Fast economic growth tends to reduce the unemployment rate. So how low can the unemployment rate go? You might be tempted to say zero, but that isn’t feasible. Over the past half century, the national unemployment rate has never dropped below 2.9%.

Can there be unemployment even when many businesses are having a hard time finding workers? To answer this question, we need to examine the nature of labor markets and why they normally lead to substantial measured unemployment even when jobs are plentiful. Our starting point is the observation that, even in the best of times, jobs are constantly being created and destroyed.

In early 2010 the unemployment rate hovered close to 10%. Even during good times, most Americans know someone who has lost his or her job. The U.S. unemployment rate in July 2007 was only 4.7%, relatively low by historical standards, yet in that month there were 4.5 million “job separations”—terminations of employment that occurred because a worker was either fired or quit voluntarily.

There are many reasons for such job loss. One is structural change in the economy: industries rise and fall as new technologies emerge and consumers’ tastes change. For example, employment in high-tech industries such as telecommunications surged in the late 1990s but slumped severely after 2000. However, structural change also brings the creation of new jobs: since 2000, the number of jobs in the American health care sector has surged as new medical technologies have emerged and the aging of the population has increased the demand for medical care. Poor management performance or bad luck at individual companies also leads to job loss for their employees. For example, in 2013, smartphone maker BlackBerry announced plans to eliminate about 4,500 jobs after years of lagging sales, even as companies such as Apple and Samsung faced growing demand for their phones.

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This constant churning of the workforce is an inevitable feature of the modern economy. And this churning, in turn, is one source of frictional unemployment—one main reason that there is a considerable amount of unemployment even when jobs are abundant.

Workers who lose a job involuntarily due to job destruction often choose not to take the first new job offered. For example, suppose a skilled programmer, laid off because her software company’s product line was unsuccessful, sees a help-wanted ad for clerical work in the local newspaper. She might respond to the ad and get the job—but that would be foolish. Instead, she should take the time to look for a job that takes advantage of her skills and pays accordingly. In addition, individual workers are constantly leaving jobs voluntarily, typically for personal reasons—family moves, dissatisfaction, and better job prospects elsewhere.

Economists say that workers who spend time looking for employment are engaged in job search. If all workers and all jobs were alike, job search wouldn’t be necessary; if information about jobs and workers were perfect, job search would be very quick. In practice, however, it’s normal for a worker who loses a job, or a young worker seeking a first job, to spend at least a few weeks searching.

Frictional unemployment is unemployment due to the time workers spend in job search. A certain amount of frictional unemployment is inevitable, for two reasons. One is the constant process of job creation and job destruction. The other is the fact that new workers are always entering the labor market. For example, in January 2014, out of 10.2 million workers counted as unemployed, 1.2 million were new entrants to the workforce and another 2.9 million were “re-entrants”—people who had come back after being out of the workforce for a time.

A limited amount of frictional unemployment is relatively harmless and may even be a good thing. The economy is more productive if workers take the time to find jobs that are well matched to their skills, and workers who are unemployed for a brief period while searching for the right job don’t experience great hardship. In fact, when there is a low unemployment rate, periods of unemployment tend to be quite short, suggesting that much of the unemployment is frictional. Figure 13.1 shows the composition of unemployment in 2000, when the unemployment rate was only 4%. Forty-five percent of the unemployed had been unemployed for less than 5 weeks and only 23% had been unemployed for 15 or more weeks. Just 11% were considered to be “long-term unemployed”—unemployed for 27 or more weeks. The picture looked very different in January 2010, after unemployment had been high for an extended period of time.

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In periods of higher unemployment, workers tend to be jobless for longer periods of time, suggesting that a smaller share of unemployment is frictional. By early 2010, when unemployment had been high for several months, for instance, the fraction of unemployed workers considered “long-term unemployed” had jumped to 41%.

Public policy designed to help workers who lose their jobs can lead to frictional unemployment as an unintended side effect. Most economically advanced countries provide benefits to laid-off workers as a way to tide them over until they find a new job. In the United States, these benefits typically replace only a small fraction of a worker’s income and expire after 26 weeks. In other countries, particularly in Europe, benefits are more generous and last longer. The drawback to this generosity is that it reduces the incentive to quickly find a new job. By keeping more people searching for longer, the benefits increase frictional unemployment. Generous unemployment benefits in some European countries are widely believed to be one of the main causes of “Eurosclerosis,” the persistent high unemployment that afflicts a number of European economies.

Frictional unemployment exists even when the number of people seeking jobs is equal to the number of jobs being offered—that is, the existence of frictional unemployment doesn’t mean that there is a surplus of labor. Sometimes, however, there is a persistent surplus of job-seekers in a particular labor market. For example, there may be more workers with a particular skill than there are jobs available using that skill, or there may be more workers in a particular geographic region than there are jobs available in that region. Structural unemployment is unemployment that results when workers lack the skills required for the available jobs, or there are more people seeking jobs in a labor market than there are jobs available at the current wage rate.

