Chapter 9

Unemployment and Its Natural Rate

SOLUTIONS TO TEXTBOOK PROBLEMS

Quick Quizzes

1. How is the unemployment rate measured? • How might the unemployment rate overstate the
amount of joblessness? How might it understate it?

The unemployment rate is measured through a survey of about 50 000 households to find out
the percentage of the labour force that is unemployed. The unemployment rate overstates the
amount of joblessness because some of those who report being unemployed may not, in fact, be
trying hard to find a job. But the unemployment rate understates the amount of joblessness
because discouraged searchers report being out of the labour force even though they want jobs.

2. How would an increase in the world price of oil affect the amount of frictional unemployment? Is
this unemployment undesirable? What public policies might affect the amount of unemployment
caused by this price change?

An increase in the world price of oil increases the amount of frictional unemployment as oil -
producing firms increase output and employment, but other firms, such as those in the auto
industry, reduce output and employment. The sectoral shift from the auto industry to oil firms
causes higher frictional unemployment for a time until workers have shifted from the auto
industry to the oil industry. Although no increase in unemployment is really desirable, this type of
frictional unemployment is necessary to reallocate resources between different sectors. Public
policies that might affect the unemployment caused by this change in the price of oil include
employment agencies, which can help auto workers move into the oil industry, job-training
programs to help workers adapt to a new industry, and unemployment insurance, which keeps
workers from suffering economic hardship while changing from one industry to another.

3. Draw the supply curve and the demand curve for a labour market in which the wage is fixed
above the equilibrium level. Show the quantity of labour supplied, the quantity demanded, and
the amount of unemployment.

Figure 1 shows the supply curve ( S ) and the demand curve ( D) for labour. The wage (W) is
above the equilibrium wage ( WE ). The result is unemployment, equal to the amount by which
labour supply (LS ) exceeds labour demand ( LD ).

Copyright © 2017 Nelson Education Ltd.

94 • Chapter 9: Unemployment and Its Natural Rate

Quantity of
Labour

Figure 1

4. How does a union in the auto industry affect wages and employment at General Motors and
Ford? How does it affect wages and employment in other industries?

A union in the auto industry raises the wages of workers employed by General Motors and Ford
by threatening to strike. To prevent the costs of a strike, the firms generally pay higher wages
than they would if there were no union. However, the higher wages reduce employment at
General Motors and Ford. Wages and employment in other industries are affected since
unemployed autoworkers seek jobs elsewhere, reducing wages and increasing employment.

5. Give four explanations for why firms might find it profitable to pay wages above the level that
balances quantity of labour supplied and quantity of labour demanded.

There are four reasons why firms might find it profitable to pay wages above the level that
balances the quantity of labour supplied and the quantity of labour demanded: (1) to ensure that
workers are in good health so they will be more productive; (2) to reduce worker turnover
because it is costly to hire new workers; (3) to make workers eager to keep their jobs, thus
discouraging them from shirking; and (4) to attract a better pool of workers.

Questions for Review

1. What are the three categories into which Statistics Canada divides everyone? How does Statistics
Canada compute the labour force, the unemployment rate, and the labour -force participation
rate?

Statistics Canada categorizes each adult (15 years of age and older) as either employed,
unemployed, or not in the labour force. The labour force consists of the sum of the employed
and the unemployed. The unemployment rate is the percentage of the labour force that is
unemployed. The labour-force participation rate is the percentage of the total adult population
that is in the labour force.

Copyright © 2017 Nelson Education Limited

 Chapter 9: Unemployment and Its Natural Rate • 95

2. Employment Insurance provides an economic incentive that encourages people to enter the
labour force. Explain.

The EI program increases the total income people receive by working. They not only earn a wage
while working, but they also become eligible to collect EI benefits should they leave their job.

3. Why is frictional unemployment inevitable? How might the government reduce the amount of
frictional unemployment?

Frictional unemployment is inevitable because the economy is always changing. Some firms are
shrinking while others are expanding. Some regions are experiencing faster growth than other
regions. Transitions of workers between firms and between regions are accompanied by
temporary unemployment.

The government could help to reduce the amount of frictional unemployment by public policies
that provide information about job vacancies in order to match workers and jobs more quickly,
and through public training programs that help ease the transition of workers from declining to
expanding industries and help disadvantaged groups escape poverty.

