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>> Today we're going to

talk about unemployment.
Unemployment's a very important
topic in economic theory,
in economic policy, and also in
our own real-world experiences.
It can be difficult
to get a job.
On the other side of the market,
for firms, sometimes it's hard
to find an employee
to fill a vacancy.
That is, it's hard to find
exactly the right employee, or,
if you're a worker
looking for a job,
it's hard to find
exactly the right job.
So the classical
theory has very little
to say about unemployment.
If we represent the market by
a supply and demand diagram,
let's put the wage
on the vertical axis.
After all, the wage
is the price of labor.
Labor supply, I'm going to draw
as though it were
upward sloping.
It doesn't have to be, but let's
assume that it is upward sloping
for the sake of discussion.
I'm going to draw labor
demand as downward sloping.
That has to be downward
sloping because the idea is
when wages are higher, firms
want to employ less labor.
So the classical
economic approach is
to say the market
equilibrates at a wage
where supply equals demand.
Let's call it W-star for
the equilibrium wage,
and let's say the quantity
of labor is L-star.
It doesn't mean everybody's
working 24 hours a day
and 7 days a week, of course.
But it means that at the wage
W-star, workers are working
as much as they'd like and,
similarly, firms are employing
as much labor as
they would like.
There is no unemployment because
even though people may not be
working 24 hours a
day, they're working
as much as they would like.
Now, of course, you could
try to amend the theory.
For example, if the wage
were, for some reason,
above the equilibrium wage,
then what you can see is
supply will exceed demand.
There's excess supply
of labor at that wage.
One might call that unemployment
because workers would
like to work a lot more
than firms want to hire and,
therefore, workers, some of
them, are going to be rationed.
It's not a crazy theory,
but it misses one point.
In the real world, not
only are there some workers
who have currently no job,
there are also some employers
who currently have
unfilled vacancies.
So if the wage is above
the equilibrium wage,
you get workers who aren't
working as much as they like,
but firms are hiring
as many workers
as they would like at that wage.
Now, symmetrically, the
wage might be too low.
In that case, you can see
there's excess demand for labor.
Workers are only
working a certain amount
because the wage is low.
Firms would like to hire more,
but the supply is
not forthcoming.
So there you can have
unfilled vacancies.
What the classical
theory cannot explain is
that there are simultaneously
some workers out of work looking
for a job and some firms
with unfilled vacancies.
In equilibrium, you
have neither.
When the wage is too high or
too low, you might have one
or the other, but
you can't have both.
This is where the study of
markets with frictions comes in.
>> So while the classical theory
of the labor market is
interesting for lots of reasons,
and it has many insights that
we can use in policymaking
and understanding
the real world,
it cannot simultaneously
generate unfilled vacancies
and people looking for work.
The modern theory of the labor
market takes friction seriously
in the sense that it takes
time and other resources
to fill a vacancy,
and it takes time
and other resources
to find a job.
The branch of theory
that we're going
to use is called search theory.
Search theory, in
general, is the theory
of looking for anything.
You could be looking to buy a
house, looking to find a spouse.
You could be looking to
sell your car or buy a car.
And for this application,
we're going to talk
about people looking
to find a job.
We'll come back to the firms
trying to fill vacancies later.
For now let's focus on the side
of the market which corresponds
to labor supply, that is
workers trying to find a job.
So I'm going to give a very
simple theoretical model.
It can be generalized and
made much more intricate,
but let's not try to
run before we walk.
The model's going
to look like this.
I have some assumptions.
Assumption one.
Only the unemployed search.
The employed do not look
for better jobs while
they're currently working.
That assumption is, of course,
important to generalize,
but let's start slow.
So what we can say is
that jobs last forever.
This means that once you
take a job, you're done.
Second assumption.
While you're unemployed,
you're going to sample wages.
Now let's assume you get
one offer per period.
That offer will be denoted at
a lower case w. It's the wage,
just like in the classical
theory, but it's going
to be a random variable.
