The unemployment rate tends to understate how many people are actually out of work
A PREVIOUS POST looked at the reasons why the reported unemployment rate in the USA tends to understate the “real” unemployment rate.
To understand why this happens, here are a few equations which show how the formula for the unemployment rate is derived:
Looking at the equations above you can see that the unemployment rate measures the percentage of the “labour force” which is unemployed.
The labour force is equal to the number of employed and unemployed people. However, a person is considered to be “not in the labour force” if he or she is not working and has not looked for work for a certain period of time. As a result, that person will not be taken into account when computing the unemployment rate.
This means that if a lot of people have dropped out of the labour force (i.e. they would like to work but have stopped looking for work) then the unemployment rate will understate the percentage of people in the population who are actually out of work.
As the financial crisis in the US continues, and the sovereign debt crisis in Europe worsens, the disparity between the reported unemployment rates and the “real” unemployment rates for these countries is likely to increase.
To help explain the unemployment issue more clearly, here is an amusing (and hopefully enlightening) explanation brought to you by Abbott and Costello.
COSTELLO: I want to talk about the unemployment rate in America.
ABBOTT: Good “subject”. Terrible “times”. It’s about 9%.
COSTELLO: That many people are out of work?
ABBOTT: No, that’s 16%.
COSTELLO: You just said 9%.
ABBOTT: 9% Unemployed.
COSTELLO: Right 9% out of work.
ABBOTT: No, that’s 16%.
COSTELLO: Okay, so it’s 16% unemployed.
ABBOTT: No, that’s 9%…
COSTELLO: WAIT A MINUTE. Is it 9% or 16%?
ABBOTT: 9% are unemployed. 16% are out of work.
COSTELLO: If you are out of work you are unemployed.
ABBOTT: No, you can’t count the “Out of Work” as the unemployed. You have to look for work to be unemployed.
COSTELLO: But … they are out of work!
ABBOTT: No, you miss my point.
COSTELLO: What point?
ABBOTT: Someone who doesn’t look for work, can’t be counted with those who look for work. It wouldn’t be fair.
COSTELLO: To who?
ABBOTT: The unemployed.
COSTELLO: But they are ALL out of work.
ABBOTT: No, the unemployed are actively looking for work…Those who are out of work stopped looking. They gave up. And, if you give up, you are no longer in the ranks of the unemployed.
COSTELLO: So if you’re off the unemployment roles, that would count as less unemployment?
ABBOTT: Unemployment would go down. Absolutely!
COSTELLO: The unemployment just goes down because you don’t look for work?
ABBOTT: Absolutely it goes down. That’s how you get to 9%. Otherwise it would be 16%. You don’t want to read about 16% unemployment do ya?
COSTELLO: That would be frightening.
ABBOTT: Absolutely.
COSTELLO: Wait, I got a question for you. That means they’re two ways to bring down the unemployment number?
ABBOTT: Two ways is correct.
COSTELLO: Unemployment can go down if someone gets a job?
ABBOTT: Correct.
COSTELLO: And unemployment can also go down if you stop looking for a job?
ABBOTT: Bingo.
COSTELLO: So there are two ways to bring unemployment down, and the easier of the two is to just stop looking for work.
ABBOTT: Now you’re thinking like an economist.
COSTELLO: I don’t even know what the hell I just said!