4. Are minimum-wage laws a better explanation for structural unemployment among teenagers or
among postsecondary graduates? Why?

Minimum-wage laws are a better explanation for unemployment among teenagers than among
postsecondary graduates. Teenagers have fewer job-related skills than postsecondary graduates
do, so their wages are low enough to be affected by the minimum wage. Postsecondary
graduates’ wages generally exceed the minimum wage.

5. How do unions affect the natural rate of unemployment?

Unions may affect the natural rate of unemployment via the effect on insiders and outsiders.
Since unions raise the wage above the equilibrium level the quantity of labour demanded declines
while the quantity supplied of labour rises, so there is unemployment. Insiders are those who
keep their jobs. Outsiders, workers who become unemployed, have two choices: either get a job
in a firm that is not unionized or remain unemployed and wait for a job to open up in the union
sector. As a result, the natural rate of unemployment is higher than it would be without unions.

6. What claims do advocates of unions make to argue that unions are good for the economy?

Advocates of unions claim that unions are good for the economy because they are an antidote to
the market power of the firms that hire workers and they are important for helping firms respond
efficiently to workers’ concerns.

7. Explain four ways in which a firm might increase its profits by raising the wages it pays.

Four reasons why a firm’s profits might increase when it raises wages are: (1) better paid
workers are healthier and more productive; (2) worker turnover is reduced; (3) worker effort is
increased; and (4) the firm can attract higher quality workers.

Copyright © 2017 Nelson Education Ltd.

96 • Chapter 9: Unemployment and Its Natural Rate

Quick Check Multiple Choice

1. The population of Ectenia is 100 people: 40 work full-time, 20 work half-time but would prefer to
work full-time, 10 are looking for a job, 10 would like to work but are so discouraged they have given
up looking, 10 are not interested in working because they are full-time students, and 10 are retired.
What is the number of unemployed in Ectenia?
a. 10
b. 20
c. 30
d. 40

2. Using the numbers in the preceding question, what is the size of Ectenia’s labour force?
a. 50
b. 60
c. 70
d. 80

3. The main policy goal of the employment insurance system is to reduce which of the following?
a. the search effort of the unemployed
b. the income uncertainty that workers face
c. the role of unions in wage setting
d. the amount of frictional unemployment

4. According to the most recent data, among workers who are paid at an hourly rate, about what
percent have jobs that pay at or below the minimum wage?
a. 2 percent
b. 6 percent
c. 15 percent
d. 40 percent

5. Unionized workers are paid more than similar nonunion workers by about what percent?
a. 2 to 5
b. 5 to 10
c. 10 to 20
d. 40

6. Which of the following is true according to the theory of efficiency wages?

a. firms may find it profitable to pay above-equilibrium wages
b. an excess supply of labour puts downward pressure on wages
c. sectoral shifts are the main source of frictional unemployment
d. right-to-work laws reduce the bargaining power of unions

1. a
2. c
3. b
4. b
5. c
6. a

Copyright © 2017 Nelson Education Limited

 Chapter 9: Unemployment and Its Natural Rate • 97

Problems and Applications

1. Statistics Canada announced that in May 2015, of all Canadians aged 15 years and older,
17 953 800 were employed, 1 307 600 were unemployed, and 9 970 800 were not in the labour
force. How big was the labour force? What was the labour-force participation rate? What was the
unemployment rate?

The labour force consists of the number of employed (17 953 800) plus the number of
unemployed (1 307 600), which equals 19 261 400. To find the labour-force participation rate,
we need to know the size of the adult population. Adding the labour force (19 261 400) to the
number of people not in the labour force (9 970 800) gives the adult population of 29 232 200.
The labour-force participation rate is the labour force (18 865 300) divided by the adult
population (29 232 200) times 100 percent, which equals 65.9 percent. The unemployment rate
is the number of unemployed (1 307 600) divided by the labour force (19 261 400) times 100
percent, which equals 6.8 percent.

2. As shown in Figure 9.3, the overall labour-force participation rate of men declined between 1976
and 1997. This overall decline reflects different patterns for different age groups, however, as
shown in the following table.

Men
All Men Men 15–24 Men 25–54 55 and Over
1976 78% 68% 95% 48%
1997 72 63 91 33

Which group experienced the largest decline? Given this information, what factor may have
played an important role in the decline in overall male labour-force participation over this period?

