The costs and consequences of unemployment and inactivity

Overview

Unemployment cost the individual who experiences it, unemployment cost firms and unemployment cost the government and the public finances.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What does unemployment cost the individual who experiences it?

   Model answer

   The immediate cost is lost income, since benefits replace only a fraction of previous earnings, so living standards fall and savings are depleted or debt accumulated. Beyond income, skills deteriorate through disuse and the person falls behind changes in their occupation, which lowers the wage they can command when they return to work. There is substantial evidence of damage to physical and mental health and to family stability, and the earnings loss persists for years after re-employment, which is described as scarring.

2. 2

   What does unemployment cost firms?

   Model answer

   Firms lose the spending power of the unemployed, so those selling to households face weaker demand for their products, which is most severe for producers of non-essential goods. They face higher taxation, since the state must fund benefits from a smaller tax base. Against this, some firms benefit in the short run from a larger pool of applicants, which reduces recruitment costs and moderates wage pressure. The longer-run effect is negative even for them, because the deterioration of skills in a long-term unemployed population reduces the quality of the workforce they will eventually need to hire from.

3. 3

   What does unemployment cost the government and the public finances?

   Model answer

   The cost is twofold. Spending rises because benefits must be paid to the unemployed and because associated demands on health and other public services increase. Revenue falls because those out of work pay no income tax and little national insurance, and because their reduced spending yields less indirect tax. The combination widens the budget deficit, so the government must borrow more, raise taxes on those still working, or reduce spending elsewhere, and the resources absorbed have an opportunity cost in the public services that could have been funded instead.

4. 4

   What does unemployment cost society as a whole?

   Model answer

   The fundamental cost is the output that the unemployed would have produced and which is lost permanently, since labour cannot be stored. This places the economy inside its production possibility frontier and means total real income is lower than it need be. There are wider costs in the social problems associated with concentrated long-term unemployment, including higher crime and poorer health outcomes, which impose further real resource costs. Unemployment also worsens the distribution of income, since it falls disproportionately on those with the fewest alternatives.

5. 5

   Why is the output lost through unemployment described as permanently lost rather than merely postponed?

   Model answer

   Labour services exist only in the moment they are supplied; an hour not worked this year cannot be worked in addition to a full year's hours later. The goods and services that hour could have produced are therefore never produced. This distinguishes idle labour from an idle machine that can be used more intensively later, and it is why economists treat unemployment as the clearest example of a failure to use scarce resources fully.

6. 6

   Illustrate the cost of unemployment using a production possibility frontier.

   Model answer

   Draw a production possibility frontier with capital goods on the vertical axis and consumer goods on the horizontal axis, curved outwards from the origin. Full and efficient use of all resources places the economy at a point on the frontier. Unemployment means labour is available but unused, so the economy operates at a point inside the frontier, producing less of both goods than it could. The vertical and horizontal distances from that point to the frontier measure the output forgone. Reducing unemployment moves the economy outwards towards the frontier, which raises output of both goods without any sacrifice, so it is not a trade-off but the removal of waste.

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