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Assessing Costs of Unemployment--Labor Economics

Assessing Costs of Unemployment--Labor Economics

Author: Kate Eskra

This lesson will explain Assessing Costs of Unemployment--Labor Economics

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Source: Image of Business Cycle created by Kate Eskra

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Hi. Welcome to Economics. This is Kate. This tutorial is on Assessing Costs of Unemployment. It's a look into labor economics. As always, my key terms are in red and my examples are in green. So in this tutorial, we'll define and explain different types of unemployment. And the ones we'll talk about are frictional, structural, and cyclical. And you'll understand that the natural rate of unemployment is when the economy is operating at full capacity.

OK, so here's a business cycle. You'll see here, if we have our rate of growth in the economy, which is measured by our GDP, or our output, and then time on the x-axis, you can see it's very natural for the economy to go through periods of growth and contraction. So this is the economy during a period of expansion. There's some peak. And then we have a contraction. If they lasts six months or longer, we typically say we're in a recession. If it lasts a really long time, then we, perhaps, call it a depression. Then we hit a trough, and the whole thing starts over again.

Most people are concerned about things such as unemployment and inflation. So even as we go up and down, even if it's natural, people are always concerned about it. And so economists, what they're going to do is use a lot of different kinds of data to help them, first of all, predict where is the economy headed? So where are we going from where we are?

But we also want to talk about what has just occurred in the economy. And look at what is currently happening in the economy right now. So we look forward, we look back, and we look at right now. One of the biggest things that economists will do is calculate unemployment. So calculating unemployment and understanding it is a really big part of this business cycle. Unemployment does tend to rise during periods of contraction. And it falls whenever we're in a period of economic growth or expansion. OK.

But what's really important to understand is that there are different kinds of unemployment. So when they state the unemployment rate is that 7.8%, for example, well, what does that mean? What kinds of unemployment are people actually experiencing? And the key idea here is, that depending on the cause of unemployment or the type of unemployment, the government may or may not want to take action.

So the first type of unemployment we'll talk about is frictional. And frictional unemployment is defined as, "Natural separation from employment." So this underlies what will define later is the natural rate of unemployment. This is where employees are looking for positions that are, in fact, available.

OK. So this type of unemployment is normal. It is always going to exist. We're never going to have 0% of the population frictionally not unemployed. So we'll always have a certain level of population frictionally unemployed. For example, a recent college graduate is not necessarily going to find a job immediately the day they graduate. People who are making career changes-- this happens all the time. It's going to take some time to interview and make that change. And then finally, people relocating to a different city.

These are just three examples. But as you can tell, these are normal life events. It's natural separation from the labor force for a short period of time, generally. And it doesn't indicate that anything is wrong with the economy, because they're looking for jobs that are, in fact, out there. OK?

Now structural unemployment is different, Structural. unemployment is the unemployment resulting from changes in the structure of the economy. Well, what do we mean by that? OK. So our economy is constantly changing in how we produce goods and services. So structural unemployment can result from people's skills not matching the skills necessary for jobs. It can be caused by new technology, new resources, changes in consumer demand, globalization, or a lack of education.

So one of the classic examples that I've read in a lot of different economics textbooks is that the invention of computers, so a change in technology, really displaced, for example, typewriter repairers. We're not using typewriters anymore, so we don't need people to repair them. Those people would be structurally unemployed, because the economy changed the way that we do things. And so they would need to probably go back and get more training to get a job that they have skills for. So they would need to change their skill set to get a new job.

Again, although this type of unemployment can be very difficult for people and painful, and it's certainly not an easy type of unemployment for families who are going through it to deal with, it doesn't really suggest that anything is wrong with the economy. Would ever be desirable for our economy to stay completely stagnant and not change and not update how we do things? So I just wanted to note that.

OK. Now we come to cyclical unemployment. And this is the type of unemployment that follows that business cycle I showed you. It falls when the economy is in an expansion, and it increases as the economy goes through a contraction, or sometimes a recession. So this is the type that we see when our economy is slowing. And when we hear that we're in a recession or a depression, generally speaking, we have pretty high unemployment rates during those times.

So we know that some unemployment is inevitable. And for that reason, full employment does not mean, ever, that there is 0% unemployment. We have never had a 0% unemployment rate. And, in fact, although this seems odd, we wouldn't necessarily want to have 0% unemployment. If unemployment went that low, there would be amazing amounts of inflation. It would put so much upward pressure on prices that it would not actually be desirable.

OK. So here's this concept of full employment then. This really takes into consideration the production capacity of our economy at any given point in time. And so full employment is the best case scenario. It's what our economy can do given the constraints that we're facing right now, whether they're resource constraints, production constraints.

Well, we know that as time goes on, we're constantly developing new technologies. And if we, in fact, can sustain permanent growth, for example, through new technology, then more people can, in fact, be employed as those constraints are adjusted over time. OK?

So then, natural unemployment is defined as the unemployment rate consistent with this concept of full employment. Typically, it's considered to be somewhere around 5%. And like I said about frictional unemployment, those normal, natural situations that we're never not going to have, this type of unemployment, it's attributed to frictional.

So again, this is the unemployment that's occurring naturally due to imperfect information or people just changing jobs. And the rate of unemployment, when our economy is operating at full capacity, like I said, it's somewhere around 5%. Economists have debated whether it could go maybe as low as 4% or as high as even 6%, or so. But somewhere right around the ballpark of 5%.

Once unemployment reaches a level significantly higher than 5%, we know that we are experiencing, then, cyclical unemployment. OK? That type of unemployment where businesses just are not hiring people anymore because they're not facing us much demand, since the economy has slowed.

So just a couple of thoughts on unemployment. If we think about sustainable business practices, would there not be a long-run benefits to businesses of retaining their workers? Because that would create, then, stability of spending in the economy. The problem is, as soon as some businesses begin to lay off workers, it's very cyclical, like I showed you on that business cycle.

As soon as some workers are laid off, now they don't have money to spend, so then that creates an even further decline in demand for goods and services. So now more employers lay off workers. And it just keeps going. So if we could somehow get businesses to understand that if they just retained workers that would create more stable spending in the economy, huh! But, you know, everyone is doing what's in their best interests. And their best interests are profitability. So these practices really have not been adopted by public companies.

When it comes to financial reporting, companies have to sometimes make job cuts in a given quarter just to try to reduce costs to meet profitability that quarter, because they have to quarterly produce their financial reports. So again, here's that business cycle. So remember, we see unemployment rise during contractions and fall during expansions.

Is that counter intuitive? Just a question for you, because if we employed more workers, that would cause economic recovery. Keeping employees would be beneficial for earnings consistency. Yet, like we said, it rises here and falls during expansion. So just an idea to think about.

In this tutorial, we talked about the different types of unemployment-- frictional, structural, and cyclical. And we talked about how the natural rate of unemployment is when the economy is operating at full capacity. And we typically see that to be somewhere around 5%. Thank you so much for listening. Have a great day.

Terms to Know
Cyclical Unemployment

Unemployment that follows the business cycle; falls as the economy expands and increases as the economy slows.

Frictional Unemployment

Natural separation from employment; underlies the "natural rate of unemployment." Employees looking for positions that are available.

Natural Unemployment

The unemployment rate consistent with full employment; typically considered to be 5% and attributed to frictional unemployment.

Structural Unemployment

Unemployment resulting from changes in the structure of the economy.