Introduction

Real wage unemployment arises when wages remain above the market-clearing level, preventing equilibrium between labour supply and demand. Understanding its causes is crucial for effective labour market policy.

Understanding Real Wage Unemployment

The Concept

Real wage unemployment occurs when wages are fixed at a level higher than that which equates labour demand with labour supply. This mismatch prevents firms from hiring all available workers, creating involuntary unemployment.

This is closely linked to rigidities in the labour market, where institutional or external factors prevent wages from adjusting downward.

The Equilibrium Wage and Labour Market Dynamics

In a competitive labour market, the equilibrium wage is the point at which the number of workers firms are willing to employ equals the number of workers willing to work.

This diagram demonstrates how setting wages above the equilibrium level (W1) creates excess supply of labour, leading to unemployment. The area between Q1 and Q3 represents the number of unemployed workers. Source

When actual wages are above equilibrium, labour supply exceeds labour demand, generating unemployment. This unemployment persists until wages fall, but wage rigidity often blocks this adjustment.

Causes of Real Wage Unemployment

1. Trade Unions and Collective Bargaining

Powerful trade unions may negotiate higher wages for their members. While this benefits employed workers, firms often respond by hiring fewer workers, leaving others unemployed.

2. Minimum Wage Legislation

If the national minimum wage is set above the market equilibrium, firms must pay higher wages. While protecting incomes, this reduces the quantity of labour demanded, particularly for low-skilled workers.

3. Wage Stickiness

Wages can be sticky downwards, meaning they do not fall easily even during recessions. Causes include:

• Long-term contracts.

• Concerns over morale and productivity if wages are cut.

• Social and cultural norms resisting nominal wage cuts.

4. Efficiency Wage Theory

Some employers deliberately pay wages above equilibrium to improve productivity, reduce staff turnover, and attract higher-quality workers. While beneficial for firms, this creates excess labour supply in the market overall.

5. Government Policies

Employment protection legislation, redundancy costs, or generous unemployment benefits may also reinforce high wage levels, discouraging firms from lowering pay or hiring more workers.

Graphical Representation

In an AD/AS labour market diagram, the equilibrium wage occurs at the intersection of labour supply and demand. A real wage set above this equilibrium creates a gap between the quantity of labour supplied and the quantity demanded, representing real wage unemployment.

This diagram illustrates classical unemployment, where wages above the equilibrium level (W2) lead to a surplus of labour (unemployment). The area between Q2 and Q3 represents the number of unemployed workers. Source

Implications for the Economy

For Individuals

• Unemployed workers face reduced incomes, lower living standards, and potential long-term skills erosion.

• Those in employment benefit from higher wages, but only a fraction of the workforce enjoys this advantage.

For Firms

• Higher wage costs raise unit labour costs, reducing competitiveness.

• Firms may substitute labour with capital investment, accelerating automation.

For the Economy

• Higher unemployment increases government spending on welfare benefits and reduces tax revenue.

• Persistent unemployment reduces aggregate demand, potentially leading to slower economic growth.

Factors Determining Real Wage Unemployment

Elasticity of Labour Demand

The degree to which firms cut employment in response to wage rises depends on the elasticity of labour demand.

• Elastic demand: Small wage increases lead to large falls in employment.

• Inelastic demand: Employment is less sensitive to wage rises.

Skills and Labour Market Segmentation

Real wage unemployment is more pronounced in sectors with low-skilled workers, where alternatives to human labour (e.g., automation, outsourcing) are readily available.

Strength of Labour Market Institutions

The power of trade unions, effectiveness of wage bargaining, and stringency of labour regulations all influence how far wages diverge from equilibrium.

Productivity Levels

If higher wages are matched by higher productivity, firms may not reduce employment. Real wage unemployment is more likely where wages rise faster than productivity.

Policy Responses

Supply-Side Measures

• Reforming minimum wage policies to balance fair pay with employment incentives.

• Reducing trade union influence in wage setting.

• Enhancing worker flexibility and mobility through training and education.

Demand-Side Measures

• Stimulating aggregate demand may reduce unemployment in the short run, but it does not directly address wage rigidities.

Labour Market Flexibility

Encouraging flexible contracts, reducing legal barriers to wage adjustments, and lowering non-wage labour costs (e.g., employer contributions) can help align wages with market conditions.

Distinguishing Real Wage Unemployment from Other Types

Real wage unemployment differs from other forms of unemployment because it arises specifically from wages being above equilibrium, not from a lack of demand (cyclical unemployment) or mismatches in skills (structural unemployment).

This makes it a supply-side issue, closely linked to the institutional structure of the labour market.