I think that simple location is a massive friction and not fully accounted for. Look at how much commuting saps happiness. Look at how unwilling people are to relocate (above and beyond the costs of doing so). Look at how little companies recruit outside their immediate area.
And, of course, encouraging homeownership makes this worse. Good thing that most of the Western world hasn't made that an explicit policy goal for the past decade...
I should note that whatever you think of this explanation, it argues that unemployment is not an economic problem. It views the unemployed as happily and rationally choosing not to work, which thus suits their preferences better and thus is of higher economic value (neglecting, of course, the cost of providing unemployment insurance).
This seems to be a non sequitur:
If a specific unemployed person in a given state of the job market maximizes their utility by not taking any job offer, it doesn't imply that they are happy of the current state of the job market. They may be unwilling to work at the conditions that are currently offered, but they may be willing to work at different conditions.
The most obvious and extreme scenario is when you are starving and all the jobs available to you are physically strenuous and yet offer starvation wages: you'd probably better off conserving energy and trying something else, including begging or stealing (if you are caught, you will go to prison where the state will feed you).
More generally, in the standard one-shot prisoner's dilemma, you are probably going to defect, since it is the choice that maximizes your utility assuming that the other pl...
Another friction is the stickiness of nominal wages. People seem very unwilling to accept a nominal pay cut, taking this as an attack on their status.
Salary negotiation is a complicated signalling process, indeed. I'm currently an unemployed bioengineer and have been far longer than I would have liked, and consequently I would be willing and eager to offer my services to an employer at a cut rate so that I could prove my worth to them, and then later request substantial raises. But this is impossible, because salary negotiations only occur after the company has decided that I am their favorite candidate out of however many hundreds apply.
Worse, if I take the first move and openly (e.g. on my resume or cover letter) inform the company of my willingness to work on the cheap, they would assume that I am signalling being a very low-quality engineer, which is very far from the case.
Unemployment does very much seem to be an information trap.
Another friction is the stickiness of nominal wages. People seem very unwilling to accept a nominal pay cut, taking this as an attack on their status.
There's actually a major reason for the stickiness of nominal wages you've failed to account for: debt overhang. Any and all debts are calculated in nominal currency, not real currency, so if the labor market deflates (across-the-board salary drops), the debts of everyone who works for a living grow correspondingly more difficult to pay.
This explanation can be generalized: the higher the average (mean or median) level of debt among any given population, the more difficulty markets among that population will have in clearing, because market adjustments don't change the price-levels on time (hence debt: borrowing is buying time) that has already been bought and sold, forcing everyone to try and obtain the old prices (corresponding to prices when they took their loans) whenever they can.
This is why liberal bankruptcy statutes are one of the most important parts of a functioning market economy: future default risk is supposed to be a risk born by all prospective future lenders, and factored into the interest rate, rather than allowing...
Well, let's consider, say, electrical generation plants that convert coal into electricity, in an isolated country. It is absolutely normal and there's nothing whatsoever mysterious that some fraction of the generating capacity would generally go unused. It's when you start abstracting out the generation capacity as a "good" traded on the market, that it becomes mysterious why it would be "unsold".
If you look at jobs, we have extremely severe discrimination based on origin (needs of citizens absolutely trump in almost all circumstances the needs of foreigners) on top of intrinsically very high cost of moving around or learning a foreign language, or learning a different skill, and regions are thus largely isolated. The labour is essentially a non moveable resource. If you have farmers struck in Antarctica, they will never be able to compete with farmers somewhere less hostile to farming, and they'll be unemployed and actively prevented from working anywhere else (because that sounds like it might drop the wages of the workers in those other regions). And they will be unable to price-cut anyone, because the fertilizer, fuel, and so on still costs the same for these guys, and their produce will cost more than anyone else's produce.
Is it really true that most markets clear, and the labor market is unusual? It seems to me that a lot of non-labor stuff also goes unsold. If I try to sell something, like my old phone, then I will probably observe that it goes unsold for at least some time. Is that also a mystery for economics?
