The Modern Job Search and Matching Theory of Unemployment

Hello world,

I know that I haven't blogged in a while and that my fans are demanding some
posts. What I have decided to do is post this paper I have been working on all
semester for my labor economics class. My underlying goal was to make something
initially so abstract ( i.e. Modern Job Search and Matching Theory of
Unemployment) seem intuitive and simple so that the general public can understand
aspects of modern macroeconomics.

In order to achieve my goal I therefore encourage anyone who reads this to download
the paper. The paper is on the Modern Job Search and Matching Theory of
Unemployment which describes unemployment in terms of search and matching
frictions. I take the following from my abstract and introduction so that you get the
general idea:

From Abstract:

This paper presents The Modern Search and Matching Theory of Unemployment in a
manner that clears up most of the confusion surrounding it. The theory is broken up
into sections analyzing the wage-setting curve, vacancy-supply curve, job creation
curve and the Beveridge curve. Additionally, several major applications of the theory
including the effects of search intensity, the minimum wage and unemployment
compensation are reviewed. A look at the timing of movements in the unemployment
rate during recessions is also provided. The hypothesis that labor demand is the main
driving force behind the unemployment rate is tested and matching efficiency is also
empirically estimated. The analysis concludes with an early search model and the
appendix covers the mathematical form of the main model covered in the body of the
paper.

From Introduction:
Among academics and professional economists alike the modern job search and
matching theory of unemployment has become the industry wide norm for analyzing
fluctuation and movements within the labor market. The contribution it has made to
modern macroeconomics is revolutionary and its implications will take years to fully
comprehend and appreciate. Standing at the forefront of modern macroeconomic
research it has already received much praise as witnessed with the recognition of the
theories founding fathers Christopher A. Pissarides, Peter A. Diamond and Dale T.
Mortensen by The Royal Swedish Academy of Sciences.

Unfortunately, it is tendency of undergraduate economics departments to lag in

teaching the revolutionary work of their graduate school counterparts. Even with the
marvelous results and realistic nature of the modern search and matching theory of
unemployment this time seems to be no different. Undergraduates everywhere are
encouraged to analyze the labor market with neoclassical assumptions about market
clearing, homogeneous agents and perfect information. Then they are told to peruse
through the Bureau of Labor Statistics' Employment Situation only to observe the
civilian unemployment rate persist around nine percent. A model as realistic as the
modern job search and matching theory of unemployment has implications that are
reinforced to students of economics by the news, while a model which calls for
markets to always clear lacks that crucial element of believability. The time for a clear
explanation must be without further delay.

This paper seeks to explore the the modern job search and matching theory of
unemployment by placing the Beveridge curve at the center of the analysis.
Applications of the model will be brought to light. These include analyzing the effects
of search intensity, the minimum wage, and unemployment insurance benefits on the
unemployment rate. Additionally, a graphical analysis will be provided to shed light
on why and when the unemployment rate moves during a recession. Using the Job
Openings and Labor Turnover Survey and FRED, the hypothesis that labor demand
drives movements in the unemployment rate during recessions is tested.

Moreover, insights from behavioral economics are used to discuss some possible
labor market policies that take advantage of this theory and individuals observed
behavioral tendencies. Lastly an early and very microeconomic model of job search is
brought to light to stress the importance of imperfect information in job search and
the impacts of a workers reservation wage on their duration of unemployment.
Job Search and Matching Theory Part One: Building Blocks
When we hear or read about the labor market, we always see this debate and
confusion over the types of unemployment (structural vs. cyclical) and the reasons
underlying movement in the unemployment rate. The modern job search theory of
unemployment helps us to end the confusion by allowing us to logically analyze the
labor market. It helps us view the labor market as a liquid arena, where jobs are
created, matches are made, and workers decide to enter or leave the labor force. It is
a constantly changing and evolving environment that has until pretty recently proved
a conundrum wrapped in an enigma. The job search theory allows us to realistically
break apart the unemployment rate in away we haven't been able to do before. It's
not just blanket defining structural unemployment, frictional unemployment and
cyclical unemployment, guessing at which one matters more, and arriving at various
highly opinionated conclusions. This theory is empirically testable! We can see with
our own beautiful eyes what is causing unemployment to rise and fall.

That is why today I will begin a special mini-series of posts regarding The Modern
Job Search Theory of Unemployment. The beginning posts will involve a very light
historical perspective and then will dive into the heart of the theory.

Some Historical Perspective

The Beveridge curve is named after William Beveridge, a British Lord, lawyer,
member of parliament and founder of the modern British state. Beveridge first
discussed the relationship between labor demand captured by the vacancies and
unemployment rate in a 1944 report titled,Full Employment In a Free
Society. Although he refrained from explicitly plotting the relationship, he provided
detailed data on the variables and discussed them at length. His work was the first to
imply that there is a negative relationship between vacancies and the unemployment
rate.
His early contributions even tackled many of the issues that remain under study
today. These include the potential mismatch between unemployed workers and job
openings, trend versus cyclical changes in the unemployment rate, measurement
issues, and aggregate demand versus reallocation factors.
The early literature of the late 1950's and the 1960's dealt with the Beveridge curve in
the context of understanding excess demand in the labor market and its direct
influence on wage inflation (Yashiv 2006). This is not surprising given how much
attention was given to the Phillips curve. In fact so much research was devoted to the
Phillips curve that Janet Yellen once referred to the Beveridge curve as,"the neglected
stepsister of macroeconomics."(More of Janet Yellen's thoughts as well as Robert E.
Hall's thoughts on the Beveridge curve can be found Hall, R. E (1989).) As Eran
Yashiv notes,
The literature typically defined excess demand as unfilled vacancies less unemployed
workers, considered the data on these variables, and then looked at the relationship
between measures of excess demand and wage behavior. (Yashiv 2006)
This literature acknowledged that even in the absence of excessive labor supply,
unemployment would still persist due to frictions. Contributions by Dow and Dicks-
Mareaux (1950), Lipsey (1960), Holt and David (1966), Hansen (1970), and Bowden
(1980), made much progress on the Beveridge curve. According to Yashiv (2006) this
literature derived,
A negatively sloped u-v curve from a model of distinct labor markets, interacting at
different levels of disequilibrium, with the markets at points off both labor supply and
demand curves.
Furthermore, the u-v curve was shown to be static and stationary, and observed
vacancy and unemployment rates were expected to cycle around it. Increases and
decreases in the excess demand for labor were reflected in movements up and down
the curve. Shifts in the curve were identified as changes in the speed of market
clearing or changes in the sectoral composition of labor demand.
In the 1970's and 1980's an alternative search and matching model approach
was developed. An important difference between this model and the earlier stand of
literature stems in its derivation of vacancies and unemployment as equilibria, as
opposed to disequilibria phenomena. This model was developed with the combined
efforts of Peter Diamond, Dale Mortensen and Christopher Pissarides.

