Economic Letter 2001-28; October 12,
Unemployment and Productivity
During the latter half of the 1990s, productivity grew at almost twice
the pace of the preceding ten years. Widely attributed to developments
in the information technology sector, this surge in productivity was accompanied
by an unemployment rate that dropped to unusually low levels. Another
example of this relationship between productivity and unemployment—though
in the reverse direction—is the decade of the 1970s. Productivity growth
slowed sharply in the early 1970s (and stayed low for several decades),
while unemployment increased noticeably. While both productivity and unemployment
do respond to other changes in the economy, these episodes make one wonder
about the impact that independent (perhaps technology driven) changes
in productivity might have on the unemployment rate. This Letter
discusses some of the reasons put forward by economists to explain such
a relationship. We begin by describing a theory of unemployment.
The search theory of unemployment
The theory starts with the assumption that workers have different skills
and that jobs have different skill requirements. Workers need to find
well-paying, desirable jobs, while firms need to find the most productive
workers. Neither firms nor workers have all the information they need
about the options available to them, so they must engage in search. Since
search is costly and time-consuming, both firms and workers must use some
of their resources to find a good match.
Workers are assumed to search only when they are unemployed. They face
an uncertain environment (just as firms do). When a worker gets a wage
offer, for instance, she must decide whether to accept it or continue
searching for a better offer. Accepting the offer means forgoing the chance
of a higher wage offer later, while continuing the search means losing
the wages she would have earned if she had accepted the offer and started
working. The wage at which the worker is indifferent between continuing
the search and accepting the current job is called the reservation wage.
The worker accepts all job offers above this wage and turns down all offers
When a search is successful, that is, when there is a match between the
needs of the worker and the firm, the worker leaves unemployment. However,
existing matches sometimes fall apart, which leads to the worker becoming
unemployed. At the equilibrium unemployment rate, the number of workers
leaving unemployment equals the number of workers becoming unemployed.
A temporary effect
The relative level of the reservation wage is obviously a crucial determinant
of the level of unemployment in the economy. If the typical worker's reservation
wage is significantly higher than the typical wage offer, she will tend
to turn down more offers and spend more time searching for a job. Consequently,
the unemployment rate will tend to be higher.
The wage offered by the firm is directly related to the worker's productivity.
Assume, now, that there is an economy-wide increase in productivity that
workers are not aware of. The higher productivity makes it more attractive
for the firm to increase employment and allows it do so by increasing
the wage it offers to workers. This, in turn, increases the likelihood
that the average worker will find an acceptable job offer and reduces
the time she is likely to spend searching. Thus, the unemployment rate
will decline in response to the increase in productivity.
This drop in the unemployment rate is unlikely to be permanent, however,
even if there is no subsequent decrease in productivity. This is because
workers will come to realize that all firms are offering higher wages
than before, and, consequently, their reservation wage will gradually
adjust to the higher level of wage offers in the economy. As this occurs,
the level of unemployment will gradually go back to the level that prevailed
before the increase in productivity. Of course, the reservation wage could
adjust slowly, and so it could take a while for the unemployment rate
to go back up to its original level. Even so, the key implication is that
a change in the level of productivity cannot have a permanent effect on
the level of the unemployment rate.
A simple, intuitive way to see the force of this argument is to examine
the long-run behavior of the unemployment rate relative to the level of
productivity. Even if we confine ourselves to the last half of the 20th
century, we find that productivity has grown by a large amount, with no
evidence of a trend in the unemployment rate (see Figure 1). For instance,
the unemployment rate in 2000.Q4 was approximately 4%, which is also the
level that prevailed in 1956.Q1 and 1967.Q4. By contrast, the level of
productivity (as measured by output per hour) in 2000.Q4 was nearly 80%
higher than it was in 1967.Q4 and 150% higher than it was in 1956.Q1.
Some reasons to expect a permanent effect
Within the context of the search theory of unemployment, one way in which
an improvement in technology could have a long-lasting effect on the unemployment
rate is if it led to a permanent increase in the rate at which searching
firms and workers "find" the right match. This is exactly what Gomme (1998)
suggests that the Internet has done. Firms now routinely post vacancies
on the Internet, so that workers can look for jobs in multiple (perhaps
remote) locations at almost no cost. Saving (2000) notes that several
million resumes are now estimated to be online and that the Internet is
available to roughly half the U.S. population. These developments should
help reduce the amount of time that firms and households have to spend
searching for the right match, and so should help lower the equilibrium
Changes in the long-run growth rate of the economy also can affect the
equilibrium unemployment rate—even without a change in the search technology.
