Approaches to the theory of unemployment

Understanding the special features of the labor markets is crucial both for the understanding of the functioning of a market economy and for the formation of public policy. Although Keynes never explicitly assumed rigid wage rates, most of the interpretations of Keynesian economics suggest that the main cause for unemployment is rigid wage rates. Moreover, the various neo-Keynesian, non-Walrasian models of recent years intended to provide a microtheory for an economic system in which prices are either rigid or slow changing while quantities adjust rapidly. In such economies, markets cannot clear in the Walrasian sense, and equilibrium is attained through the formation of quantity constraints on economic agents. Market clearance in these economies means that, in general, rationing takes place; and in the particular case of the labor market, one would expect society to develop institutions that ration the relatively limited supply of jobs. Such unemployment is obviously not voluntary.

On the other extreme we have a rapidly growing literature based on the “market-clearing” hypothesis, which holds that all markets are cleared in the Walrasian sense and wage flexibility implies that observed unemployment is voluntary. This school of thought implies that a voluntary decision to be unemployed represents nothing but an intertemporal substitution of current leisure for future labor, which is expected to be provided at higher wage rates.

The two theories face serious empirical and conceptual challenges. Some historical evidence may be provided to support the hypothesis of wage inflexibility.