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That is, any given period --
a period could correspond
to a month, or three months,
or a year, depending on
the application at hand.
So for our purposes, a period
is some length of a time,
and each period you're going
to get a random wage offer.
I'm going to call it
a wage, but of course,
jobs have many characteristics.
There could be prestige
considerations,
do you get a corner
office, perks and benefits.
That's all summarized, for
this talk, by the wage.
Now let's also assume
if you turn down a job,
you cannot later call them back
and say I've changed my mind.
We call that No Recall, an offer
which is rejected
is lost forever.
Again, that's easy
to generalize,
but let's do the
simple case first.
So what do you get
when you're working?
You get some wage.
What do you get when
you're not working?
Well, let's denote it by B,
B for unemployment
insurance benefits.
Actually it captures a lot
of other things as well.
It could be the value
of leisure.
You could be doing
some home production.
Whatever you're doing, and
whatever you're getting,
let's denote it by B. The only
other assumption we need is
that agents discount the future.
There's some discount
rate in economics.
Beta is typically what we
use for the discount rate.
And beta is a number
less than one.
What it means is a wage
next period is worth less
than a wage this period.
You'd rather have
it now than later.
How much less?
Well $1 next period is worth
beta, less than $1 today.
>> So based on those five
assumptions, what would you do
if you were looking for a job?
I'm going to describe it in
terms of a couple of equations,
which may look complicated,
but they're very easy
to understand once we talk
about them just a little bit.
So the first thing
I want to work
out is what's the
value of a job?
Let's say upper case W is what
you value a job while working.
And it's going to be a function,
of course, of the wage.
So upper case W is a function
of lower case W. What do you get
when you're employed at wage W?
Well, the first thing you get
is you get the wage, W. Now,
next period, which we
discount at rate beta,
you get something else.
Because jobs last forever,
and because this world is
not changing over time,
and you're not growing older,
what you get tomorrow is the
same as what you get today,
W of W. This says that the value
of a job is the current wage
plus the continuation value.
Next period, you
keep the same job.
This equation is pretty simple.
I can solve it.
The value of a job
is just lower case W,
the wage, over 1 minus beta.
How'd I get that?
Well, I moved upper case
W to the left-hand side,
grouped terms, and divided.
This is the present
discounted value
of earning W per period forever.
The second equation I'm going
to need is the value
to being unemployed.
Let's denote that by upper
case U. So what do you get
when you're unemployed?
By similar logic you get
your current reward, B,
that was our definition for
the value of being unemployed
within a period, and the
next period, which, as usual,
we discount at rate beta,
you get something else.
What do you get?
Well, by assumption
you get a job offer.
Now when you get a job offer,
you don't have to take it.
Why might you not take it?
You might want to hold
out for a better offer
from some other employer.
What you do is you
take the maximum payoff
to either accepting
or rejecting.
If you accept, well, upper case
W is our definition of the value
to working at that job.
If you reject, well, upper
case U is, by definition,
the value to remaining
unemployed.
It's almost the final
version of the equation.
You may notice I left
a little space there.
I want to put in
E for expectation.
What does that mean?
Well, recall that
the wage is random.
It may be high, it may be
low, it may be middling.
So you have to form
some expectations.
Technically, it's
simply the average.
So, for example, if the
wage is either 1 or 10,
each with a probability
one-half,
then the average offer is
1 plus 10 is 11 over 2.
Now I'm taking the expectation
over something more
tricky, not just the wage.
It's the expected value
of either accepting
or rejecting, whichever
is greater.
>> Okay, let's try to
represent those two equations
in terms of a simple diagram.
What I'll do is put the wage,
lowercase w on the
horizontal axis,
and now I'll draw the two
functions we just discussed.
The first one's pretty easy.
The value to working
at wage w is,
you may recall, w
over 1 minus beta.
The present discounted value
of working at wage w forever.
Well, that's just the
line through the origin.
It's a linear equation
with a slope,
1 over 1 minus beta
and 0 intercept.
So, I've depicted the value to
working at a job that pays w
as a function of w, by
this upward sloping line.