The supply and demand model tells us that the price of a good, service, or factor of production tends to move toward an equilibrium level that matches the quantity supplied with the quantity demanded. This is equally true, in general, of labor markets. Figure 13.2 shows a typical market for labor. The labor demand curve indicates that when the price of labor—the wage rate—increases, employers demand less labor. The labor supply curve indicates that when the price of labor increases, more workers are willing to supply labor at the prevailing wage rate. These two forces coincide to lead to an equilibrium wage rate for any given type of labor in a particular location. That equilibrium wage rate is shown as W_E.

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Even at the equilibrium wage rate, W_E, there will still be some frictional unemployment. That’s because there will always be some workers engaged in job search even when the number of jobs available is equal to the number of workers seeking jobs. But there wouldn’t be any structural unemployment caused by a surplus of labor, as there is when the wage rate, for some reason, is persistently above W_E. Several factors can lead to a wage rate in excess of W_E, the most important being minimum wages, labor unions, efficiency wages, and the side effects of government policies.

Minimum Wages As explained in Module 8, a minimum wage is a government-mandated floor on the price of labor. In the United States, the national minimum wage in mid-2014 was $7.25 an hour. For many American workers, the minimum wage is irrelevant; the market equilibrium wage for these workers is well above this price floor. But for less skilled workers, the minimum wage may be binding—it affects the wages that people are actually paid and can lead to structural unemployment. In countries that have higher minimum wages, the range of workers for whom the minimum wage is binding is larger.

Figure 13.2 shows the effect of a binding minimum wage. In this market, there is a legal floor on wages, W_F, which is above the equilibrium wage rate, W_E. This leads to a persistent surplus in the labor market: the quantity of labor supplied, Q_S, is larger than the quantity demanded, Q_D. In other words, more people want to work than can find jobs at the minimum wage, leading to structural unemployment.

Given that minimum wages—that is, binding minimum wages—generally lead to structural unemployment, you might wonder why governments impose them. The rationale is to help ensure that people who work can earn enough income to afford at least a minimally comfortable lifestyle. However, this may come at a cost, because it may eliminate employment opportunities for some workers who would have willingly worked for lower wages. As illustrated in Figure 13.2, not only are there more sellers of labor than there are buyers, but there are also fewer people working at a minimum wage (Q_D) than there would have been with no minimum wage at all (Q_E).

Although economists broadly agree that a high minimum wage has the employment-reducing effects shown in Figure 13.2, there is some question about whether this is a good description of how the minimum wage actually works in the United States. The minimum wage in the United States is quite low compared with that in other wealthy countries. For three decades, from the 1970s to the mid-2000s, the U.S. minimum wage was so low that it was not binding for the vast majority of workers—employers paid most workers more than the minimum wage. In addition, some researchers have produced evidence that increases in the minimum wage actually lead to higher employment when, as was the case in the United States at one time, the minimum wage is low compared to average wages. They argue that firms that employ low-skilled workers sometimes restrict their hiring in order to keep wages low and that, as a result, the minimum wage can sometimes be increased without any loss of jobs. Most economists, however, agree that a sufficiently high minimum wage does lead to structural unemployment.

Labor Unions The actions of labor unions can have effects similar to those of minimum wages, leading to structural unemployment. By bargaining collectively for all of a firm’s workers, unions can often win higher wages from employers than workers would have obtained by bargaining individually. This process, known as collective bargaining, is intended to tip the scales of bargaining power more toward workers and away from employers. Labor unions exercise bargaining power by threatening firms with a labor strike, a collective refusal to work. The threat of a strike can have very serious consequences for firms that have difficulty replacing striking workers. In such cases, workers acting collectively can exercise more power than they could if they acted individually.

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When workers have greater bargaining power, they tend to demand and receive higher wages. Unions also bargain over benefits, such as health care and pensions, which we can think of as additional wages. Indeed, economists who study the effects of unions on wages find that unionized workers earn higher wages and more generous benefits than non-union workers with similar skills. The result of these increased wages can be the same as the result of a minimum wage: labor unions push the wage that workers receive above the equilibrium wage. Consequently, there are more people willing to work at the wage being paid than there are jobs available. Like a binding minimum wage, this leads to structural unemployment.

Efficiency Wages Actions by firms may also contribute to structural unemployment. Firms may choose to pay efficiency wages—wages that employers set above the equilibrium wage rate as an incentive for their workers to deliver better performance.

Employers may feel the need for such incentives for several reasons. For example, employers often have difficulty directly observing how hard an employee works. They can, however, elicit more work effort by paying above-market wages: employees receiving these higher wages are more likely to work harder to ensure that they aren’t fired, which would cause them to lose their higher wages.

