14.1 The Natural Rate of Unemployment

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%.

To understand how there can be so much unemployment even when many businesses are having a hard time finding workers, 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.

Job Creation and Job Destruction

Even during good times, Americans lose their jobs. In July 2007, the U.S. unemployment rate was only 4.7%, relatively low by historical standards. Yet in that month there were 4.5 million “job separations”—terminations of employment that occur because workers are either fired or quit voluntarily.

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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 after 2000. However, structural change also brings the creation of new jobs: after 2000, the number of jobs in the American health care sector surged as new medical technologies and an aging population increased the demand for medical care. Poor management performance or bad luck at individual companies also leads to job loss for employees.


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.

Frictional Unemployment

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.

Workers who spend time looking for employment are engaged in job search.

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.

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 62 million “job separations,” in which workers left or lost their jobs. Total employment grew because these separations were more than offset by more than 63 million hires. 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 labor force.

Figure 14-7 shows the average monthly flows of workers among three states: employed, unemployed, and not in the labor force during 2007, a year of relatively low unemployment. What the figure suggests is how much churning is constantly taking place in the labor 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.

Figure 14.7: FIGURE 14-7 Labor Market Flows in an Average Month in 2007
Figure 14.7: Even in 2007, a low-unemployment year, large numbers of workers moved into and out of both employment and unemployment each month. On average, each month in 2007, 1.781 million unemployed became employed, and 1.929 million employed became unemployed.
Data from: Bureau of Labor Statistics.


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 14-8 shows the composition of unemployment for all of 2007, when the unemployment rate was only 4.6%. Thirty-six percent of the unemployed had been unemployed for less than 5 weeks, and only 33% had been unemployed for 15 or more weeks. Only about one in six unemployed workers were considered to be “long-term unemployed”—unemployed for 27 or more weeks.

Figure 14.8: FIGURE 14-8 Distribution of the Unemployed by Duration of Unemployment, 2007
Figure 14.8: In years when the unemployment rate is low, most unemployed workers are unemployed for only a short period. In 2007, a year of low unemployment, 36% of the unemployed had been unemployed for less than 5 weeks and 67% for less than 15 weeks. The short duration of unemployment for most workers suggests that most unemployment in 2007 was frictional.
Data from: Bureau of Labor Statistics.

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. The fraction of the unemployed who had been out of work for six months or more from 2007 to mid-2014 jumped to 45% after the Great Recession, and was still historically high five years after the recession officially ended.

Structural Unemployment

In structural unemployment, more people are seeking jobs in a particular labor market than there are jobs available at the current wage rate, even when the economy is at the peak of the business cycle.

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, 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. Structural unemployment is unemployment that results when there are more people seeking jobs in a particular 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 14-9 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 WE.

Figure 14.9: FIGURE 14-9 The Effect of a Minimum Wage on a Labor Market
Figure 14.9: When the government sets a minimum wage, WF, that exceeds the market equilibrium wage rate in that market, WE, the number of workers who would like to work at that minimum wage, QS, is greater than the number of workers demanded at that wage rate, QD. This surplus of labor is structural unemployment.

Even at the equilibrium wage rate WE, 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 labor market. Structural unemployment occurs when the wage rate is, for some reason, persistently above WE. Several factors can lead to a wage rate in excess of WE, the most important being minimum wages, labor 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 labor. In the United States, the national minimum wage in early 2014 was $7.25 an hour. A number of state and local governments also determine the minimum wage within their jurisdictions, typically for the purpose of setting it higher than the federal level. For example, the city of Seattle has set a minimum wage at $15 an hour.

For many American workers, the minimum wage is irrelevant; the market equilibrium wage for these workers is well above the national 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 labor. Other wealthy countries have higher minimum wages; for example, in 2014 the French minimum wage was 9.40 euros an hour, or around $12.40. In these countries, the range of workers for whom the minimum wage is binding is larger.

Figure 14-9 shows the effect of a binding minimum wage. In this market, there is a legal floor on wages, WF, which is above the equilibrium wage rate, WE. This leads to a persistent surplus in the labor market: the quantity of labor supplied, QS, is larger than the quantity demanded, QD. 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 14-9, not only are there more sellers of labor than there are buyers, but there are also fewer people working at a minimum wage (QD) than there would have been with no minimum wage at all (QE).


Although economists broadly agree that a high minimum wage has the employment-reducing effects shown in Figure 14-9, there is some question about whether this is a good description of how the U.S. minimum wage actually works. 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 American minimum wage was so low that it was not binding for the vast majority of workers.

In addition, some researchers have produced evidence showing 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 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: 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. In the United States, however, due to a low level of unionization, the amount of unemployment generated by union demands is likely to be very small.

Efficiency wages are wages that employers set above the equilibrium wage rate as an incentive for better employee performance.

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 the United States, these benefits typically replace only a small fraction of a worker’s income and expire after 26 weeks. (This was extended in some cases to 99 weeks during the period of high unemployment in 2009–2011). 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. During the 1980s, it was often argued that unemployment benefits in some European countries were one of the causes of Eurosclerosis, persistently 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 housing bust of 2009, there were more construction workers looking for jobs than were available. Another form is geographic as in Michigan, 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.

The Natural Rate of Unemployment

The natural rate of unemployment is the unemployment rate that arises from the effects of frictional plus structural unemployment.

Cyclical unemployment is the deviation of the actual rate of unemployment from the natural rate due to downturns in the business cycle.

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. 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 of the business cycle.

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

(14-3) Natural unemployment =
Frictional unemployment + Structural unemployment

(14-4) 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 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.