Macroeconomics (by which I mean mainly the Keynesian/Monetarist schools) is built on the seeming trivial observation that the salaries of workers are the means by which they buy products, and that the sale of these products are the income of the firms that employ people. Therefore, if the job market doesn't "clear" it's not as simple as just waiting for salaries (the price of that market) to adjust. If salaries fall, this feeds into less cash for consumers, which generally implies less consumption, which feeds into less revenue for firms, lowering their demand for workers, etc...
How is this different between the labor market and any other market? If I try and fail to sell my old phone, that also affects my ability to buy stuff.
This essay by a business school prof argues that companies are irrationally demanding in who they choose to hire: http://www.upenn.edu/gazette/0113/feature2_1.html
Sticky wages are something it's quite possible to study in isolation from the business cycle and it should be no surprise that people have done so. I found a lot of enlightening things in that link, though of course it doesn't answer how much sticky wages end up contributing to unemployment. All the same, though, I don't think I would place much trust in economic models that don't include sticky wages at all.
The first idea to come to my mind, on reading this article, is that companies do not produce jobs and attempt to sell them to potential employees. Rather, potential employees produce labour, which they attempt to sell to companies (or, in the case of entrepreneurs, which they use to produce goods or services for sale).
Labour is... a very odd good. Most goods are produced, for a cost, and can then be stored and transported for a time before being sold at a profit.
Labour, on the other hand, can be produced at very little cost, but must be used in some manner...
Another class is excluded: Workers have the option to voice their opinon and thereby affect the market on a higher level. See Hirschman http://en.wikipedia.org/wiki/Exit,_Voice,_and_Loyalty
I mentioned this on LW here: http://lesswrong.com/lw/isk/a_voting_puzzle_some_political_science_and_a_nerd/
I like this post, because I find it very familiar, but it is familiar because it is reminiscent of the sorts of confusions and mix-ups that can result from half an economics education. And please allow me to push back on some points, to invite your further thoughts and considerations.
Just going in order, you treat classical economists as if they adhered to a revealed preference theory. That theory is Paul Samuelson's, introduced at the tail end of neoclassical economics. It cannot explain anything the classical economists did. And in general, those who are...
This is a fantastic post and I'd really like to see more like it, on any topic really.
It'd be really really cool if we could maintain them as wiki articles too, i.e. update them with new info. Is that feasible? Would you, Stuart, be interested in doing that for this topic?
Here's some comments from an economist blogger I follow (that found you thru Yvain's blog).
Do you know of any numerical models of economics which simulate and track each person (employer and employee) with their skills, preferences and such?
People make such models, but unknown parameters proliferate so rapidly that it's hard to say these simulations are accurate or even useful.
this is from henry george's book progress and poverty. he explains why there is the "enforced idleness" i.e. unemployment. i quite liked this part but i know its a bit dated and i don't really get economics. i think this would be one of those macroeconomic explanations for it.
" [22] All trade, let it be remembered, is the exchange of commodities for commodities, and hence the cessation of demand for some commodities, which marks the depression of trade, is really a cessation in the supply of other commodities. That dealers find their sales d...
I think I'd be happiest as a NEET for the short term future but I'm scared it will become a lifestyle. Is it plausible that NEETS might get exterminated, forced into labour or left to starve/get-malnourished in Western countries like Australia within the next 50 years?
Are NEETs just passive aggressive and bad at externalising, like expressing anger which may motivate them to get stuff done?
When I knew nothing of economics, unemployment wasn't mysterious. People wanted a job, and couldn't get one - well, people often want stuff they can't get. Nothing strange there, just one of those things.
Then I learnt some simple economics, and it became more mysterious. The employment market is a market, with the salary being the price. Why doesn't this market clear? Why doesn't the price (salary) simply adjust, and then everyone gets a job? It seemed profoundly mysterious that this didn't happen.
I've been gradually introducing myself to more economics (mostly indirectly) and I've encountered a lot of explanations for this perpetual market failure. Thus the mystery of unemployment is, if not resolved, at least somewhat explained. Since I would really have enjoyed reading a collection of unemployment explanations when I was initially puzzled (almost any explanation of unemployment you read in the press is worthless) I thought I'd do this for others. So here is my (entirely personal and idiosyncratic) summary of the main explanations I've encountered.
