What are the economic costs of high unemployment?
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Last updated 31 Jan 2023
This study note looks at some of the main economic costs of an economy experiencing a high rate of unemployment in their labour market.
- Lost Output: High unemployment results in a loss of potential output, as unemployed workers are not able to contribute to the economy. The economy is operating well within their production possibility frontier.
- Decreased Consumer Spending: Unemployed workers have less real disposable income, which can result in decreased consumer spending and a reduction in aggregate demand. This in turn can cause a fall in planned investment spending by firms increasing the risk of a deeper recession.
- Reduced Tax Revenue: High unemployment can also reduce direct and indirect tax revenue, as fewer workers are paying into the system and more are receiving unemployment benefits.
- Increased Government Spending: High unemployment can increase government spending on social welfare programmes, which then leads to a rise in the size of a government's budget deficit and a higher level of national debt.
- Reduced Investment: High unemployment can reduce investment, as firms may be less confident in the future prospects of the economy and may not be willing to invest in new projects or expand their operations.
- Lower Labour Force Participation: High unemployment can lead to discouragement, where workers drop out of the labour force and may not return, reducing the size of the potential labour force and the economy's long run productive capacity. This is known as labour market hysteresis.
- Increased Relative Poverty: High unemployment can result in increased poverty, as unemployed workers are unable to meet their basic needs and may require government support.
Overall, high unemployment can result in significant economic costs, including lost output, decreased consumer spending, reduced tax revenue, increased government spending, reduced investment, lower labor force participation, and increased poverty.
What is labour market hysteresis?
Labour market hysteresis refers to the idea that the long-term impact of a recession or period of high unemployment can persist even after the economy has recovered.
- Skill Erosion: During a recession, workers may lose skills and become less productive, making it harder for them to re-enter the labor market even after the economy has recovered.
- Reduced Labour Force Participation: High unemployment can lead to discouragement, where workers drop out of the labour force and may not return, reducing the size of the potential labour force and the economy's productive capacity.
- Real Wages: Wages may not fully recover even after the economy has recovered, as workers who have been unemployed for a long time may accept lower wages to re-enter the labour market.
- Long-Term Unemployment: High unemployment can result in long-term unemployment, where workers may remain unemployed for extended periods, reducing their chances of finding work in the future and contributing to the persistence of high unemployment.
Labour market hysteresis suggests that the economic and social costs of a recession can be persistent and long-lasting, even after the economy has recovered. This can result in reduced productivity, lower wages, and increased poverty for affected workers and can have negative impacts on the overall economy especially long run aggregate supply and competitiveness.