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 annual national unemployment rate has never dropped below 3.6%.

How can there be so much unemployment even when many businesses are having a hard time finding workers? To answer this question, we need to examine the nature of labour 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.

Even during good times, most Canadians know someone who has lost his or her job. In October 2007, the national unemployment rate was only 5.3%, relatively low by historical standards. Yet in that month there were about 450 thousand “job separations”—terminations of employment that occur because a worker is either fired or quits 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: after 2000, the number of jobs in the health care sector surged as new medical technologies and the aging of the population 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 2005 General Motors announced plans to eliminate 30 000 jobs globally after several years of lagging sales, even as Japanese companies such as Toyota announced plans to open new plants in North America to meet growing demand for their cars. Research in Motion (RIM, now known as BlackBerry) cut about 2000 jobs in the summer of 2011 due to stiffer competition from other smartphone producers such as Apple and Samsung. RIM announced another round of layoffs in July 2012, and this time it planned to cut approximately 5000 jobs.

Continual job creation and destruction are a feature of modern economies, making a naturally occurring amount of unemployment inevitable. Within this naturally occurring amount, there are two types of unemployment—frictional and structural.

When a worker loses a job involuntarily due to job destruction, he or she often doesn’t 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 online. 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 was 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 due to the constant process of economic change. Thus even in 2007, a year of low unemployment, there were millions of “job separations,” in which workers left or lost their jobs. Total employment grew because these separations were more than offset by millions of new hires—with more than 370 thousand net new jobs created in 2007. Inevitably, some of the workers who left or lost their jobs spent at least some time unemployed, as did some of the workers newly entering the labour force.

Figure 8-6 shows the 2007 flows of workers among three categories: employed, unemployed, and not in the labour force. What the figure suggests is how much churning is constantly taking place in the labour market. An inevitable consequence of that churning is a significant number of workers who haven’t yet found their next job—that is, frictional unemployment.

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 8-7 shows the composition of unemployment for all of 2007, when the unemployment rate was only 6%. Forty percent of the unemployed had been unemployed for less than 5 weeks, and only 27% had been unemployed for 14 or more weeks. Only about one in eight unemployed workers were considered to be “long-term unemployed”—unemployed for 27 or more weeks.

In periods of higher unemployment, however, workers tend to be jobless for longer periods of time, suggesting that a smaller share of unemployment is frictional. By 2010, the fraction of unemployed workers considered “long-term unemployed” had jumped to 21%.

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 labour. Sometimes, however, there is a persistent surplus of jobseekers in a particular labour market, even when the economy is at the peak of the business cycle. 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, or are unwilling to work at the offered wage. Structural unemployment is unemployment that results when there are more people seeking jobs in a particular labour market than there are jobs available at the current wage rate. This unemployment is usually driven by technological change and other demand shocks that create structural differences between job vacancies and the pool of unemployed workers.

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 labour markets.

Figure 8-8 shows a typical market for labour. The labour demand curve indicates that when the price of labour—the wage rate—increases, employers demand less labour. The labour supply curve indicates that when the price of labour increases, more workers are willing to supply labour at the prevailing wage rate. These two forces coincide to lead to an equilibrium wage rate for any given type of labour in a particular location. That equilibrium wage rate is shown as W_E.

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 in this labour market. Structural unemployment occurs when the wage rate is, for some reason, persistently above W_E. Several factors can lead to a wage rate in excess of W_E, the most important being minimum wages, labour unions, efficiency wages, the side effects of government policies, and mismatches between employees and employers.

Minimum Wages A minimum wage is a government-mandated floor on the price of labour. In Canada, each province and territory sets its own minimum wage. As Table 8-2 shows, most set it to be about $10 per hour. For many Canadian 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 particular markets for labour. Other wealthy countries have higher minimum wages; for example, in 2012 the French minimum wage was 9.22 euros an hour, or around $11.53. In these countries, the range of workers for whom the minimum wage is binding is larger.

Figure 8-8 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 labour market: the quantity of labour 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 the opportunity to work for some workers who would have willingly worked for lower wages. As illustrated in Figure 8-8, not only are there more sellers of labour 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 8-8, there is some question about whether this is a good description of how minimum wage actually works. The minimum wages in Canadian provinces and territories are quite low compared with those of other wealthy countries. For three decades, from the 1970s to the mid-2000s, Canadian minimum wages were so low that they were not binding for the vast majority of workers.

In addition, some researchers have produced evidence that increases in the minimum wage actually lead to higher employment when, as was the case in Canada 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.

Labour Unions The actions of labour 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. Labour unions exercise bargaining power by threatening firms with a labour strike, a collective refusal to work. The threat of a strike can have serious consequences for firms. In such cases, workers acting collectively can exercise more power than they could if acting individually.

Employers have acted to counter the bargaining power of unions by threatening and enforcing lockouts—periods in which union workers are locked out and rendered unemployed—while hiring replacement workers.

When workers have increased 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: labour 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. In Canada, however, due to a falling level of unionization over the past 15 years, the amount of structural unemployment generated by union demands has declined.

