In this chapter, we delve deeper into the microeconomic foundations of models of the determination of the equilibrium (or natural) unemployment rate, assuming that there are matching frictions in the labor market.
We focus on one of the most important dynamic models of this category, the Mortensen-Pissarides model.1
In this model, employers are incurring costs to create job vacancies, and the process of creating jobs involves the matching of firms that have vacancies with unemployed job seekers.
At each instant, there are two flows: into and out of unemployment. Some workers lose their jobs and move from jobs to unemployment, and some of the unemployed find jobs, through the matching process, with firms that have vacancies. Thus, this model explains both equilibrium unemployment and labor market flows in and out of unemployment.In the simpler versions of the model, the probability of job termination is exogenous. This parameter describes the structural or cyclical shocks affecting the economy, leading to the destruction of jobs.
The probability of filling a vacancy, as well as the probability of an unemployed job seeker finding a job, are endogenous variables in this model. They depend on the degree of labor market tightness, which is defined by the ratio of vacancies to the number of unemployed. The higher the tightness of the labor market is, the greater will be the probability that an unemployed job seeker will find a job, and the lower the probability that a firm will fill a vacancy.
In the steady state, the flows to and from unemployment are equalized, and the equilibrium unemployment rate depends (1) positively on the exogenous probability of termination of a job and (2) negatively on the endogenous probability of an unemployed job seeker finding a job. The equilibrium unemployment rate therefore depends negatively on labor market tightness, and of course is determined endogenously. The negative relationship between the equilibrium unemployment rate and the vacancy rate that is implied by this dependence is known as the Beveridge curve.
Real wages are determined in equilibrium by decentralized bargaining between firms that have vacancies and unemployed job seekers. The equilibrium real wage is the result of this negotiation. It depends positively on the relative bargaining power of the unemployed, the level of unemployment benefits, labor productivity, the cost of maintaining a vacancy, and labor market tightness.
In the equilibrium of this model, the unemployed are worse off than the employed. Consequently, unemployment is an undesirable and involuntary condition and is not the result of choice by the unemployed, unlike in competitive models of the labor market without frictions.
The basic idea of search or matching models of the labor market, such as the Mortensen-Pissarides model, is that the labor market functions in a decentralized and uncoordinated way, and job creation is a costly process that requires time for both job seekers and firms. Consequently, jobs entail rents, something that does not apply to fully competitive labor market models. This matching class of models is the class we shall focus on in the remainder of this chapter.
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