Dale T. Mortensen wrote in 1992 about a divergence in neoclassical macroeconomic

labor theory. He stated that, (Mortensen also summarized the rest of search theory
very nicely in "Search theory and macroeconomics: a review essay"(1992))
Two views were born out of Phelps (1970) volume: An intertemporal generalization
of the traditional income-liesure model of labor supply and an early version of what
came to be known as the job-search model. Subsequently, the Lucas-Rapping
approach with its emphasis on intertemporal substitution and market clearing came
to dominate the macroeconomic scene. One reason for the lesser role played by the
search-theoretic approach in macroeconomics was its partial-partial nature,
specifically the absence of a consistent view of how the labor market operates when
transaction cost and time lags are important in the job/matching process.
Although there was a lack of development early on, the realism embodied by the
search model's characterization of the individual workers experiences moving in and
out of employment and among jobs has proved a substantially more valuable tool for
empirically understanding the labor market than has intertemporal substitution.
(Intertemporal substitution is used in Real Business Cycle models to describe the
decisions workers must make between leisure and work for pay. The logic goes like
this: a higher a real interest raises the opportunity cost of sitting around because
money is worth more so people respond by entering the labor force and when the real
interest rate is lower then people leave the labor force because they value leisure and
home production more so.)
It was in a 1971 paper, that Peter Diamond first showed that the mere presence of
costly search and matching frictions prevented the law of one price from holding.
Diamond found that even a minute search cost moves the equilibrium price far from
the the competitive price and that the only equilibrium price was a monopoly one.
This finding dubbed the "Diamond Paradox" has generated much additional
research.
An additional issue with search markets is wether there is too much or too little
search, or another way of phrasing this is, do markets deliver efficient outcomes or
not? The economy undeniably has search frictions, so the relevant issue is not
whether an economy is inefficient because of frictions, but rather is the economy
constrained efficient i.e. delivers the optimal result, given these restrictions.
Diamond, Mortensen and Pissarides all contributed important insights into the
efficiency question with the first work appearing in the late 1970s and early 1980s. A
standard result is that efficiency cannot be expected and policy interventions
therefore become necessary.
It was Christopher Pissarides that brought to light and demonstrated that the
transactions approach to the labor market can serve as a useful framework for macro-
labor analysis. He helped develop the idea of a matching function and pioneered the
empirical work on its estimation. For a survey of the matching function please see
Petrongolo and Pissarides (2001).
The sum of the research done by these three economists has fundamentally
influenced our views on the workings of the labor market. A key contribution is the
development of a new framework for analyzing labor markets both positive and
normative questions. These resulting advancements are now known as the Diamond-
Mortensen-Pissarides model (or the DMP model). The DMP model originated from
the insights of the first search and matching models of the 1970s and other crucial
developments followed. As the Economic Sciences Prize Committee of the Royal
Swedish Academy of Sciences puts it:
The DMP model allows us to consider simultaneously (i) how workers and firms
jointly decide whether to match or to keep searching; (ii) in case of a continued
match, how the benefits from the match are split into a wage for the worker and a
profit for the firm; (iii) firm entry, i.e., firms’ decisions to “create jobs”; and (iv) how
the match of a worker and a firm might develop over time, possibly leading to agreed-
upon separation.
The resulting models and their subsequent advances have been quite rich and the
applied research on labor markets, both empirical and theoretical, has blossomed.
Theoretical work includes both positive and normative economic analysis. This
theory makes it relatively straightforward to examine the policy effects on hiring
costs, firing costs, minimum wages laws, taxes and unemployment benefits on both
unemployment and social welfare.
Empirical work consists of ways to evaluate the search and matching model using
aggregate date on vacancies and unemployment. This includes the development of
data bases and analysis of labor market flows, such as the flows of workers between
different types of employment. Moreover, the DMP model is used to analyze how
aggregate shocks affect the labor market and lead to cyclical fluctuations in
unemployment, vacancies and employment flows.
This model brought with it a level of practicality that had not been found in
previous labor market theories. Because of its focus on job flows into and out of
employment and its potential to greatly enhance the way we analyze the labor market,
the Bureau of Labor Statistics in 2000 started the Job Openings and Labor Turnover
Survey (JOLTS) to specifically fit this model (Clark and Hyson 2001):
The JOLTS data series on job openings, hires, and separations will assist policy
makers and researched in addressing some fundamental issues concerning labor
demand and movements in the labor market. The JOLTS data will provide a basis for
improved understanding of the factors driving fluctuations in unemployment and the
overall economy, determining appropriate approaches for reducing unemployment,
and studying how workers flow in and out of establishments, are matched with job,
and are distributed across sectors (pg. 33).
With these time-series researchers are now able to make tangible and empirically test
labor market search and matching theories.
The Labor Search and Matching Theory of
Unemployment
The labor market is known to have problems clearing. Economists have long
recognized this fact and attribute the labor markets inability to flawlessly and
effortlessly match workers and jobs to “frictions”. These “frictions” occur because
labor is not homogenous and instead labor has the fortunate or unfortunate quality of
being heterogeneous. Being heterogeneous means that there is not one universal
price that can be exchanged for one universal unit of labor. This makes it a market
that acts much differently from other commodities, like gold whose “law of one price”
attribute allows it to consistently clear. We are dealing with a commodity that can
speak, feel, learn and prides itself of differentiation and individuality. The
heterogeneity of labor makes it difficult for employers to distinguish the productive
from the unproductive, and even the process of moving from one job to the next is
not costless. The search and matching model of unemployment provides the
theoretical groundwork for us to effectively model these frictions.
The search and matching model contains three elements; setting wages, creating job
vacancies and matching workers and jobs. The first element describes how wages are
set through the bargaining process. The second element determines the number of
job openings that firms make available, and the third ties them together in the act of
creating jobs.

