11.4 ​The cost of losing a job

Imagine you’re a worker at a steel mill. You’ve worked there for ten years. One day, your employer announces that the mill is shutting down and all of the workers will lose their jobs. Meanwhile, other mills in the area remain open.

A natural experiment: People losing their jobs in mass layoffs

natural experiments

An empirical study that exploits a difference in the conditions affecting two populations (or two economies), that has occurred for external reasons: for example, differences in laws, policies, or weather. Comparing outcomes for the two populations gives us useful information about the effect of the conditions, provided that the difference in conditions was caused by a random event. But it would not help, for example, in the case of a difference in policy that occurred as a response to something else that might affect the outcome.

Cases such as this one, where an entire firm closes or a mass layoff occurs, provide a useful natural experiment to measure the cost of job loss⁠ precisely because virtually all workers lose their jobs, regardless of their performance. We can then compare the workers’ earnings before and after they lose their jobs.

Louis Jacobson, Robert Lalonde, and Daniel Sullivan used this approach to study the cost of job loss for experienced full-time workers, including many steel mill workers, hit by mass layoffs in Pennsylvania in 1982. Adjusted for inflation up to 2014, those who lost their jobs had average earnings of $50,000 in 1979. Those who found work in less than three months took jobs that paid a lot less, averaging only $35,000. Being laid off meant that their earnings declined by $15,000! Even four years later, workers laid off in 1982 still earned $13,300 less than similar workers whose firms did not lay off their workers.

Economists Steve Davis and Till von Wachter studied the cost of job loss during good and bad economic periods. Using data from 1974 through 2008, they compared the earnings of male workers under the age of 50 who lost their jobs in mass layoffs to similar workers who kept their jobs. They then divided the workers who lost their jobs into two groups: those who lost their jobs during a recession and those who lost their jobs during a period of economic growth.

Figure 11.1 shows data for each of these groups, with those who lost their jobs in a recession shown in blue and those who lost their jobs in an expansion (a period of growth) shown in red. Both groups see a dramatic decrease in their earnings, and, even decades later, still earn less on average than they would have if they had not been laid off. Workers laid off during a recession had noticeably lower wages than those laid off during an expansion.

The consistent message is that losing a job is costly to workers. To illustrate the cost of job loss more clearly, imagine a steelworker in Pittsburgh named Bob. In 1979, he was making $50,000 per year. Starting in 1982, he will find himself in one of two situations:

outside option

The payoff a player will receive if they do not engage in the particular interaction being modeled. The outside option is also sometimes called the player’s reservation position or reservation option (it is “held in reserve”). Sometimes it is called the next-best alternative because it is the alternative to the agreement that is “next-best” in terms of how good it is.

• Keeps his job: Bob continues to get paid his wage of $50,000 per year and continues to bear the costs of doing the job, such as the cost of exerting effort, the body aches and pains from an intense manual job, and the annoyance of his commute from home to work.
• Loses his job: If he loses his job, he will rely on an outside option, which is a job that pays $35,000 per year. Because it is a similar job, he incurs a similar personal cost of working. He works at this job for five years. At the end of 1987, he is promoted to a new job equivalent to his old one, paying $50,000 per year.

Figure 11.2 models this situation.

• Keeps his job: The blue line represents Bob’s wages between 1982 and 1987 if he keeps his job at the steel mill.
• Loses his job: The red line represents Bob’s lower-wage outside option over the same period, which moves up in 1987 to represent the promotion and wage increase.

employment rent

The economic rent a worker receives when the net value of their job exceeds the net value of their next-best alternative (that is, being unemployed or their next-best alternative job). Also known as the cost of job loss.

economic rent

Economic rent is the difference between the net benefit (monetary or otherwise) that an individual receives from a chosen action, and the net benefit from the next-best alternative (or reservation option).

economic rent

Economic rent is the difference between the net benefit (monetary or otherwise) that an individual receives from a chosen action, and the net benefit from the next-best alternative (or reservation option).

The area between the two lines represents the total lost wages if Bob loses his job, which, if we include only wages and income, is the total cost of losing his job. Bob will lose a total of $75,000 over this period if he loses his job in 1982 ($50,000 – $35,000 per year = $15,000 per year for 5 years). That $75,000 is his employment rent for those five years, which is the economic rent a worker receives by keeping a job whose value is higher than their outside option.

Bob knows that his original job at the steel mill was better than his next-best option and that his employment rent was reasonably large. For Bob, doing the best he can meant working hard at the steel mill to maximize his chances of keeping that job and keeping his employment rent.

Keeping a job also has costs. The employment rent that workers earn will depend on the overall value of a job and the overall value of their outside option, not just their current wage.

Costs and benefits of a job

The net benefit to Bob of his job is the total benefit of the job minus the total costs of the job. Because the value of a job is something workers experience across time, we typically think about the net benefit of a job over a period of time. For our example, we will use six months.