The other function's
even easier; u,
the value of being unemployed
doesn't depend on the wage,
because you don't have a
wage when you're unemployed.
What you do is you search, and
you try to find a good wage.
So, that's just a number.
That is to say, it's a
horizontal line as a function
of w. Now, from this picture,
the optimal search
strategy is quite clear.
Let's denote the
intersection of those two lines,
the horizontal line and the
upward sloping line representing
respectively the value of
being unemployed, and the value
of working at a particular
wage by the letter R. R stands
for reservation, because
that's your reservation wage
in technical jargon.
What it means is, you're
indifferent between working
at the wage R or continuing
to search for a better wage.
So, the strategy is clear, if
you get an offer less than R,
you should reject that offer;
since by definition you're
indifferent between working
at the reservation wage
and continuing to search,
you strictly prefer searching
at any wage below
the reservation wage.
And, symmetrically, for any wage
above the reservation
wage, you should accept.
Again, you're indifferent
between working between working
at wage R and continuing the
search, so if you get an offer
above R, you should accept.
The search strategy
is therefore clear;
agents should compute
the reservation wage,
the wage at which they're
indifferent between continuing
to search and starting to work,
and sample offers over time,
until they get an offer
above the reservation wage.
At that point, they
start working.
We're going to use this theory
to talk about the duration
of unemployment, and then later
about the unemployment rate.
But, we've got the
critical first piece.
It's the decision of workers
to accept or reject offers.
>> Okay we determined the
optimal search strategy
as the determination of
a reservation wage, R,
such that you're
indifferent between working
and continuing to search.
Let me show you how to figure
out in more detail
what R should be.
First off since the value
to working at any wage
by definition is W of that
wage, the value to working
at the reservation wage is W of
R. Now since you're indifferent
between working at the
reservation wage and continuing
to search, W of R must equal
U. U, after all, is the value
of continuing to search.
Now I'll re-write the
left hand side as follows.
Since the value to
working at any wage, W,
is simply W over one minus
beta, in particular the value
to working at the reservation
wage is R over one minus beta.
Now the right hand side
I'll also re-write.
The value to searching
is U and that equals B:
unemployment benefits, plus
leisure, plus other things;
plus next period you
will get a new offer.
You discount so I must put
in beta, the discount factor;
then it's going to
be a random offer -
I have to put in
your expectation.
You have to average over
different possible offers.
Then I have to put,
you may recall,
this maximization operator
because when you get an offer
next period you may accept it
or reject it.
If you accept it, I'm
going to plug in the value
of accepting that job.
As I say, that's W
over one minus beta.
Remember the W is random, that's
why we have the expectation.
If you reject the offer,
you continue to search
and I've just convinced you
of the fact that the value
to searching is R over one minus
beta, so let's plug that in.
That's basically
the final answer.
You may choose to re-write
it by multiplying both sides
by one minus beta;
it's slightly nicer.
The reservation wage will be one
minus the discount factor times
the value, the instantaneous
terms
of being unemployed including
benefits, leisure, etc..
Plus you see when I multiply
by one minus beta it's going
to cancel inside the
maximization operator?
So I'm left with
something pretty nice.
This is one equation
and one unknown.
This equation determines
the reservation wage.
Now the exact formula for the
reservation wage will depend
on parameters like B,
beta, and the distribution
of possible wage offers.
So I'm not going to try to
give you an exact answer;
it's going to depend
on many things.
This one equation and one
unknown is enough for us
to understand unemployment.
>> Okay, we've seen now what the
optimal job search strategy is.
You should choose a
reservation wage R. We've talked
about how to determine that.
And then you should
keep searching
until you get a job offer where
the wage exceeds R, then accept.
So the actual reservation
wage solves
that reservation wage equation.
It determines R but it will be
a function of the parameters
of the problem including,
for example,
beta and B. Now it's not
hard if you know calculus
to take a derivative
and show the following:
if beta is higher, the
reservation wage will be higher.
