CAUSES AND TYPES OF EMPLOYMENT AND UNEMPLOYMENT

There should be an understanding of how employment and unemployment may be determined by

both demand-side and supply-side factors and candidates should be able to analyse and evaluate
these determinants with the help of production possibility curves and AD/AS diagrams.
Candidates should understand the terms cyclical, frictional, seasonal and structural
unemployment. There should be an understanding of the output gap in relation to economic
growth, unemployment and the price level.

Demand side versus supply side causes of unemployment

Voluntary unemployment (classical unemployment)
Voluntary unemployment is sometimes called classical unemployment because of economists
such as Jean Baptiste Say (1767 -1832), a member of the Classical school of economics. Say
believed that supply created its own demand. If people worked they earn wages, and the amount
of money earned must be able to buy everything that was produced. Therefore if people worked
there must be enough demand to but all the things they made. The only reason for unemployment
must be that people are unwilling to work.

Voluntary unemployment can be made worse, according to free market economists, by minimum
wages, unemployment benefits and trades unions. These labour market imperfections mean that
wages are above the market-clearing rate and employers are not able to afford to pay them which
increases the numbers of people prepared to work. Free market economists therefore blame
trouble with the supply of labour for unemployment.

Involuntary/Demand-deficient or Cyclical unemployment
Demand-deficient unemployment happens when there is insufficient demand to employ
everybody who wants to work. Keynesian economists believe that goods and services markets
can be in equilibrium, but at a level of aggregate demand which is too low to provide enough
derived demand in the labour market for full employment. If demanddeficient employment
exists then the unemployment in the Great Depression of 1930s, and in Greece and Spain in 2012
are excellent examples. Demand deficient unemployment is also called cyclical unemployment
as it coincides with the recession and slump phases of the economic cycle. Occasionally it is also
called Keynesian unemployment. Yet another name is involuntary unemployment.

TYPES OF UNEMPLOYMENT

Frictional or search unemployment
Frictional unemployment occurs because at any moment in time there is a proportion of the
workforce between jobs. They may leave one job and then find another within a short period of
time. When the economy is recovering, frictional unemployment is likely to be lower because it
takes a shorter period of time to find a job.

Seasonal unemployment
Seasonal unemployment occurs when demand for workers occurs only in some months of the
year. Hotels, catering, tourism and farming are industries that experience peaks and troughs in
demand for workers. This sort of unemployment tends to be regionalised and counties such as
Cornwall suffer in winter when tourist numbers fall.

Structural unemployment
During the 1970s and 1980s some age-old industries such as coal mining, steelmaking and
shipbuilding went into decline. Oil, gas and nuclear power made British deep-mined coal
uneconomical. New shipyards and carmakers in the Far East used new management techniques
to outcompete the west. As the structure of the UK economy changed from depending on
manufacturing to a greater emphasis on the service sector, areas of the country with high
concentrations of labour employed in the older industries experience structural unemployment.
Whilst younger workers are more occupationally and geographically mobile, those with family
ties and an inability to adapt to new technologies find it hard to get new work so that this
structural unemployment has also become regional.

THE COSTS OF UNEMPLOYMENT

Loss of output
Unemployment means that the economy is not operating at full capacity and is not achieving
economic (Pareto) efficiency. In other words the economy is working inside the production
possibility frontier.

Fiscal costs
Increased unemployment results in reduced government tax revenue. Without work people pay
no income tax or national insurance. Without and income consumption falls and revenue from
indirect taxes such as VAT fall. If an economy provided unemployment benefits such as the UK
does in the form of Job Seekers Allowance government spending also rises. In recessions where
demand deficient unemployment exists government budgets are likely to go into deficit.

Psychological impacts
Long periods of unemployment may result in depression, divorce, suicide, stress, family violence
and crime whilst not solely caused by unemployment all increase in periods of high
unemployment. Apart from the individual private costs endured by families the state often has to
pick up the cost for the externalities, i.e. the health care bill and increased policing costs.

Hysteresis
Workers without jobs for a prolonged period of time may lose their skills. As time goes on these
skills also become outdated and even when demand for labour returns they find themselves
unemployable. In 2008-2012 a generation of young people not in education, employment of
training (NEETS) is at risk of just this problem.

Income inequality
One of the main reason for inequality is that one group who are often in relative poverty are the
unemployed. Equality itself is an economic aim although not for all economists. Free market
economists see inequality as a driving force. The poor are incentivised to work because of their
poverty and desire to escape it. One way out of the poverty trap is to come up with new ideas and
inventions. In this way society moves forward and avoids atrophy. Other economists see social
unrest resulting from too much inequality. Louis the XVI or Tsar Nicholas II might be able to
make some meaningful contribution to this argument if we could bring them back from the dead.