Men aged 55 and over experienced the greatest decline in labour-force participation. Older men
now retire earlier and live longer.

3. The labour-force participation rate of women increased sharply between 1976 and 1997, as
shown in Figure 9.3. As with men, however, there were different patterns for different age
groups, as shown in this table:

Women Women Women

All Women 15–24 25–54 55 and Over
1976 46% 58% 52% 18%
1997 57 59 76 17

Why do you think that younger women experienced a bigger increase in labour-force participation
than older women?

Younger women experienced a bigger increase in labour-force participation than older women
because more of them have entered the labour force (in part because of social changes), so
there are more two-career families. In addition, women have delayed having children until later
in life and have reduced the number of children they have, so they are in the labour force for a
greater proportion of their lives than was the case previously.

Copyright © 2017 Nelson Education Ltd.

98 • Chapter 9: Unemployment and Its Natural Rate

4. Between 2008 and 2009, total employment in Canada decreased by 277 000 workers, but the
number of unemployed workers increased by 400 000. How are these numbers consistent with
each other?

The fact that employment decreased by 277 000 while unemployment increased by 400 000 is
consistent with an increase in the labour force of 123 000 (= 400 000 − 277 000). The labour
force is equal to the number of employed plus the number of unemployed. Since the labour force
does not remain constant, the change in unemployment does not have to mirror the change in
employment.

5. Go to the Government of Canada’s website at http://srv129.services.gc.ca/rbin/eng/postalcode_

search.aspx and enter your postal code. You will be told the unemployment rate in your region,
the number of hours of employment you will need to quality for EI benefits, and the number of
weeks you will be eligible to collect EI, depending on your recent employment history. Now enter
a postal code for someone living in an area of the country with a much different unemployment
rate from that in your area. How might these differences influence labour market behaviour in
one region versus the other?

Many answers are possible.

6. Are the following workers more likely to experience short-term or long-term unemployment?
Explain.
a. a construction worker laid off because of bad weather
b. a manufacturing worker who loses her job at a plant in an isolated area
c. a stagecoach-industry worker laid off because of competition from railroads
d. a short-order cook who loses his job when a new restaurant opens across the street
e. an expert welder with little formal education who loses her job when the company
installs automatic welding machinery

a. A construction worker who is laid off because of bad weather is likely to experience
short-term unemployment, since the worker will be back to work as soon as the weather
clears up.

b. A manufacturing worker who loses her job at a plant in an isolated area is likely to
experience long-term unemployment, since there are probably few other employment
opportunities in the area. She may need to move somewhere else to find a suitable job,
which means she will be out of work for some time.

c. A worker in the stagecoach industry who was laid off because of the growth of railroads
is likely to be unemployed for a long time. The worker will have a lot of trouble finding
another job when his entire industry is shrinking. He will probably need to gain additional
training or skills to get a job in a different industry.

d. A short-order cook who loses his job when a new restaurant opens is likely to find
another job fairly quickly, perhaps even at the new restaurant, and thus he will probably
have only a short spell of unemployment.

e. An expert welder with little formal education who loses her job when the company
installs automatic welding machinery is likely to be without a job for a long time, since
she lacks the technological skills to keep up with the latest equipment. To remain in the
welding industry, she may need to go back to school and learn the newest techniques.

Copyright © 2017 Nelson Education Limited

 Chapter 9: Unemployment and Its Natural Rate • 99

7. Using a diagram of the labour market, show the effect of an increase in the minimum wage on
the wage paid to workers, the number of workers supplied, the number of workers demanded,
and the amount of unemployment.

Quantity of
Labour

Figure 2

Figure 2 shows a diagram of the labour market with a binding minimum wage. The initial
equilibrium with minimum wage m1 has quantity of labour supply L1S greater than the quantity of
labour demanded L1D , with unemployment equal to L1S – L1D . An increase in the minimum wage
to m2 leads to an increase in the quantity of labour supplied to L2S and a decrease in the quantity
of labour demanded to L2D . As a result, unemployment increases as the minimum wage rises.

8. Do you think that firms in small towns or in cities have more market power in hiring? Do you
think that firms generally have more market power in hiring today than 50 years ago, or less?
How do you think this change over time has affected the role of unions in the economy? Explain.