The "revealed preferences" idea holds that we can't establish what people want from what they say, but only from observing their actions and their choices. So if people are not getting jobs, maybe they don't really want them? Or maybe they don't want them, given government unemployment insurance?
I should note that whatever you think of this explanation, it argues that unemployment is not an economic problem. It views the unemployed as happily and rationally choosing not to work, which thus suits their preferences better and thus is of higher economic value (neglecting, of course, the cost of providing unemployment insurance).
If a market fails to clear, the first step is to look at outside interventions that may be preventing it from doing so. Trade unions and governments are typical candidates for this. Trade unions engage in collective bargaining, requiring that employers pay their workers a certain minimum level (in terms of salary, safety, or working conditions). This raises the price of employees above the market clearing level, and thus causes a shortage of jobs.
Similarly, governments can set minimum wages, regulate who is allowed to work in certain professions, and tax employers or employees (the difference is not relevant economically) for the job. They can impose other restrictions, such as making it harder to fire employees, or creating red tape that must be dealt with (thus raising the cost of employing anyone).
The market equilibrium is an attractor state the market is supposed to move towards. Frictions are things that oppose this movement or slow it down. "Irrationalities" are ways in which humans differ from the perfectly informed selfish expected utility maximisers of classical economics. They may not be irrationalities in the standard sense, just deviations from the model (note that unlike the stereotype, economists are often very aware of the limitations of their models).
There are costs involved in changing most jobs. The employee may need to change their social circles, their habits, their schedules, and may need to relocate to another area. The employer may need to arrange training for a new worker, integrate them into a team, and so on. Changing a job is often a very stressful event, implying that employees, at least, feel these costs are significant. In consequence, people don't relocate for a slight improvement of conditions, and employers don't fire people to replace them with slightly cheaper workers. The market is thus less likely to adjust.
Another friction is the stickiness of nominal wages. People seem very unwilling to accept a nominal pay cut, taking this as an attack on their status. This prevents companies from rapidly adjusting to new economic conditions (in both directions: they are less likely to raise wages, if they can't claw that raise back later) with their current employees. Some jobs have important non-monetary aspects to them (eg working for government and charities because one wants to make a difference, working for a market leader, working for a company with a certain corporate culture, etc...); these aspects (that form part of the whole compensation package) cannot be rapidly adjusted up or down. Managers and workers often develop relationships with each other, reducing the likelihood that bosses would rapidly fire workers or cut wages if economic conditions demanded it.
Human behaviour and biases can provide a general explanation why agents follow behaviours that make little economic sense (issues of status, of habit, prejudices, etc...). Into this category go all the "relative status" explanations: it's not important to have a good standard of living, but a comparatively good standard of living.
Another interesting friction is changes in the economy produced by new technologies, new innovations, new companies, and people entering or leaving certain industries. The economic landscape is always changing, and all economic agents have difficulty adjusting rapidly (because of the frictions above, and because of lack of information about the new setup, see next section). This explanation is particularly interesting, because they provide a possible reasons that frictions wouldn't die out, but could continue for a long time. But if the equilibrium state is constantly changing, then frictions can maintain themselves indefinitely, perpetually slowing down any move toward labour market equilibrium.
Information economics is a fascinating field, full of weird insights, including several that can contribute to unemployment. At the most basic level, employees don't know about the jobs on offer (they don't know all job descriptions, and even those job descriptions only give a very partial impression of what the job entails) and employers similarly don't know about all potential employees. There is a cost to finding this information.
Information markets are unlike any other market, though. Even the smallest of information errors can create new equilibriums - stable equilibriums where the market doesn't clear. What this means is that, lack of information can explain stable rates of involuntary unemployment even in the absence of any other frictions.
The principal agent problem is another huge factor here. If the "principal" requires an "agent" to do work for them, they cannot be sure the agent will do so in the way they expect (this problem can be seen as an information issue: the principal doesn't know something - the agent's performance - and the agent cannot fully demonstrate it to them). Hiring managers may not fully trust their candidates, and they might not be fully trusted by their bosses, who are not fully trusted by the shareholders, and so on.
This means that worker X may be willing to do a job for salary S (including implicit remuneration), and firm Z may be willing to offer that, but neither can trust the other to uphold the deal. Obviously this effect is stronger when the output can't be measured formally, or when implicit aspects of the job (working conditions, office atmosphere) are important to the employee.
