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Theoretical and Empirical Literature on Determinants of Unemployment

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Theoretical and Empirical Literature on Determinants of Unemployment essay

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Theoretical Literature

Labor Market Theory

Political economists argue that labor market institutions can also influence the rates of unemployment. Labor market institutions such as trade unions set wages by rules and not price mechanism. Wage setting through rules forms part of the labor market legislation, which constitutes various laws that the government uses to govern the labor market processes and hence determine labor market outcomes. There are laws, for instance, which specify minimum wage rates and govern the process by which trade unions acquire bargaining rights and the procedures by which they and employers engage in collective bargaining (Hirsch, 2007). By not hiring workers with lower levels of capital, higher unemployment rates are observed for the less educated and inexperienced. In the Kenyan context, this mainly affects women especially in the rural areas where the majority of population resides.

Gender gap in unemployment may also be due to difference in degree of labor market attachment between men and women. Relatively weak attachment of women to the labor market generates disincentives to acquire human capital (Azmat 2006). Low levels of human capital make the gap between marginal product when at work and the reservation wage small. In addition, organizations that reduce labor turnover or employ on contract basis may increase the gender gap if women have a higher outflow rate from employment than men; with reduced hiring rate, the gap is magnified. The outflow of women may be due to family responsibility such as care for young children, special children or the fact that men are supposedly breadwinners and should provide. Another likely cause of the gap in unemployment and underemployment is discrimination. This occurs due to disparities in hiring rates between males and females.

However, where laws that prevent discrimination exist, it is exercised through differential hiring rates. Psacharopoulos (1989) argues that supply and demand for labor change during the process of development. In the early stages of industrialization, agricultural sector loses its importance as the main employer of women. Given that industries expand slowly as compared to contraction of agriculture, the result is an initial increase of female unemployment but the situation reverses with the expansion of service and government sectors. Labor shortages lead to higher availability of part-time jobs and higher wages for women giving rise to a U-shaped pattern of female employment in the process of development.

Classical Economic Theory

Pigou (1933) and Solow (1981) classical theorists argue that the labor market consists of demand and supply of labor. Demand for labor is a derived demand obtained from the declining portion of the marginal product of labor. The demand curve is a negative function of real wage in that if wages increase, the quantity demand for labor declines and the reverse is true. The supply of labor is derived from worker’s choice on whether to spend part of time working or not working (leisure). Supply of hours worked is a positive function of the real wage because if the real wage rises, workers supply more hours of work. In equilibrium, demand and supply of labor are intersected at a clearing point that determines the equilibrium real wage rate and full employment.

Full employment does not imply no unemployment. Frictional unemployment still exists at the going real wage rate. For example, if a worker perceives the disutility of work being greater than the benefit of work or the utility of the real wage, this worker will resolve to not working. This type of unemployment is called voluntary unemployment. Frictional unemployment arises due to the dynamic nature of the labor markets, availability of information and search for better jobs, random fluctuations in demand for labor such as closing of a plant and opening of a new plant. Duration of frictional unemployment is determined by the unemployment insurance benefits and the speed of the information.

Wicksell analyzes technical unemployment due to technological change as well. The introduction of machinery would cause unemployment but the unemployed will search for new jobs hence result to lower wages. For the normal (frictional) unemployment, Wicksell thinks that advertisements and employment agencies can reduce the normal rate of unemployment. Cyclical unemployment, as another type of unemployment, is due to the lack of effective demand. He advocated for a wage rise so that workers buy more. However, this action may cause workers to lose their jobs as a result of higher wages. Essentially, for Wicksell the cyclical unemployment was due to the wrong investment of capital. Capital was invested in areas where rates of return were low.

