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2010-2011 - What role, if any, should government play in job creation?

In the aftermath of one of the worst recessions in U.S. history, it’s natural that jobs occupy the public’s attention. Nearly one in 10 Americans looking for a job is out of work, not quite the one in four reached during the Great Depression of the 1930s, but a higher rate of unemployment than has been seen during the lives of today’s young people.

This environment has led to a great deal of discussion about government policies to create jobs. But this discussion is hardly new. There is a long history of job-creation policies, and for obvious reasons. Jobs provide people with incomes to fulfill their needs and desires. Some types of jobs are believed to be better than others for an economy’s long-term growth, and thus deserve greater encouragement. Perhaps most importantly, unemployment can be a miserable experience, and during recessions more people suffer it.

While the decisions about employment policy are made in the political realm, the issue is fundamentally an economic one. Economic analysis is a tool that can be used to understand how labor markets work, what causes unemployment, and what the costs and benefits of job-creation policies might be. For this reason, the Federal Reserve Bank of Minneapolis is asking students in its 23rd Annual Student Essay Contest, “What role, if any, should the government play in job creation?

This primer is intended to get students thinking about the topic. It is far from the last word on labor markets and job creation, but rather is a stepping-off point for students who want to write a good essay.

Labor markets: A first look

Upon first look, the job market is pretty much like any other market. Businesses demand labor, which is supplied by workers. As in other markets, there is an equilibrium where the price of labor—the wage—is such that the quantity of labor supplied by workers equals the quantity firms demand.

Workers face a basic trade-off: work versus play. Workers decide how much they want to work by weighing their respective tastes for consumption, purchased with income earned by working, and leisure. Obviously, the wage they can earn affects this decision.

Firms contend with a trade-off in that they have some ability to substitute machinery and other capital for labor. Given wages and prices for other inputs, along with the prices for the products and services it sells, a firm hires the amount of labor that will maximize its profits.

If for some reason government officials decide the level of employment is not high enough, they have two basic options to increase demand for labor. One option is to change the incentives for private employers to hire. For example, the government can subsidize hiring through direct payments or targeted tax rebates for companies that hire workers. Another option is for the government to directly hire workers, as it did during the Great Depression.

A closer look

This simple labor market model provides useful insights into supply and demand, but it abstracts from prominent features of markets that give rise to unemployment. In fact, the simplest model has no unemployment—everyone who wants to work at the market wage does so. What can help us understand unemployment?

Workers’ skills are often highly specialized, and finding an open job that makes use of those skills and pays an acceptable wage may take quite a bit of time. For the same reasons, firms also don’t immediately find new employees to fill positions. Such “search frictions” imply that at any given time, many workers may be unemployed and looking for a job.

Often when workers lose their jobs, they spend a lot of time searching for a new one that fits with their skills. Over time, a worker’s skills can weaken, so that long bouts of unemployment are costly not just because of lost income, but also from damage to future career prospects.

Another factor leading to employment is that, unlike other prices, wages don’t seem to adjust smoothly in the real world—they are “sticky.” In particular, firms are often reluctant to decrease wages and often respond to declining demand by laying off workers rather than asking them to take a pay cut, resulting in unemployment.

There are other reasons labor markets may operate differently than in our simple model, and imperfections in information are major underlying causes. However, the basic tools of economics still apply to labor markets and can be used to help us understand possible rationales for government intervention as well as its consequences.

A case for intervention?

Though government is heavily involved in labor markets, when, why and how it should intervene are difficult questions. The classic examples of market failure—externalities and public goods—are tricky to apply (see “Economic Principles to Keep in Mind” for more on market failure). Monopolies are considered cases for intervention, but monopolies in labor markets are rare.

The most prominent roles the government plays are dealing with unemployment and promoting growth. In turn, these types of policies can be divided between microeconomic policies that are targeted at specific industries or markets and macroeconomic policies intended to affect the economy as a whole.

Nearly everyone bears some risk of losing their job at some point, and because of the high costs of unemployment mentioned above, we all might like some insurance to help us should we find ourselves without a job. For several reasons, markets for private unemployment insurance might not exist, so in most modern economies, the government provides it. However, insurance can have the unintended consequence of weakening an unemployed worker’s incentive to look for a job, thus making the unemployment problem worse. Finding the right balance is an example of a microeconomic policy to address unemployment.

In a recession, there is less demand for labor in all industries. So if the government can intervene to prevent or mitigate recessions, this could reduce unemployment. In severe economic downturns, the government can even hire the unemployed and put them to work, as the U.S. government did during the Great Depression. Therefore, various types of macroeconomic stability policies (fiscal and monetary) could be considered unemployment or job-creation policies.

Some policymakers advocate investment in growing industries such as biotechnology or renewable energy to lead to greater employment in the future. Other kinds of policies use taxes and subsidies in an attempt to drive job creation to certain places, such as inner cities or rural areas. Others say that the best thing the government can do to encourage job growth is to simply get out of the way, removing restrictions on private sector labor markets and letting them work on their own. These are examples of microeconomic policies targeted toward economic growth and job creation.

At a broader level, economic growth is affected by the rules of the game set up by the government. These rules include taxes, regulations and property rights that provide the environment for individuals and businesses to make decisions. While finding the right set of rules and bringing the government enough revenue to provide public services without hampering growth is very difficult, it might be the most important job-creation policy of all.

Make your case

In your essay, you can elaborate on any of these ideas. You might write about a narrowly targeted policy or take a big-picture approach. Or you could suggest your own ideas for job creation.  But first, consider some guidelines for writing an effective essay.

First, you must be clear about the need for intervention. If you argue that the government should play a role, you must explain why. Further, you need to consider the benefits of government policies as well as their costs, and your account of the costs should consider possible unintended consequences. If you want to argue that the government should take a more hands-off approach, you need to explain why you think that will work better than the status quo.

In order to make a good case, you will need to research this topic, starting (but not stopping!) with the resources we have provided. Finally, your essay should be clear and well written, following the rules outlined on our contest Web site. This is a lot to ask, because it is a difficult question. Don’t let that deter you; with solid thinking and hard work, you could be our essay contest winner.

If you have any questions, contact Joe Mahon at or call 612-204-5254.