Everything you need to know about cyclical unemployment

Owain Simpson, Content Writer ·

Cyclical unemployment is a fuller picture of why the labour market fluctuates. The labour market and the market for your product in your sector are inextricably linked. This link can amplify your successes, but also your failures, so getting ahead of the curve in understanding cyclical unemployment could make all the difference when it comes to hiring new employees.

If you understand what drives employment and the impact of labour markets on your business, then you have the upper hand when it comes to being an efficient employer. You can optimise your employment strategies because you have a better understanding of what will impact them and you will know that not reacting soon enough can be a hard mistake to come back from.

We are trying to help you with this. The economic concept of cyclical unemployment is a great theory for explaining in pragmatic terms the fluctuations in unemployment. This could turn every change in unemployment levels into an opportunity to be ahead of the curve.

It is important in explaining cyclical unemployment to start with a basic and common understanding of what unemployment is in economic terms. Unemployment can be understood as the difference between people in employment and those that are in the market for jobs. 

Monitoring unemployment levels and even defining unemployment is controversial and has taken up maybe too much time in economic careers. We’ll steer clear and stick to our definition, so here it is again: unemployment is the difference between those that are employed and the total number of people in the jobs market.

supply and demand

You can understand the basic concept of cyclical unemployment by using common sense and the fundamental economic principles of supply and demand. When there is a downward shift in demand in any sector, market, or economy, then supply has to reduce the amount it is producing.

Subsequently, the demand for labour in the relevant labour market will drop and therefore unemployment will rise. This is commonly understood as Keynesian or cyclical unemployment.

To give an example, in the retail sector, Debenhams is a very large player and also a really large employer. However, right now Debenhams is under threat from a significant drop in demand resulting from their customer base moving from buying in their stores to shopping online with other retailers.

The result is that demand within the retail sector has dropped and hence supply will have to play catch up and this will mean the closure of stores, which we aren’t just seeing with Debenhams, but also M&S, John Lewis, and House of Fraser. This catch up by supply is meaning that a lot of jobs will fall by the wayside and hence we have an increase in unemployment.

The reason that this theory considers unemployment as cyclical is that it is a result of the business cycle. The theory of business cycles attempts to explain the process of expansion and contraction that occurs often in any economy. Data from the time of Dutch colonialism has pretty much confirmed that economies are almost always in a flux between ‘boom and bust’. 

The traditional business cycle theory first gained traction within academia in the 19th century. Before this, economists thought that economies shifted away from their equilibria, the state in which supply and demand are steady, as a response to external factors. These economists deemed the disjoint between supply and demand to be due to ‘market failure’ - in other words, real life!

Business cycle theory argued that these shifts were actually an inherent part of the supply and demand relationship - and of markets. The theory of markets and the relationship between supply and demand is a massive part of understanding the labour market, and so the idea of cyclical unemployment was derived from theories of the business cycle.

In contrast to cyclical unemployment, classical unemployment is modeled differently and is understood as a market failure within either the demand or supply in any given market. Unemployment in this model is caused by a disparity between the wage offered and the cost of performing jobs within the labour market.

This disparity causes greater unemployment when the wage offered is higher than the cost of performing the job and so more people want to work than there are jobs.

Classical unemployment is different to the cyclical theory of unemployment which understands that the cycle in demand for goods causes supply to drop, thus employment drops. Classical unemployment, in contrast, implies that the sector is booming and in search of many new employees generating high unemployment. Whereas, cyclical requires that unemployment is high when things are going badly.

 

The following example might offer the opportunity to contrast the theories of cyclical and classical unemployment and see which you think is a more realistic explanation. Let's look at the market for chemical engineers.

About a decade ago there was a massive upsurge in demand for chemical engineers. There was a shortage of graduates and the result was that wage offerings were very high compared with other engineering disciplines.

Now, though, things are very different, with the market for chemical engineering graduates being very poor and graduates having to turn to more generalist careers rather than specifically chemical engineering. The two theories conflict in explaining why this might have happened.

Firstly, classical unemployment theory will suggest there was a market failure because supply was not meeting demand. Their explanation will be that the elevated wages for chemical engineers that resulted from this mismatch in supply and demand resulted in many more prospective employees choosing to try and find jobs as chemical engineers and the result was greater unemployment.

The cyclical theorists will instead point out that the oil industry was behind this fluctuation - the external factor. Cyclical unemployment has a more inclusive and dynamic model of supply and demand that can include this sort of logic. In the case of chemical engineers, they will highlight that the demand for oil rose and then fell dramatically in the period that we are looking at.

This meant that the supply of oil had to increase and thus employment rose, but then when the oil price crashed and governments began focussing on carbon quotas, the supply had to decrease to meet lower demand and hence employment of chemical engineers in the petrochemicals industry moved with this fluctuating supply and demand.

chemical engineering

At this point, it’s worth weighing up which way of interpreting unemployment is better. Undoubtedly, for an economist, the classical understanding of unemployment and its dynamics has uses. It is very easily modeled and employment does move in the right way with the evidence. However, you’re probably not a macro-economist, whose macro-economist theories can be overly technical and doesn’t make much sense in real life.

Cyclical employment theory is much better in this sense. It get closer to the whole picture and it is obvious that when business is bad, unemployment is high, and vice versa. This makes much more sense than talking about marginal profit versus marginal utility in failing labour markets.

Another advantage of cyclical unemployment theory is that it can incorporate newer models of the business cycle. The real business cycle is technically distinct from the traditional business cycle, for example,  but it can still fit into the cyclical theory of unemployment.

This adaptability of the cyclical theory is in part attributable to the fact that understanding the economy as a dynamic system gives a fuller picture and allows for easier adaptation of the theory for advances in the technicality and detail of future models.

To you and me, this means that we can keep understanding employment in terms of cycles. But the statistics and forecasts we look at to tell us what is going to happen to unemployment, and therefore to the supply of new recruits into our teams, can become more advanced and offer better estimates.

A final important note when grappling with the concept of cyclical unemployment is that it isn't truly cyclical. A truly cyclical unemployment model would require predictability.

For instance, in the market for broccoli, you can guarantee that employment is at its highest from May to November when the crops are being harvested. During the winter months, Broccoli is not really harvested so you would see a substantial decline in the amount of labour hired to pick this labour intensive crop.

This sort of employment is truly cyclical, the fluctuation has no apparent randomness, as it occurs annually at the same time and is thus easily predicted. This sort of employment is called seasonal.

Seasonal unemployment is easy for people to deal with because they know it’s going to happen and can make arrangements to mitigate its impact. For instance, employers can design special contracts so they aren’t left needing to pay employees year-round for jobs that only require six months.

Understanding unemployment as a cycle can help improve the performance of your company. Knowing there are times you will need to let people go for the good of the business, and there are other times when you need to have recruitment drives ready can put you ahead of the pack.

If you are ready for changes then you can prevent the exposure of your organisation to the tumultuous environment that is any sector, market or economy today.

With disruptors encroaching everywhere, and ever more complex and interconnected processes driving our economy, shocks and changes to demand for our products can come from anywhere. Being more ready, by understanding the bigger picture of employment markets, is going to leave you more ready to keep your business on course.

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