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real wage tends to be higher than the market-clearing wage, leading to unemployment (see Chapter 14, pp. 354-360). In this regard, the natural rate of unemployment is also defined as the unemployment rate running at the current real wage: recalling figure 14.2(a), if the real wage is (w/p)1, the natural rate of unemployment is represented by AB / OLF.

After economic shocks (e.g., an oil price increase) or periods of recession, unemployment rises, but is expected to return to the original level when the recession is over (figure 14.3 - a). Hysteresis theory tries to give theoretical support to a contradictory evidence which shows that unemployment, far from reverting to its original level after these shocks, remains high (figure 14.3 - b). In other words, unemployment, once created, develops its own dynamic. There are several causes for hysteresis are these and can be listed as follows:

i) Unemployment causes depletion of human capital, loss of motivation and loss of self-esteem for the unemployed, particularly for those individuals out of work for a long period. This 'depreciation' of human capital is perceived by the employer who becomes unwilling to hire long-term unemployed people, thus perpetuating and deepening this spiral.

ii) Recession leads to restructuring of the economy. Labour-intensive sectors are gradually replaced by capital and skill-intensive sectors. This process creates a mismatch in the labour market between supply and demand: low skilled redundant workers have greater difficulties in finding a new job.

iii) Asymmetric information between the applicant's self-knowledge and the employer's perception of the applicant creates a 'market for lemons'.  Unemployed people offering labour at a wage below the existing one, instead of clearing the market, tend to increase employer's suspicion about the applicants' skills, rendering their access into the labour market more difficult.

iv) Efficiency wages and trade union power both tend to stiffen the labour market, the former from the demand side, the latter from the supply side.  This implies a deepening of the gap between insiders (high wages and better protection) and outsiders (higher unemployment and market for lemons).

From this list, economic and social costs due to hysteresis can be exacerbated and described as follows:

i) Unemployment, in technical terms, means under-utilisation of human capital. It represents a permanent loss of potential income and wealth not only to the society as a whole, but also to the unemployed individual and his/her family.

ii) Unemployment has psychological costs (loss of self-esteem and motivation) and social costs (marginalisation, violence and crime) which go beyond any economic analysis.


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