Types of Unemployment
Calculating the Unemployment Rate
The Costs of Unemployment
The Effect of Minimum Wage Laws on Unemployment
The Relationship Between Inflation and Unemployment

Types of Unemployment

Structural unemployment: Structural unemployment exists when job-seekers do not have the skills necessary to fill open positions. It implies that enough jobs are available in the economy for these job-seekers, but the people who make hiring decisions don't believe that the job-seekers are qualified for the positions which are available. Structural unemployment is often associated with changes in technology. New technology often requires new job skills, and jobs utilizing older technology are eliminated. Structural unemployment is considered to be part of the natural rate of unemployment.

Frictional unemployment: Frictional unemployment arises from the fact that there is always a time gap between the time when a person without a job starts actively looking for a job, and the time when that person finds a job. In a dynamic economy, many people will fall into this category at any point in time, including the time when the unemployment statistics are compiled. Frictional unemployment is considered to be part of the natural rate of unemployment.


Cyclical unemployment: Cyclical unemployment is associated with an economy that is operating at below its full-employment, or optimal, level of output. Cyclical unemployment is directly caused by a downturn in the business cycle. It is most closely associated with a recession. Since cyclical unemployment is caused by a downturn in the economy, it is not part of the natural rate of unemployment.

Seasonal unemployment: Seasonal unemployment is caused by the fact that some jobs have busy seasons and slow seasons. During the slow seasons, many workers are laid off, but expect to be rehired once the busy season returns. Seasonal unemployment is considered to be part of the natural rate of unemployment.

Calculating the Unemployment Rate

First, the formula used:

The unemployment rate is equal to the number of people classified as unemployed divided by the total labor force, expressed as a percentage.
This formula requires definitions of the terms used:

Unemployed persons: Only people without jobs who are actively looking for work are counted as being unemployed. This means that discouraged workers and others not active in a job search are not counted. The U.S. Department of Labor considers a person to be actively looking for work if that person is available for work and has looked for work within the past four weeks; or is waiting for a recall after being laid off; or is starting a job within 30 days.

Total labor force: The number of employed persons plus the number of persons counted as unemployed. This means that people with jobs are counted as employed, even though many of them may be considered underemployed. For example, they may be working part time but are looking for full time work. The formula used by the U.S. Department of Labor excludes the following residents from the total labor force: residents under 16 years of age, institutionalized adults, and adults who are neither working nor looking for work.

Other terms associated with a discussion of unemployment, even though they are not part of the unemployment rate calculations:

Discouraged workers: Discouraged workers are people without jobs who have given up looking for work. They are no longer active in their job searches. These people are not counted as being part of the total labor force, and are not counted as unemployed. They are not part of the unemployment statistics.

Total population: This is the number of people who live in the economy, including those who are too young to be counted as part of the labor force and those who are retired.

Working age population: The working age population includes every citizen 16 years of age or older. Retired persons are considered to be of working age.

Labor force participation rate: The percentage of the working age population that is counted in the total labor force. This includes those who are counted as employed as well as those who are counted as unemployed.
In the United States, the official unemployment statistics are compiled and published on a monthly basis by the Bureau of Labor Statistics, which is a division of the Department of Labor.

The Bureau of Labor Statistics compiles these statistics by taking an extensive survey of U.S. households. This survey is called the household survey.

Some people mistakenly believe that the unemployment rate is based on the number of claims for jobless benefits. Those numbers are compiled weekly, not monthly, and have nothing to do with the unemployment statistics.

An example of the calculation for the unemployment rate

The following example is based on a hypothetical economy using this data:

Total population: 100,000,000
Working age population: 75,000,000
Residents employed full-time: 40,000,000
Residents employed part-time: 15,000,000
Non-employed adults actively seeking employment: 5,000,000
Discouraged workers: 1,000,000

In this example, the number of employed persons is 55,000,000. For calculating labor statistics, it doesn't matter whether a person is employed full time or part time.

The number of unemployed persons is 5,000,000. Only those residents who are not employed and also are actively seeking work are counted as unemployed.

The total labor force is 60,000,000. This is the sum of those counted as employed and those counted as unemployed.

The labor force participation rate is 80%. This is the percentage of the working age population that is counted in the total labor force. In this example, that would be 60,000,000 divided by 75,000,000.

The unemployment rate is 8.33%. This is the percentage of the total labor force that is counted as unemployed. In this example, that would be 5,000,000 divided by 60,000,000.

How reliable are the official unemployment statistics? The household survey is extensive enough to be considered statistically significant, so the numbers should be reliable. But they ignore two important categories of citizens: the hidden unemployed and the hidden employed.

