At A2 level, students are expected to understand the idea of an equilibrium rate of unemployment. We now turn to the concept of the natural rate.

Equilibrium unemployment in an economy

The natural rate of unemployment is defined as the equilibrium rate of unemployment i.e. the rate of unemployment where real wages have found their free market level and where the aggregate supply of labour is in balance with the aggregate demand for labour. At the natural rate, all those wanting to work at the prevailing real wage rate have found employment and thus there is assumed to be no involuntary unemployment. There remains some voluntary unemployment as some people remain out of a job searching for work offering higher real wages or better conditions.

It is worth stating at this point that some economists simply do not believe in the validity of a simple natural rate of unemployment when the labour market is in balance and where a rate of unemployment “settles” at a level consistent with stable wage and price inflation. The natural rate concept is supported by economists who believe in the power of markets to clear at an equilibrium price and who view the labour market much as any other market in the economy.

Consider the next diagram which shows some labour demand and supply analysis. At the real wage rate W1, E1 workers are employed. But at this prevailing wage rate, the total labour force exceeds than the employed labour force. The natural rate of unemployment = AB and consists of frictional and structural unemployment. The government might attempt to reduce the natural rate by bringing down the horizontal distance between the supply of labour and the labour force curve.
 

Any supply-side policy that can increase the number of people willing of working age that are willing and able to find employment in the labour market will shift the labour supply curve to the right, thus narrowing the gap. This is shown in the second diagram.

Policies to reduce the natural rate of unemployment normally focus on improving the efficiency of the labour market be removing what are called “labour market imperfections”. For example a government wanting to achieve a lower equilibrium rate of unemployment might do the following:

• Reform the system of welfare benefits so as to reduce the risk of the “poverty trap”
• Reforming trade unions to reduce their collective bargaining power and also reducing some of the barriers to labour mobility put up by professional bodies and associations which have the effect of limiting the supply of labour into an occupation
• Reducing income tax to improve the incentives to look for and accept paid work
• Adopting a more relaxed approach to labour migration

In general terms, economists who believe that the natural rate of unemployment can be reduced argue that government policies should seek to make labour markets more competitive and flexible. We now move on to discuss the nature of flexible labour markets as part of strategies to boost employment and thereby reduce unemployment.

Economic activity and inactivity

			Millions
	Total economically active	Total in employment	Economically inactive
1980	26.9	25.2	15.8
1990	28.9	26.9	15.9
1993	28.2	25.3	16.8
2000	29.1	27.4	17.0
2005	30.1	28.7	17.6
Source: ONS
Data is for the spring of each year. Includes people aged 16 and over

 

The economically active are those in work or actively searching for work. As we can see from the table above, since the end of the last recession in 1993 the number of economically active in the UK has grown by nearly two million people. But over the same time period, there has also been a rise in the number of people classified as economically inactive. There are various reasons for inactivity. People may choose to return to or stay in full-time education beyond the age of 16; others will leave the labour market to raise a family or look after ill relatives. Others may choose to take early retirement. And for some, the experience of long term unemployment is enough for them to give up the search for work; they move into the welfare system and become almost permanent claimants of a variety of state welfare benefits. If the economy can reduce the number of inactive people, the benefit would be an expansion in the active labour supply and a boost to our long-term growth potential.

The importance of human capital in raising employment and reducing unemployment

Employment rate: by sex and highest qualification, 2005
			Percentages
	Men	Women	All
Degree or equivalent	89	87	88
Higher education	87	84	85
GCE A level or equivalent	81	73	77
Trade apprenticeship	83	73	81
GCSE grades A* to C or equivalent	79	71	75
Qualifications at NVQ level 1 and below	75	63	69
No qualifications	54	42	48
All	79	70	74
Percentage of the working-age population in employment
Source: Labour Force Survey, ONS

 

Upgrading and improving the skills of people is really important in raising employment rates. The data in the table above is taken from 2005 and shows that employment rates among people of working age is significantly higher for people with a good base of GCSE qualifications or above or vocational qualifications at level 1 or above.

Key Points

• Equilibrium in the labour market is when labour demand equals labour supply
  Even when the labour market is in equilibrium there will still be frictional and structural unemployment and also some seasonal unemployment
• The natural rate of unemployment can be reduced mainly through supply-side labour market policies which improve work incentives and re-skill people looking for work
• It is very difficult to observe the natural rate of unemployment directly because it is rare for the labour market to be in a state of equilibrium!