Setting Wages
Although it is important to recognize that not all wages are determined in the same
way, we can assume that many are the result of a bargaining process between
workers and their employers. Additionally, it is really helpful to note here that unlike
Walrasian theory, there is no unique equilibrium concept inherent in the theory of
markets with transaction costs. Wages must be determined by some form of
bargaining and the implications of the model are sensitive to which form of
bargaining solution is imposed (Mortensen 1992). The bargaining process itself relies
on the relative bargaining strength and outside options of both parties involved,
which in our case is the potential employer and worker. The party with the most
bargaining power can extract a larger fraction of the surplus that stems from their
relationship. The outside options of these parties depends on their relative incomes if
"unmatched" as well as their capacity to locate alternative resources if the negotiation
falls through. Outside options are affected by labor market imbalances like the
number of vacancies and the number of unemployed workers. Labor market tightness
is what helps us determine this relative bargaining power. Labor market tightness is
represented by:

θ ≡ vt/ut

Where labor market tightness, θ , is defined as the number of vacancies vt at

time t divided by the number of unemployed ut at time t. This θ, is a measure is a
measure of worker scarcity and enables us to operationalize the idea of bargaining
power. It is this crucial element that lets us finally introduce the wage-setting curve.
The wage-setting curve, WS, is the positive relationship between a workers relative
bargaining power which is represented by labor market tightness and the market
wage. Looking at Figure 1 it becomes evident that as labor market tightness
increases, the bargaining strength of market participants shifts in the favor of
workers and wages increase.
Additionally their bargaining is enhanced because they are presented with a larger
array of possible alternatives for employment. This allows workers to request a higher
wage and reflects movement up the wage-setting curve.
If the number of vacancies per unemployed worker is high, we are faced with a
"tight" labor market where workers outside options are decent thus allowing them to
ask for a higher wage. Firms are willing to pay this high wage to avoid the hassle of
finding another worker and incurring higher recruiting costs. On the flip-side, if
vacancies are scarce relative to unemployed workers, we have a "loose" labor market
where workers outside options are poor thus increasing their willingness to accept a
lower wage to avoid a long spell of unemployment.

Figure 1: A rightward shift of the Wage-Setting Curve

The wage-setting curve shifts whenever the economic fundamentals change.

Factors that shift the wage-setting curve include:

a). Changes in worker productivity (+)

b). Changes in worker bargaining power (+)

c). Changes in unemployment benefits (+)

Rightward shifts from WS1 to WS2 would be caused by increases in worker

productivity, worker bargaining power and unemployment insurance benefits.

Vacancy Supply and Job Creation

We will now focus on determining the number of workers that firms want to hire. If a
firm found workers instantaneously and with zero recruiting cost, they would
continue hiring workers as long as each new worker's productivity exceeded the
market wage. Since hiring a worker is neither costless or instantaneous there must
exist market frictions.
Various frictions include promoting job openings and evaluating potential
candidates. A firm will want to make a job opening available if the sum of profits it
makes from hiring compensates for the recruiting expenses. This is referred to as
the vacancy-supply condition and is represented by the downward sloping curve VS
that is in Figure 2. It is interesting to note that the Vacancy-Supply curve replaces the
labor demand curve found in standard Walrasian theory.
It says that the number of vacancies opened in a labor market is determined as a
function of the market wage ,w, and recruiting costs. The downward relation is
intuitive, firms have less incentive and ability to create jobs as the market wage
increases.
At lower wages, workers generate higher profits, and firms are willing to open a large
number of vacancies. As the number of vacancies increases it becomes more
challenging for firms to find employees. As a result, hiring and recruiting costs
increase until the incentives to open up new vacancies disappears.

Figure 2: Upward Shift of the Vacancy-Supply curve

Shifts in the vacancy-supply curve stem from changes in labor market fundamentals.
The vacancy-supply curve shifts upward, as in Figure 2, whenever firms want to hire
more workers and therefore offer more job openings. Factors that shift the vacancy-
supply curve upward from VS1 to VS2 include:

a.) Increase in worker productivity

b.) Decrease in cost of advertising vacancies and recruitment

c.) Process of finding workers becomes more efficient

The intersection of the wage-setting and vacancy-supply curves is what determines

the labor market tightness θ and market wage, w. The determination of labor market
tightness is what provides the essential link for determining the equilibrium
unemployment rate and job openings.

Matching Workers with Jobs

In the previous two sections we gave a brief overview of the wage-setting and
vacancy-supply curves and determined that their intersection provides us with two
important links, labor market tightness and the market wage.

To get a complete picture of the labor market however, we will need to incorporate
two last items: the unemployment rate and the vacancy rate. These two things in
relation to each other and labor market tightness will lead us to the derivation of the
equilibrium unemployment and vacancy rate. To make this connection it is required
that we understand how the number of vacancies affects unemployment, which
requires that we develop an understanding of how vacancies and unemployed
workers are matched to create jobs.
Frictions have been used to explain unemployment in the labor market. In the
majority of cases, the modeling tool preferred to capture the influence of frictions on
equilibrium outcomes is the aggregate matching function. The matching functions
appeal is that it enables the modeling of frictions to be added to conventional models,
but with a very minimal amount of added complexity (Petrongolo and Pissarides
2001). Frictions stem from asymmetric information, heterogeneities, slow mobility,
congestion from large numbers, and numerous other factors. The matching function
captures the frictions cumulative effects on equilibrium in terms of a very small
number of variables, and usually without explicit reference to the source of the
frictions. Petrongolo and Pissarides (2001) explain the key idea very well,
The matching function summarizes a trading technology between agents who place
advertisements, read newspapers and magazines, go to employment agencies, and
mobilize local networks that eventually bring them together into productive
matches. The key idea is that this complicated exchange process is summarized by a
well-behaved function that gives the number of jobs formed at any moment in time in
terms of the number of workers looking for jobs, the number of firms looking for
workers, and a small number of other variables.
This matching process is called a productive process and has one output and two
inputs. The one output is the number of jobs created through the matching process
and the two inputs are the number of unemployed and the number of job openings.
The relationship between the stock of unemployed and the stock of vacancies to the
number of jobs created is the matching function. The matching function in equation
form is as follows:

H = xt* M(Lu , Lv )