The hidden unemployed are mentioned above: they include discouraged workers and underemployed workers. Discouraged workers are people who are not working but have given up trying to find work. They want to work, but they have determined that nobody will hire them, so they have quit actively seeking work. They have looked for work in the past year, but not within the past four weeks. Underemployed workers are those who have jobs but are not using all of their productive potential. They are counted as employed, but they would prefer to be doing something more productive. This includes part time workers who would prefer to be working full time, and full time workers who have jobs that do not utilize their particular job skills.The hidden employed are workers in the underground economy. These are people with jobs and incomes that are unreported. As a result of not reporting their jobs, they may be counted as unemployed. These jobs are unreported for a variety of reasons. They represent unreported taxable income. Self-employment or employer / employee taxes are being avoided. Jobs may be unreported in order to avoid minimum wage laws or other regulations or reporting requirements. Income earned as a result of illegal activity is almost always unreported. Jobs may be unreported in order to avoid immigration laws.

The Costs of Unemployment

Unemployment has many negative consequences for society. Some of the important ones are:

GDP output gap
Distribution effect
Social costs

GDP Output Gap:

When unemployment increases, the nation's total output falls below potential output, reducing the standard of living. Potential GDP is the level of GDP when unemployment is at the natural rate of unemployment. When unemployment is higher than the natural rate, it creates a shortfall of GDP below potential GDP. This shortfall is called the output gap.

The natural rate of unemployment is also known as the non-accelerating inflation rate of unemployment (NAIRU). This is the lowest unemployment rate consistent with not putting upward pressure on prices and wages.

You may be accustomed to the term "full employment" instead of "natural rate of unemployment". Many economists are moving away from using the term "full employment" because it has caused confusion. Full employment does not mean zero unemployment, as its name may seem to imply. Frictional, structural, and seasonal unemployment always exist in a dynamic economy. "Natural rate of unemployment" implies a realistic level of output.
Measuring the natural rate of unemployment is difficult. It changes over time, and the GDP gap at any given time is difficult to measure. It is different in different countries with different policies and labor markets. Economists tend to agree that in the United States, the natural rate of unemployment varies over time between 4% and 7%.

Business investment falls during times of high unemployment, which could cause the future level of output to decrease as well.

How large is the GDP output gap for a given level of unemployment? One rule of thumb to measure the output gap is called Okun's Law. Okun's Law states that for every 1% that the unemployment rate increases above the natural rate of unemployment, the output gap increases by 2.5%. Okun's Law is quantified using this formula:

Okun’s Law:

((potential GDP minus actual GDP) divided by actual GDP) x 100 = (actual unemployment rate minus the natural unemployment rate).

Distribution Effect

High rates of unemployment do not affect everybody equally. Its negative impact is felt mostly by the unemployed persons themselves, and their families. These are the persons who suffer from a loss of income, a lower standard of living, and a loss of social status.

Moreover, high unemployment tends to impact disadvantaged demographic groups more than others. Young workers, unskilled workers, and minority groups tend to have higher rates of unemployment than other groups.
Unemployment tends to redistribute wealth from the lower classes to the upper classes.

Social Costs

High unemployment is associated with such social costs as high crime rates and alcoholism. Infrastructure and public services suffer due to lower tax revenues. Lower investments in education, combined with the negative effect of unemployment on the motivation of young people, can impact all of the costs associated with unemployment for future generations.

The Effect of Minimum Wage Laws on Unemployment

In the market for labor, a legal minimum wage is a price floor. The price in the labor market is the wage rate. An effective price floor would be set above the equilibrium price. This means that the supply of labor would be higher than the demand for labor at that price (wage rate). A surplus is the result. More people would be willing and able to work at that wage rate than businesses would be willing to hire at that wage rate. The number of workers hired would be lower than the number of workers who would have been hired at the equilibrium price in the absence of a minimum wage law. Fewer people will be employed and more people will be classified as unemployed. More people are out of work as a result.

It is important to note which groups of people will be affected by minimum wage laws. Minimum wage laws increase the cost of production. This means a decrease in the supply of goods and services, resulting in higher prices and lower quantities available for consumers.

Minimum wage laws do not just affect the wages of workers who work for minimum wage. If employers are forced to pay higher wages to their least productive and most inexperienced workers, they are also likely to raise the pay for more productive workers. This will allow them to provide an incentive to their workers to become more efficient. This also will mean higher production costs and the resulting decrease in supply. This will magnify the amount of the labor surplus, creating more unemployment.

Many small businesses and start-up companies are especially affected by minimum wage laws. These are the kinds of businesses that are most likely to depend on low labor costs in order to survive. One of the costs to society of minimum wage laws is the amount of economic growth that does not occur because of higher input prices preventing an increase in supply. Since small businesses tend to be the largest source of new jobs, this creates a permanently higher unemployment rate and a decrease in output. Perhaps the largest cost of minimum wage laws is one that cannot accurately be measured: the number of potential businesses that do not even get started because of higher labor costs. Probably many people have ideas for starting a business, but the ideas never materialize because the labor costs make them unfeasible. The mobility of people moving into the entrepreneur class is curtailed.

