The Unemployment Paradox

“A man willing to work, and unable to find work, is perhaps the saddest sight that fortune’s inequality exhibits under the sun.” – Thomas Carlyle

Unemployment by definition is probably one of the main issues in any developed/developing nation with its right mind should have in its agenda in policy-making. Well think of it as this, the more people work, the more they can spend, the more they spend the more economic activity can occur and other businesses gain from this spending, and that increases their standard of living, it’s a virtuous cycle!

Unemployment however is a moody child deprived of sugar, it wants something in exchange for something else, aim for the short-run and you could hurt the long run. Enforce wages you could cause more unemployment, form unions and collective bargaining that sets wages above the equilibrium level and you could find yourself at a monopolistic labor supply.

Even at periods of high unemployment some governments issues an unemployment insurance, to help its people cope with the situation, which if a person is unemployed they get paid for the amount for some of the time they are unemployed, text books and studies have shown that long periods of unemployment insurance can cause even more unemployment. The problem and issue of unemployment can be mind-boggling, however many factors come in play and the role of government is vital.

If the goal is to substantially lower the natural rate of unemployment, policies must aim at the long-term unemployed., because these individuals account for a large amount of unemployment. Yet policies must be carefully targeted, because the long-term unemployed constitute a small minority of those who become unemployed. Most people ho become unemployed can find work within a short time. (Mankiew-Macroeconomics p190)

The graph depicts the following. (for savvy economic readers, I chose to post a typical S&D graph to help illustrate the results of price floors, rather than incorporating the wage rigidity graph)

  • The vertical Axis labeled Price, by price I mean the price of hiring labor, or think of it as salaries/wages. The Horizontal Axis labeled Quantity(In labor).
  • Supply of Labor(Red Color) shows the positive relation it has with price and as price goes up more, more people are willing to work.
  • Demand for Labor(Blue color)shows the negative relation it has with price and as price goes up, less firms are willing to hire labor.
  • The equilibrium level is the Market clearing Price & Quantity. labeled QE & (E)equilibrium price.

When governments, unions, or any institution intervene on the labor market and enforce a price floor above the Equilibrium level, which means a minimum wage, or minimum salary that is above the initial equilibrium price (Point of intersection QE&QP).This in fact does two things in the short run. The first thing it does is that it creates a (surplus) that can be shown in the graph a red inverted triangle. Quantity supplied is now greater than Quantity demanded, which means the amount of people willing to work at this price exceeds the amount firms are willing to hire at this price level. This in  fact causes an imbalance between the forces in act.

In simpler terms: Lets say you have a firm and you have a budget of $10,000/month to hire workers each month. People are willing to work for $500/month, so that means that you can hire 20 workers each month for your operation. Now suppose the government wants to create a price floor and wanted to increase wages for workers and imposed a minimum $1000/worker to help workers earn more. Your firm’s budget is still $10,000/ month, however now you can only hire 10 workers.

So 10 people are happier and another 10 are sad, its a trade-off, fair or not depends on where you stand my friend.

Short term effect on the average consumer as oil prices drop. (Theoretical approach)

Most economists agree that Oil is considered to be a normal good, by normal we mean that as your income goes up you would buy more of that good, that is a basic definition. As  oil prices fall you would expect that oil consumption would increase, however in the short-run that is not the case. Oil in fact is inelastic in the short run, inelastic means that its consumption is not sensitive to price. Companies still need to operate at the same rate to satisfy their operations and people still need to drive to get to work. It takes time for markets to adjust and people to change their way of living. The long run is a different topic by itself and is out of the scope of this post. You are not going to buy a 8 cylinder pick up after you hear oil fell this month are you?

We can then agree that oil consumption would not change in the short run. Now we can check the graph that I have made to illustrate a theoretical approach of what consumers are going through at this point of time.

Lets say that you pay $500 rent a month for 5 years. Suddenly rent became $300, means you have $200 more to spend on other things other than rent or you could decide to save it. So in simple terms lower oil prices has caused income to increase, which means people can consume or save more than they previously could.

Check below for technical details on how I reached this conclusion using Consumer behavior theory.

The graph you see is the consumer theory diagram.

First be noted of the following.
  • The Vertical Axis labeled “A.O.G”(All Other Goods)- In terms of Quantity. (The farther up means more)
  • The Horizontal Axis labeled “Oil”.- In terms of Quantity (Further right is more)
  • The red line depicts a budget. Where “I” is the starting point. The Horizontal intercept of the Budget at I & I*, to be known as (Income/Price of Oil). The Vertical Intercept is unchanged since their prices are presumed to be constant,Ceteris Paribus.
  • U-shaped curve depicts the indifference curve.
  • The green dotted line is Hicksion line, a line parallel to the new Budget line and tangent to the old Indifference curve.

A decrease  in the price of oil would shift the Horizontal-intercept on the Oil axis to the right, meaning that “Income has risen”, as indicated  I —> I*, where I*>I. Using the Hicksion method we find that initial change for the substitution effect, for as Income goes up we would have to consume more, for the normal good condition. Moving oil Consumption from X*—>X and shown on the original indifference curve Point (A) to point (C). Since we have established that oil is inelastic in the short run, so that would mean that consumption levels of Oil would go back to its initial starting level X* but on the new Indifference curve on the new budget line resulting in tangency of Point (B), which satisfies the inelastic condition, where consumption for oil does not change. However that results in A.O.G consumption  increase from Y —> Y1. Which satisfies that a drop in oil prices in the short run leads consumers to spend more on other goods, Ceteris Paribus.

In summary

A—->C = Substitution Effect

C—->B = Income Effect

A—->B= Total Effect