Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Derivation of the natural rate of unemployment

The labour force (L) comprises the employed (E) and the unemployed (U):

(1)
In equilibrium, the number of people finding a job is exactly equal to the number of people losing their job:

(2)

Using equation (1), the unemployment rate can be written as

(3)
Substituting equation (2) into equation (3) gives

(4)
Thinking about supply-side policies


Supply-side policies are ones designed to increase the productive capability of the economy. Applied to the labour market, supply-side policies attempt to reduce the rate of job separation (s) and increase the rate of job finding (f). (Check out the preceding section if these terms seem unfamiliar to you.)

Sometimes supply-side policies can be politically unpopular because they can negatively affect certain groups in the short run. However, in the long run, policy makers hope that by reducing unemployment (and increasing wages), the policies will benefit everyone. Here are some examples of supply-side policies to consider:

Curtailing trade union power: As we mention in the earlier section

‘Considering possible causes of structural unemployment’, powerful trade

unions can increase industry wages by threatening industrial action. This

reduces the demand for labour and increases unemployment. Reducing

trade union power should bring wages closer to the market equilibrium

wage where everyone who’s willing and able to work for that wage can

find employment.


Reducing taxes on labour: Taxes on labour such as income tax and National Insurance lead to deadweight loss, which means that they destroy some potential trades that would make both employer and employee better off.

For example, suppose that Catherine is willing to work for you for

£10/hour and you’re willing to pay her £11/hour. Clearly, in this case you should employ her at £10.50 an hour – whereby you and Catherine both make a surplus of 50p/hour. However, now suppose that the government levies a 20 per cent tax on labour. Now you need to pay Catherine around £12/hour in order for her to take home £10/hour – something you’re unwilling to do. Thus you don’t employ her, and the potential surplus isn’t realised and is lost forever.

Reducing taxes on capital: Like taxes on labour, taxes on capital also lead to deadweight loss. Instead of firms investing in capital stock in the UK, they decide to place it elsewhere. This has a negative effect on real wages because it lowers the marginal product of labour. By reducing taxes on capital, the government can increase the demand for the labour needed to make use of the additional capital.


Of course, the government has to raise revenue from somewhere (to pay for the National Health Service, education, road building, defence and security, and so on). Whether it does so by taxing capital, labour or goods, some amount of deadweight loss is inevitable. The point is that policy makers should levy taxes carefully in order to minimise deadweight loss.


Being careful with benefits: Overly generous benefits can be a strong disincentive to search for work. As a result, the rate of job finding reduces and the natural rate of unemployment increases. Of course, most people quite rightly want a fair benefit system that protects the most vulnerable in society, but economists start to worry when people able to work choose not to, or at least choose not to search seriously for work.

Ensuring labour market flexibility: Perhaps surprisingly, making it very difficult to fire workers can increase the natural rate of

unemployment. How? If firms know that firing someone who’s unproductive is difficult, they become reticent to hire. This can reduce the rate of job finding and increase the natural rate of unemployment.

Removing subsidies: Economists think that countries should specialise in producing those things that they can make comparatively better than other countries. For example, the UK is quite good at professional services such as consulting and accountancy but not very competitive at producing agricultural goods. Only the massive farming subsidies maintain the UK’s reasonably large agricultural sector. Economists think that this situation diverts factors of production away from their most productive use. Not to mention the fact that it spends large amounts of taxpayers’ money, leads to higher food prices (by blocking imports) and impoverishes farmers in poor countries. Removing subsidies reallocates capital and labour more efficiently and leads to lower unemployment and higher wages.