The benefit to Bob of keeping his job for six months is six months of salary payments.

personal cost of working

The net physical and psychological costs of doing the work an employer asks of a worker.

The cost to Bob of keeping his job is his personal cost of working, which is the cost to him of doing the work. Bob’s work is hot, repetitive, and physically taxing. He experiences the work itself as a cost across these six months, because it reduces his well-being.

The net benefit of a job is the total value of the benefits minus the total value of the costs. In mathematical terms:

\[\text{net benefit of a job} = \text{total benefits of a job} - \text{total costs of job}\]

Thus, if the benefits get bigger, the net benefit of the job increases. If the benefits decrease, the net benefit of the job decreases. The opposite holds for costs. If the cost of the job increases, the net benefit of the job decreases.

Outside option

For Bob, losing his job will mean enduring a period of unemployment, after which he will find another job. But he cannot know in advance exactly how long he will be unemployed, or exactly what job he will get. Unlike the net benefit of his current job, which he can observe and experience directly, the net benefit of his outside option is based on what he expects to happen if he quits or is fired.

The net benefit of his outside option includes its expected benefits and expected costs. The expected benefit of his outside option has two main components:

unemployment benefits

A government transfer that is paid to an unemployed person while they are unemployed (or for part of the unemployment period). In the United States, the government calls unemployment benefits “unemployment insurance” or UI, and amounts, eligibility, and other rules vary by state.

• Unemployment benefits: If Bob is fired, and certain other conditions hold, he will qualify for unemployment benefits, which are payments received from the government for a specific period while workers are unemployed. If Bob expects to be unemployed for six months, he will expect to receive six months of unemployment benefits. The size of this benefit depends on how long he expects to be unemployed, along with state rules regarding eligibility.
• Net benefits from a new job: Bob expects he can find another acceptable job in six months if he quits or is fired. He assumes that he will have a worse job and make less money than he does in his current job. The size of this benefit also depends on his expectations of how long he will be unemployed (and state rules regarding eligibility).

As with the net benefit of keeping a job, the net benefit of his outside option is the total benefits minus the total costs.

Employment rent

We can now determine Bob’s employment rent if he had kept his original job at the steel mill for six months. We will assume the six-month period starts at the beginning of January and goes until the end of June. Figure 11.3 models his employment rent over this period.

As in Figure 11.2, the red line represents Bob’s path if he loses his job and then is hired at an equivalent job with the same pay after six months. The blue line represents his path if he keeps his current job over those six months. The red area at the bottom represents the total income he will receive from six months of unemployment benefits (his fallback option). Stacked above that, the green area is Bob’s personal cost of working. The blue area is his employment rent, which is what he will lose if he loses his job.

Any change in the costs and benefits of a worker’s current job and outside option will affect the employment rent. This has some important implications.

First, employers have some control over their workers’ employment rents. If an employer wants to increase the employment rents for its workers, they could:

• raise wages
• reduce the personal cost of working by improving working conditions.

Second, governments can affect the size of employment rents by changing the rules of the game. Unemployment benefits are an especially important example. Governments set the size and duration of unemployment benefits. A change in either affects employment rents for many workers.

Third, employment rents are affected by the economy’s unemployment rate. Imagine that when Bob started his job, the unemployment rate was 3.5%. But by the beginning of the following year, the unemployment rate was 6%. Higher unemployment means there will be more competition among workers for fewer open jobs.

So, if Bob loses his job, he expects to be unemployed longer than he would have been when the unemployment rate was lower. He may even have to extend his unemployment benefits over a longer period, which will decrease his monthly spending. He may also expect that any job he can find will pay less than it paid when the unemployment rate was lower. Both of these changes decrease the net benefit of his outside option and so raise his employment rent. Extension 11.4 describes how we can model the effect of higher unemployment on Bob’s employment rent.

Why employment rents give employers power

Employers benefit from employment rents in two critical ways:

1. The worker is more likely to stay with the firm. The bigger a worker’s employment rent, the more likely they are to remain at the job. The employer therefore does not have to hire and train a new worker.
2. The employer can threaten to fire the worker. A larger employment rent means a larger cost to the worker of losing their job, which in turn makes the threat of being fired more effective and makes workers act in ways they would not likely do otherwise. A larger employment rent, in other words, increases the bargaining power of employers.

structural power

The extent of a person or firm’s advantage in a bargain that is determined by the relative value of their next-best alternative to the bargain.

A worker’s outside option affects the size of their employment rent at a given wage, and outside options are therefore connected to an employer’s structural power. Any change that increases the net benefit of a worker’s outside option decreases employers’ structural power.

For example, as the unemployment rate goes up, the outside option for workers gets worse, increasing the employer’s structural power. A weaker outside option makes it harder for workers to quit or turn down a job offer, and the wage that employers need to offer to incentivize workers to work will decrease.

In the next section, we apply what we’ve learned so far in this chapter to better understand some of the questions we raised in Section 11.1, such as how wages and effort levels are determined.