July 2017

Labour Market Bulletin

Jargon Buster: Full employment and slackness in the labour market

This section explains two key economic principles that are finding prominence within the press; full employment and labour market slackness.

Full employment is a counter-intuitive term which actually refers to a particular level of unemployment. The unemployment rate* is a measure of the amount of able and willing workers who are currently out of work. The employment rate is a measure of the amount of able workers in work. The latter includes those who are economically inactive (those not willing to work), therefore, 0% unemployment will never coincide with 100% employment. Furthermore, full employment is not 100% employment or 0% unemployment.

The unemployment rate can never be zero because of: 1) Frictional Unemployment - people moving between jobs who, as a result, may be temporarily unemployed. 2) Structural Unemployment - people being out of work due to industrial organisation (like people losing their jobs to machines). These people then need to re-train to find employment. 3) Skills mismatch - there will always be a proportion of people who cannot find work because their skills are not right for the job. Therefore, there will always be some level of unemployment.

We can then easily deduce that the employment rate could never be 100%. Not only is there always a proportion of the workforce who will not want to work (students, sick, inactive etc.), if there is some level of unemployment, by definition, we cannot have 100% employment. As a result, full employment will be at some positive rate of unemployment and at an employment rate much lower than 100%.

An easy way of grasping the full employment level is by using a sequence of illustrations representing different economic scenarios. Below are three seesaws containing two counter-balancing weights; the unemployment rate and wage growth.

Scales graphic 1

Firstly, consider a scenario in which the unemployment rate is high (1). In this case, a large proportion of people, who are able and willing to work, will be out of work. The economy is effectively not utilising all the labour at its disposal and will therefore not be growing as fast as it can. Wage growth will be low for two reasons; One - there are more unemployed people to choose from for each vacancy, reducing the bargaining power of each worker. Two – an under-performing economy will not be able to afford higher wages.

On the right seesaw (3), the unemployment rate is low. The economy will be utilising almost everybody who is able and willing to work. If we apply the two variables in the first scenario, wage growth will be high; One - the pool of unemployed will be smaller and to get the right person for a job you either have to pull them away from another job or incentivise those who are economically inactive. Both require higher wages. Two – an over-performing economy will be able to afford higher wages. Higher wages will result in higher costs for businesses and subsequently higher prices for consumers. This is one way low unemployment creates inflation.*

The last scenario (2) is the point of full employment. The unemployment rate is at a level where all the workers who can easily or usefully be hired are working, and new hires can only occur by luring people from jobs by offering them higher wages. This level of unemployment is known as the natural rate of unemployment. This rate has typically been 4.5% for the UK, however it varies by economy. In short, it will depend on skills and education, the degree of movement between jobs, the supply of labour, and the sectors most prominent in the economy.

Using what we know, let us take Warwickshire’s economy as a case study. Skills and education within the economy are generally higher or on-par with the national average. A better-skilled and qualified workforce tend to be employed in better jobs. Job turnover (the movement from one job to another) is lower among better-skilled occupations, reducing the movement of workers between jobs. The workforce is also relatively small (large older population), meaning the pool of unemployed will be absorbed relatively quickly if the demand is there. These factors play a role in reducing the natural rate of unemployment, showcased by Warwickshire’s consistently low unemployment rate and high employment rate.

Slackness describes the responsiveness of wages to changes in the labour market. When a labour market is slack there are many job-seekers chasing a few vacancies, corresponding to low wage growth. This will tend to be the case in Scenario 1, above. When the unemployment rate is high, there are many job-seekers, and because the economy will be under-performing, firms will find it hard to create jobs. Consider a coil on the below seesaw - when the coil is slack, the labour market will be slack, and wage growth will be low.

However, if the unemployment rate drops, the coil will become taut. In this case, it is said that the labour market is tight. Intuitively, this is a scenario in which there are many vacancies chasing few job-seekers. We can, therefore, imagine that at the natural level of unemployment, or full employment, the labour market will be tight and that wages will begin to rise.

Scales graphic 2

The degree of labour market slackness helps policy makers estimate the natural rate of unemployment. The point at which the unemployment rate coincides with a ‘normal’ level of wage growth (when wages grow at the same rate as inflation), will depend on the responsiveness of wages to unemployment changes. This responsiveness, or slackness, will depend on the balance between labour supply (which is dependent on the unemployment rate, participation, population and hours worked) and labour demand (dependent on the employment rate and job vacancies).

Again, let us take Warwickshire’s economy as a case study. On the supply-side, Warwickshire’s unemployment rate is below its long-run average. Participation of the 16+ population is declining and the older population is growing faster than the increase in over 65 participation. On the demand side, employment is increasing and the number of job vacancies is growing at a faster-than-average rate. We should, therefore, assume that Warwickshire’s labour market is tight and that wages will respond strongly to this fall in unemployment. In the past year, wages have already started to increase in the county and one could assume that they will continue to outgrow the national average.

*An example of low rates of unemployment was during post-war periods. The only reason wage-growth and inflation did not increase at an unsustainable rate during these times is because the majority of workers were in low-skilled, low-wage jobs. These tended to have less bargaining power and thus saw smaller increases in wages.

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