Similarly, if B is higher, the
reservation wage will be higher.
It's fairly intuitively obvious.
If beta is higher,
you put more weight
on the future - you
discount less.
So you're leaning more
towards getting a good offer.
You're willing to
hold out longer.
In fact, if beta were 0 that
would mean you don't care
about the future at all.
You only value your
current income.
In that case, go back and check
the reservation wage equation.
It's obvious that
when beta equals 0,
R equals B. That means your
reservation wage is simply equal
to the value of being
unemployed.
Now similarly, when B goes
up you can take a derivative
if you know calculus
and show logically
that the reservation
wage must be higher.
That's also fairly clear.
If unemployment insurance
for example is higher,
it's less painful being
unemployed - you're more willing
to hold out for a better job.
Let me introduce one
more new variable: gamma,
the Greek letter gamma.
And that's going to be
simply the probability
of getting a job.
That's simply W greater
than R. In other words,
you accept a job whenever the
offer exceeds the reservation
wage, therefore your probability
of getting a job is the
probability of sampling an offer
above R. Now whenever
you have a probability
which is the same every
period, in this case gamma,
how long will you search?
Turns out there is a very
simple formula from statistics
that says the expected
duration of search,
in other words the expected
duration of unemployment,
is simply 1 over the probability
of getting a job in that period.
For example, we now
can say things
about how policy
affects unemployment.
If B goes up, so unemployment
insurance is higher for example,
we've established that the
reservation wage will be higher.
This will reduce gamma because
it's a lower probability
of getting a W in excess of
a higher reservation wage
and this will increase
the expected duration
of unemployment.
It doesn't mean you're
worse off, but it means
that it will take you
longer to find a job.
Why? When B is higher
unemployment is not so painful
so you're more willing to
hold out for a better offer.
Okay, let's take stock.
We've derived the
reservation wage equation
which determines R, the
reservation wage, as a function
of parameters of the
problem including B:
the value of unemployment
insurance, plus leisure,
plus et cetera; and beta,
the discount factor.
We want to now talk about
individual employment histories
as agents moving into and out
of unemployment over time.
We have to generalize the model.
The first thing we'll do
is add a variable lambda.
Let's call that the layoff rate.
The Greek letter lambda
corresponding to L for layoff.
This means that every period
when you're working at a job,
with probability lambda, the job
ends, you're back on the market.
With probability 1 minus
lambda, you continue in the job.
While we're at, it let's
introduce one more new
parameter: the Greek letter
alpha, for the arrival rate.
This is the probability
of getting an offer
any given period.
The previous model had
lambda equal 0, so no layoffs
and alpha equal 1, so you
get an offer every period.
Now we're going to
generalize it.
One can derive the reservation
wage following the same
procedure as before, and I'm
not going to do it for you.
You can do it on your own.
Then we just rewrite the
equations in their new form.
Starting with the value of
unemployment, U, as usual,
you get B within the period and
next period, which you discount
at rate beta, something happens.
Before, what happened
was you got a job offer
with probability 1.
Here, you only get an offer
with probability alpha
and when you do, we just
apply what we learned before:
to write the expected maximum
of either accepting that job
and working at wage
W, or rejecting it
and remaining unemployed.
However in this generalized
version of the model,
with probability 1 minus
alpha, you do not get an offer
so you're forced to
remain unemployed.
One could see that
if alpha equals 1,
this is precisely the
value of unemployment
from the simpler
version of the model.
The next equation I'll show you
is W of W, the value to working
at wage W. As in the
simpler version of the model,
you get the wage that
period and as always,
you get the discounted value
of what happens next period.
Now what happens next
period is pretty simple.
With probability 1 minus
lambda you are not laid off,
hence you continue in your job.
But with probability
lambda, you're laid off
and you're forced to rejoin
the ranks of the unemployed.
One could see that
if lambda equals 0,
this reduces the equation
from the simpler model.
This generalized
version of the model
which allows both random
arrival rate of offers
and random layoffs is
interesting because we can talk
about labor market transitions
into and out of unemployment.