This is one of the reasons that companies often pay "efficiency wages", ie pay more than the market rate for jobs where output can't be measure formally. Employees who value being part of the company, have good relations with their bosses, and fear losing their good position, will work harder to demonstrate their competence, and bring more value to their employer (intuitive explanation for this: the marginal worker, paid at the market rate, only prefers having a job to quitting it by an infinitesimal amount, and will quite if anything goes slightly worse - is this the kind of employee you'd like to have on staff?). Thus companies that pay efficiency wages often profit from doing so.
But paying above the market rate, even for good reasons, still means that the market won't clear. Note that efficiency wages alone are also enough to explain involuntary unemployment.
Macroeconomics (by which I mean mainly the Keynesian/Monetarist schools) is built on the seeming trivial observation that the salaries of workers are the means by which they buy products, and that the sale of these products are the income of the firms that employ people. Therefore, if the job market doesn't "clear" it's not as simple as just waiting for salaries (the price of that market) to adjust. If salaries fall, this feeds into less cash for consumers, which generally implies less consumption, which feeds into less revenue for firms, lowering their demand for workers, etc...
There are some theorems that imply that the job market should still reach equilibrium... if there are no frictions. In the presence of frictions, there is no reason to assume that the job market would clear: persistent involuntary unemployment can be a permanent feature of the economy. In classical economics, wages cannot rise in a sector while a single person remains involuntarily unemployed (because they could undercut someone and get their job or a fraction of their job); in practice, wages do start rising long before involuntary unemployment goes to zero (a "strong job market for programmers" does not require every aspiring programmer to have a job). This raises the cost of hiring someone, preventing unemployment from disappearing.
Furthermore, the economy need not settle down to a stable equilibrium either: it can go through cycles of expansion and contraction, thus explaining the business cycle. This adds yet another explanation for unemployment: the economy being in recession.
The other claims of macro are that there are several different states that the economy could be in, for the same given inputs, and that fiscal and monetary policy (government taxing/spending and interest rate changes) can move it from one state to another, affecting the unemployment rate. The main practical differences between Keynesian and Monetarists revolve around the role of government and what to do when interest rates are at zero, but that is not relevant for this analysis.
This is where I get to share my own unvarnished and unwashed opinions as to the validity of these arguments. Take this section with many caveats and doubts. Then add a few more.
First of all, classical explanations. Most of them seem off, for the same two reasons: being unemployed is very painful for most of the population, and most people care more about their relative position (are they as well off as their peers?) than about their absolute position. This means that if some intervention gradually reduces everyone's salaries by 50%, then most people will still be willing to work. Thus there seems to be little explanatory power in classical explanations that assume that people won't work because the salary is too low. This category also includes employment taxes, since, whoever nominally pays them, the actual burden falls on those with the least flexibility, ie the employees (you can start talking about elasticity here, if you want).
But firms are not individuals, and function very differently. Thus classical explanations that explain why firms won't hire people (rather than why people won't be hired) seem much stronger. This includes minimum wages and labour market rigidities (eg firms can't easily fire people once hired). In practice, minimum wages seem to have little impact (there are a bunch of contradictory studies here), but labour market rigidities seem very important. Cross country comparisons ("Southern Europe" unemployment rates versus "Northern Europe"/Anglo Saxon ones) seem to bear this out.
I feel that labour market rigidities along with the various frictions and information issues (to a greater or lesser extent) seem a good explanation for the background rate of unemployment of a country (averaged over the business cycle).
Conversely, the Keynesian/Monetarist model seem good at explaining the business cycle. Some of the classical theory is also of value in explaining recessions caused by external shocks (eg the oil shocks of the 1970s).
Notice what is absent from these explanations: general education level, free trade (or its absence), infrastructure, technology, company X opening (or closing) a factory/research centre/office in location Y. It seems the stories that are always reported in the media may affect who gets a job (and at what wage), and may affect the overall growth rate, but they don't directly affect the unemployment rate at all (indirect effects may exist, but they have to be analysed carefully and are often hard to predict).
So. Now you (kinda) know.