Academic journal article Federal Reserve Bank of St. Louis Review

The Revealed Cost of Unemployment

Academic journal article Federal Reserve Bank of St. Louis Review

The Revealed Cost of Unemployment

Article excerpt

Traditionally the costs of unemployment have been thought of in terms of the output or national income directly foregone. The most notable of these approaches is Okun's Law, which states that a one-percentage point increase in the unemployment rate translates roughly into a three-percent shortfall in output. Approaches such as this are incomplete for normative analysis because they do not provide a measure of the utility losses attributed to cyclical unemployment. Our proposed method for measuring these losses is based on the notion that the unemployment rate is a measure of general labor market risk. Because fluctuations in the unemployment rate reflect changes in risk, the cost of cyclical unemployment can be measured by the amount that people are willing to pay to avoid it.

Rosen (1979) and Roback (1982) view general lab or market conditions, as represented by the unemployment rate, as a region-specific amenity that is taken into consideration when agents make migration decisions. The standard of living is the utility level that the average agent attains from the income and amenities of a region. If migration is frictionless: Utility-maximizing agents are optimally located at every point in time, the standard of living is uniform across regions, and interregional income differentials indicate the compensating differentials paid for differences in unemployment and other amenities (the 'voting with your feet" criterion of Tiebout, 1956). Therefore, the compensating differential for a region's unemployment rate can be obtained by controlling for the differences in the other amenities. [1]

Following Tiebout, a large body of work has been produced in the regional economics and regional science literature dealing with compensating differentials, wages, and migration (see Porell, 1982, for a partial survey). At the same time, following Harris and Todaro (1970) and Hall (1970), macro-labor economists have produced many papers examining the relationships between migration, wages, and unemployment rates (see Ghatak, Levine, and Wheatley Price, 1996, for a survey). The most recent significant addition to this latter literature is Blanchflower and Oswald (1994), who have called into question a basic result of Harris-Todaro type models, which is that high unemployment rates are compensated for with higher wages.

The most glaring difference between the two approaches is that the macro-labor literature generally ignores the fact that potential migrants consider things other than wages and unemployment. Because of this, the literature searches for a link between those two variables as a means of proving or disproving that compensating differentials exist. It is recognized in the regional literature, however, that such a link, although interesting, proves little because wages and unemployment rates both can be compensated for with high levels of amenities. More importantly, given the ongoing debate among regional economists about the appropriateness of the assumption of standard-of-living equivalence, which is common to both literatures, the empirical results of both should be viewed with some trepidation. [2]

Our approach follows Rosen (1979) and Roback (1982) in considering the unemployment rate as a region-specific amenity. It is a departure from their models in that we recognize the possibility that, in the short run, frictions may prevent the optimal allocation of agents across regions. Because of these frictions, differences in unemployment rates and other amenities are not likely to be completely compensated for, meaning that standard-of-living equivalence does not occur at each point in time. To account for this, we follow Greenwood, Hunt, Rickman, and Treyz (1991) in using migration rates to measure the extent to which the system deviates from standard-of-living equivalence.

In our model, the probability of a consumer migrating between his present region and any other region depends on moving costs and the standard-of-living differential he perceives. …

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