When many firms pay efficiency wages, the result is a pool of workers who want jobs but can’t find them. So the use of efficiency wages by firms leads to structural unemployment.

Because some frictional unemployment is inevitable and because many economies also suffer from structural unemployment, a certain amount of unemployment is normal, or “natural.” Actual unemployment fluctuates around this normal level. The natural rate of unemployment is the rate of unemployment that arises from the effects of frictional plus structural unemployment. It is the normal unemployment rate around which the actual unemployment rate fluctuates. Figure 13.3 provides estimates of the natural rates of unemployment in the 34 relatively wealthy countries that belong to the Organization for Economic Cooperation and Development (OECD). Cyclical unemployment is the deviation of the actual rate of unemployment from the natural rate; that is, it is the difference between the actual and natural rates of unemployment. As the name suggests, cyclical unemployment is the share of unemployment that arises from the business cycle. We’ll see later that public policy cannot keep the unemployment rate persistently below the natural rate without leading to accelerating inflation.

We can summarize the relationships between the various types of unemployment as follows:

(13-1) Natural unemployment =
Frictional unemployment + Structural unemployment

(13-2) Actual unemployment =
Natural unemployment + Cyclical unemployment

Perhaps because of its name, people often imagine that the natural rate of unemployment is a constant that doesn’t change over time and can’t be affected by policy. Neither proposition is true. Let’s take a moment to stress two facts: the natural rate of unemployment changes over time, and it can be affected by economic policies.

Private-sector economists and government agencies need estimates of the natural rate of unemployment both to make forecasts and to conduct policy analyses. Almost all these estimates show that the U.S. natural rate rises and falls over time. For example, the Congressional Budget Office, the independent agency that conducts budget and economic analyses for Congress, believes that the U.S. natural rate of unemployment was 5.3% in 1950, rose to 6.3% by the end of the 1970s, and fell back to 5.0% from late 1999 until early 2008. In 2013, the estimated rate was back up to 6%. European countries have experienced even larger swings in their natural rates of unemployment.

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What causes the natural rate of unemployment to change? The most important factors are changes in the characteristics of the labor force, changes in labor market institutions, and changes in government policies. Let’s look briefly at each factor.

Changes in Labor Force Characteristics In January 2014 the overall rate of unemployment in the United States was 6.6%. Young workers, however, had much higher unemployment rates: 20.7% for teenagers and 12.9% for workers aged 20 to 24. Workers aged 25 to 54 had an unemployment rate of only 6.1%.

In general, unemployment rates tend to be lower for experienced than for inexperienced workers. Because experienced workers tend to stay in a given job longer than do inexperienced ones, they have lower frictional unemployment. Also, because older workers are more likely than young workers to be family breadwinners, they have a stronger incentive to find and keep jobs.

One reason the natural rate of unemployment rose during the 1970s was a large rise in the number of new workers—children of the post–World War II baby boom entered the labor force, as did a rising percentage of married women. As Figure 13.4 shows, both the percentage of the labor force less than 25 years old and the percentage of women in the labor force surged in the 1970s. By the end of the 1990s, however, the share of women in the labor force had leveled off and the percentage of workers under 25 had fallen sharply. As a result, the labor force as a whole is more experienced today than it was in the 1970s, one likely reason that the natural rate of unemployment is lower today than in the 1970s.

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Changes in Labor Market Institutions As we pointed out earlier, unions that negotiate wages above the equilibrium level can be a source of structural unemployment. Some economists believe that strong labor unions are one of the reasons for the high natural rate of unemployment in Europe. In the United States, a sharp fall in union membership after 1980 may have been one reason the natural rate of unemployment fell between the 1970s and the 1990s.

Other institutional changes may also have been at work. For example, some labor economists believe that temporary employment agencies, which have proliferated in recent years, have reduced frictional unemployment by matching workers to jobs. Furthermore, Internet websites such as monster.com may have reduced frictional unemployment by making information about job openings and job-seekers more widely available, thereby helping workers avoid a prolonged job search.

Technological change, coupled with labor market institutions, can also affect the natural rate of unemployment. Technological change probably leads to an increase in the demand for skilled workers who are familiar with the relevant technology and a reduction in the demand for unskilled workers. Economic theory predicts that wages should increase for skilled workers and decrease for unskilled workers. But if wages for unskilled workers cannot go down—say, due to a binding minimum wage—increased structural unemployment, and therefore a higher natural rate of unemployment, will result.

Changes in Government Policies A high minimum wage can cause structural unemployment. Generous unemployment benefits can increase frictional unemployment. So government policies intended to help workers can have the undesirable side effect of raising the natural rate of unemployment.

Some government policies, however, may reduce the natural rate. Two examples are job training and employment subsidies. Job-training programs are supposed to provide unemployed workers with skills that widen the range of jobs they can perform. Employment subsidies are payments either to workers or to employers that provide a financial incentive to accept or offer jobs.

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