would reduce unemployment both by decreasing the quantity of labor supplied and by increasing the quantity of labor demanded. Increases in the prices of goods or services produced by labor raise dollar revenues attributable to any given amount of labor, thus increasing the amount employers would be willing to pay to obtain any given number of workers. Also, higher prices mean that a given money wage has less purchasing power, so an increase in prices means a reduction in real wages. Higher productivity means higher physical product per worker which, in turn, means higher revenues per worker, similarly increasing demand. Finally, a shift to the left in the labor supply curve reduces the gap between the quantity of labor demanded and supplied.
If labor supply is highly inelastic (relatively nonresponsive to wage changes) and if it moves over time slowly and predictably with demographic and other trends, then the theorizing above would suggest that short-term variations in unemployment are determined by changes in money wages, prices, or the productivity of labor.5 As indicated, the money wage divided by the price level is the real wage. The real wage per unit of physical output is simply the real wage divided by the productivity of workers, or what we might call the “adjusted real wage” or “real unit-labor costs.” The bulk of the remainder of this volume will be devoted to testing the validity of the proposition that unemployment in the United States has been systematically positively related to the adjusted real wage: higher adjusted real wages mean higher unemployment.
There is another way of expressing the basic hypothesis that unemployment is positively related to the adjusted real wage. Real wages are equal to money wages (W) divided by some price index (P), or W/P. Similarly labor productivity equals money output per hour (O) divided by a price index (P), or O/P. Assuming the same price index in both calculations, dividing real wages, W/P, by labor productivity, O/P, gives W/O. The latter expression is simply labor compensation as a proportion of total output (GNP, or using distributive-shares data, national or personal income). Thus the adjusted real wage can be measured by looking at labor’s share of personal income. If that share rises, the adjusted real wage is rising and, the theory predicts, unemployment should rise as well.6
While the theory as expressed above was not often or well articulated by the bulk of economists living in the first third of the twentieth century, few would disagree with it. At least one, A. C. Pigou, laid the theory out very explicitly and at great length.7 One obvious problem with the theory is that, at any given moment of time, there always was some unemployment, and the wage mechanism was never fully successful in completely clearing the labor market—unemployment never fell to zero.
Pigou recognized this, and considered “frictional unemployment” explicitly. At any given time, a certain number of workers would be temporarily between jobs; when one loses one’s job, it is unusual for the unemployed worker instantly to obtain new employment. Learning about job opportunities takes time and effort, and the fact that labor-market information is not costless and instantly available means that some unemployment is inevitable, as unemployment is traditionally defined.
Later economists, particularly in the 1960s, introduced the concept of structural unemployment, arguing that often there is a mismatch between the skills of those out of work and the skills needed for available jobs. Unskilled, unemployed construction workers cannot fill vacant positions for computer programmers.
The labor force can be defined to exclude those temporarily idle individuals currently between jobs (the frictionally unemployed); some economists consider these workers voluntarily unemployed and thus not part of the involuntary jobless.8 It might be defined also to exclude those whose inappropriate skill levels make them de facto not “able” to work at jobs that are available—the so-called structurally unemployed. So defined, a full-employment (no-unemployment) level occurs where the quantity of labor demanded equals the quantity of labor supplied.
Less than full employment, or what economists generally call “cyclical unemployment,” exists when wages exceed the market-clearing equilibrium wage. It is possible also to have, temporarily, a below-equilibrium wage where there are, in the context of figure 2.1, labor shortages, or, to use conventional contemporary terminology, negative cyclical unemployment—people are working who would not normally work at the prevailing wage. They work because they are temporarily misinformed as to their true wage since they suffer from “money illusion,” or perhaps because labor contracts require them to do so even though they would not choose to do so if the legal obligation were not present.
Normally, however, the theory suggests that wages will tend to move toward equilibrium. Using our restricted labor-force definition, unemployment is zero at that equilibrium. Using the official unemployment definition, there is frictional and structural unemployment. Officially defined unemployment at the equilibrium wage equals what is now often called the natural rate of unemployment.
While most of the remainder of this book attempts to use the simple wages model discussed above to explain variations in cyclical unemployment in the United States in the twentieth century, in chapters 13 and 14 historical dimensions of frictional and structural unemployment are discussed, both in general and with respect to demographic (race, gender, and age) and geographic variations in the natural rate of unemployment.
AUSTRIAN PERSPECTIVES ON UNEMPLOYMENT
No school of economic thought has placed a greater emphasis on the importance of markets in coordinating economic activity than the Austrian school. With respect to unemployment, Austrians accept the view that unemployment reflects discoordination and disequilibrium in the labor market, or, more simply, excessive wage levels.9 As the late Friedrich von Hayek put it, “The cause of unemployment … is a deviation from the equilibrium prices and wages which would establish themselves with a free market and stable money.”10 Recently, scholars have supported this view empirically.11
Recognizing that, however, the Austrians generally believe that the disequilibrium in the labor market often may be a by-product or consequence of human-caused disturbances in other markets. In particular, increases in the stock of money induced by monetary policies of the central bank (Federal Reserve Bank in the United States) change the purchasing power of the circulating medium. Such a move tends to push interest rates in a downward direction not justified by true human time preferences. The price of capital resources falls relative to the price of labor services. This, in turn, leads to a distortion in resource allocation toward capital-intensive ventures and away from labor-intensive ones.
A Digression on Unemployment Statistics
In the discussion above, we suggested that the labor force could be defined to exclude workers who are conventionally classified as frictionally or structurally unemployed. That may seem artificial and arbitrary. It is important to realize, however, that the official unemployment definition is inherently arbitrary in several ways. For example, at the present time no one under the age of sixteen is included in the labor force, even though there are some child entertainers whose work earns them seven-digit annual incomes. There are millions of housewives and househusbands who “work around the house” doing economically productive activity. Yet they are excluded from the labor force since they do not sell their services in a market. A person working in a child-care facility is “employed”, while a mother who takes care of her own four children at home is “not employed” (as distinct from “unemployed”) even though she probably provides as many (and as high-quality) child care services as the person selling her services in the labor market.
Another problem comes from the fact that many of those persons classified as unemployed in fact have opportunities to work and have chosen not to exercise them. They choose to be unemployed. Suppose an aerospace engineer with graduate degrees is dismissed from his $60,000-a-year job with a defense contractor because of defense cutbacks. Suppose he stops into a local fast-food restaurant after his last day of work and starts talking with his friend,