With all of the costs associated with minimum wage laws, why do they even exist at all? For one thing, the problems listed above are largely based on supply and demand theories which include assumptions – assumptions which may not apply in the real world. In addition, minimum wage laws are associated with benefits which should be weighed against the costs.

Many people rely on jobs that pay minimum wage for their living standards. These jobs are the only source of income for many people. It is not true, as many people have asserted, that minimum wage jobs only go to teenagers working part time, or that they are only short term situations for people working their way up the pay ladder. For many people, especially in rural areas, minimum wage jobs might be the only available options for working careers. For the people who have these jobs, the minimum wage laws may prevent poverty. Minimum wage laws also decrease the cost of welfare programs provided by the government. Such welfare represents a cost shift from employers who hire workers at low wages to taxpayers. In effect, welfare paid to workers who receive less than a livable wage is actually a taxpayer subsidy to employers.

Minimum wage laws have been developed largely as a result of market failure. Historical evidence points to workers being exploited by employers in the absence of government intervention. This kind of market failure means that workers are not always compensated for their contributions - for their increased productivity - as economic theory would suggest. Much historical evidence suggests that many employers will be exploit workers if they are legally allowed to do so. When this happens, the minimum wage laws may be the only way to keep a large percentage of the labor force from working at wages that are below poverty level. This point of view means that minimum wage laws are a source of correcting for existing market failure: In effect, minimum wage laws enhance - rather than decrease - market efficiency.

The amount of unemployment and its associated costs resulting from minimum wage laws may be greatly overstated. One reason is related to the elasticities of demand and supply. At the wage rate of an effective minimum wage, labor demand is lower than the labor supply. More people would be willing to work, but employers would be willing to hire fewer workers. The difference between the quantity of labor supplied and the quantity of labor demanded would be the amount that the minimum wage law creates an increase in unemployment. However, only a portion of this amount represents workers who would have had jobs in the absence of a minimum wage law. Only the amount by which the number of workers hired is below the free market equilibrium quantity - not the total below the labor supply curve - represents people who have lost jobs due to the minimum wage. The rest of the difference between supply & demand - the difference between the market equilibrium quantity of labor and the quantity of labor supplied at the minimum wage - represents people who wouldn't have had jobs anyway. They wouldn't have looked for work at the equilibrium rate, but they would look for work at the minimum wage rate. When they begin to look for work, they simply get reclassified from not in the labor force to unemployed. How much of the unemployment represents people who would have had jobs at the equilibrium rate, and how much simply represents people who are reclassified but wouldn't have jobs in either case, depends on the elasticities of supply and demand in the labor market.

The macroeconomic effect of an increase in wages is another reason that the amount and costs of unemployment due to a minimum wage law might be overstated. The economic model which is used to show that an effective minimum wage creates a surplus of labor does not show the effects of an increase in wages on demand for products and services. When people with a relatively high marginal propensity to consume receive more income, an obvious result will be an increase in demand for goods and services. Since labor is a derived demand, this will in turn create an increase in the demand for labor.

The macroeconomic effect of an increase in wages will offset the effects of a surplus in labor to some extent – perhaps even more than offset these effects. Unemployment will increase by a smaller amount – or perhaps even decrease – with a minimum wage increase when the macroeconomic effect is taken into consideration.

What does the historical record suggest about the effects of a minimum wage on unemployment?

Since the introduction of a minimum wage in the United States, the federal minimum wage has been increased 21 times – spread out over the years between 1939 and 2009. Looking at the results of each incident of a minimum wage increase over a two-year time frame – the year that the increase went into effect regardless of the time of year when the increase occurred, plus the full year following the increase so that the policy change would have time to affect the economy – the following results have occurred:

Number of times that the minimum wage has been increased, starting in 1939: 21
Number of times that production (as measured by real GDP) has increased: 17
Number of times that production (as measured by real GDP) has decreased: 4
Number of times that the number of jobs in the economy has increased: 17
Number of times that the number of jobs in the economy has decreased: 3
(The jobs numbers add up to 20 instances instead of 21, because the data for 1939 is not available)

The minimum wage increases have come at varying stages in the business cycle. It has been increased during recessions, it has been increased when the economy was in the process of recovering from recessions, it has been increased prior to recessions, and it has been increased at times far removed from recessions.