Total gross domestic product (GDP) that could be produced by an economy if all its resources
were fully employed.

Read more: http://www.businessdictionary.com/definition/potential-
output.html#ixzz3Box5XdAX
Macroeconomic Equilibrium
Author: Geoff Riley Last updated: Sunday 23 September, 2012
Introduction
You may already be familiar with the concept of equilibrium from your study of microeconomics
equilibrium occurs at a market clearing price which balances supply and demand. Now we
look at the concept of equilibrium at a macroeconomic level.
Equilibrium for the whole economy
Macro-economic equilibrium is established when AD intersects with SRAS. This is shown in
the next diagram. At price level P1, AD is equal to SRAS i.e. at this price level, the value of
output produced within the economy equates with the level of demand for goods and services.
The output and the general price level in the economy will tend to adjust towards this
equilibrium position
If the general price level is too high, there will be an excess supply of output and producers will
experience an increase in unsold stocks. This is a signal to cut back on production to avoid an
excessive level of inventories. If the price level is below equilibrium, there will be excess
demand in the short run leading to a rundown of stocks a signal for producers to expand output.
Equilibrium is where the level of income flowing round the system is constant in successive time
periods.
M a c r o - e c o n o m i c e q u i l i b r i u m i s e s t a b l i s h e d w h e n A D i n t e r s e c t s w i t h S R A S

Some people question whether it can ever be the case that an economy can come close to
reaching equilibrium since it would only take one market to be out of equilibrium for this to be
blocked?
Our interpretation of the idea of equilibrium is a little different from a microeconomic level.
What matters here is whether the total demand for goods and services is close to the actual
level of production from domestic and external sources.
We will come back to this when we look at excess demand and supply and the concept of the
output gap.
Changes in Aggregate Demand
In our diagram below we see the effect of an increase in aggregate demand which causes an
expansion of aggregate supply and a higher equilibrium level of national output / income (i.e.
higher real GDP)
C h a n g e s i n A g g r e g a t e D e m a n d

Changes in short-run aggregate supply (SRAS)
C h a n g e s i n s h o r t - r u n a g g r e g a t e s u p p l y ( S R A S )

In the example above we see the impact of a rise in supply (i.e. due to falling costs of
production)
Changes in Aggregate Demand and Supply
In the example below there has been an outward shift of AD (e.g. caused by a rise in exports)
and an inward shift of SRAS (e.g. caused by a rise in unit wage costs). Our focus is on the
equilibrium level of real GDP but also consider what is likely to happen to the general price level
shown on the vertical axis.
C h a n g e s i n A g g r e g a t e D e m a n d a n d S u p p l y

In the next example we see the impact of a recession where aggregate demand has fallen and
also the impact of a rise in the cost of importing energy and other raw materials. Both factors
have the effect of depressing the real value of output.

The Output Gap
How much spare capacity does an economy have to meet a rise in demand?
How close is an economy to operating at its productive potential?
Will the 2008-10 recessions have a permanent effect on our ability to supply goods and
services?
These sorts of questions all link to an important concept the output gap.
The output gap is the difference between the actual level of national output and its potential
level and is usually expressed as a percentage of the level of potential output.
The estimated output gap for the UK is shown in the chart below. Notice the big swing in the
output gap from being positive to negative during the years 2008-2010 as the recession hit
Britain.
T h e O u t p u t G a p i n t h e U K E c o n o m y

Negative output gap downward pressure on inflation
The actual level of real GDP is given by the intersection of AD & SRAS the short run
equilibrium.
If actual GDP is less than potential GDP there is a negative output gap. Some factor
resources such as labour and capital machinery are under-utilized; the main problem is
likely to be higher unemployment.
More people out of work indicate an excess supply of labour, which causes downward
pressure on real wage rates.
Positive output gap upward pressure on inflation
If actual GDP is greater than potential GDP then there is a positive output gap.
Some resources including labour are likely to be working beyond their normal capacity
e.g. making extra use of shift work and overtime.
The main problem is likely to be an acceleration of consumer price inflation.
Recession and the output gap
The latest forecasts from the OECD suggest that the UK will operate with a large negative output
gap for some time to come. There are some economists who argue that the fall-out from the
slump will have long-term damage to our productive capacity and that the economy may
experience a permanent loss of output. This might arise from a sharp rise in the number of
business failures together with a long-term loss of people from the labour market if they suffer
extended periods out of work.

