An Aspect of the Economic Role of Unemployment

Economic thought on the role of unemployment has evolved in the past decade from the view that unemployment is a simple waste of resources to the view that at least some unemployment is privately and socially beneficial because it yields a better match between jobs and workers. The papers by Phelps, Holt, and Mortensen in the famous volume, Microeconomic Foundations of Employment and Inflation Theory (1970) have been especially influential in bringing about this change in thinking. The literature on the microeconomics of unemployment has not settled the issue of the optimality of the equilibrium level of unemployment present in an unfettered competitive economy. The extreme view that the private and social costs and benefits are precisely equal is not widely held. In his thoughtful review of the subject (Tobin, 1972), James Tobin has observed that the process of job search involves externalities associated with congestion and queuing, but is uncertain ‘whether the market is biased toward excessive or inadequate search’ (p. 8). My purpose in this paper is to study one specific externality in considerable microeconomic detail. The externality arises from the effect of unemployment in the market on the hiring and firing policies of employers. Earlier empirical work of mine has suggested the following hypothesis, which Arthur Okun has picturesquely called the ‘spare tyre theory’: firms in chronically tight labour markets try to minimise turnover by holding overhead labour during temporary reductions in demands for their products. The costs of recruiting in tight markets motivates this policy. In chronically slack markets, on the other hand, firms treat the unemployed as a readily available buffer stock from which they can draw whenever labour is needed. They do not hold overhead labour because recruiting labour when it is needed is inexpensive.