Where, H= new hires, Lu_t = Unemployment (it's the unemployment rate times the
labor force) and Lv_t= the number of vacancies (it's a vacancy rate v=(Vacancies\
Labor Force) times the labor force). xt = Total Factor Productivity and also known as
the "Solow Residual". We can estimate the matching function using a Cobb-Douglas
production function. The Cobb-Douglas works well as the proper matching function
because it has constant returns to scale. Constant returns to scale means that
doubling the inputs yields double the output. According to Pissarides (2000) the
reason constant returns to scale are assumed is because "It is empirically supported
and plausible, since in a growing economy constant returns ensures a constant
unemployment rate along the balanced-growth path" pg.6 We can estimate the
following matching function:

M (Lu, Lv) = Lu^α*Lv^(1-α)

Where, α + (1 − α) = 1
Next I use the JOLTS data to compute the matching function "Solow residual". We
assign α =.5 so 1-α = .5. Next I take the log of the Cobb-Douglas production function:
log(x)=log(H) −0.5log(Lu)−0.5log(Lv)
I do this In the style of David Andolfatto who is the V.P. of Research at the St. Louis
Federal Reserve and also author of a marvelous blog named MacroMania. The
following data sets from FRED were used over the time span 12/01/2007 to
06/01/2009, JTSJOL Job Openings: Total Nonfarm (JTSJOL), Level in Thousands,
Monthly, Seasonally Adjusted
UNEMPLOY Unemployed (UNEMPLOY), Thousands, Monthly, Seasonally
Adjusted, JTSHIL Hires: Total Nonfarm (JTSHIL), Level in Thousands, Monthly,
Seasonally Adjusted. Figure 3 plots the results of the above equation in log form.
Figure 3: Matching Function TFP

A quick glance at Figure 3 reveals that total matching function efficiency from the
beginning of the recession to the very end declined by about 35 percent. I use the
official NBER dating of the recession which can be found
at http://www.nber.org/cycles.html. Obviously thats a pretty substantial decline, but
how does that impact the big picture? Changes in matching efficiency play on average
a pretty small role but can decline substantially during recessions. In fact, between
2008 and 2009, lower matching efficiency added about 1 1/2 percent to the
unemployment rate (Barnichon and Figura 2010).
The matching function is depicted below in Figure 4. Unemployed workers and
vacancies meet each other which feeds a flow of job creations into the stock of
employed workers. The stock of unemployed workers and the stock of vacancies are
both replenished by job destructions. If the economy were not subject to shocks, it
would end up in a steady state.

Figure 4: Job Flows

The number of jobs created equals the number of jobs destroyed and the stock of
unemployed workers would remain unchanged. In this steady state the
unemployment rate would be low if the flow of job creations were large relative to job
destructions. The flow of job creations is large relative to job destructions when the
number of vacancies is large. In contrast, if there were few vacancies then the flow of
job creations would be small, and the unemployment rate would be high.
Although Figure 4 does a good job of giving a nice explaination of matching between
unemployed workers and the available job openings, it is rather naive. For example,
workers are often encouraged to move from one job to another to increase their
lifetime earnings potential. This flow is significant and for the United States is
estimated to account for around 15 percent of job creation. That leaves the other 85
percent of new job creation to stem from those that are unemployed and those
moving from out of the labor force directly into employment. A quick glance at the
diagram shows that neither the flow to new matching from employment or from out
the labor force is accounted for. As for the rest of the 85 percent, it is estimated that
45 percent of that stems from those in the unemployment stock while the other 40
percent are from outside the labor force (These are the estimates produced by
Blanchard and Diamond (1989))
Within the United States the flow of hires from outside the labor force and those
moving from job to job are both said to be procyclical.

The figure does still however lead us to the intuition that the more job openings made
available, the more job creation that can take place, and hence the lower the
unemployment rate will be. The negative relationship between vacancies and
unemployment (in our static steady state) is called the Beveridge Curve. The
Beveridge curve was named after Lord William Beveridge who in the 1940's first
identified the relationship between vacancies and unemployment (Bleakley and
Fuhrer (1997). On another interesting note Janet Yellen, referred to the Beveridge
curve as the, "neglected stepsister of macroeconomics."(More of Janet Yellen's
thoughts as well as Robert E. Hall's thoughts can be found Hall, R. E (1989). If the
Beveridge curve was the neglected stepsister it was because her more flashy sister the
Phillips curve was falsely getting all the attention.)

The Beveridge curve is where equilibrium unemployment is determined. Along the

Beveridge curve the flows into and out of employment are balanced. The negative
slope reflects the the dependence of unemployment duration on labor market
tightness. It is important to realize that variables which shift the Beveridge curve to
the right also increase equilibrium unemployment.

As Figure 5 demonstrates, movements along the Beveridge curve reflect cyclical

factors. Recessions are often characterized by low vacancies and high unemployment
which corresponds to the lower right hand branch of the curve. The upper left hand
side is characterized by expansions because these are generally times with many
vacancies and a lower unemployment rate. Movements along the curve, from left to
right are recessions and the subsequent recovery swing’s back up the other way.

Figure 5: The Beveridge and Job Creation Curve

Additionally, movements along the downward sloping Beveridge curve are typically
characterized as cyclical movements in the labor market, while persistent inward and
outward shifts in the curve are frequently attributed to overall labor market
activity. This is sometimes interpreted as the intensity of "reallocation", which is
movement of workers from one job to the next and even from one sector to another
within the economy.
You may notice that Figure 5 has a line called Job Creation intersecting the Beveridge
curve. Where the job creation curve and Beveridge curve intersect is where
equilibrium frictional unemployment is determined. The slope of the job creation
curve is the labor market tightness θ, that we determined from the intersection of the
wage-setting and vacancy-supply curves. This is what ties our analysis of the labor
market all together.
The job creation curve rotates clockwise and counterclockwise whenever there is a
change in labor market tightness. Changes in labor market tightness stem from shifts
in the wage-setting and vacancy-supply curves. Whenever the labor market becomes
less tight the job creation curve rotates clockwise and when there is an increase in
labor market tightness the job creation rotates counterclockwise. The job creation
curve is upward sloping because as the the pool of the unemployed grows, employers
can more easily fill open vacancies; this reduction in hiring costs leads to more
vacancies being posted. Asking a question about the current position of the job
creation curve is equivalent to asking "How much tightness is currently found within
the labor market?" Well if we divide job openings by the number of unemployed we
get Figure 6. What this graph shows us is that labor market tightness peaked around
August 2007 before falling off and declining from 70 percent to about 15 percent.
Figure 6: Labor Market Tightness from March 2001 to January 2011
Another crucial insight is that the job creation curve represents the labor demand
curve. With that in mind it rotates when there are changes in the cyclical components
that affect the unemployment rate.
What might lead to a rise in the equilibrium unemployment rate?
This can be caused by an outward shift in the Beveridge curve, a downward shift in
the job creation curve or a combination of both. First consider an outward shift in the
Beveridge curve from BC0 to BC1 as depicted in Figure 7.
Figure 7: Outward shift in the Beveridge curve
For a given job creation curve this shift increases the equilibrium unemployment rate
from U* to U1 and me move from point A to point B. Because the job creation curve is
upward sloping equilibrium unemployment increases by less than the outward shift
of the Beveridge curve, to a degree that depends on the the slope of the job creation
curve which as we already know is labor market tightness θ. In order for the
unemployment rate to increase by the same amount as the rightward shift in the
Beveridge curve the job creation curve must either be flat or must simultaneously
rotate downward.
Figure 8:Clockwise rotation of the Job Creation curve

