The Labor Market: 2. Permanent Unemployment

by Lindy Davies

In the last post I showed that the market for unskilled, unregulated labor is perfectly competitive. The econ-speak definition of that is “a market in which profit is maximized when price equals marginal cost.” And in the case of laborers:

Profit Maximization = working at all, instead of starving
Marginal Cost = subsistence

We also said that this would always be the sad truth, as long as there was unemployment. Now, unemployment is an acute problem right now; we’re climbing out of a Great Recession and it’s all over the news. But the fact is, we’ve had an unemployment problem all along — even when times seemed good.

To see this, it’ll help know a bit about how unemployment is defined and counted. For the US government’s counting purposes, a person is employed if he or she has worked for pay for any time at all, even just one hour, during the past week. A person is unemployed if he or she has not worked for pay during that time but has actively sought work. People who have neither been working nor seeking work are defined as “outside the labor force”. Using these definitions, the US Department of Labor puts the current unemployment rate (September, 2012) at 8.1%, and the “labor force participation rate” at 63.5%.

Seems bad. Yet in 2000, the US economy was chugging along. The Federal government was even running an annual budget surplus! Yet that year we still had an unemployment rate of 3.8%. And our labor force participation rate has never been higher than the roughly 67% it reached in the late 1990s.

Even in good times, a very sizable percentage of the adult population is not working for a living. If — according to standard macroeconomic theory — we were to put very many of these people to work, inflation would shoot through the roof.

Businesses hire workers as long as it is profitable for them to do so. We wouldn’t expect them to keep hiring workers just to stand around and get in each other’s way, would we? No, we want businesses to be lean, mean profit-maximizing machines. But, some workers always get left out.

Why should labor be unemployed? There’s no shortage of desires to satisfy. Why can’t every person willing and able to work find land to work on and capital to work with? Why can’t we send our unemployment rate down to zero?

All right: so let’s move in that direction. What happens when the economy is going great guns, more people are working, producing more stuff, increasing demand? For a while, it’s pretty easy to meet the increased demand: factories just produce more, right up to their full capacity. But: what happens when demand continues to increase? Factories will have to add more assembly lines; workers will have to work overtime. That will tend to drive prices up at a faster rate than output is increasing. In other words, it’ll lead to inflation.

There appears to be a point beyond which the economy cannot hire more people to produce more stuff, because doing so would lead to an unacceptably severe rise in prices. There must be a point, then, at which we have the highest possible number of people working without creating too much inflation. Economists call that level of production the potential output of the economy at any given time. The level of employment that exists at the economy’s potential output is called the full employment point. (It is also called the Non-Accelerating Inflation Rate of Unemployment, or NAIRU.)

So, because of the problem of inflation, “full employment” does not mean that everyone who wants a job can find one! “Full employment” in the US has hovered in the range of five to six per cent unemployed for decades.

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