Employment is the primary source of income for majority of the people. If less number of people are employed, it results in less expenditure in the economy thereby leading to lower GDP growth. This will be explained in detail in our article on measuring GDP. Generally high unemployment rate signals recession and problems with the economy. Thus it is very important to observe and track unemployment levels in an economy to determine its health.
Let’s try to understand this concept with an example. Suppose, there is a tiny island called Wonderland. The total population of Wonderland is 30,000. Out of these 30,000 people, 5,000 are below the age of 16 which is the minimum working age on the island. So working age population on the island is 25,000 (30,000 – 5,000). Labor force includes all the people who are willing and able to work. So students, retirees, disabled people and homemakers won’t be included in the labor force. Most of the people whom we just mentioned are the ones who are not able to work due to various reasons, but labor force also excludes people who are not willing to work. There might be few people who are very rich; too lazy to go out for work; or just tired of searching for a job. These people are also not included in the labor force, as they are not willing or actively seeking to work. Let’s again assume that amongst the working age population, 5000 people are either not able to work or are not willing to work. So the island’s labor force, representing people who are able and willing to work, would be 20,000 (25,000-5,000). Now let’s understand labor force participation rate:
Labor force participation rate = (Labor Force/Population above the minimum working age)*100
In our example this would be 80% (=20,000/25,000*100). This represents the ratio of willing and able to work people within working age population over total working age population. Labor force consists of both – people who are employed and the ones who are not. A person is called unemployed if he is able and willing to work, but does not have a job right now. Unemployment rate is the percentage of people in labor force who do not have a jobs.
Unemployment rate = (Unemployed People/Labor Force)*100
Let’s say, in wonderland 2,000 people do not have a job, but are able, willing and actively seeking employment. Then unemployment rate would be 10% (=2,000/20,000*100). If after a year unemployment rate goes down to 5% and nothing else changes, it means many jobs were created last year due to which there are less number of unemployed people now. Jobs are created when new factories and production plants are setup. Factories are setup to produce more goods and services, and as we learnt in our first article, more goods and services translate to higher GDP. Thus, a low unemployment rate generally represents a healthy economy and vice versa.
Now let’s see how these variables change with change in business cycles, as an economy progresses.