ECON 100 Why is There Unemployment

St. Charles Community College
ECON 100   Survey Economics

In a theoretical sense, the reason why there is unemployment is that the labor market does not clear.  The questions should then be rephrased so that we can ask why doesn’t the labor market clear (or, what prevents the labor market from clearing).

Essentially, there are four reasons commonly given as to why the labor market does not clear:

I.    Sticky Wages: 

Definition:  "Sticky wages" is a term that means that wages are not flexible.  They do not fluctuate with the shift in the demand for labor. 



  • Wages seen to “stick” at W0 rather than fall to a new equilibrium at W1.


Examples of “sticky wages” scenarios are:  

  1. Social or Implicit Contracts:

    • Unspoken agreements between workers and firms that employers will not cut wages.
    • When we take a job we assume that we will work be paid the wages stated when we were hired.  OR We assume that our employers will not cut our wages during economic downturns.
    • We may get laid off during economic downturns, but we will still get our promised wages as long as we are employed.
  2. Relative-wage Explanation of Unemployment.

    • This is an explanation for “sticky wages”. 
    • If workers are concerned about their wages relative to other workers in other firms and industries, they may not be willing to accept a wage cut unless they know that all other workers are receiving similar cuts.
    • In like manner, if some one is looking for work, he or she may not take a job with an employer that is known to pay wages that are not competitive in that particular industry.
    • OR, if someone is looking for work, he or she may not take a job with an employer that is known to attempt to reduce wages during an economic downturn.
  3. Explicit Contracts:

    • These are, “Employment contracts that stipulate worker’s wages, usually for a period of one to three years.”
    • Examples of “explicit contracts” are:
    • Union contracts:   Union contracts or collective bargaining contracts are usually very specific as to job descriptions, personnel qualifications, wage rates, wage benefits, hours of employment, jobsite safety conditions, etc.  They usually cover the bargaining employees for a specific period, and they are re-negotiated at the end of that period.  Also, employers are not generally permitted to cut wages under these contracts.
    • Individual employment contracts:    These contract have the same general features as collective bargaining contracts except that they cover individuals instead of bargaining groups.  They are commonly used when employers want to hire a specific employee for a specific contract or a specific period of time or for a specific temporary job.  Such contracts are commonly for a higher wage rate but for lower wage benefits.
  4. Cost of Living Adjustments:

    • Examples of  COLAs are:
    • Some union contracts have provisions that tie wages to the cost of living, usually the rate of inflation.
      • The greater the inflation rate, the more that wages are raised.
      • Comment: Reverse COLAs are unheard of in labor contracts.


II.    Efficiency Wage Theory:

Definition: The concept here is that good employees who are very productive have great value to firms, and their productivety will increase with higher wages. If this is the case, firm have great incentives to pay wages that are above the market-clearing wage.

  • This goes back to the idea that “the most expensive item in business is cheap help.”
  • OR, it is the idea that if you have a good employee, pay that employee more money to keep him or her on your payroll.
  • “A well-paid employee is a happy and productive employee.”
  • In micro terms, we go back to the marginal product of labor, and the wage is set just below the MPL .
    • Higher marginal product of labor justifies a higher wage.
  • Empirical studies of the labor market have identified potential benefits that firm receive from paying workers more than the market clearing wage.
    • Lower turn-over of personnel.
    • Improved morale.
    • Reduced “shirking” of work.
    • Implies that well paid employees work harder because they don’t want to lose their “good jobs”.
  • We can assume the “efficiency wage” is a short term phenomenon because it probably won’t explain large fluctuations in unemployment over time.


III.    Imperfect Information:

  • We have been assuming that firms know what the “market-clearing” wage is.
  • But what if employers have no idea what the market-clearing wage is. What if they simply decide to pay slightly over the “going wage”.
  • At a wage rate above the “going rate”, workers will seek employment. But, many won’t be employed.
    • Unemployment.
  • In other words, with this imperfect information, thousands of firms are setting wages utilizing this imperfect information, and millions of workers are applying for jobs.
    • But neither side knows what the market clearing wage level is. The result is additional unemployment.


IV.    Minimum Wage Laws:

Definition: These are laws that set a floor for wage rates.....that is, a minimum hourly rate for any kind of labor.


  • The law sets up a flooring price for wages.
  • The resulting unemployment will be short term.


V.    Training Costs:

  • Once a firm has trained an employee, that firm does not want to lose that employee.
  • Firms want to obtain a return on their employee training investment.
  • Firms will not cut the wages of trained employees.



Overall Comments:

  • All of these reason, some of them mutually exclusive, are reasons why there is unemployment, or why the labor market does not clear.
  • There are no simple answers for the unemployment question.