In our chart above we plot the output gap and the rate of unemployment in the UK. During years
of strong growth the British economy operated with a positive output gap (peaking in 2007) with
unemployment rates falling steadily (measured as a percentage of the labour force.) But when the
recession struck the unemployment rate soared to nearly 8 per cent this is an indication of spare
capacity in the economy.
Spare Capacity
When a business is operating at less than 100% capacity, it is said to have spare capacity.
Demand factors:
Lower demand due to a decline in consumption
Loss of market share due to poor marketing or competitors having better products
Seasonal variations in demand - i.e. temporary spare capacity during off-peak times
Supply factors:
Increase in capacity not yet matched by increased demand
Because new technology has been introduced in anticipation of higher demand
Improvements in productivity mean capacity increases for a given level of demand
Spare capacity can be useful in that it allows businesses to respond to short-term or an
unexpected increase in demand, when there is some productive slack, aggregate supply is price
elastic.
Potential Output
Potential Output describes what an economy can produce with its current technology, equipment,
natural resources, and willing workers. When an economy produces at its potential output, it
operates at full employment.
Potential output is the target for good economic performance. It need not be the absolute
maximum that could be produced. For example, it might be possible to increase production by
forcing more people to work or to force longer hours on the people already working. That
outcome would not be desirable, of course. Potential output represents the full use of resources
consistent with the voluntary choices made by firms and workers in the economic system.

Potential Output
Definition
Potential Output can be described as what an economy can produce when all its resources such
as workforce, equipment, technology, natural resources and others are fully utilized; or the GDP
that the economy can attain upon proper application of its resources. An economy that produces
at its potential output can be called as working at full employment. [1]
Potential Output can also be defined as the level of economic activity at which aggregate demand
and aggregate supply are consistent with a stable inflation rate. It is used by policymakers to
estimate inflation, and use it as a level of output where any rise or fall in prices becomes
unnecessary.[2] One can obtain a measure of the degree of spare capacity in the economy, and
the rate at which capacity is expanding by calculating the level and rate of growth of potential
output, and comparing the results with observed output trends.
Significance
The concept of potential output is also essential to government operations. In the short term, an
evaluation of the degree of excess demand or excess supply will have its impact on the fiscal
policy. The monetary policy can also have an amplifying effect on the business cycle by posing
either an over-expansionary stance when excess demand conditions are evident or an over-
constricting stance when the spare resources are abundant.In relation to the labor market policy,
measures of potential output are helpful in finding out the factors responsible for unemployment,
and aid in preparing the corresponding responses.[3] Additionally, they are also used to derive
indicators such as cyclically adjusted government budget balances which are used to assess the
fiscal policy stance.
The evolution of potential output is dependent on a lot of underlying factors; at the forefront
among all of them is supply conditions such as the endowments of the economy relating to the
key inputs of capital and labor and their productivity. Hence, potential output growth reflects
developments in these supply-side elements that are consequently linked to various factors such
as demographic and labor market trends, variations in investment and technological
innovations.[4]
The recent advent of economic crises in multiple countries around the world also brought to
attention the effects they have on potential output. A crisis can reduce potential output in the
short and medium term through its adverse impact on investment as a result of the ensuing
slower capital accumulation combined with acceleration in the aging of some capital vintages
due to economic restructuring. Additionally, in the case of a prolonged recession, extended
unemployment can have ill effects on human capital, possibly leading to an irreparable increase
in the Non-Accelerating Inflation Rate of Unemployment (NAIRU), and further drop in the
potential output levels.[5]
Measuring potential output
Multiple methods have been developed to calculate potential output and output gap. However,
according to many economists, none of the methods are satisfactory. The problem arises from the
fact that neither is directly observable, and has to be inferred from existing data using statistical
and econometric methods.
REFERENCES
1. http://muddywatermacro.wustl.edu/potential-output
2.www.imf.org/external/pubs/ft/fandd/2013/09/basics.htm
3.Potential Output: Concepts and Measurement by Darren Gibbs
4. European Central Bank Monthly Bulletin January 2011
5.European Economy Occasional Papers 49 June 2009
Output Gap Definition
The output gap is a measure of the difference between actual output (Y) and potential output
(Yf).
The output gap = Y- Yf
Negative Output Gap
This occurs when actual output is less than potential output gap. This is also called a deflationary
(or recessionary) gap. In this situation the economy is producing less than potential. There will
be unemployment, low growth and / or a fall in output. A negative output gap will typically
cause low inflation or even deflation.
Positive Output Gap
This occurs when actual output is greater than potential output. This will occur when economic
growth is above the long run trend rate (e.g. during an economic boom). It will involve firms
asking workers to overtime.
With a positive output gap, there will be inflationary pressures. It will also tend to cause a bigger
current account deficit as consumers buy more imports due to domestic supply constraints.
Output Gap.
U K o u t p u t g a p