This is represented in Figure 8, which shows that unemployment will only increase by
the full amount of the shift in the beveridge curve if the job creation curve does a
clockwise rotation. Notice how much more the unemployment rate increases if it is
accompanied by a flat or rotating job creation curve. Instead of ending up at B and U1
as in Figure 7 the unemployment rate ended up all the way at U2 at point c.

Given our ability to derive the job creation curve from the vacancy-supply and wage-
setting curve it would now be nice to see what shifts the Beveridge curve. We need to
distinguish what part of the rise in the unemployment rate reflects cyclical
fluctuations in labor demand (or the job creation curve) and what part is due to other
transitory or permanent factors. We will now discuss some of the known causes of
shifts in the Beveridge curve.

Figure 9: Rightward Shift in the Beveridge Curve

Shifts in the Beveridge curve for any given labor market tightness can be caused by
each of the following:

a). The matching process will determine how efficiently workers find new jobs and
thus determine the position of the Beveridge curve. Increased matching efficiency
shifts the curve inward and vice-versa. Increased matching efficiency can come from
many sources which includes the use of internet job sites, more temporary help
service centers and help from One-Stop Career Centers. Additionally lower union
participation rates and increased labor mobility are also found to increase matching
efficiency. Increased mobility of labor is also a way of saying a reduction of barriers to
mobility which include both geographical and occupational factors. Generous
unemployment insurance benefits may also slow down the matching process but
more information will be deferred to our example that will be presented in a later
post.

b). Changes in the labor force participation rate will shift the Beveridge curve. One
example of something that would shift the curve outward is an increase in the labor
force participation rate (Please see DiCecio, Riccardo and Charles S. Gascon,
“Vacancies and Unemployment,” Federal Reserve Bank of St. Louis Economic
Synopses; 2009. Number 44). As new workers enter the labor market, they join the
ranks of the unemployed searching for work. Higher levels of labor force growth
translates to greater unemployment, since more workers are searching for jobs at any
particular time. In the short-run, vacancies may not fully adjust to an increase in
labor force growth. In the long-run however, vacancies will increase roughly in line
with unemployment (Bleakley and Fuhrer 1997). Additionally, labor force
participation increases when more people are educated and as immigration increases.

c). Average duration of unemployment will shift the Beveridge curve. Long-term
unemployment will force the curve outward because those unemployed face human
capital deterioration and loss of skill. Employers negative perception of these
workers may lead them to consider a less experienced and cheaper college graduate
when making a hiring decision.

d). A change in the degree of "churning" in the labor market will shift the Beveridge
curve. Job loss, quits, and job creation is related to the overall pace of reallocation or
"churning" in the economy. Reallocation occurs even when the economy is stable, as
some firms expand and others contract for firm or industry-specific reasons. The
pace of reallocations increases during recessions and in fast expansions as firms are
driven to contract or expand significantly, which leads to both greater flows of
workers and jobs. Thus, changes in the pace of reallocation imply potentially large
movements in the gross flows of the labor market- flows into and out of
employment. More churning implies lower average job tenure, higher turnover and
more time spent moving among firms (or even sectors) in the economy. An increase
in churning means that each month more workers flow into unemployment and new
vacancies are posted. Such an increase would shift the Beveridge curve outward
(Bleakley and Fuhrer 1997).

e). Changes in worker and employer search intensity will impact matching
efficiency and cause shifts in the Beverage curve. Increased search intensity by
workers and recruiters alike will improve matching efficiency and shift the beverage
curve inward. Decreased search intensity by workers and recruiters will lessen
matching efficiency and shift the Beveridge curve outward for any given labor market
tightness.

f). The availability of credit and the presence of credit-constraints will shift the
Beveridge curve. In recessions many of the unemployed find themselves in a credit
constrained position because of uncertainty in the financial markets. Credit
constraints are found to have a large impact on job search intensity which may
explain an outward shift of the Beveridge curve. The less money available to the job
searcher the less intense the job search will be, especially if the credit availability is a
crucial component to paying down a mortgage which would impact the workers
mobility.

g). Changes in "House Lock" shifts the Beveridge curve. House lock prevents mobility
by job searchers. People who find themselves underwater on their mortgages
(negative equity) may find it difficult to move, especially after a housing bubble. An
increase in house lock shifts the Beveridge curve out to the right, increased mobility
of homeowners shifts it to the left. Empirically, the effects of house lock have been
found to be very minimal.

Up till this point, we have explained the three building blocks of labor search
theory. The point where the wage-setting curve intersects the vacancy-supply curve
determined both the going market wage w and the vacancy-unemployment ratio. The
vacancy-unemployment ratio is referred to as labor market tightness. Labor market
tightness determines the slope of the job creation curve, whose intersection with the
Beveridge curve derives the unemployment rate.

Next time we will delve into some applications, the first of which will involve the
minimum wage and search intensity.
Job Search Part 2: Minimum Wage Effects on Job-Search Effort and
Labor Force Participation
In the previous post we built a solid foundation with the tools and terms of job search
theory. Let's take what we've learned and apply it to analyzing the effects of an
increase in the minimum wage.