The firm's decision to hire a worker involves balancing the costs of hiring
that worker against the profits that will accrue once the worker is hired.
As Pissarides (2000) points out, the hiring costs are incurred now, while
the profits are realized over time. Other things equal, an increase in
the trend rate of growth raises future profits and makes it attractive
to increase hiring today. Thus, an increase in the trend growth rate will
lead to a decrease in unemployment, while a decrease in the trend growth
rate will lead to an increase in unemployment.
This result is sensitive to changes in certain assumptions underlying
the model. For instance, Aghion and Howitt (1998) point out that technological
progress does not occur evenly across sectors and that it tends to destroy
old jobs at the same time that it creates new ones. If an increase in
the pace of innovation actually increases the rate of job destruction
more than it increases the rate of job creation, the equilibrium unemployment
rate may actually go up.
Mortensen and Pissarides (1998) look at how technology affects unemployment
in a model in which firms are assumed to lock in the existing technology
when they create a new job. Because of technical progress, the technology
embodied in a particular job becomes obsolete over time. The firm then
has a choice of whether to spend the money to update the technology in
the existing job (and this may involve retraining the worker) or to destroy
the job. In their model, the cost of updating the technology is the key
determinant of the relationship between productivity and unemployment.
To take one example, if updating costs are prohibitively high, faster
technical progress (which makes existing capital obsolete faster) leads
to greater job destruction. Note that because job creation and destruction
depend upon job updating costs which are likely to vary by firm and by
industry, the model does not provide an unambiguous prediction about the
relationship between economy-wide productivity growth and unemployment
in the data.
The model by Manuelli (2000) provides perhaps the most direct link between
the 1970s and the 1990s. In his model, an anticipated (but not yet realized)
improvement in technology reduces the market value of existing firms,
which causes firms to cut back on investment and job creation. Thus, the
unemployment rate goes up. Once the new technology becomes available,
firms begin to increase investment and create more jobs, causing the unemployment
rate to fall. Manuelli argues that stock markets fell and unemployment
rose in the mid-1970s partly because markets realized that new technologies
were coming that would make existing ones obsolete. These new technologies
(relating to computers and information technology) began to mature sometime
in the 1980s, causing unemployment to fall and productivity to rise over
time. His model does not predict a productivity slowdown in the 1970s,
though others have proposed similar models that do.
Economic theory provides us with a number of reasons why the unemployment
rate might be affected by a surge or a fall in the rate of productivity
growth that is due to technological developments. However, at this point,
we do not have a lot of evidence on the relative importance of the different
links emphasized by different models. It will take further research to
determine the relevant empirical magnitudes.
It is likely, though, that part of the decrease in unemployment during
the second half of the 1990s represents a temporary response to the surge
in productivity and the associated boom in the economy. To the extent
that this is true, one should expect to see the unemployment rate stabilize
above the lows seen during this expansion—even if productivity continues
to grow at rates comparable to those achieved during the second half of
the 1990s. The development of the Internet as a tool for job search, on
the other hand, argues that the level of unemployment at which the economy
settles—the equilibrium level—is likely to be lower than before. Once
again, at this point it is hard to say how much lower.
Aghion, Phillipe, and Peter Howitt. 1998. Endogenous Growth Theory.
Cambridge: MIT Press.
Gomme, Paul. 1998. "What Labor Market Theory Tells Us about the 'New
Economy'." Federal Reserve Bank of Cleveland Economic Review QIII,
Manuelli, Rodolfo E. 2000. "Technological Change, the Labor Market and
the Stock Market." NBER Working Paper 8022 (November).
Mortensen, Dale T., and Christopher A. Pissarides. 1998. "Technological
Progress, Job Creation, and Job Destruction." Review of Economic Dynamics,
Pissarides, Christopher A. 2000. Equilibrium Unemployment Theory.
Cambridge: MIT Press.
Saving, Jason L. 2000. "The Effect of Welfare Reform and Technological
Change on Unemployment." Federal Reserve Bank of Dallas Economic and
Financial Review QII, pp. 26-34.