Involuntary unemployment

Involuntary unemployment occurs when a person is unemployed despite being willing to work at the prevailing wage. It is distinguished from voluntary unemployment, where a person refuses to work because their reservation wage is higher than the prevailing wage. In an economy with involuntary unemployment, there is a surplus of labor at the current real wage. This occurs when there is some force that prevents the real wage rate from decreasing to the real wage rate that would equilibrate supply and demand (such as a minimum wage above the market-clearing wage). Structural unemployment is also involuntary. Economists have several theories explaining the possibility of involuntary unemployment including implicit contract theory, disequilibrium theory, staggered wage setting, and efficiency wages. The officially measured unemployment rate is the ratio of involuntary unemployment to the sum of involuntary unemployment and employment (the denominator of this ratio being the total labor force). Models based on implicit contract theory, like that of Costas Azariadis, are based on the hypothesis that labor contracts make it difficult for employers to cut wages. Employers often resort to layoffs rather than implement wage reductions. Azariadis showed that given risk-averse workers and risk-neutral employers, contracts with the possibility of layoff would be the optimal outcome. Efficiency wage models suggest that employers pay their workers above market-clearing wages in order to enhance their productivity. In efficiency wage models based on shirking, employers are worried that workers may shirk knowing that they can simply move to another job if they are caught. Employers make shirking costly by paying workers more than the wages they would receive elsewhere, incentivising them not to shirk. When all firms behave this way, an equilibrium is reached where there are unemployed workers willing to work at prevailing wages.