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.

US Unemployment Rate Systematically Understated

RECENT falls in the officially reported US unemployment rate are an optimistic sign. 

That said, it is worth remembering that the official US unemployment rate (currently around 9.1%) systematically understates the “real” unemployment rate. This is not a new phenomenon, and occurs because of the particular way in which the US Bureau of Labor Statistics chooses to define a person as either “employed” or “unemployed”.

1. Understating the number of unemployed people

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.

The second criteria potentially excludes a large number of people from the definition of “unemployed person” because, in order to be considered unemployed, a person needs to have actively looked for work in the 4 weeks prior to the survey date.

It seems reasonable that an unemployed person would actively look for a job in any given month, but there are two reasons why they may not do so:

  1. Discouraged workers: An unemployed person might become discouraged. As difficult economic times persist, more and more people stop looking for work. This may happen because an unemployed person:
    • becomes discouraged due to previous unsuccessful attempts to obtain work;
    • believes (reasonably or not) that there are no jobs available in their industry or location;
    • lacks the skills needed for the jobs which are available, either because they never had the required skills or because their skills have eroded due to a long period of unemployment;
    • is discriminated against by prospective employers for some reason beyond their control (e.g. age, race, gender); or
    • becomes addicted to Twinkies and day time television. This one sounds like a joke, but it is conceivable that after a prolonged period of unemployment a person who previously had an aversion to receiving welfare payments could become welfare dependent.
  2. Passive job search: Anyone who has not made active efforts to look for work in the last 4 weeks is excluded from the definition of “unemployed” person. The US Bureau of Labor Statistics considers passive job search methods to be any form of job search that does not have the potential to result in a job offer.  So, this would mean that a person who has attended a job training program, searched through online job boards, and read through job classifieds for the last four weeks would not be considered unemployed. It is more likely that they are unemployed, but that they have become discouraged workers (see point 1).

2. Overstating the number of employed people

The US Bureau of Labor Statistics considers a person to be employed if they did any work at all for pay or profit during the week in which they are surveyed.  

There are two reasons why the official estimate of the number of “employed” people will overstate the real number of employed people:

  1. Underemployment: Some people are underemployed. For example, a PhD graduate who works at McDonalds would be considered underemployed because the person is highly skilled yet works in a low paid/low skill job. Any part-time or casual workers who would prefer to work full-time are also considered underemployed. For the purposes of calculating the unemployment rate, underemployed people are considered to be “employed” which means that the unemployment rate overstates the percentage of population that is fully-employed.
  2. Unpaid family workers: Under the US government’s definition of employment, a person is considered employed if they have worked without pay for 15 hours or more per week in a business operated by someone in their family. While working for free for your family may be dutiful and supportive, to consider a person who works for free to be “employed” would seem to overstate their employment status. Unless slavery within the family is permissible (I’m not a US lawyer, so I stand to be corrected), it would seem more logical to categorise unpaid family workers as neither employed nor unemployed. The problem with doing that of course is that it would increase the officially reported unemployment rate.

Mankiw’s 10 Principles of Economics

Economics is about decision making in situations of scarcity

ECONOMICS is the study of how individuals, firms and government make decisions to manage scarce resources.  What does this mean exactly?

Professor Greg Mankiw teaches economics at Harvard University and is the author of a popular economics text book called Principles of Economics which is used at many Ivy League schools. Mankiw’s status within the economics profession makes him uniquely well placed to help us understand the basic principles of economics.

Set out below are Mankiw’s 10 Principles of Economics:

How People Make Decisions

1. People face tradeoffs: To get one thing, you have to give up something else. You may have heard economists say “there is no such thing as a free lunch”. What they mean by this is that, for example, you might get a free bowl of soup at the student co-op, but the soup is not free because you have to give up 35-minutes waiting in line to be served.

2. The cost of something is what you give up to get it: Making a decision requires comparing the costs and benefits of alternative courses of action. The cost of one option is not how much it will cost in dollar terms, but rather the value of your second best alternative. For more explanation, see understanding the cost benefit analysis.

3. Rational people think at the margin: People make decisions by comparing the marginal benefit with the marginal cost. For example, you might buy one cup of coffee in the morning because it helps you start the day, but you might not buy a second cup because this gives you no extra benefit (and costs another $3).

4. People respond to incentives: Behaviour changes when costs or benefits change. For example, if your hourly wage increases then you are likely to work more (unless of course your income is already too high).

How People Interact

5. Trade can make everyone better off: Trade allows people to specialise in what they do best. By trading, each person can then buy a variety of goods or services. For example, you may be a skilled management consultant. Money you earn through your consulting work might be used to build a house even though you may not have the skills to build the house yourself.

6. Markets are usually a good way to organise economic activity: Individuals and firms that operate in a market economy respond to prices and thereby act as if guided by an “invisible hand” which leads the market to allocate resources efficiently. For example, if there is an oversupply of wheat on the world market then individual farmers will lower the price they charge until they can sell all of their wheat.  Lower wheat prices will also likely reduce the total quantity of wheat that farmers decide to produce. Market prices are able to adjust to equate supply and demand without the need for any central planning.

7. Governments can sometimes improve market outcomes: Sometimes a market may fail to allocate resources efficiently, and government regulation can be used to improve the outcome. Market failures can occur due to the existence of public goods, monopolies and externalities. For example, an electricity supplier might have a monopoly. Government regulation may be required to ensure that the supplier does not abuse its market power.

How the Economy Works

8. A country’s standard of living depends on its ability to produce goods and services: A country whose workers produce a large number of goods and services per unit of time will enjoy a high standard of living.

9. Prices rise when the government prints too much money: Printing money causes inflation. When a government prints money, the quantity of money increases and each unit of money therefore becomes less valuable. As a result, more money is required to buy goods and services. For more explanation, see quantitative easing.

10. Society faces a short-run tradeoff between inflation and unemployment: Reducing inflation often causes a temporary rise in unemployment. This tradeoff is the key to understanding the short-run effects of changes in taxes, government spending and monetary policy. For more explanation, see the Phillips curve.