HM treasury forecast an output gap of -2.7% for 2012/13. This is the amount of spare capacity
they feel the UK has.
Note: it can be difficult to measure the amount of spare capacity See: What is the UKs actual
output gap?
Lost Output During 2008-12 Recession
r e a l g d p a n d t r e n d

This shows how actual real GDP fell behind the trend growth rate of GDP.
What Determines Size of Output Gap?
1. Level of unemployment. Higher unemployment increases the negative output gap.
2. Levels of spare capacity. If firms report they are under-utilising capacity, there is a bigger
negative output gap.
3. Productivity growth. If productivity growth falls, this decreases the growth of potential
ouptut and therefore limits the negative output gap.
4. Inflation. Inflation can be a guide to the output gap. If inflation is high and firms pushing
up prices, this suggests there is a positive output gap.
Output Gap and Economic Growth
o u t p u t - g a p - r e a l - g d p

Output gap and real GDP
Output Gap using AD/AS analysis
In this diagram the level of full capacity (Yf) is shown by the point where the AS curve is
inelastic (equivalent to inelastic LRAS). However, in short term, output Y1 is less than Yf
indicating spare capacity.
y f

Types of Unemployment
There are three major types of unemployment including cyclical, frictional, and structural. Let's
take a look at each one of them through the eyes of workers in the town of Ceelo. As a matter of
fact, I'd like to introduce you to a few of them and then find out what type of unemployment
they're experiencing.
Cindy just graduated from college, and she's looking for work by scanning job sites, reading
newspaper listings and attending job fairs. Good for you, Cindy. Cindy's dad, Matt, is a
manufacturing worker in Ceelo who loves to pull levers and wear hard hats. Matt's Uncle Fred
works as a temporary Santa Claus each holiday season; in particular, he loves to work at
commodities trading firms on Wall Street. Fred's brother Frohm is a high school gym teacher
who is desperately trying to teach kickboxing to the school's guinea pigs with the help of
students. He was hired as a second gym teacher last year.
Okay, so this is the town of Ceelo, and these are the workers we're talking about. Now, let's talk
about the economy.
Cyclical Unemployment
Over time, the economy experiences many ups and downs. That's what we call cyclical
unemployment because it goes in cycles. Cyclical unemployment occurs because of these
cycles. When the economy enters a recession, many of the jobs lost are considered cyclical
unemployment.
For example, during the Great Depression, the unemployment rate surged as high as 25%. That
means one out of four people were willing and able to work, but could not find work! Most of
this unemployment was considered cyclical unemployment. Eventually, unemployment came
down again. As you can see, at least part of unemployment can be explained by looking at the
cycles, or the ups and downs of the economy.
Frictional Unemployment
Frictional unemployment occurs because of the normal turnover in the labor market and the
time it takes for workers to find new jobs. Throughout the course of the year in the labor market,
some workers change jobs. When they do, it takes time to match up potential employees with
new employers. Even if there are enough workers to satisfy every job opening, it takes time for
workers to learn about these new job opportunities, and for them to be considered, interviewed
and hired.
When Cindy graduates from college, she begins looking for work. Let's say it takes her four
months to land a new job. During this time, she is frictionally unemployed.
Structural Unemployment
Let's talk about structural unemployment occurs because of an absence of demand for a certain
type of worker. This typically happens when there are mismatches between the skills employers
want and the skills workers have. Major advances in technology, as well as finding lower costs
of labor overseas, lead to this type of unemployment.
When workers lose jobs because their skills are obsolete or because their jobs are transferred to
other countries, they are structurally unemployed. It's structural unemployment because the
structure of the economy has changed, not because of the regular ups and downs of it.
For example, Matt loses his job because the manufacturing company he worked for in Ceelo
moves overseas, and some of the factory workers left at home are not needed because of new
high-tech gear that was recently installed. So, Matt becomes structurally unemployed. Most of
the new jobs require a college degree or new skills, so Matt decides to go back to school. It's a
very common example of what's happened in the economy, especially during challenging times.
Question in Economics
Asked on July 18, 2011 Answers (1)
3.1 a. List three factors that can change the
economys potential output. b. What is the impact of shifts of the
aggregate demand curve on potential output?
C. Illustrate your answers
with a diagram.

a. The following is the list of three factors
that can change the economys potential that I have found:



The supply of labor may change
over time because of a change in the size, composition, or quality of the labor
force or a change in preference for labor versus leisure.

The quantity and quality of
other resources also change over time.
And, the capital stock-machines, buildings, and trucks-increases when
gross investment exceeds capital depreciation.

Institutional changes that
define property rights more clearly or make contracts more enforceable, such as
the introduction of clearer patent and copyright laws, will increase the
incentives to undertake productivity activity, thereby increasing potential
output.

b. ?





c. ?
Answers (1) Best answer:

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