## Abbott and Costello explain unemployment

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!

## US Unemployment Rate Drops: good news?

Recent improvements in the unemployment rate have come from people dropping out of labour force

THE unemployment rate in the US has dipped to its lowest level in more than 2 years (source: NYT).

Is this good news?

Before answering this question, it would help to understand exactly how the US Bureau of Labor Statistics measures the unemployment rate.

### Measuring the unemployment rate

The “unemployment rate” refers to the percentage of the labour force that is unemployed.

The labour force consists of anyone who is either employed or unemployed, which means that the “unemployment rate” refers the number of unemployed people as a percentage of all those people who are either employed or unemployed.

The US Bureau of Labor Statistics defines a person as unemployed if they fit three criteria:

1. they do not have a job;
2. they have actively looked for work in the last 4 weeks; and
3. they are currently available for work.

### Implications

As a result, there are three ways that the unemployment rate can drop. An unemployed person might:

1. become employed (good); or
2. become underemployed (less good); or
3. fail to find a job and stop looking for work, and as a result no longer be considered “unemployed”. That is, a person might drop out of the labour force (plain ugly).

Why has the unemployment rate in the US fallen recently?

According to the New York Times, the US unemployment rate dropped partly because 315,000 workers simply stopped applying for jobs (this is ugly).  Bloomberg Businessweek stated on Wednesday that, “In November about two-thirds of the improvement in the jobless rate came from people dropping out of the labour force and thus out of the calculation of the unemployed. Only one-third was because of actual job creation.”

Even excluding the people who left the labour force, the US has more than 13 million unemployed workers whose average period of unemployment is a record high 40.9 weeks (source: NYT).  The large number of Americans who are long term unemployed are at risk of becoming discouraged, and if they stop looking for work this is a bad sign for the US economy.

That being said, if a large number of people stop looking for work this could significantly lower America’s officially reported unemployment rate.

With presidential election set for next year, this could be good news for Obama.