Figure A: Conditions Before a Minimum Wage Increase

Assume that initially the wage-setting (WS0) and vacancy-supply

(VS0) curves intersect at point A determining both the equilibrium market wage w*
and equilibrium labor market tightness, θ*. The job creation curve (whose slope
is θ*) intersects our Beveridge curve at point A1which determines that our
equilibrium vacancy rate is V* and equilibrium unemployment rate is U*. These are
represented graphically in Figure A.

Figure B: After a Mandated Increase in the Minimum Wage

Then out of the blue the government introduces a minimum wage w1 that exceeds the
market wage w*.
 The wage-setting curve now has a
"floor" and this is represented by its vertical portion at the minimum wage. As higher
wages cut into business profits, firms open fewer vacancies. We move from point A to
B in Figure B. Since labor market tightness has now decreased from θ* to θ1, the job
creation curve (with its new slope θ1) rotates downward. The rotation of the job
creation curve from JC0 to JC1 increases the unemployment rate from U* to U1. We
moved from our original position at A1 to B1 and the job openings rate has decreased
from V* to V1. In this situation a binding minimum wage raises both wages and
unemployment.

Incorporating Workers Job-Search Effort

Let's assume now that workers can choose the intensity with which they search for a
job- how much time they spend searching the internet for a job, how many job
applications they fill out, ect. Under this assumption, a higher wage has two
simultaneously opposing effects:

a) A higher expected wage increases the payoff for workers when they finally do find a
job. A worker with this in mind will be motivated to look harder and "more
intensely." This increase in work intensity would shift our Beveridge curve inwards.
b) It weakens firms' incentives to create jobs because it cuts into their profit and thus
making workers less likely to succeed and so depressing their search efforts. Less
intense search effort by the firm would correspond to an outward shift of the
Beveridge curve.

The net effect of these countering forces depends on where the wage
stood before the increase. To visualize this, consider two extreme cases where wages
are initially really high or really low, depending on the extent of the workers
bargaining power. First, suppose that workers are powerless and have no bargaining
power, firms post wages unilaterally, and workers search until they find an acceptable
wage offer. Since employers appropriate the entire surplus from their relationship
with labor, unemployed people have very little incentive to search actively for a job
and the result is high unemployment. Now consider the other extreme, where
workers have all the bargaining power to set wages. Firms make no profit from hiring
more workers. Since opening and advertising job vacancies is costly, firms rather not
do so, and unemployment increases.

Figure C: Increased Search Intensity by Workers

Markets that tend to be dominated by employers or equivalently where workers'

bargaining power is pretty low, a compulsory increase in the wage can lead to higher
search intensity and higher employment. If the market wage is low, then a binding
minimum wage can make employment more attractive to workers which strengthens
their search efforts and reduces unemployment. Figure C graphs this result. The
increase in workers search intensity would shift the Beveridge curve inward from BC0
to BC1 and the unemployment rate would go from U1 to U2, before the shift we were
at point B1 and after the shift we settle at point C1. In this respect the search model's
results are consistent with the monopsony model as it explains how, in theory, a
minimum wage can reduce unemployment. If the the market wage is high, a binding
minimum wage may discourage workers from looking for a job because there are
fewer vacancies. It can also be shown that worker's search effort and social welfare
move together. The wage that maximizes search effort also maximizes social welfare.
If the minimum wage is small enough, it can improve labor market conditions and
increase social welfare.
Another interesting result of this model is that the minimum level of
unemployment occurs when the market wage is below the one maximizes workers
search effort. This means that a minimum wage can make workers better off even if it
increases unemployment.

Adding Labor Force Participation

If we focus our attention on the workers' decision to participate in the labor force we
can use logic that mirrors that from our search intensity example. If the market wage
is very low because workers have little bargaining power, they might decide to not
even look for a job at all. They have no incentive to enter the market because non
market activities, like home production and leisure, are more valuable than working
and thus employment is low. Conversely if the market wage is very high, firms are not
hiring, unemployment durations are long, and workers stay out of the labor force. In
general, employment is a hump-shaped function of the wage. However, unlike the
model with workers' search effort, unemployment always decreases with the wage.
Although participation is weaker when wages are low, firms still create jobs
because their profits are high. This has the effect of swelling the number of vacancies
relative to the number of job seekers, making it more probable that they will find
employment. If the market wage is too low and workers lack bargaining power, the
introduction of a binding minimum wage strengthens labor force participation even
though the duration of unemployment increases. In contrast, if the market wage is
high, a minimum wage reduces the supply of vacancies and increases unemployment
duration, which has the balancing effect of discouraging workers from entering the
labor force.
Job Search Part 3: Modeling A Recession with Unemployment
Insurance Benefits
Let's look at what happens in a recession spurred on by an adverse financial shock
(most of the search literature would say that recessions are caused by productivity
shocks which fits in nicely with labor market dynamics. I have chosen to instead
attribute this recession to a financial shock which is substantially more realistic and
at least graphically still consistent within this framework). Say that a financial shock
occurs, maybe a series of bank failures makes financial institutions more risk adverse
and less likely to lend. Firms that have to borrow money from commercial banks in
the commercial paper market may find themselves in a squeeze as liquidity dries up
(Some companies maintain day to day operations by borrowing from the commercial
paper market).
Figure A: Downward shift in Vacancy-Suppy curve Lowers Labor Market
Tightness, θ

Businesses have to cut back and hire less people than previously anticipated. This can
be witnessed in Figure A where the vacancy-supply curve shifts downward from
VS1 to VS2. We move from point A to B and workers face a lower market wage (w*
to w1). As Figure B demonstrates the decrease in labor market tightness rotates the
job creation curve clockwise from JC to JC1.
Figure B: Downward Rotation of the Job Creation curve increases
Unemployment

The rotation happens because the job creation curves slope which is labor market
tightness θ, is now less than before so we move along the Beveridge curve from point
A1 to B1. The vacancy rate declines from V* to V1 and the unemployment rate
increases from U* to U1.

