Decline in Bargaining Power of the Trade Unions

Decline in Bargaining Power of the Trade Unions (Example)

The power of trade unions to bargain for higher wages for its members, creates wage rigidity and therefore gives rise to classical unemployment. So a decline in the bargaining power of unions will reduce classical unemployment and therefore reduce the NRU. So in your answer to this question, you need to describe what the union does and how it creates classical unemployment, which therefore means that once its power is reduced it will cause a decline in NRU.

demand management policies

Demand management policies

Monetary policies and fiscal policies are used as demand management policies to correct fluctuations in the economy that is connected with the business cycle. So generally these policies are used to correct cyclical unemployment and it is very unlikely that an expansionary MP has been used for such a sustained period of time. Hence, when we look at such long term low unemployment rate it is more likely that we are looking at a low natural rate of unemployment (Notice the word average unemployment rate? This gives the hint that we are looking at NRU). Hence, when we are looking at a low NRU, the reason why it is low is not so much because of the use of the an easy MP but because of the other policies.

The reason why NRU is low is connected more with the issue of unemployment benefits, minimum wage, the power of the trade union, efficiency wages, training programs. But we must also not forget that since cyclical unemployment can affect the NRU through the hysteresis effect, then to some extent the use of an easy MP which can help to reduce cyclical unemployment can also help keep the NRU low.

Sacrifice ratio

What is the sacrifice ratio, and how might it be affected by the credibility of monetary policy announcements?

The term ’sacrifice ratio’ was covered in the chapter on inflation. The Sacrifice Ratio – measures how much of a year’s real GDP that must be foregone to reduce inflation by 1% point. There are many variations in this estimate but a typical estimate is about 5. This means that for every percentage fall in inflation, output must fall or there must be a 5% sacrifice in output. Let’s say that the monetary policy is to lower inflation from the current 4% to 2%.

In order to lower inflation, a contractionary MP is adopted. This as you know will cause output to fall (and unemployment to rise). If people do not believe that the monetary policy will really be carried out to lower inflation (as it will result in unemployment), their expectations of price will not change and therefore there will be no shift in the Phillips curve (since expected inflation does not change). Hence, the contractionary MP when adopted causes actual price to fall (and be different from expected price) - there is now a movement along the same Phillips curve and you will see that the fall in inflation results in an increase in unemployment (or a decrease in output), so the sacrifice ratio is positive. The more credible the monetary policy announcement is, people’s expectations of price will change immediately. They know that price will fall for sure and therefore change their expectations accordingly.

So the Phillips curve shifts down (as expected price falls) and at the new equilibrium, actual price and expected price are the same, and unemployment remains at the natural rate, which means that there is no change in output either. So the sacrifice ratio is zero. The more credible the monetary policy announcement, expectation of price will change accordingly and the Phillips curve will shift resulting in a smaller sacrifice ratio.

Literature about unemployment

In recent years a large literature has developed which explores the idea that persistence in
unemployment might be explained by the tendency for actual unemployment to cause an upward movement in equilibrium unemployment. So what you need in your answer is to explain hysteresis i.e. how extended period of cyclical unemployment can result in higher NRU. The term hysteresis comes from a Greek verb meaning ‘that which comes after’ and therefore refers to effects which persist after the initial impulse which gave rise to those effects is removed. Hence another theory that has also been used to explain hysteresis is the insider/outsider model of decision making about employment. Insiders such as the unionized workers ratchet up wage rates beyond where it is profitable to hire the unemployed. Outsiders who are unemployed don't get to be part of the negotiation process.

Hysteresis

Actual Unemployment can have effect on NRU

Extended period of cyclical unemployment can result in higher NRU through the hysteresis effect as it

Can change the person who has become unemployed
à lose their job skills and therefore their ability to find jobs even after the recession
à Changes the individual’s attitude toward work and reduces his desire to find work probably because of lack of confidence in finding work

Change employers perspective
à Perceive long term unemployed workers as having lesser employability à decrease demand for labour

Actual Unemployment

Actual Unemployment

Output can fluctuate around the full-employment level therefore the actual unemployment rate can fluctuate around the NRU.

Difference between the actual unemployment and the NRU is called cyclical UN.
Cyclical Unemployment is involuntary unemployment

Involuntary unemployment – labour is willing and able to work but unable to find an available job

Efficiency wages

Efficiency wages

Efficiency wages – these are theories in which high wages increase worker productivity as they (i) attract higher quality job applicants; (ii) increase worker effort and reduce ‘shirking’; (iii) reduce turnover, which is costly because of the higher wages they are earning now and (iv) improve health of workers (in developing countries).

