This may seem like a dumb question. An abnormally high rate of unemployment is often treated as synonymous with a depression, as by those economists who insist that until the unemployment rate reaches 10 percent (or some other number), the economic situation cannot be described as a depression. This method of distinguishing depressions from recessions is unsound; they should be distinguished on the basis of total costs, of which unemployment is only one. But the tendency to measure a recession/depression by the unemployment rate attests to the significance attached to the rate as a measure of the gravity of the bottom of the business cycle.
But there is a puzzle: why should there be a high unemployment rate just because some shock to the economy (like a fall in household wealth because of the bursting of a housing and stock market bubble) reduces the demand for goods and services across the board, at their existing prices? Why don't prices and wages just fall and, as a result, the original demand be restored?
Suppose that as a result of an economy-wide demand shock people decide to spend less and save more because they are anxious about the future. Then the average firm will experience a reduction in the demand for its products at their existing prices. It will adjust by moving down its supply curve, which will result in its reducing both its price and its output. But this assumes that its supply curve is unchanged. Yet with the fall in demand for goods and services, demand for labor will also have fallen, and so the equilibrium wage--the wage that clears the market for labor, leaving no workers unable to find jobs who want a job--will have fallen. By reducing wages to the new equilibrium level, the firm will make a further, downward price adjustment, because its labor costs will be lower. Lower prices will increase demand for the firm's products, and in turn for labor. There will be full employment.
But that is not what is observed. Here are some reasons why it is not observed.
1. When wages fall, so do incomes, and this results in a fall of demand for goods and services and therefore in the demand for labor, which is derived from the demand for goods and services. This income effect of a decline in wages is unlikely to be fully offset by a fall in prices, because a decline in a firm's costs are rarely passed on 100 percent to customers, and anyway labor costs are only one component of a firm's costs. If labor costs are 50 percent of a firm's total costs, and it reduces these costs by cutting wages and benefits by one half, its total costs will fall by 25 percent. If half that reduction is passed on in the form of a lower price, its price will fall by only 12.5 percent. Thus, wages have fallen farther than prices, and so the price effects of a wage cut will not restore the demand for labor to its previous level.
2. When demand for a firm's products falls, it can adjust by reducing output, but it cannot do anything to reduce its fixed costs, such as debt that carries a fixed interest rate. The result may be bankruptcy, which, even if the firm's depressed price exceeds its marginal cost, may result in liquidation rather than in a successful reorganization, because of the costs, delays, and uncertainty of a reorganization in bankruptcy. Liquidation will result in termination of all the firm's employees. Moreover, a fall in demand may, by preventing a firm from achieving economies of scale, cause its marginal cost to fall below the maximum price that the market will pay for the firm's products, and then reorganization will not be an option unless there is optimism about a quick economic recovery.
3. Depression-induced reductions in price may not restore demand for goods and services to its previous level while the depression is going on. As Keynes emphasized, consumers nervous about the future may reduce their spending, in favor of increased saving. This is happening in our current depression: the personal savings rate has increased in the last year from 1 percent to almost 6 percent. If the quantity of goods and services demanded falls even though prices are lower, industry will not need as many workers.