Changes in the Natural Rate of Unemployment

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, but has fallen to 4.9% at the beginning of 2016. 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 labor force characteristics, changes in labor market institutions, and changes in government policies. Let’s look briefly at each factor.

Changes in Labor Force Characteristics In 2007 the rate of unemployment in the United States was 4.6%. Young workers, however, had much higher unemployment rates: 15.7% for teenagers and 8.2% for workers aged 20 to 24. Workers aged 25 to 54 had an unemployment rate of only 3.7%.

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 14-10 shows, both the percentage of the labor force less than 25 years old and the percentage of women in the labor force grew rapidly 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.

Figure 14.10: FIGURE 14-10 The Changing Makeup of the U.S. Labor Force, 1948–2016
Figure 14.10: In the 1970s the percentage of women in the labor force rose rapidly, as did the percentage of those under age 25. These changes reflected the entry of large numbers of women into the paid labor force for the first time and the fact that baby boomers were reaching working age. The natural rate of unemployment may have risen because many of these workers were relatively inexperienced. Today, the labor force is much more experienced, which is one possible reason the natural rate has fallen since the 1970s.
Data from: Bureau of Labor Statistics.

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 the high natural rate of unemployment in Europe is caused, in part, by strong labor unions. 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 be at work. For example, some labor economists believe that temporary employment agencies, which have proliferated in recent years, have reduced frictional unemployment by helping match workers to jobs.


Technological change, coupled with labor 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 reduce the demand for unskilled workers. Economic theory predicts that wages should increase for skilled workers and decrease for unskilled workers as technology advances. 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 during periods of faster technological change.

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.

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Structural Unemployment in East Germany

image | interactive activity

In one of the most dramatic events in world history, a spontaneous popular uprising in 1989 overthrew the communist dictatorship in East Germany. Citizens quickly tore down the wall that had divided Berlin, and in short order East and West Germany united into one democratic nation.

Then the trouble started.

After reunification in 1989, East Germany found itself suffering from severe structural unemployment that continues to this day.
Robert Wallis/Corbis

After reunification, employment in East Germany plunged and the unemployment rate soared. This high unemployment rate has gradually come down, but remains well above the rate in the rest of Germany. In late 2014 the unemployment rate in what was formerly East Germany was more than 9%, compared with 5.6% in the former West Germany. Other parts of formerly communist Eastern Europe have done much better. For example, the Czech Republic, which was often cited along with East Germany as a relatively successful communist economy, had an unemployment rate of only 5.7% in October 2014. What went wrong in East Germany?

The answer is that, through nobody’s fault, East Germany found itself suffering from severe structural unemployment. When Germany was reunified, it became clear that workers in East Germany were much less productive than their cousins in the west. Yet unions initially demanded and received wage rates equal to those in West Germany. These wage rates have been slow to come down because East German workers objected to being treated as inferior to their West German counterparts. Meanwhile, productivity in the former East Germany remains well below West German levels, in part because of decades of misguided investment under the former dictatorship. The result has been a persistently large mismatch between the number of workers demanded and the number of those seeking jobs, and persistently high structural unemployment in the former East Germany.


Quick Review

  • Frictional unemployment occurs because unemployed workers engage in job search, making some amount of unemployment inevitable.

  • A variety of factors—minimum wages, unions, efficiency wages, the side effects of government policies such as unemployment benefits, and mismatches between employees and employers—lead to structural unemployment.

  • Frictional plus structural unemployment equals natural unemployment, yielding a natural rate of unemployment. In contrast, cyclical unemployment changes with the business cycle. Actual unemployment is equal to the sum of natural unemployment and cyclical unemployment.

  • The natural rate of unemployment can shift over time, due to changes in labor force characteristics and institutions. Government policies designed to help workers are believed to be one reason for high natural rates of unemployment in Europe.

Check Your Understanding 14-2

Question 14.4

1. Explain the following statements.

  1. Frictional unemployment is higher when the pace of technological advance quickens.

    When the pace of technological advance quickens, there will be higher rates of job creation and destruction as old industries disappear and new ones emerge. As a result, frictional unemployment will be higher as workers leave jobs in declining industries in search of jobs in expanding industries.

  2. Structural unemployment is higher when the pace of technological advance quickens.

    When the pace of technological advance quickens, there will be greater mismatch between the skills employees have and the skills employers are looking for, leading to higher structural unemployment.

  3. Frictional unemployment accounts for a larger share of total unemployment when the unemployment rate is low.

    When the unemployment rate is low, frictional unemployment will account for a larger share of total unemployment because other sources of unemployment will be diminished. So the share of total unemployment composed of the frictionally unemployed will rise.

Question 14.5

2. Why does collective bargaining have the same general effect on unemployment as a minimum wage? Illustrate your answer with a diagram.

A binding minimum wage represents a price floor below which wages cannot fall. As a result, actual wages cannot move toward equilibrium. So a minimum wage causes the quantity of labor supplied to exceed the quantity of labor demanded. Because this surplus of labor reflects unemployed workers, it affects the unemployment rate. Collective bargaining has a similar effect—unions are able to raise the wage above the equilibrium level to a level like WU in the accompanying diagram. This will act like a minimum wage by causing the number of job-seekers to be larger than the number of workers firms are willing to hire. Collective bargaining causes the unemployment rate to be higher than it otherwise would be, as shown in the accompanying diagram.


Question 14.6

3. Suppose that at the peak of the business cycle the United States dramatically increases benefits for unemployed workers. Explain what will happen to the natural rate of unemployment.

An increase in unemployment benefits at the peak of the business cycle reduces the cost to individuals of being unemployed, causing them to spend more time searching for new jobs. So the natural rate of unemployment would increase.

Solutions appear at back of book.