Firms in small towns have more market power in hiring because there are fewer opportunitie s for
workers to find jobs elsewhere. Firms generally have less market power now than they used to,
since it is now easier for employees to travel farther to go to work. This change in the market
power of firms has reduced the need for unions, since competition from other firms keeps
workers’ wages and benefits high and reduces the need for collective bargaining.

Copyright © 2017 Nelson Education Ltd.

100 • Chapter 9: Unemployment and Its Natural Rate

9. Consider an economy with two labour markets, neither of which is unionized. Now suppose a
union is established in one market.
a. Show the effect of the union on the market in which it is formed. In what sense is the
quantity of labour employed in this market an inefficient quantity?
b. Show the effect of the union on the nonunionized market. What happens to the
equilibrium wage in this market?

a. Figure 3 illustrates the effect of a union being established in one labour market. When
one labour market is unionized, shown in the figure on the left, the wage rises from w1U
to w2U and the quantity of labour demanded declines from U1 to U2D . Since the wage is
higher, the quantity supplied of labour increases to U2S , so there are U2S – U2D
unemployed workers in the unionized sector. The quantity of labour employed in this
market is inefficient, since more workers would like to have jobs at the existing wage.

b. When those workers who become unemployed in the union sector seek employment in
the nonunionized market, shown in the figure on the right, the supply of labour shifts to
the right from S 1 to S 2. The result is a decline in the wage in the nonunionized sector
from w1N to w2N and an increase in employment in the nonunionized sector from N1 to
N2.

Quantity of Quantity of
Labour Labour

Figure 3

Copyright © 2017 Nelson Education Limited

 Chapter 9: Unemployment and Its Natural Rate • 101

10. It can be shown that an industry’s demand for labour will become more elastic when the demand
for the industry’s product becomes more elastic. Let’s consider the implications of this fact for the
Canadian automobile industry and Unifor, the union that represents Canadian autoworkers.
a. What happened to the elasticity of demand for Canadian cars when the Japanese
developed a strong auto industry? What happened to the elasticity of demand for
Canadian autoworkers? Explain.
b. As the chapter explains, a union generally faces a tradeoff in deciding how much to
raise wages because a larger increase is better for workers who remain employed but
also results in a greater reduction in employment. How did the rise in auto imports
from Japan affect the wage–employment tradeoff faced by Unifor?
c. Do you think the growth of the Japanese auto industry increased or decreased the gap
between the competitive wage and the wage negotiated by Unifor? Explain.

a. When the Japanese developed a strong auto industry, Canadian auto demand became
more elastic as a result of increased competition. With more elastic demand for autos,
the elasticity of demand for Canadian autoworkers increased.

b. Since the rise in auto imports made the demand for autoworkers more elastic, to
maintain a higher-than-competitive wage rate requires a greater reduction in the quantity
of labour demanded. So the union had to choose between allowing the union wage to
decline or facing the loss of many jobs.

c. Given the tradeoff faced by the union, the growth of the Japanese auto industry forced
the union wage to move closer to the competitive wage.

11. Some workers in the economy are paid a flat salary and some are paid by commission. Which
compensation scheme would require more monitoring by supervisors? In which case do firms
have an incentive to pay more than the equilibrium level (as in the worker -effort variant of
efficiency-wage theory)? What factors do you think determine the type of compensation firms
choose?

Workers need to be monitored if they earn a flat salary but little monitoring is needed under a
commission structure. Under a system with flat salaries, the wage needs to exceed the
equilibrium wage to encourage greater effort by workers. The wage need not exceed the
equilibrium wage under a system with commissions, since workers can choose their level of effort
and get paid in proportion to their effort. The factors that determine the type of compensation
scheme include the cost of monitoring, the willingness of workers to bear risk under the
commission scheme, and the interdependence of tasks.

Copyright © 2017 Nelson Education Ltd.