Out of the 21 times that the minimum wage has been increased:

10 occurred when the economy was already experiencing recessionary forces
3 occurred shortly after the economy had recovered from a recession
2 occurred shortly before the start of a recession
6 occurred at times unrelated to a recession

Nearly every time the federal minimum wage has increased, both production and the number of jobs have increased. There is no statistical correlation between minimum wage increases and the business cycle. This statistical evidence does not mean that an increase in the minimum wage will increase jobs and increase economic production. The general trend is for jobs and production to both increase over time whether or not a minimum wage increase goes into effect. However, claims that it will do the opposite – that a minimum wage increase will cause job losses and lower productivity – would be expected to show up as a statistical trend if the claims were true. No such trend is revealed by the historical evidence.

Businesses facing an increase in costs due to an increase in the minimum wage can respond by using one or some combination of the following:

They can decide that they cannot afford to stay in business, and shut down.
They can increase their prices, passing the additional costs on to their customers.
They can reduce the number of work hours that they hire, which involves decreasing production or increasing efficiency.
They can move production to another country with lower labor costs.
They can simply pay the extra labor costs by reducing profits.

Now, consider the types of industries which tend to employ minimum wage workers. You may be able to see which of the above options are available and likely to be utilized within specific industries.

The Relationship Between Inflation and Unemployment

The Phillips Curve

The Phillips Curve is a graph that illustrates the observed relationship between the inflation rate and the unemployment rate. It is a downward sloping curve, indicating that a trade-off exists between inflation and unemployment.
This has important implications for government policies which attempt to achieve economic stability. Expansionary policies may reduce unemployment at the expense of higher inflation. Contractionary policies may reduce inflation at the cost of higher unemployment. Activist government policies, then, require that the costs and benefits associated with such policies be considered.

Policies tend to adjust as economic realities change the perceived costs and benefits over time.

Why does the relationship between inflation and unemployment exist?

Economists have come up with a few possible reasons:

Leverage on wages
Production bottlenecks
Normal shifts in aggregate demand and aggregate supply

Leverage on Wages
Changes in the price level are closely related to changes in wage rates. In fact, the original Phillips Curve was developed to show the observed relationship between wage inflation - not price inflation - and unemployment. Economists at a later time changed it to show price inflation in part because of the close relationship between wage inflation and price inflation. Wages contribute a large share of the costs of production.

During times of economic expansion, profits are high and few replacement workers are available. Workers are in a good position to bargain for higher wages. Businesses would stand to lose profits if a labor strike occurred. With aggregate demand high, businesses can more easily pass along the increase in labor costs to their customers in the form of higher prices. In this situation, low unemployment occurs, resulting in upward pressure on wages and prices. Unemployment decreases while inflation increases.

However, when unemployment is high, businesses have more leverage than workers. Workers can more easily be replaced because of the large pool of unemployed workers. Sales and profits are low, so the opportunity costs of a strike will be relatively low. Workers know the possibility of unemployment is very real, and the priority of keeping a job increases relative to the priority of wage increases. In this situation, high unemployment occurs, resulting in little upward pressure on wages and prices. Unemployment increases while inflation decreases.

Production Bottlenecks
When output is low and unemployment is high, excess capacity exists. The economy will have little incentive for price increases. As aggregate demand picks up, output increases and unemployment decreases. Excess capacity decreases. As businesses reach capacity, they reach a limit of how much they can produce in the short run. As a result of increased demand and production limits, prices will increase. The result of this situation: Unemployment decreases while inflation increases.

Normal Shifts in Aggregate Demand and Aggregate Supply
The Aggregate Demand / Aggregate Supply model is a graph that plots a nation's price level against the level of real output. In this model, an increase in the price level would be equivalent to inflation. A decrease in output could be considered a substitute for unemployment, since unemployment tends to increase when output decreases.

This trade-off between inflation and unemployment would be associated with a shift in aggregate demand, since the aggregate demand curve is downward sloping. The aggregate supply curve is upward sloping.

A shift in aggregate supply would not indicate a trade-off between inflation and unemployment. When the aggregate supply curve shifts leftward, both inflation and unemployment will increase. This situation is called stagflation, usually caused by a supply shock.

Economic forces cause the aggregate demand and aggregate supply curves to shift constantly. The general trend over time, however, is for both curves to shift rightward. Aggregate demand shifts rightward as the money supply increases, and as household and government spending increase. Aggregate supply shifts rightward as resources (labor and capital) are increased, and as technology increases.

The normal trend is for aggregate demand to shift more than aggregate supply. When that happens - given that both curves tend to shift rightward - over time the new equilibrium created with each shift will show that prices increase when output increases. Since an output increase generally reflects a decrease in unemployment, this would create a normal trend that mirrors a trade-off between inflation and unemployment.

Many economists believe that in the long run, the actual unemployment rate will equal the natural rate of unemployment. In this case, the long run Phillips Curve is a vertical line at the natural rate of unemployment. According to this theory, no trade-off exists between inflation and unemployment in the long run.