Unemployment is a situation in which an individual who is actively looking for employment is

unable to secure one. The unemployment rate represents the number of these unemployed individuals in
the workforce.

CAUSES BASED ON THE CATEGORIES AND TYPES OF UNEMPLOYMENT

The two broad categories of unemployment are voluntary unemployment and involuntary unemployment.
Unemployment is voluntary when an individual willingly left his or her job in search of a new one. There
are specific and more personal causes of voluntary unemployment including a desire to look for a higher
salary, professional development, migration or relocation, and conflicts with the employer or colleagues,
among others.

On the other hand, unemployment is involuntary when an individual has been laid off and has no other
choice but to look for another job or when he or she is willing to work at the prevailing wage but remains
jobless. A high rate of involuntary unemployment within an economy indicates a surplus of labor.

There are more specific types of unemployment apart from the aforementioned categories. These are
structural unemployment, frictional unemployment, and cyclical unemployment. They provide a partial
explanation of the causes of unemployment. Take note of the following:

• Structural Unemployment: Structural unemployment arises from the inability of the labor market to
provide jobs for every member of the workforce because of a mismatch between the skills of the
unemployed individuals and the skills requirements of specific jobs, or because of technological advances
in which people are replaced by machines or their skills become outdated because of inability to keep up
with latest trends.

• Frictional Unemployment: Frictional unemployment occurs when an individual is in between jobs. It

corresponds to the time when this individual has to find another job after leaving his or her employer or
when he or she is transitioning from one job to another. Note that this type of unemployment has some
overlaps with structural unemployment. However, its defining characteristic is that it is usually short-
lived.

• Cyclical Unemployment: Cyclical unemployment represents the offshoots of the business cycle and the
boom-and-bust cycle of the economy. Keynesian economics explains that the frequent shifts in the
business cycle and severe economic downturns, such as in the case of the Great Depression, lead to a
shortage in aggregate demand that is not enough to provide employment for everyone who wants to work.

MAJOR THEORIES EXPLAINING THE CAUSES OF UNEMPLOYMENT

There are several theories of unemployment. Each theory provides an explanation of the factors and
causes of unemployment.

1. Classical Unemployment Theory

Several schools of thought in economics such as classical economics and the Austrian School of
economics argue that unemployment increases with government regulation or intervention. Their
arguments collectively form the classical unemployment theory.

There are different ways regulations and interventions contribute to unemployment. For example, raising
the minimum wage increases the labor costs more than the economic value of the actual labor, especially
the value of jobs that merely require low competencies. Businesses respond to these minimum wage laws
by refusing to hire more laborers to reduce their costs and optimize their operations.
 Labor laws that restrict layoffs or downsizing promote the security of tenure, and mandate the provision
of benefits beyond wages are another example. Some businesses are less likely to hire or expand their
workforce because of the legal and financial risks stemming from stringent labor laws.

2. Implicit Contract Theory

Greek macroeconomist Costas Azariadis and American economist Joseph Stiglitz introduced the implicit
contract theory of unemployment in 1983. They developed this theory to explain why there are quantity
adjustments or layoffs instead of price adjustments or wage adjustments in the labor market, especially
during economic downturns. In other words, this theory tries to explain the primary cause of
unemployment during a recession.

The implicit contract theory specifically claims that labor contracts and labor laws make it difficult for
employers to cut the wage of their existing laborers. Hence, during a recession in which businesses need
to save costs and optimize their operations, they usually choose to layoff their laborers or downsize their
workforce instead of implementing wage reductions.

3. Efficiency Wage Theory

Renowned economist Alfred Marshall introduced the term “efficiency-wages” in his 1890 book
“Principles of Economics” to indicate the equivalent wage per efficiency unity of labor. Proponents of
this preliminary concept argued that employers should pay their workers differently based on their
efficiency. In other words, a more efficient worker should have a higher wage than a less efficient worker.

The Marshallian concept evolved until it became the efficiency wage theory. It argues that businesses can
operate more efficiently and become more productive if they provide wages above the equilibrium level.
To be specific, increasing wages beyond the current labor benchmark could lead to better efforts from the
employees, decrease employee turnover, attract highly competent employees, and promote the wellbeing
of employees.

However, there is a downside to paying high wages beyond the equilibrium level. A high-paying
employer will naturally attract more employees. Other employers might also offer higher payouts to keep
up with the competition in the labor market. Unemployment might transpire if this practice becomes
widespread because it not only makes labor costlier, thus compelling employers not to expand their
workforce, but also creates unrealistic expectations in the labor market in which employees would not
dare offer to work for lower wage and employers would rather stay away from hiring individuals offering
work for a lesser payout because such might be an indicator of incompetence.

4. Keynesian Theory of Unemployment

Keynesian economics provides an alternative theory of unemployment. John Maynard Keynes and
adherents of the Keynesian school of thought have explained that unemployment occurs when there is not
enough aggregate demand in the economy. After all, if demands for goods and services decrease, then
there is a lesser need for production and consequently, lesser needs for workers.

Economic costs of unemployment

 Loss of earnings to the unemployed. Unemployment is one of the biggest causes of poverty. Prolonged
periods of unemployment can push households into debt and increase rates of relative poverty.

 Potential homelessness. Loss of income can leave people without sufficient income to meet housing
costs. Rises in unemployment often exacerbate the rates of homelessness.
 Harms future prospects. Those who are unemployed will find it more difficult to get work in the future.
 Stress and health problems of being unemployed. Amongst studies of unemployed men, signs of
depression, mental anxiety, and health problems are noticeably higher. (Effects of unemployment on
health).
 Lost human capital. If people are out of work, they miss out on ‘on the job training’ This is a vital
component of human capital and labour skills; high rates of unemployment can reduce labour
productivity. If someone is out of work for two years, they miss out on latest working practices and
trends. Being unemployed can also affect the confidence of the unemployed and they become less
employable in the future.
 Increased government borrowing. Higher unemployment will cause a fall in tax revenue because there
are fewer people paying income tax and also spending less (hence lower VAT). Also, the government will
have to spend more on unemployment and related benefits. The government doesn’t just pay
unemployment benefit, but a family who has unemployment will be more likely to receive housing
benefit and income support.
 Lower GDP for the economy. High unemployment indicates the economy is operating below full
capacity and is inefficient; this will lead to lower output and incomes. The unemployed are also unable to
purchase as many goods, so will contribute to lower spending and lower output. A rise in unemployment
can cause a negative multiplier effect.
 Increase in social problems. Areas of high unemployment (especially youth unemployment) tend to
have more crime and vandalism. It can lead to alienation and difficulties in integrating young unemployed
people into society.
 Political instability. The period of mass unemployment in the 1930s led to social unrest. In Germany, an
unemployment rate of 6 million was an important factor in the rise of Hitler and the Nazi party.