Hayek (Nishhiyama and Leube 1984: 7) contends that unemployment is due to a discrepancy between the distribution of labor between industries and the distribution of demand among their producers. This discrepancy is caused by a distortion of the system of relative prices and wages. In other words, unemployment is caused by a deviation from the equilibrium prices and wages which would establish themselves with a free market and stable money. This is actually a mismatch between demand and supply of labor, which is usually caused by expansionary monetary and fiscal policies as well as powerful trade unions. These policies create economic dislocation and structural changes in an economy which misdirect labor and other economic resources to other alternatives. Unions are also able to set higher wages compared to market wages which generate unemployment, particularly in industries that become less profitable. In short, for Hayek the unemployment problem is caused by resources being in the wrong places at the wrong time and can be corrected if wages and prices are determined by the equilibrium of supply and demand.

In line with Hayek theory of unemployment, Trehan (2001) provides an important explanation of the search theory of unemployment. Firms search for productive workers and workers search for high-paying jobs. As a result, both agents continue searching until matches are reached. At this point, a worker will leave the unemployment pool. On the contrary, if a worker realizes later on that her productivity is worth higher wages and firms are paying high wages on the average, then the worker’s reservation wage will increase. Consequently, the unemployment rate will start rising gradually indicating a mismatch has occurred again.

The classical theory has little practical significance. It does not provide any solution to the problems of unemployment or trade cycles, hence cannot be used to solve actual problems of the world.

Neoclassical Theory of Unemployment

In the 1950s, major factors of production in the economy of the United States of America were known to be physical capital, labor, land and management (Becker 1964). This changed in the early 1960s when growth of the economy could not be simply explained using the four traditional factors of production. Human capital- a new form of capital that included peoples’ learning capacities was considered as a factor of production in producing goods and services. Since then, the Human Capital Theory (HCT) has been used to understand decisions made by economic agents for instance: choice of employment and health care. The theory of human capital emphasizes role played by education and training in reducing unemployment. It precisely depicts formal education as highly instrumental and necessary in improving the productive capacity of a population. Becker (1964) describes schooling as capital among other factors that raise a person’s earnings. He compares investment in an individual’s education and training to business investments as equipment in that, they both increase productivity and competitiveness. Highly productive workers are usually preferred by employers as compared to less productive workers. Consequently, it is expected that individuals who have higher education are perceived to be more productive and hence more likely to be employed. Similarly for self-employed workers, those with higher education and hence higher productivity are expected to perform better in their businesses than their low productivity counter parts.

A notable limitation of this theory is that it focuses on education as a major determinant in employment hence ignoring the fact that talent may also lead one to employment as seen in the modern world today.

Keynesian Theory of Unemployment

Keynes (1936) considers unemployment as an involuntary phenomenon. He opines that employment is cyclical thus generated by the deficiency of aggregate demand (Mouhammed 2010). Capitalists hire workers and invest to produce output when the expectations about the economy and profits are favorable. If expectations about the future are supported by reality, investments and employment continue rising until equilibrium is reached. This equilibrium is attained by the intersection of the aggregate demand and supply-the point of effective demand which may be less than the full employment equilibrium. If expectations about the future of the economy are not favorable, capitalists invest less and employ less number of workers. Hence, equilibrium is achieved when cyclical unemployment exists. This unemployment is due to the deficiency of the aggregate demand, particularly investment expenditures. Consistent with Keynes’s teaching, Davidson (1998), a representative of Post Keynesian economics, argues that involuntary unemployment is explained by insufficiency of effective demand, instability of exchange rates and international mobility of finances which create uncertainty. This weakens entrepreneurial confidence to make investments to reduce unemployment.

Similarly, other Keynesian theorists argue that unemployment is due to the contractionary nature of the U.S. monetary policy which creates deficiency in aggregate demand. Moreover, Keynesians think that unexpected increase in price level or a higher rate of inflation reduces the real wage and increases demand for labor resulting to a decline in unemployment rates. This idea harks back to the old proposition of Phillips curve suggesting a trade-off between the rate of unemployment and the rate of inflation.

Keynesian theory poses several limitations in that:

It emphasizes more on cyclical unemployment hence ignores other forms of unemployment such as frictional unemployment, technological unemployment, etc.

It does not tell us how to secure full and fair employment.

There exists no direct and determinable relationship between effective demand and volume of employment. It all depends upon the relationship between wage rate, prices and money supply. Moreover, in modern times, most countries are facing the problem of stagflation (i.e., unemployment with inflation).

