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Chapter 06


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York University
ECON 2450

CHAPTER 6 Search and Unemployment KEY IDEAS IN THIS CHAPTER 1. The model constructed in this chapter is intended to explain Statistics Canada labor market data, and to organize our thinking about the role played by the labor market in the macroeconomy. 2. Key labor market variables are the unemployment rate, the participation rate, and the employment/population ratio. 3. In the Diamond-Mortensen-Pissarides (DMP) labor search model, on the supply side of the labor market, there are N consumers who choose between home production and labor market search. On the demand side of the labor market, firms can either be idle or can pay a cost to post vacancies. The number of searching would-be workers and the number of searching firms determines the number of successful matches in the labor market, through the matching function. Each successful match produces output. 4. For consumers, searching for work becomes more attractive the higher the market wage, the higher is labor market tightness, and the higher is the unemployment insurance benefit. 5. For firms, posting vacancies becomes more attractive the lower is the cost of posting a vacancy, the lower is labor market tightness, the higher is productivity, and the lower is the market wage. 6. In equilibrium, a higher unemployment insurance benefit increases the unemployment rate, reduces labor market tightness, reduces the vacancy rate, and has an ambiguous effect on the labor force. 7. In equilibrium, an increase in productivity increases labor market tightness, reduces the unemployment rate, increases the vacancy rate, and increases the labor force. 8. In equilibrium, a decrease in matching efficiency reduces labor market tightness, increases the unemployment rate, and may result in an increase or a decrease in the vacancy rate. The labor force decreases. 9. A form of Keynesian analysis is introduced. In the DMP model, bargaining between a matched firm and worker determines the wage, but bargaining strength can be “sticky” of the result of social norms, which leads to Keynesian indeterminacy. It is possible to have a bad Keynesian equilibrium where the wage and the unemployment rate are inefficiently high. Copyright © 2013 Pearson Canada Inc. - 62 - Chapter 6: Search and Unemployment NEW IN THE FOURTH EDITION 1. The entire chapter is new. TEACHING GOALS Including a version of the DMP model in an intermediate macroeconomics text is a novelty. Students should not have difficulty understanding the model, but they may need some additional help, as the approach is somewhat different than what we use in standard competitive equilibrium models, for example in Chapter 5. However, it helps to think of the labor market in terms of demand and supply sides. Then, it is possible to use what a student knows from Chapter 5 to teach them about the DMP model. Workers and firms care about the wage in the same way they do in a competitive model, but now the market “clears” in a different way. Workers care not only about the wage, but the employment insurance benefit (because their job search may be unsuccessful) and labor market tightness (which determines the chances of finding a job). Would-be employers care about labor market tightness and the cost of posting a vacancy, as well as the market wage. The matching function, which determines the number of successful matches as a function of matching efficiency and the numbers of firms and consumers searching, is an important concept. In this case, appeal to what students know about the production function, as the matching function has the same properties. Then, one can appeal by analogy to production so that the student understands how the matching process takes place. It is important first to understand the labor market data. The DMP model is very nice, as the variables in the model match up almost exactly with the labor market data as measured. The unemployed are those who chose to search but were unsuccessful, the labor force is the number of people who actively searched and found a job (employed) plus the number who actively searched and were unsuccessful (the unemployed), etc. The experiments in the model – increase in the employment insurance benefit, increase in productivity, decrease in matching efficiency – are all useful in understanding recent economic events and less-recent ones. A problem in Canada is that Statistics Canada does not collect vacancy data, so sometimes it might be useful to bring in U.S. data. The Beveridge curve correlation is particularly helpful. The “Keynesian DMP Model” comes from ideas in work by Roger Farmer. This is a nice way to understand Keynesian ideas (for starters). With bargaining indeterminacy the wage could be “stuck” at too high a level, with an unemployment rate that is too high. We don’t deal with Keynesian economic policies in this chapter, leaving that for later chapters. Copyright © 2013 Pearson Canada Inc. - 63 - Instructor’s Manual for Macroeconomics, Fourth Canadian Edition CLASSROOM DISCUSSION TOPICS It should not be hard to get students talking about unemployment. Most of them should know someone who has been unemployed, or they have read about unemployment as it relates to the recent recession. However, students may not understand how unemployment is actually defined, or how economists think about it. An important feature of the DMP model is that there will be unemployment under any circumstances, and students should understand that we cannot make unemployment go away, nor should we want it to. It will be helpful if students understand why a search-model approach is necessary to understanding unemployment. Get them thinking about what an unemployed person is actually doing, and what is motivating them. Unemployment is an economically measurable activity, and we want to take a scientific approach to thinking about it. Also, get the students to think about what motivates firms to search for workers to fill job openings. Why is searching for workers costly? What difficulties does a firm face in hiring workers? How does matching between firms and workers take place? Why is the market for labor similar to, and different from, the market for a good or service? Students should be encouraged to think about government intervention and how it matters for labor market behavior. What will employment insurance do? How can the government speed up or slow down the matching process in the labor market? OUTLINE 1. The Behaviour of the Unemployment Rate, the Participation Rate, and the Employment/Population Ratio in Canada a) Unemployment Rate, participation rate, and employment/population ratio: data. b) Key determinants of the unemployment rate: aggregate economic activity, demographics, government intervention, mismatch 2. The Diamond-Mortensen-Pissarides Model of Search and Unemployment a) Consumers b) Firms c) Matching d) Optimization by Consumers e) Optimization by Firms f) Equilibrium g) An increase in the unemployment insurance benefit h) An increase in productivity i) A decrease in matching efficiency j) The Beveridge curve k) A Keynesian DMP model Copyright © 2013 Pearson Canada Inc. - 64 - Chapter 6: Search and Unemployment TEXTBOOK QUESTION SOLUTIONS Problems 1. M ore labour-saving devices has the effect of reducing the payoff to working at home for all consumers, which reduces v(Q) for each value of Q. As a result, the curve in panel (a) of Figure 6.1 shifts up. In equilibrium, Q increases, but j remains unchanged. The unemployment rate and the vacancy rate are unaffected, but the labor force Q increases. Since j = A/Q, therefore the number of firms A increases. Aggregate output Y = Qem(1,j), so Y increases, as Q has risen and j is unchanged. Labour saving devices makes searching for work more attractive relative to working at home for consumers. With more consumers in the market, labour market tightness tends to go down, which attracts more firms into the labour market. Ultimately, the number of active firms increases proportionally to the number of consumers searching for work, and there is no change in labour market tightness in equilibrium. Output goes up because there are more successful matches in the labour market. Figure 6.1 Copyright © 2013 Pearson Canada Inc. - 65 - Instructor’s Manual for Macroeconomics, Fourth Canadian Edition 2. (i) With a subsidy s to hiring a worker, for a successful match, the surplus of the firm is z+s-w, the surplus of the worker is w-b, total surplus is z+s-b, and the wage (from Nash bargaining) is w=a(z+s)+(1-a)b. Then, on the supply side of the labour market, the equation determining the curve in panel (a) of Figure 6.2 is given by
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