A second reason for unemployment is wage rigidity—the failure of wages to adjust to a level at which labor supply equals labor demand. In the equilibrium model of the labor market, as outlined in Chapter 3, the real wage adjusts to equilibrate labor supply and labor demand. Yet wages are not always flexible. Sometimes the real wage is stuck above the market-clearing level.

Figure 7-3 shows why wage rigidity leads to unemployment. When the real wage is above the level that equilibrates supply and demand, the quantity of labor supplied exceeds the quantity demanded. Firms must in some way ration the scarce jobs among workers. Real-wage rigidity reduces the rate of job finding and raises the level of unemployment.

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The unemployment resulting from wage rigidity and job rationing is sometimes called structural unemployment. Workers are unemployed not because they are actively searching for the jobs that best suit their individual skills but because there is a fundamental mismatch between the number of people who want to work and the number of jobs that are available. At the going wage, the quantity of labor supplied exceeds the quantity of labor demanded; many workers are simply waiting for jobs to open up.

To understand wage rigidity and structural unemployment, we must examine why the labor market does not clear. When the real wage exceeds the equilibrium level and the supply of workers exceeds the demand, we might expect firms to lower the wages they pay. Structural unemployment arises because firms fail to reduce wages despite an excess supply of labor. We now turn to three causes of this wage rigidity: minimum-wage laws, the monopoly power of unions, and efficiency wages.

The government causes wage rigidity when it prevents wages from falling to equilibrium levels. Minimum-wage laws set a legal minimum on the wages that firms pay their employees. Since the passage of the Fair Labor Standards Act of 1938, the U.S. federal government has enforced a minimum wage that has usually been between 30 and 50 percent of the average wage in manufacturing. In addition, many states enact minimum wages that are higher than the federal one: for example, in 2014, when the federal minimum wage was $7.25 per hour, California had a minimum wage of $9.00 per hour. For most workers, the minimum wage is not binding, because they earn well above the legislated minimum. Yet for some workers, especially the unskilled and inexperienced, the minimum wage raises their wage above its equilibrium level and, therefore, reduces the quantity of their labor that firms demand.

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Economists believe that the minimum wage has its greatest impact on teenage unemployment. The equilibrium wages of teenagers tend to be low for two reasons. First, because teenagers are among the least skilled and least experienced members of the labor force, they tend to have low marginal productivity. Second, teenagers often take some of their “compensation” in the form of on-the-job training rather than direct pay. An internship is a classic example of training offered in place of wages. For both these reasons, the wage at which the supply of teenage workers equals the demand is low. The minimum wage is therefore more often binding for teenagers than for others in the labor force.

Many economists have studied the impact of the minimum wage on teenage employment. These researchers compare the variation in the minimum wage over time with the variation in the number of teenagers with jobs. These studies find that a 10 percent increase in the minimum wage reduces teenage employment by 1 to 3 percent.4

The minimum wage is a perennial source of political debate. Advocates of a higher minimum wage view it as a way to raise the income of the working poor. Certainly, the minimum wage provides only a meager standard of living: in the United States, a single parent with one child working full time at a minimum-wage job would fall below the official poverty level for a family of that size. Although minimum-wage advocates often admit that the policy causes unemployment for some workers, they argue that this cost is worth bearing to raise others out of poverty.

Opponents of a higher minimum wage claim that it is not the best way to help the working poor. They contend not only that the increased labor costs raise unemployment but also that the minimum wage is poorly targeted. Many minimum-wage earners are teenagers from middle-class homes working for discretionary spending money, rather than heads of households working to support their families.

Many economists and policymakers believe that tax credits are a better way to increase the incomes of the working poor. The earned income tax credit is an amount that poor working families are allowed to subtract from the taxes they owe. For a family with very low income, the credit exceeds its taxes, and the family receives a payment from the government. Unlike the minimum wage, the earned income tax credit does not raise labor costs to firms and, therefore, does not reduce the quantity of labor that firms demand. It has the disadvantage, however, of reducing the government’s tax revenue.

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A second cause of wage rigidity is the monopoly power of unions. Table 7-1 shows the importance of unions in several major countries. In the United States, only 13 percent of workers have their wages set through collective bargaining. In most European countries, unions play a much larger role.