In recessions, more workers find themselves in the pool of unemployed and tap
into unemployment insurance to sustain their consumption levels while searching for
new employment. With unemployment insurance benefits workers find themselves in
a better position when unemployed which allows them to negotiate a higher wage. As
a result, firms have a lower incentive to open vacancies because they would make
lower profits off of them. As witnessed in Figure C this results in a rightward shift of
the wage-setting curve from WS1 to WS2 and movement along VS2 from B to C. The
resulting increase in unemployment benefits increases wages but reduces market
tightness from θ1 to θ2. Workers claim a higher wage because the cost of
unemployment is lower. Higher wages induce firms to create fewer jobs and lead to
reduced labor market tightness.
Figure C: Rightward Shift of Wage-Setting Curve

As Figure D demonstrates the job creation line rotates clockwise from JC1 to JC2 as
we move along the Beveridge curve from B1 to C1 thus reducing vacancies and
increasing the unemployment rate. Wages increased from w1 to w2 and the
unemployment rate increased from U1 to U2.
Figure D: Clockwise Rotation of JC curve and an Outward Shift of the
Beveridge curve

Increases in the generosity of benefits, either through increases in benefit levels or

the duration of benefits, seem to lengthen the unemployment spells of unemployment
insurance recipients (for more information on Unemployment Insurances effects on
unemployment please refer to Babcock, Congdon, Katz, and Mullainathan (2010)).
As previously stated, more generous unemployment benefits like extending
unemployment insurance to 99 weeks, also slows down the time it takes to match
workers and firms. Individuals may not be all too optimistic when they form
expectations about wages and consider their possible employment opportunities. This
negative bias will cause many unemployed workers to be more lackadaisical when
searching for a job and search with a lower intensity because they have more time till
their income stream dies out (empirical work by Krueger and Mueller (2008)
supports this claim as they find, using time use data, that across the 50 states and
D.C. job search intensity is inversely related to the generosity of unemployment
benefits with and elasticity between -1.6 and -2.2).
Furthermore, workers tend to set inefficiently high reservation wages in response to
more generous unemployment benefits. When given the false sense of confidence and
self worth brought on by more generous benefits the unemployed become more
selective in terms of the type of job and wage they will accept (although, Krueger and
Mueller (2008) find that the predicted wage is a strong predictor of time devoted to
job search with an elasticity in excess of 2.5).
Because of these effects the Beveridge curve BC1 shifts outward to BC2 along the
job creation curve JC2. This means that for the given labor market tightness θ2 we
have a greater number of vacancies and a higher unemployment rate. In Figure D
above we move from C1 to D1 as unemployment increases from U2 to U3 and the
vacancy rate settles back at its previous level, V2. One important fact to realize is that
the shift to BC2 is only temporary because those unemployment insurance benefits
can't last indefinitely. When unemployment insurance benefits get close to expiring,
logic would suggest that the unemployed would pick up their searching intensity as
they realize that time is running out. In fact, research by Krueger and Mueller (2008)
tells us that job search intensity for those on unemployment insurance increases prior
to benefit exhaustion. This increase in search intensity would shift the Beveridge
curve back to BC1.
Job Search Part 5: It's Policy Time!
This is the last post of this special mini-series on the job search and matching theory
of unemployment. I will probably be extremely distracted for the next few months,
including a month-long vacation in Europe to shake the horrors of undergrad off me.
I am pleased to have provided the world with my take and interpretation of this
theory, please feel free to comment if you have any suggestions. I can be reached at
stevensabol@me.com for general economics help and discussion. Cheers!

Labor market policies meet their objectives only to the extent to how they accurately
account for how individuals make their decisions about leisure and work, job search,
and seizing opportunities for training and education. These models are
predominantly built around the classic neoclassical assumptions that people are
perfectly rational, time consistent and entirely self-interested. Recent research from
the behavioral economics is providing more realistic and empirically centered
findings about human behavior. This research has found that people can be put off
by complexity, they procrastinate and that they hold non-standard preferences and
beliefs. To the extent that these are relevant in labor markets, they change our
understanding of what polices and how policies should be designed to meet their set
objectives.

In what follows we will look at the following three labor market policies that are
relevant to boosting employment within the model we have just explored:
1). The first involves unemployment compensation and its effect on job search
intensity. One solution to the negative effects on job search intensity caused by
unemployment benefits is the inclusion of some sort of wage-loss insurance. Wage-
loss insurance assists individuals with the psychological adjustment that comes with
changing labor market conditions and helps mitigate likely biases in wage
expectations that more than likely deter work incentives.
2). The second is with respect to employment services and job search assistance.
These programs help to match employers with employees and thus improve matching
efficiency. It is argued that these should be expanded to provide accessible and
meaningful information about labor market conditions and occupational
projections. These should help address procrastination in job search and provide
help to the unemployed and low wage individuals in a way that both reflects and
takes advantage of the way people process information.
3). When dealing with mismatch (as we have discussed) job training is essential to
moving workers from dying industries to thriving ones. It is suggested that these job
training programs should simplify take-up, navigation and completion and provide
user-friendly information of the quality of training providers. These should also
structure choices to reflect limited abilities of individuals to manage complexity and
exert self-control.

Unemployment Benefits
Unemployment compensation policies are essential for sustaining consumption over
the business cycle by helping the unemployed to survive without completely relying
on there savings habits (people in the United States generally have pretty poor saving
habits). The problem as stated earlier is the tendency of these benefits to distort
incentives to search for and take new employment. Increases in the generosity of
benefits, either through increases in benefit levels or the duration of benefits, seem to
lengthen the unemployment spells of those receiving unemployment
insurance. Individuals return to work when they receive a job offer that pays more
than theirreservation wage.

Reservation Wage: The wage w^r is called the reservation wage and represents the
lowest wage offer that an unemployed worker will accept.

One thing that behavioral economics tells us is that individuals have imperfect self-
control which are expressed by time-inconsistent preferences. As a direct
consequence, workers may procrastinate in their job search efforts even when such
delay goes against their own long-run self interest. The unemployed may be hesitant
to consider and slow to accept even quite reasonable job offers. Individuals holding
out for offers that will never come remain on unemployment insurance for
inefficiently long periods. One reasonable possibility is that individuals will set their
reservation wage at the level they have received in the past, but this may prove to be a
severe upward bias in their wage expectations given current labor demand
conditions. Additionally, individuals might be loss averse in the sense of having
preferences that rely on previous wages with a potentially large demoralizing
psychological cost of taking a job paying below their previous earnings. Restated
another way, people would rather not take a job that paid below what they think
they're worth (because it may seem degrading or "beneath" them) than take a job and
at least have some working income.
Loss aversion: An individuals tendency to strongly prefer losses to acquiring gains.
These effects lead individuals to be reluctant when accepting job offers below their
previous wage, to be unwilling to move or relocate to areas with greater job
opportunities and to search for jobs mainly just like the one they just got fired from
or even to pass up reasonable opportunities while waiting for their old job (or a very
similar one) to return. This observation is sometimes referred to as "retrospective
wait unemployment" and is particularly important for long-termed unemployed
workers displaced from high wage sectors in decline (like the automobile and steel
industries). It is reinforced by the social status and personal identities of many
workers strongly tied to their former jobs, after all it is what they are good at and
comfortable with. Wage-loss insurance is one promising policy which may help to
address these issues.
Wage-loss Insurance

