses.
Figure 1 below shows how an inward shift of aggregate demand ($AD_1$ → $AD_2$) creates a deflationary gap and leads to cyclical unemployment:
TipUnderstanding how a fall in AD leads to cyclical unemployment (Figure 1)
Figure 1 illustrates how a fall in AD leads to cyclical unemployment:
- Initial equilibrium ($AD_1$, $Y_p$):
- At $AD_1$, the economy is at its full employment level of output ($Y_p$).
- Firms produce at their maximum sustainable capacity, and unemployment is low (only frictional and structural unemployment exist).
- Decrease in aggregate demand ($AD_1$→ $AD_2$):
- A decline in consumption (C), investment (I), government spending (G), or net exports (X - M) causes AD to shift inward from $AD_1$ to $AD_2$.
- This may be due to economic recessions, financial crises, or external shocks (falling consumer confidence, reduced business investment, global economic downturns...).
- Deflationary gap and output decline:
- The fall in AD lowers real GDP from $Y_1$ to $Y_2$, creating a deflationary gap.
- Since firms sell fewer goods and services, they cut production costs, including wages and jobs.
- Increase in cyclical unemployment:
- As firms reduce output, unemployment rises, especially in cyclical industries such as construction, manufacturing, and retail.
- With fewer job opportunities, households have less income, further reducing consumer spending, worsening the decline in AD, and creating a negative spiral of unemployment and reduced demand.
Cyclical unemployment is closely linked to the business cycle and is often temporary, improving as the economy recovers.
Structural unemployment
Structural unemployment
Structural unemployment happens when there is a mismatch between workers’ skills and available jobs.
Some common causes of structural unemployment are:
- Technological advancements.
- Changes in the preferences of demand, which causes shifts in the labour skills demanded.
- Geographical mobility of jobs.
- Labour market rigidities: mechanisms that prevent wages to reach market equilibrium. These include:
- Minimum wages.
- Labour laws restricting wage cuts.
- Strong trade unions demanding higher wages.
- Long-term contracts that prevent wage flexibility.
Labour rigidity: minimum wages
In subtopic 2.7.2, we introduced the idea that minimum wages are price floors in the labour market. Figure 2 below illustrates the effect of a minimum wage on the labour market:
TipUnderstanding minimum wages lead to structural unemployment (Figure 2)
Understanding the axes
- Y-axis (Vertical) → Represents wages ($W$) paid to workers.
- X-axis (Horizontal) → Represents quantity of labour ($Q$): the number of workers employed in the labour market.
Identifying market equilibrium
- The initial market equilibrium occurs at $W_e$​ (equilibrium wage) and $Q_e$​ (equilibrium employment level).
- At this wage level, the quantity of labour supplied equals the quantity of labour demanded, meaning there is no involuntary unemployment.
Imposing a minimum wage
- A minimum wage is introduced at $W_min$, which is higher than the equilibrium wage $W_e$​.
- This means that firms are now legally required to pay workers at least $W_min$​, even though the market-clearing wage was lower.
Effects on labour supply and demand
- Labour supply increases
- Since wages are now higher, more workers are willing to work, increasing the quantity of labour supplied to $Q_s$.
- This is shown by the movement along the blue labour supply curve.
- Labour demand falls
- Firms hire fewer workers because higher wages increase production costs, reducing the number of workers they can afford to employ.
- This leads to a decrease in labour demand to $Q_d$, as shown by the movement along the red labour demand curve.
Creation of unemployment (labour surplus)
- The difference between $Q_s$​ (labour supply) and $Q_d$​ (labour demand) represents unemployment (labour surplus).
- This is highlighted as the gap between the two curves, where the number of people willing to work exceeds the number of jobs available.
- The area labeled "labour surplus = unemployment" reflects workers who want jobs but cannot find employment due to the artificially high wage level.
It is a common mistake to confuse who are producers and consumers in the labour market. It can be a bit counter-intuitive, but:
- Workers are the producers (they supply labour and so are represented by the supply curve).
- Employers are the consumers (they demand labour and so are represented by the demand curve).
Seasonal unemployment
Seasonal unemployment
Seasonal unemployment arises when jobs are only available during certain times of the year.
Tourism and agriculture often experience seasonal fluctuations in employment.
Frictional unemployment
Frictional unemployment
Frictional unemployment occurs when people are temporarily between jobs or entering the workforce for the first time.
Think of frictional unemployment as the "gap" between stepping off one train and boarding another. It’s a natural part of the job market.
Natural rate of unemployment
Natural rate of unemployment
The level of unemployment that persists even when the economy is operating at full-employment. It consists of the sum of structural, frictional, and seasonal unemployment.
The natural rate of unemployment is the sum of structural, seasonal, and frictional unemployment:
$$\text{Natural Rate of Unemployment} = \text{Structural} + \text{Seasonal} + \text{Frictional}$$
Common MistakeCyclical unemployment is not included in the calculation of the natural rate of unemployment. This is because when an economy experiences cyclical unemployment during a recessionary gap, it is not operating at full-employment.
ExampleIf a country has 2% structural, 1% seasonal, and 3% frictional unemployment, its natural rate is 6%.
NoteThe natural rate of unemployment varies across countries and over time, influenced by factors like labour market policies and technological changes.
Costs of unemployment
Unemployment has a broad range of individual and social costs, including:
- Personal costs:
- Financial hardship: loss of income can lead to difficulties in meeting basic needs.
- Mental health issues: unemployment is linked to stress, anxiety, and depression.
- Skill erosion: extended unemployment can lead to a loss of skills, making it harder to find future employment.
- Social costs:
- Increased crime rates: economic hardship can lead to higher crime rates.
- Strain on public services: unemployment increases demand for welfare benefits and social services.
- Economic costs:
- Lost output: unemployment means fewer goods and services are produced, reducing GDP.
- Lower tax revenues: fewer employed people result in lower tax collections, limiting government spending on public goods.
- Higher public spending: governments may need to increase spending on unemployment benefits, leading to budget deficits.
How do different societies prioritize the trade-offs between unemployment and other economic objectives, such as inflation or environmental sustainability?
