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this measure. Neither measure is perfect since the standardized measure excludes those in receipt of payments but not actively looking for work.

8.2.1LABOUR MARKET ANALYSIS: TYPES OF UNEMPLOYMENT

Within the broad heading ‘unemployment’ it is useful to distinguish between frictional, structural, cyclical and seasonal unemployment.

Frictional unemployment is unemployment that arises because of changes or friction in particular markets.

Frictional employment reflects changes in people’s preferences or tastes, or the introduction of new technologies that alter demand for products over time, with knock-on effects on the demand for labour to produce them. The most appropriate ways to supply also change with technological developments, which can also impact on the demand for labour. Thus, within the normal activities of the economic system some firms go out of business while others open up. This means there are always people losing their jobs, switching from one job to another, and entering or leaving the labour force. Frictional unemployment is regarded as natural, and it is associated with the ‘natural rate of unemployment’.

The natural rate of unemployment is the rate of unemployment that would prevail when the labour market is in long-run equilibrium – some people choose to change jobs and even in boom periods it can take a worker time to find a job best suited to their skills.

The natural rate of unemployment is also called the non-accelerating inflation rate of unemployment – NAIRU – to emphasize that since it is a long-run phenomenon, it puts no pressure on prices to increase. Hence, frictional unemployment is also regarded as voluntary.

Structural unemployment refers to unemployment arising from a permanent decline in employment in industries located in a particular region or area.

Structural unemployment differs significantly from frictional. It may be due to mismatch between job vacancies and the skill/occupations of the unemployed, e.g. there may be job vacancies for carpenters, but this will do little to alleviate unemployment among plumbers. It is a more serious types of unemployment than frictional unemployment because it takes time for mismatches to be addressed via reskilling, for example, or for new industries to be attracted to an unemployment

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black spot. Such unemployment is particularly harsh if a recession is prolonged. The natural rate of unemployment could be reduced if some of the structural unemployment were eradicated.

Cyclical unemployment is associated with the recessionary phase of the business cycle.

When the growth rate of economic activity slows down in a recession, there is a fall in aggregate demand and some firms will react to this fall in planned expenditure of consumers by reducing their output and may make some of their employees redundant. When the economy picks up again and the growth rate of economic activity rises, planned expenditures will rise and in response firms who wish to expand their output accordingly may hire additional workers. Cyclical unemployment refers to short-run employment.

Seasonal unemployment occurs in seasonal industries such as tourism and fishing. People in these industries may become temporarily unemployed over the winter months when the industries slow down.

In the long run, the labour market is in equilibrium at the natural rate of unemployment. In the short run, unemployment can be higher than the natural rate, in which case economic policies are often used to try to address the problem. In the short run it is also possible to have unemployment below the natural rate – the implications are discussed in a later section of the chapter.

Like other markets, labour supply and labour demand determine the equilibrium price – wage rate – and the quantity of workers employed. Many countries impose wages not determined by ‘market forces’ as in the case of the minimum wage.

Minimum wage: wage rate set by the government below which employers are not legally permitted to pay workers. Employers are free to pay workers above this wage rate if they choose.

Minimum wages are implemented to address arguments that workers would otherwise earn wages that are too low to allow them a reasonable standard of living. The determination of what constitutes ‘reasonable’ depends on the views of those involved in negotiations that lead to the decision to implement a minimum wage. In situations where a minimum wage applies the effects on employment can be analysed (similar to the situation of price floors considered in Chapter 2). The possible effects of a minimum wage are shown in Figure 8.1 where in panel A the wage is set above the ‘free-market’ level and where resulting effects on consumer

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A					B	P
							LS
P					d
			LS
	Unemployment				b1
wmin						e
							c1
w*					b		c
				LD			LD
					a
QLD	Q*	QLS		Q			Q

F I G U R E 8 . 1 M I N I M U M W A G E S ( P R I C E F L O O R ) A N D T H E L A B O U R M A R K E T : C A S E 1

and producer surplus are considered in panel B. LS refers to labour supply and LD to labour demand.

In Figure 8.1 panel A, with no intervention in the labour market, the equilibrium quantity would be Q and the equilibrium wage would be at w . However, a minimum wage is set at wmin which is higher than w . At the wage wmin, labour supply is greater than labour demand implying an excess supply of labour. More workers wish to work at this wage rate than firms demand. The results of the minimum wage when it is set above the market wage is that the number of workers employed is lower – Q LD is lower than Q – although those who can find employment at the higher wage (wmin compared to w ) do earn a higher wage. Since a lower quantity of workers earn the higher wage it is difficult to determine which situation is best for workers in general. A worker who can find work at the higher wage will probably think it is a fairer situation than a worker who is unemployed when wages are high but can find work at the lower wage w .