>> Okay let's take stock.
We now have a theory of
the reservation wage,
that is the wage r at which
workers are indifferent
between accepting a job
and continuing to search.
And we worked out how that
r depends on the parameters
of problem including b,
on employment insurance
plus the value of leisure,
including lambda the layoff
rate, including alpha,
the arrival rate
of offers etcetera.
Let's now put this
theory into words to talk
about individual's transition
between employment
and unemployment.
So first in this version
of the model, lambda,
the layoff rate is
the probability
that an individual
transits between employment
and unemployment, which
I'll denote this way.
Then we have the probability
of going the other way
that was called gamma before,
it's the probability of going
from unemployment to employment.
Let's write that out.
It's the product of two terms.
Alpha is the probability
of getting an offer,
I have to multiply
that by the probability
that the offer is acceptable,
which means the probability
of the random w is an access
of the reservation wage.
Sometimes we refer to this
as saying job creation is the
product of choice and chance.
Choice means you have to accept.
It is also you have to
have a chance to accept
by getting the offer
in the first place.
This theory can be used to
describe how individuals transit
between employment
and unemployment.
Next we use this theory to talk
about the aggregate
unemployment rate.
>> Okay, let's now imagine
an economy consisting
of a large number of
individuals who look just
like the individual
we studied earlier.
Sometimes they're unemployed;
they're searching to get a job
and they keep searching
until they get a W in excess
of the reservation wage.
And when they're employed
there's some probability lambda
that they're laid off.
So let me now represent
the population in terms
of the following diagram.
There is some fraction who
are unemployed, call that U;
and there's some
fraction who are employed,
we can call that E - but since
they're fractions they add
up to one, it's just
one minus U. Now those
who are unemployed end
up becoming employed
at a certain rate
that we called gamma.
Those who are employed become
unemployed at a certain rate
that we called lambda.
This economy will evolve over
time, starting with any division
of individuals into the
employed and the unemployed.
Some will get jobs,
some will lose jobs.
We could write out
the law of motion
for the unemployment rate,
describing how it changes
over time, but let's
for simplicity focus
on what's called a steady state,
which is an unemployment rate
which does not change over time.
It's the unemployment rate to
which the economy will gravitate
as time goes on - sometimes
called the natural rate
of unemployment.
To compute the natural rate
of unemployment we simply have
to multiply the number of
unemployed - or the fraction
of unemployed - times the
flow from left to right,
and equate that to the flow
in the other direction,
which is the fraction
of the population
that are employed
times the layoff rate.
This is one equation
and one unknown.
I can solve it easily
enough for the natural rate
of unemployment, which is
lambda over lambda plus gamma.
This is the rate of unemployment
to which the economy will
gravitate in the longer run,
holding constant parameters,
in particular lambda and gamma.
>> Okay. Let's wrap up.
We've developed a theory
in terms of a model
that represents how
individuals look for work.
Any individual gets
offers randomly over time.
And when they're
acceptable, they transit
from unemployment to employment.
While working, sometimes
they have the misfortune
of being laid off and transit
in the other direction.
This theory can be used to talk
about the unemployment
rate in the economy.
At any point in time,
there will be some fraction
of the population working and
some fraction not working,
and people will move
back and forth.
But the system tends
to gravitate towards the
natural rate of employment
which stays constant over time,
even though individuals
are moving back and forth.
This looks a lot different
from the classical theory.
There's no supply
and demand diagrams,
although they are
related - workers looking
for work are supplying labor.
The interesting thing
about search theory is
that search is a
productive activity.
Holding out for a
better job is good.
Now, you don't want
to hold out forever.
At some point, you've got
to stop searching
and start working.
We determined theoretically
exactly what you should do:
choose a reservation wage and
accept when a job gives an offer
above the reservation wage.
It's still not all the way there
vis-a-vis the classical theory,
because we've got
workers looking for jobs.
We still want to build
in the other side
of having firms looking
for workers.
That's the subject
of the next lecture.
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