The wages of unionized workers are determined not by the equilibrium of supply and demand but by bargaining between union leaders and firm management. Often, the final agreement raises the wage above the equilibrium level and allows the firm to decide how many workers to employ. The result is a reduction in the number of workers hired, a lower rate of job finding, and an increase in structural unemployment.

Unions can also influence the wages paid by firms whose workforces are not unionized because the threat of unionization can keep wages above the equilibrium level. Most firms dislike unions. Unions not only raise wages but also increase the bargaining power of labor on many other issues, such as hours of employment and working conditions. A firm may choose to pay its workers high wages to keep them happy and discourage them from forming a union.

The unemployment caused by unions and by the threat of unionization is an instance of conflict between different groups of workers—insiders and outsiders. Those workers already employed by a firm, the insiders, typically try to keep their firm’s wages high. The unemployed, the outsiders, bear part of the cost of higher wages because at a lower wage they might be hired. These two groups inevitably have conflicting interests. The effect of any bargaining process on wages and employment depends crucially on the relative influence of each group.

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The conflict between insiders and outsiders is resolved differently in different countries. In some countries, such as the United States, wage bargaining takes place at the level of the firm or plant. In other countries, such as Sweden, wage bargaining takes place at the national level—with the government often playing a key role. Despite a highly unionized labor force, Sweden has not experienced extraordinarily high unemployment throughout its history. One possible explanation is that the centralization of wage bargaining and the role of the government in the bargaining process give more influence to the outsiders, which keeps wages closer to the equilibrium level.

Efficiency-wage theories propose a third cause of wage rigidity in addition to minimum-wage laws and unionization. These theories hold that high wages make workers more productive. The influence of wages on worker efficiency may explain the failure of firms to cut wages despite an excess supply of labor. Even though a wage reduction would lower a firm’s wage bill, it would also—if these theories are correct—lower worker productivity and the firm’s profits.

Economists have proposed various theories to explain how wages affect worker productivity. One efficiency-wage theory, which is applied mostly to poorer countries, holds that wages influence nutrition. Better-paid workers can afford a more nutritious diet, and healthier workers are more productive. A firm may decide to pay a wage above the equilibrium level to maintain a healthy workforce. Obviously, this consideration is not important for employers in wealthier countries, such as the United States and most of Europe, because the equilibrium wage is well above the level necessary to maintain good health.

A second efficiency-wage theory, which is more relevant for developed countries, holds that high wages reduce labor turnover. Workers quit jobs for many reasons—to accept better positions at other firms, to change careers, or to move to other parts of the country. The more a firm pays its workers, the greater is their incentive to stay with the firm. By paying a high wage, a firm reduces the frequency at which its workers quit, thereby decreasing the time and money spent hiring and training new workers.

A third efficiency-wage theory holds that the average quality of a firm’s workforce depends on the wage it pays its employees. If a firm reduces its wage, the best employees may take jobs elsewhere, leaving the firm with inferior employees who have fewer alternative opportunities. Economists recognize this unfavorable sorting as an example of adverse selection—the tendency of people with more information (in this case, the workers, who know their own outside opportunities) to self-select in a way that disadvantages people with less information (the firm). By paying a wage above the equilibrium level, the firm may reduce adverse selection, improve the average quality of its workforce, and thereby increase productivity.

A fourth efficiency-wage theory holds that a high wage improves worker effort. This theory posits that firms cannot perfectly monitor their employees’ work effort and that employees must themselves decide how hard to work. Workers can choose to work hard, or they can choose to shirk and risk getting caught and fired. Economists recognize this possibility as an example of moral hazard—the tendency of people to behave inappropriately when their behavior is imperfectly monitored. The firm can reduce the problem of moral hazard by paying a high wage. The higher the wage, the greater the cost to the worker of getting fired. By paying a higher wage, a firm induces more of its employees not to shirk and thus increases their productivity.

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Although these four efficiency-wage theories differ in detail, they share a common theme: because a firm operates more efficiently if it pays its workers a high wage, the firm may find it profitable to keep wages above the level that balances supply and demand. The result of this higher-than-equilibrium wage is a lower rate of job finding and greater unemployment.6

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