Efficiency Wages Actions by firms can 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 perform better.

Employers may feel the need for such incentives for several reasons. For example, employers often have difficulty observing directly 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.

Side Effects of Government Policies In addition, government policies designed to help workers who lose their jobs can lead to structural 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 Canada, these benefits, called employment insurance (EI) benefits, typically replace up to 55% of a worker’s average insured income up to a yearly maximum insurable amount—currently equal to $45 900—and expire after 19 to 45 weeks, depending on the unemployment rate in the region. During the recession of 2008–2009, as a measure to combat hardship caused by more frequent and longer occurrences of unemployment, the federal government temporarily increased the maximum length that employment insurance benefits could be paid by five weeks. In other countries, particularly in Europe, benefits are more generous and last longer. The drawback to this generosity is that it reduces a worker’s incentive to quickly find a new job. Generous unemployment benefits in some European countries are often argued to be one of the causes of “Eurosclerosis,” the persistent high unemployment that afflicts a number of European economies.

Mismatches between Employees and Employers It takes time for workers and firms to adjust to shifts in the economy. The result can be a mismatch between what employees have to offer and what employers are looking for. A skills mismatch is one form; for example, in the aftermath of the U.S. housing bust of 2006–2009, there were more construction workers looking for jobs than were available. Another form is geographic as in Windsor (Ontario), which has had a long-standing surplus of workers after its auto industry declined. Until the mismatch is resolved through a big enough fall in wages of the surplus workers that induces retraining or relocation, there will be 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 normal unemployment rate around which the actual unemployment rate fluctuates. It is the rate of unemployment that arises from the effects of frictional plus structural unemployment. The natural rate of unemployment is often called the non-accelerating inflation rate of unemployment (NAIRU) because it is the rate of unemployment that will not put any pressure on the inflation rate. 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 downturns and upturns caused by the business cycle. As such, cyclical unemployment can be positive, negative, or zero.

We’ll see in Chapter 16 that an economy’s natural rate of unemployment is a critical policy variable because government 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:

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 government 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 government policies.

Private-sector economists and government agencies sometimes use estimates of the natural rate of unemployment both to make forecasts and to conduct policy analyses. Almost all these estimates show that the Canadian natural rate rises and falls over time. For example, the OECD estimated that Canada’s natural rate of unemployment was about 4% in 1960, rose to 5% in 1970, rose to 8% in 1980, and fluctuated between 8 and 10% during the 1980s and 1990s. It declined to less than 8% by the late 1990s. In the late 1990s, the Bank of Canada decided to de-emphasize the gap between the measured unemployment rate and the estimated natural rate of unemployment as a guide for determining the future direction of monetary policy. In fact, in the late 1990s, Canada’s unemployment rate fell below the OECD’s estimate of the natural rate without causing any significant economic problems, such as inflation. This implies that the OECD estimate may have been too high. According to the OECD, some European countries have experienced even larger swings in their natural rates of unemployment.

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

Changes in Labour Force Characteristics In 2007 the overall rate of unemployment in Canada was 6%. Young workers, however, had much higher unemployment rates: 14.8% for teenagers and 8.7% for workers aged 20 to 24. Workers aged 25 years and over had an unemployment rate of only 5.0%.

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 labour force, as did a rising percentage of married women. As Figure 8-9 shows, both the percentage of the labour force less than 25 years old and the percentage of women in the labour force grew rapidly in the 1960s and 1970s. By the end of the 1990s, however, the share of women in the labour force had levelled off and the percentage of workers under 25 had fallen sharply. As a result, the labour 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.

Changes in Labour 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 labour unions are one reason for the high natural rate of unemployment in Europe, discussed in the Global Comparison. In Canada, a 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 be at work. For example, some labour economists believe that temporary employment agencies, which have proliferated in recent years, have reduced frictional unemployment by helping match workers to jobs. Furthermore, as discussed in the Business Case at the end of the chapter, Internet websites such as Workopolis.com and Monster.ca may have reduced frictional unemployment.

Technological change, coupled with labour market institutions, can also affect the natural rate of unemployment. Technological change tends to increase 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 both structural and 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.

The 1970s represented the height of Canada’s Unemployment Insurance (UI) program in terms of coverage, benefits, and eligibility. This may have contributed to increased frictional and structural unemployment, thereby raising the natural rate of unemployment during this decade. It is possible that with generous UI benefits a worker might take longer to find a suitable new job; that is, there would be higher frictional unemployment. Similarly, generous benefits might induce a worker to hold out for a higher paying job rather than a lower paying job that is available; that is, there would be higher structural unemployment. In the 1980s and 1990s, the federal government introduced changes to the UI program, which was renamed the Employment Insurance (EI) program. These changes were designed to reduce payouts in order to help balance the federal budget. As a result, benefits were slashed, and coverage and eligibility were reduced drastically. These changes likely contributed to the fall in Canada’s natural rate of unemployment that occurred in the late 1980s and 1990s.