All these (B,C and D) prevent workers from being able to find jobs immediately (nothing to do with cyclical factors but some structural problem )

Trade Unions and Unions

Trade Unions and Unions

Trade Unions and Unions exercise monopoly power to secure higher wages for their members. When the union wage exceed the equilibrium wage, unemployment results. Employed union workers are insiders whose interest is to keep wages high. Unemployed non-union workers are outsiders and would prefer wages to be lower so that labour demand would be high enough for them to get jobs.

Minimum Wage

B) Minimum Wage

This is the other public policy that will increase the natural rate of unemployment.
[Note that the minimum wage is well below the equilibrium wage for most workers, so it cannot explain the majority of natural rate of unemployment.

However, the minimum wage may exceed the equilibrium wage of unskilled workers and therefore increases in the minimum wage would increase unemployment among this group].

What can cause the NRU to increase?

What can cause the NRU to increase?

A. The presence of Unemployment Benefits

Unemployment benefits are payments made by governments to unemployed people.
Unemployment benefits increases frictional unemployment (and therefore NRU) by decreasing the opportunity cost of unemployment, thereby increasing the lowest wage that the job seeker would be willing to accept and lengthening the job search. (reduces f)
So public policies like these have an impact on the natural rate of unemployment. (this as you will see is not the only public policy that affects the NRU)

Note that unemployment benefits increases the replacement ratio - Measures the ratio of the state benefits whilst out of work to average earnings in work
The more unemployment benefits given to a person out of work compared to his average earnings while at work i.e. an increase in the replacement ratio à lowers the opportunity cost of being unemployed and therefore lowers f.

Conclusion about natural rate of unemployment

Conclusion about natural rate of unemployment:

The natural rate of unemployment is the sum of the frictional, structural and classical unemployment (to me classical unemployment is something like structural unemployment in the sense that the wage rigidity results in a mismatch). It does not include cyclical unemployment that results from a downturn in the business cycle.

Classical Unemployment

Classical Unemployment

Unemployment caused by some form of real wage rigidity

(i) Minimum wage laws
[You need to know how minimum wage creates classical unemployment]
(ii) Trade Unions

[You need to know how the presence of trade unions result in classical unemployment.]
(ii) Efficiency wages [Please refer to the notes I have uploaded for you on efficiency wages. For this you also need to know the reasons why firms offer efficiency wages]

Structural Unemployment

Structural Unemployment

Unemployment that arises because of a mismatch between the character of the job and the workers in terms of

(i) Location (are jobs and unemployed workers located in the same area?)
(ii) Skills (what are the skills required for the jobs vacancies and the skills of those who are unemployed)

Mismatch arises because of changes in demand and technology
For example, technological change may have caused a worker's skills to become obsolete, and he or she may experience a period of unemployment before finding the opportunity to develop new skills and to adapt.

Frictional Unemployment

Frictional Unemployment

Unemployment that arises because it takes time for those:

(i) Who enter the job market for the first time to find jobs;
(ii) Who quit one job to find another

This is mainly due to the fact that information is imperfect and therefore it takes time for employers and workers to find an appropriate match. For example, job seekers tend to spend time to find the best possible job rather than take the first one available, and employers take the time to interview several candidates to find the best fit.

Voluntary Unemployment

What do we understand by the word ’voluntary unemployment’?

Voluntary Unemployment

Unemployment created when labour chooses not to work on the available jobs while anticipating better jobs to be forthcoming

Unemployment cannot be zero when the economy is at full employment or the NRU. Since zero unemployment is unachievable in a free labor market, Milton Friedman used the term natural rate of unemployment to describe the baseline rate of unemployment as some unemployment cannot be avoided. Types of unemployment present when the economy is at its natural rate of unemployment:

Introduction to Unemployment

Key concepts that you need to know:

Natural Rate of Unemployment

It is the average rate of unemployment around which the economy fluctuates. Can also be viewed as the rate of unemployment at which the economy gravitates in the long run . At this rate of unemployment there is no tendency for real wage to change as the labour market is in equilibrium (labour demand = labour supply)

Everyone who wants to work has a job. Therefore all unemployment is regarded as voluntary.