Keynesian theory is not applicable in underdeveloped countries. Keynes deals with the problem of cyclical unemployment, whereas the underdeveloped countries face the problems of chronic unemployment and disguised unemployment.

Empirical Literature

Kamau and Wamuthenya (2013) analyze causes of youths being unemployed in Kenya’s urban areas. They use a probity model with cross-sectional data of labor force survey in periods 1986, 1998 and 2005 to estimate the determinants of being unemployed. The findings revealed clear differences in gender in unemployment among the youth. Second, age was found to influence the chances of being unemployed for both gender. Third, extra education is key, it increased chances of being employed than being unemployed between 14 to 36 per cent for youths who are female and 0 to 12 per cent for youths who are male. Lastly, married male youths are most likely to find work whereas the female counterparts are most likely not to find work. Kiiru (2009) analyzed factors that explain why some young people would be openly unemployed or would be underemployed whereas other young people are in a position to get full employment in Kenya. The study used multinomial logit model with data from the Kenya Integrated Household Budget Survey (KIHBS) of the period 2005 / 2006. Results obtained revealed that economic background played a role for youth unemployment. Female youths compared to male youths were established as likely to be unemployed and under employed rather than being employed fully. A slight rise in the educational level was found to make a youth be unemployed openly than be employed fully.

Zepeda (2013) studied Kenya’s youth employment challenge. The study analyzed the Kenya Integrated Household Budget Survey data of 2005/2006, and the United Nations Population Statistics of 2011. Youth unemployment challenge was significant both in rural and urban areas. The study showed that young people up to the age of 28 years, depending on the level of education suffered unemployment. Unemployment faced by females is worse than that faced by males. Those that lack formal education experience the highest rates of unemployment. The most burning unemployment problem for the youths is of persons with primary level and secondary level of education. Rate of unemployment amongst persons with tertiary education was restricted to a small percentage of youths and some age groups. Youths appearing in the least 40 percent of the pyramid of income tend to have consistently higher unemployment rates.

Muiya (2014) looked into the nature, challenges and consequences that face unemployment of urban youths in Nairobi. He used primary and secondary data collected from the youth and reports from the government in Mathare slums in July 2013. Data was analyzed continuously throughout the study period using field notes taken daily and establishing emerging patterns which were noted and recorded. The study results implied that majority of young people in Mathare were unemployed because they lacked education and other necessary skills.

Escudero and Maurelo (2013) carried out a study on getting to understand what drives the market for labor in Kenya. They used an econometric model precisely, a time series and data from the period 1990-2011 for Kenya. The study showed that labor market conditions greatly influence the youth in the labor market. In addition, the lower youth employment elasticity of 0.4 compared to the general employment elasticity of 0.9 implied that gains from the growth of overall employment have been absorbed by adults and not the youths. The study also indicated that young females aged (15-24) had 21.1 per cent greater probability of being inactive compared to young males, 26 per cent lesser probability of getting employed and 17.1 percent lesser probability for the population of adults. Tertiary education also played a major role in explaining the gap that existed between young people and adults in getting entrance to the labor market. The aspects reduced the chance of being inactive with 31 and 8.5 per cent, respectively, and increased the chance of getting work by 24 and 7.7 per cent respectively. Further, the idea of a person being employed in the household increased the chances of him/her getting work as well as become entrepreneurial.

Overview of Literature Review

Based on the above literature, it is possible to find various factors that determine unemployment. The theoretical literature brings out education as a necessary factor in improving the productive capacity of a population. Education is seen as investment in human capital. The empirical studies bring out other factors that determine youth unemployment. These are marital status, economic background, whether youths are located in urban or rural areas, gender/age and education level. Whereas various studies have examined determinants of unemployment in Kenya including education levels, these studies do not examine the extent to which the effect of education on employment varies by type of unemployment.

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Theoretical and Empirical Literature on Determinants of Unemployment. (2020, Oct 27). Retrieved from https://samploon.com/theoretical-and-empirical-literature-on-determinants-of-unemployment/

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