Wage-loss insurance (also called wage insurance) is a policy which temporarily

subsidizes worker earnings upon reemployment when the wage they receive on their
new job is less than that of their old job. It lowers the reservation wage of the
individual receiving unemployment insurance thus leading to shorter durations of
unemployment. By manipulating the realized value of wages and making job offers
more attractive, it takes care of some of that psychological fear that most workers
have about making less than before. In the longer run, it may even smooth the
painful but sometimes necessary process of psychological adjustment to a lower wage
employment. In making job offers more appealing, a wage-loss insurance program
would effectively lower wage expectations and mitigate the effect of loss aversion. By
taking away the social stigma of accepting a lower wage wage-loss insurance
encourages the search effort of the unemployed and increases the job acceptance rate
of those receiving unemployment benefits.

Employment Services and Job Search Assistance

One major goal of labor market policies is to help searching individuals find a job.
These policies therefore effect the efficiency with which job matches occur and
directly impact our matching function. There are currently a handful of
interconnected programs that enhance the returns from job search and these include
informational services as well as actual job search help. The Employment Service
provides placement assistance to both workers and employers, maintains labor
exchange listing, and performs outreach to employers. The Workforce Investment Act
(WIA) provides both counseling and assistance for job seekers. Workers obtain
access to these services through multiple channels, the most important of which are
referrals from workers taping into the Unemployment Insurance (UI) program. The
goal of these programs is to help individuals return to work quickly and even help
improve the quality of matches between workers and jobs.
Searching for work is a strenuous and complicated process. Behavioral
economics stresses that individuals are limited in the attention and computational
capacity they can bring to multifaceted problems. In fact, the speed and quality of
employment matches may suffer due to the less than perfect ability of individuals to
manage the complex tasks of job search. Looking for work is a substantial
information problem. Workers have to understand labor market conditions, have
knowledge of openings and application processes, posses an accurate understanding
of their own still sets and how firms and markets may value those skills. Additionally,
searching for work requires willpower, which can be difficult for people with zero will
power (we call these people unmotivated). Workers, more likely than not, will be
tempted to procrastinate in their job search in favor of other activities, like watching
AMC and making daily trips to United Dairy Farmers convenience stores. Properly
designed job search assistance programs can help deal with these issues.

Policy Options

Increase Enrollment

Employment services and job search programs generally work well. So one idea is to
increase the amount of people using these resources and maybe even mandating that
those on unemployment insurance must enroll into one of these programs. This
would certainly help individuals to overcome the desire to procrastinate. There is
even evidence that the threat of enrolling someone into a job search program will
cause them to accept a job much sooner than they would have otherwise.

Simplify and Streamline the Experience

Simplifying and streamlining the experience should help individuals with managing
the complexity found in the job search process. Employment and job search
assistance tools should be widely available and easy to use, both physically with One-
Stop Career Centers (the Walmart for job search) and online.

Job Training

As we have seen one of the causes for outward shifts in the Beveridge curve are when
employees skills become obsolete. One vital set of labor market policies, alleviates
this impact as they are aimed at providing workers with the skills they need to take
advantage of career opportunities. The current workhorse of these U.S. public-sector
job training efforts is the Workforce Investment Act (WIA). The WIA offers
occupational skills training and on-the-job training programs to both dislocated and
disadvantaged workers. Services are delivered through One-Stop Career Centers and
funds are made available in Individual Training Accounts (ITAs). Other major
supports for job training include Pell Grants, which low-income workers can use to
fund educational programs that lead to a certificate or degree, and the Lifetime
Learning Credit, which is a nonrefundable tax credit available to offset educational
expenses.
Overall the results of these programs are found to be disappointing. Although the
labor market returns to education are well established, programs that support job
training for mid-career individuals have a mixed-record. For women the returns
through improved earnings are significant, but men have seen little improvement in
earnings.
Behavioral economics suggests that the unsatisfying results of some job training
programs may be due in part to a failure of such programs to respond accurately to
the psychology of workers who could benefit from training. Results from behavioral
economics suggest that the determination and whether to undertake job training, the
selection of a field to be trained in as well as a provider, and the pursuit and
completion of that training, represents an inherently challenging sequence of choices
and actions for imperfect individuals. Individuals often fail to choose optimally
under stress and have difficulty exerting self-control in starting up and persisting in
investment activities with distant payoffs. People are inherently short-sighted.
Therefore, a successful job training program is one that reduces complexity and the
need for willpower.
Current job training programs focus on administrative efficiency rather than end
user experience. As a result, these programs are complicated to use and access.
Furthermore, there has been a push from publicly providing job training to providing
individuals access to funding to pursue their own choice of training. This policy may
put too much responsibility in the workers hands, as they may be ill equipped to
manage all of the tasks involved. There is a very strong possibility that the very
individuals who might benefit most from the training may have the most difficulty in
obtaining it.

Policy Proposal: Simplify

Following from the above observations- an explicit goal of the WIA program should
be to provide job training services in a streamlined and user friendly fashion. Job
training programs should be user friendly not administrative friendly. These job
training programs should take steps to reduce the barriers to entry that are so
currently prevalent. At the very least they should ensure that the requirements are
not more onerous for those that need it the most.
 Training programs provided through One-Stop Career Centers should emphasize
reducing complexity and providing guidance to participants as priorities.
Additionally, access to Pell grants should be simplified and programs should be
integrated. For example Pell recipients enrolled at a community college should
receive services through the associated One-Stop Career Center. The One-Stop
system is deemed by many to be the right model on which to build, but regardless
policy should reflect an emphasis on the user friendliness from the participant
perspective.

This section is based on work done by Babcock, Congdon, Katz, and

Mullainathan (2010)

Well, this post wraps up my special mini-series on the modern job search and
matching theory of unemployment. If you would like more information please refer
to the paper from which all of this is the basis of. This will probably be my last post
for a while, thank you.

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