102 • Chapter 9: Unemployment and Its Natural Rate

12. Structural unemployment is sometimes said to result from a mismatch between the job skills that
employers want and the job skills that workers have. To explore this idea, consider an economy
with two industries: auto manufacturing and aircraft manufacturing.
a. If workers in these two industries require similar amounts of training, and if workers at
the beginning of their careers could choose which industry to train for, what would you
expect to happen to the wages in these two industries? How long would this process
take? Explain.
b. Suppose that one day the economy opens itself to international trade and, as a result,
starts importing autos and exporting aircraft. What would happen to demand for
labour in these two industries?
c. Suppose that workers in one industry cannot be quickly retrained for the other. How
would these shifts in demand affect equilibrium wages both in the short run and in the
long run?
d. If for some reason wages fail to adjust to the new equilibrium levels, what would
occur?

a. Wages in the two manufacturing industries should eventually become equal. If one
industry would consistently pay higher wages, more workers would choose to train for
that industry and labour supply would increase, driving down wages in that industry. This
adjustment process may take a few years, since training takes time.

b. The labour demand in the auto industry falls and in the aircraft industry rises. Wages rise
in the aircraft industry and fall in the auto industry in the short run.

c. In the long run more workers would choose to (re)train for the aircraft industry and
wages again equalize.

d. If wages stay high in the auto industry they send the wrong signal to new workers, who
do not make the right decision to train for the aircraft industry. There is going to be
structural unemployment in the auto industry and it takes longer until workers learn that
it is harder to find a job in the auto industry and they should train for the aircraft
industry.

13. (This problem is challenging.) Suppose that Parliament passes a law requiring employers to
provide employees some benefit (such as dental care) that raises the cost of an employee by $4
per hour.
a. What effect does this employer mandate have on the demand for labour? (In
answering this and the following questions, be quantitative when you can.)
b. If employees place a value on this benefit exactly equal to its cost, what effect does
this employer mandate have on the supply of labour?
c. If the wage is free to balance supply and demand, how does this law affect the wage
and the level of employment? Are employers better or worse off? Are employees
better or worse off?
d. If a minimum-wage law prevents the wage from balancing supply and demand, how
does the employer mandate affect the wage, the level of employment, and the level of
unemployment? Are employers better or worse off? Are employees better or worse
off?
e. Now suppose that workers do not value the mandated benefit at all. How does this
alternative assumption change your answers to parts (b), (c), and (d) above?

Copyright © 2017 Nelson Education Limited

 Chapter 9: Unemployment and Its Natural Rate • 103

a. If a firm was not providing such benefits prior to the legislation, the curve showing the
demand for labour would shift down by exactly $4 at each quantity of labour, because
the firm would not be willing to pay as high a wage given the increased cost of the
benefits.

Quantity of
Labour

Figure 4

b. If employees value the benefit by exactly $4 per hour, they would be willing to work the
same amount for a wage that’s $4 less per hour, so the supply curve of labour shifts
down by exactly $4.

c. Figure 4 shows the equilibrium in the labour market. Since the demand and supply
curves of labour both shift down by $4, the equilibrium quantity of labour is unchanged
and the wage rate declines by $4. Both employees and employers are just as well off as
before.

d. If the minimum wage prevents the wage from falling, the result will be increased
unemployment, as Figure 5 shows. Initially, labour supply is L1S and labour demand is
L1D , so unemployment is given by L1S – L1D . The downward shift of both the demand and
supply curves gives a new equilibrium with labour supply L2S , labour demand L2D , and
unemployment L2S – L2D . The wage is unchanged, the level of employment declines, and
the level of unemployment rises. Employers are worse off because they hire less labour
at a higher wage (including benefits). The workers who become unemployed are worse
off because of the policy, while workers who remain employed are better off, since their
wages plus benefits have increased.

Copyright © 2017 Nelson Education Ltd.

104 • Chapter 9: Unemployment and Its Natural Rate

Quantity
of Labour

Figure 5

Quantity
of Labour

Figure 6

e. If the workers do not value the mandated benefit at all, the supply curve of labour does
not shift down. As a result, in part (c), the wage rate will decline by less than $4 and the
equilibrium quantity of labour will decline, as shown in Figure 6. The new wage, w2, will
be less than w1, but greater than w 1 – $4. Employers are worse off, since they now pay a
greater total wage plus benefits for fewer workers. Employees are worse off, since they
get a lower wage and work less.

With a minimum wage in effect, as in part (d), the impact on unemployment is not as
bad as when the workers valued the benefits. Looking back at Figure 5, the only
difference is that the labour-supply curve does not shift, so the equilibrium quantity of
labour supplied stays the same at L1S . So the wage stays the same, labour demand
declines, labour supply is unchanged, and unemployment rises. As before, employers are
worse off since they get less labour at a higher wage plus benefits. Employees are worse
off, too, since there is less employment at the same wage.

Copyright © 2017 Nelson Education Limited