Labor-Market Adjustments and the Persistence of Unemployment

Abstract

Persistent unemployment, like that plaguing Europe since the early 1980's, has been a persistent problem for economic theory. Competitive equilibrium theory assumes that all markets clear, including the labor market. All theories of unemployment thus must reflect significant departures from that paradigm. The last 20 years have generated a plethora of such theories. The challenge is to construct models that generate unemployment and are broadly consistent with a host of other labor and macroeconomic phenomena, including patterns of real wages and hours. The traditional approach is to focus on a simple static equilibrium in which wages are kept above their market-clearing level for a variety of reasons: in the older versions of this story minimum wages, union power, and normative traditions; in its more recent incarnations, efficiency-wage considerations.' Within the United States, the older variants of these models have received decreasing credence, as union power has eroded, the real value of the minimum wage has declined, and empirical evidence has buttressed a broader set of theoretical arguments (based on imperfect competition within the labor market and efficiency-wage considerations) suggesting at most negligible effects from these government interventions. Efficiency-wage variants are more broadly consistent with observed labormarket behavior and help explain both natural rates of unemployment and certain cyclical phenomena (e.g., the use of layoffs rather than job-sharing) (see Carl Shapiro and Stiglitz, 1984; Lawrence Summers, 1990). Moreover, to the extent that unemployment compensation and protection against separations for cause have improved recently in Europe, these models can explain the secular rise in European unemployment (see Edmund Phelps, 1994).2 On the other hand, as conventionally formulated, they leave many aspects of the labor market unexplained.3 More-recent theories analyze unemployment as the result of imbalances between flows into and out of the job market.4 In these models, in steady state, on average, the flow supply into unemployment must balance the flow out. The equilibrium level of unemployment is thus determined through relations between these flows and the level of unemployment. Most noted within this genre are the labor-turnover theories, in which labor costs are affected by wages and the unemployment rate, and the job-search models, in which unemployment arises from the need for job matches, which by assumption, can only occur among the