Economists reserve the concept of unemployment for people who are involuntarily unemployed. That is to say, people are unemployed if they are actively seeking jobs but unable to find them, as opposed to people who have voluntarily opted out of the labor market to pursue activities like raising children, going to school, or traveling.
Some economists follow A. C. Pigou and his 1933 argument that unemployment does not exist. Their argument rests on the following two premises: (1) There is a real wage low enough to make it profitable for employers to hire every person actively seeking a job, and (2) people are in a position to offer to work at that real wage.
If these two premises are valid, then unemployment does not exist. For everyone could have a job if only they were willing to work at a real wage low enough to make it profitable for employers to hire them. Instead, people who appear to be unemployed voluntarily opt out of the labor market by deciding that the utility they derive from activities like raising children is greater than the utility they would derive from the consumption of the goods and services that could be purchased with such a low real wage.
In 1936, J. M. Keynes and his followers undermined Pigou’s argument against the existence of unemployment on both theoretical and empirical grounds. The theoretical reason for rejecting Pigou’s argument is that its second premise is invalid. Rather than being in a position to offer to work at the real wage low enough to make it profitable for employers to hire them, people are only in a position to offer to work at a lower money wage. As equation 1 shows, the relationship between the money wage (Wm) and the real wage (Wr) is mediated by the price level (P):
Wr = Wm IP (1)
For the second premise of the argument against the existence of unemployment to be valid, it must be the case that people who offer to work at a lower money wage (Wm) are also invariably offering to work at a lower real wage (Wr). But equation 1 shows that a lower money wage (Wm) only results in a lower real wage (Wr) if the price level (P) does not fall proportionately with the fall in the money wage (Wm).
The second premise of Pigou’s argument is invalid, because once the macroeconomic effects of a lower money wage (Wm) are taken into account, it is most likely that the price level (P) does fall proportionately with the fall in the money wage (Wm), so that the real wage (Wr) is not affected. The money wage (Wm) is the major determinate of aggregate demand. By offering to work for a lower money wage (Wm), people reduce aggregate demand. As a result, inventories pile up, causing firms to lower prices (P), so that the price level (P) falls as part of the effort of firms to get rid of unplanned inventory accumulations. In short, the price level (P) tends to fall in tandem with a falling money wage (Wm), with the result that it is not likely that the real wage (Wr) will be affected.
Social scientists have developed two empirical methods for measuring the adverse effects of unemployment. One method estimates the output forgone because people actively seeking jobs were unable to find them, and the other method estimates the deleterious effects of unemployment on the psychological well-being of the unemployed. As an example of the former, A. M. Okun estimated in 1970 that every percentage-point increase of unemployment above the full-employment level causes total output to fall 3 percentage points below the amount that could have been produced with full employment.
Until quite recently, the methods used by social scientists to estimate the deleterious effects of unemployment on the psychological well-being of the unemployed led to more ambiguous results than their methods for estimating the output forgone because of unemployment. The ambiguity resulted from two design flaws in their empirical methods. One design flaw was overly narrow definitions of psychological well-being. The other design flaw was the effort to distinguish between the two relevant sets of jobless people—those who are involuntarily unemployed and those who have voluntarily opted out of the labor market—by comparing their psychological well-being with the psychological well-being of a set of people that included all of the employed. For example, in 1979, K. B. Clark and L. H. Summers followed Pigou in arguing that there is no meaningful distinction between the psychological well-being of these two sets of jobless people, and in 1983 C. J. Flinn and J. J. Heckman followed Keynes in arguing that a meaningful distinction can be made between their psychological well-being, as compared with the psychological well-being of the set of all employed people.
More recent studies have corrected these two design flaws and, consequently, come down unambiguously on the side of Keynes. For example, in 1998 I. Theodossiou developed a comprehensive measure of psychological well-being that includes indices of anxiety, depression, self-confidence, self-control, and self-esteem. He also segregates, out of the set of employed, the subset of employed people with comparable skills and experience to those who are jobless, either because of involuntary unemployment or voluntary opting out of the labor market. Theodossiou then demonstrates that the set of people who have voluntarily opted out of the labor market do not have statistically significant differences in psychological well-being from the subset of employed people with comparable skills and experience, as compared with the psychological well-being of the set of employed people with greater skills and experience. But the set of people who are involuntarily unemployed have significantly less psychological well-being than the subset of employed people with comparable skills and experience, as compared with the same control group of employed people with greater skills and experience.
In short, there are both theoretical and empirical grounds for the argument that unemployment not only exists but is a fundamental social problem in wealthy modern societies. Because people actively seeking employment can do no more than offer to work at a lower money wage, and a lower money wage tends to cause a lower price level, it is of no help to the unemployed that there is a real wage low enough to make it profitable for employers to hire every person actively seeking a job. To the degree that there is unemployment, there are monetary costs to society as a whole in terms of output forgone, and there are also deleterious effects on the psychological well-being of the people who cannot find jobs, as compared with the psychological well-being these people would enjoy if they were able to find employment.
- Clark, K. B. and L. H. Summers. 1979. “Labor Market Dynamics and Unemployment: A Reconsideration.” Brookings Papers on Economic Activity 1:13-72.
- Flinn, C. J. and J. J. Heckman. 1983. “Are Unemployment and Out of Labor Force Behaviorally Distinct Labor Force States?” Journal of Labor Economics 1(1):28-42.
- Keynes, J. M.  1964. The General Theory of Employment, Interest and Money. New York: Harcourt Brace Jovanovich.
- Okun, A. M. 1970. “Potential GNP: Its Measurement and Significance.” Pp. 145-58 in Economics for Policymaking. Cambridge, MA: MIT Press.
- Pigou, A. C. 1933. The Theory of Unemployment. London: Macmillan.
- Solow, R. 1980. “On Theories of Unemployment.” American Economic Review 70(1):1-11.
- Theodossiou, I. 1998. “The Effects of Low-Pay and Unemployment on Psychological Well-Being: A Logistical Regression Approach.” Journal of Health Economics 17:85-104.