Welfare analysis can be conducted to consider the changes resulting from a minimum wage. In Figure 8.1 panel B there is a direct transfer of consumer surplus to producer surplus arising from the implementation of the minimum wage. In the labour market, firms that employ workers are consumers of labour while workers offering their labour for payment are the producers. Producer surplus increases, as suggested by the increase in the area between the prevailing wage and the supply curve. Producer surplus is the area above the supply curve and below the price. Before the minimum wage, producer surplus is the area abc which rises to ab1c1 if the minimum wage is used.

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With the minimum wage consumer surplus falls. Without a minimum wage, consumer surplus (the area between demand function and price) is the area bcd. With the minimum wage consumer surplus falls to b1de. Some of the loss in consumer surplus, bb1ec is transferred to producer surplus. The area cc1e, however, is a net gain to producer surplus (not a transfer). This area represents the ‘cost’ in welfare terms of the minimum wage. It indicates the extra wages received by some suppliers over and above what they require to supply their labour. It could be called excessive since it entices some labour to enter the labour market for a wage beyond what is required to provide them with an incentive to work. Unfortunately, since the demand for labour is lower than the supply at wmin, all labour above QLD cannot find work.

Therefore, the minimum wage increases producer surplus, decreases consumer surplus and creates a cost for the economy. In terms of the outcome regarding employment, fewer people are employed, although those who can find work earn the higher minimum wage.

Such unemployment is explained by examples where trades unions negotiate wages above market-clearing levels. If wages reach such levels it is quite easy to offer a solution to the problem – wage rates need to fall. In practice, however, workers in employment and their union representatives will be unwilling to let this happen. A further potential problem with a drop in the average wage occurs if the decline is too large and workers overall respond by reducing their consumer expenditure which could lead to a decline in aggregate demand with no positive net impact on unemployment.

A similar situation is presented in Figure 8.2 with one significant difference, however, since the minimum wage is set below the ‘free-market’ level. Such a minimum wage could arise if the government is incorrect in its assessment of labour

P
LD	LS
	Unemployment
w*
wmin
QLS	Q* QLD	Q

F I G U R E 8 . 2 M I N I M U M W A G E S ( P R I C E C E I L I N G ) A N D T H E L A B O U R M A R K E T : C A S E 2

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demand and labour supply and there are instances where such mistakes have been made. Here the effects of a minimum wage would be that some workers wishing to supply their labour at the higher wage w no longer have the incentive to work at the lower wmin and so labour supply is lower at QLS than if the free equilibrium position prevailed at Q . At the lower wage of wmin, firms’ demand for workers is higher than at the wage of w hence, QLD is higher than Q . Demand for workers outstrips supply and there is a shortage of workers at wmin. This shortage can be cleared only if wages are allowed to rise to w . The impact on unemployment in this situation is that fewer workers wish to supply their labour at the lower wage, hence unemployment is higher than under the ‘free-market’ situation.

Since policy-makers do not know with certainty what the labour demand and labour supply curves look like, any attempt to impose a minimum wage represents their ‘best guess’ or ‘guesstimate’ which may have either the consequences shown in Figures 8.1 or 8.2. The better the economic analysis provided to policy-makers, the more focused and successful the policy may be, but setting wage rates is never a policy without costs.

In practice, fears about reductions in employment as a result of minimum wages have appeared largely unfounded, i.e. the outcome has been different to that suggested in Figures 8.1 and 8.2. Employers have not reacted to the minimum wage by reducing their numbers of employees. Why? One plausible reason is that firms choose to absorb any additional costs generated by minimum wages, which essentially means they lowered their preferred profit margins. Firms may be happy to do this in the short run if workers become more productive when paid a higher wage so that an initial jump in firms’ average costs caused by paying the minimum wage is balanced by a decline in average costs over time as productivity improves. It is also plausible that higher wages act as a signal to attract higher-skilled workers. The concept of efficiency wages may also provide an explanation.

An efficiency wage rate lies above the market clearing wage rate to provide motivation for workers, to keep worker turnover low (avoiding costs of hiring) and to act as a signal to attract appropriately skilled workers.

The implication of efficiency wages is that firms may have an incentive to pay higher wages than the market clearing rate or a minimum wage. Firm profitability may ultimately be higher due to the motivation, turnover and signalling effects provided by efficiency wages.

In many countries the actual process through which wages are determined is through collective wage-bargaining where government representatives, trades union