CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 599
equilibrium wage of $2 and hiring Ted. It can offer $10 per hour, inducing both Bill
and Ted to apply for the job. By choosing randomly between these two applicants
and turning the other away, the firm has a fifty-fifty chance of hiring the compe-
tent one. By contrast, if the firm offers any lower wage, it is sure to hire the incom-
petent worker.
In many situations in life, in-
formation is asymmetric: One
person in a transaction knows
more about what is going on
than the other person. This
possibility raises a variety of
interesting problems for eco-
nomic theory. Some of these
problems were highlighted in
our description of the theory of
efficiency wages. These prob-
lems, however, go beyond the
study of unemployment.
The worker-quality variant
of efficiency-wage theory illus-
trates a general principle called adverse selection. Adverse
selection arises when one person knows more about the at-
tributes of a good than another and, as a result, the unin-
formed person runs the risk of being sold a good of low
quality. In the case of worker quality, for instance, workers
have better information about their own abilities than firms
do. When a firm cuts the wage it pays, the selection of work-
ers changes in a way that is adverse to the firm.
Adverse selection arises in many other circumstances.
Here are two examples:

the temptation of imper fectly monitored workers to shirk
their responsibilities. According to the worker-effort variant
of efficiency-wage theory, the principal can encourage the
agent not to shirk by paying a wage above the equilibrium
level because then the agent has more to lose if caught
shirking. In this way, high wages reduce the problem of
moral hazard.
Moral hazard arises in many other situations. Here are
some examples:
◆ A homeowner with fire insurance buys too few fire ex-
tinguishers. The reason is that the homeowner bears
the cost of the extinguisher while the insurance com-
pany receives much of the benefit.
◆ A babysitter allows children to watch more television
than the parents of the children prefer. The reason is
that more educational activities require more energy
from the babysitter, even though they are beneficial for
the children.
◆ A family lives near a river with a high risk of flooding.
The reason it continues to live there is that the family
enjoys the scenic views, and the government will bear
part of the cost when it provides disaster relief after
a flood.
Can you identify the principal and the agent in each of these
three situations? How do you think the principal in each
case might solve the problem of moral hazard?
FYI
The Economics
of Asymmetric
Information

ORD FACTORY
CHAPTER 26 UNEMPLOYMENT AND ITS NATURAL RATE 601
was profitable for the firm. Henry Ford himself called the $5-a-day wage “one
of the finest cost-cutting moves we ever made.”
Historical accounts of this episode are also consistent with efficiency-wage
theory. An historian of the early Ford Motor Company wrote, “Ford and his as-
sociates freely declared on many occasions that the high-wage policy turned out
to be good business. By this they meant that it had improved the discipline of
the workers, given them a more loyal interest in the institution, and raised their
personal efficiency.”
Why did it take Henry Ford to introduce this efficiency wage? Why were
other firms not already taking advantage of this seemingly profitable business
strategy? According to some analysts, Ford’s decision was closely linked to his
use of the assembly line. Workers organized in an assembly line are highly in-
terdependent. If one worker is absent or works slowly, other workers are less
able to complete their own tasks. Thus, while assembly lines made production
more efficient, they also raised the importance of low worker turnover, high
worker quality, and high worker effort. As a result, paying efficiency wages
may have been a better strategy for the Ford Motor Company than for other
businesses at the time.
QUICK QUIZ: Give four explanations for why firms might find it
profitable to pay wages above the level that balances quantity of labor
supplied and quantity of labor demanded.
CONCLUSION
In this chapter we discussed the measurement of unemployment and the reasons
why economies always experience some degree of unemployment. We have seen
how job search, minimum-wage laws, unions, and efficiency wages can all help ex-
plain why some workers do not have jobs. Which of these four explanations for the
natural rate of unemployment are the most important for the U.S. economy and
other economies around the world? Unfortunately, there is no easy way to tell.

amount of frictional unemployment.
◆ A second reason why our economy always has some
unemployment is minimum-wage laws. By raising the
wage of unskilled and inexperienced workers above the
equilibrium level, minimum-wage laws raise the
quantity of labor supplied and reduce the quantity
demanded. The resulting surplus of labor represents
unemployment.
◆ A third reason for unemployment is the market power
of unions. When unions push the wages in unionized
industries above the equilibrium level, they create a
surplus of labor.
◆ A fourth reason for unemployment is suggested by the
theory of efficiency wages. According to this theory,
firms find it profitable to pay wages above the
equilibrium level. High wages can improve worker
health, lower worker turnover, increase worker effort,
and raise worker quality.
Summary
labor force, p. 581
unemployment rate, p. 582
labor-force participation rate, p. 582
natural rate of unemployment, p. 582
cyclical unemployment, p. 583
discouraged workers, p. 586
frictional unemployment, p. 587
structural unemployment, p. 587
job search, p. 587
unemployment insurance, p. 589
union, p. 592

2. As shown in Figure 26-3, the overall labor-force
participation rate of men declined between 1970 and
1990. This overall decline reflects different patterns
for different age groups, however, as shown in the
following table.
M
EN
M
EN
M
EN
A
LL
M
EN
16–24 25–54 55
AND OVER
1970 80% 69% 96% 56%
1990 76 72 93 40
Which group experienced the largest decline? Given this
information, what factor may have played an important
role in the decline in overall male labor-force
participation over this period?
3. The labor-force participation rate of women increased
sharply between 1970 and 1990, as shown in Figure 26-3.
As with men, however, there were different patterns for
different age groups, as shown in this table.
A
LL
W

d. a short-order cook who loses his job when a new
restaurant opens across the street
e. an expert welder with little formal education who
loses her job when the company installs automatic
welding machinery
6. Using a diagram of the labor market, show the effect of
an increase in the minimum wage on the wage paid to
workers, the number of workers supplied, the number
of workers demanded, and the amount of
unemployment.
7. Do you think that firms in small towns or cities have
more market power in hiring? Do you think that firms
generally have more market power in hiring today than
50 years ago, or less? How do you think this change
over time has affected the role of unions in the
economy? Explain.
8. Consider an economy with two labor markets, neither of
which is unionized. Now suppose a union is established
in one market.
a. Show the effect of the union on the market in which
it is formed. In what sense is the quantity of labor
employed in this market an inefficient quantity?
b. Show the effect of the union on the nonunionized
market. What happens to the equilibrium wage in
this market?
9. It can be shown that an industry’s demand for labor will
become more elastic when the demand for the
industry’s product becomes more elastic. Let’s consider
the implications of this fact for the U.S. automobile
industry and the auto workers’ union (the UAW).