Important Theories
Shapiro-Stiglitz model of efficiency wages: Explains why there is unemployment
Approach one: If demand for labor falls, wages fall (companies have less incentives to give more wages). However, that makes workers have fewer incentives to work hard (shirking).
In order to prevent shirking, employers would lower the wages at a slower rate than the decreasing rate of demand, thus creating high enough wages to create the incentives to work harder.
Because there's little decrease in wages and companies have a limited source of money, there's less demand for labor and thus unemployment occurs and probably rises.
Looking at it another way: If higher employment rates do occur, there would be less threat of unemployment for the workers, thus creating fewer incentives to work hard, which results in shirking as well.
The fact that employers want to avoid shirking means that 100% employment is impossible, for when employment rate approaches 100%, incentives for the workers to work hard approach zero, thus presenting the problem of shirking. Consequently, unemployment must occur.
Information asymmetry: transactions when one side has more information about the deal than the other
When the access of information for both sides is unequal, a free market cannot operate with efficiency. This thus shows how the “invisible hand” only functions when complete information is guaranteed to all parties
In order to solve this problem, Stiglitz researched on screening (he got the Nobel Prize for this), where one party, usually the one that knows less, obtains information about the other without intruding privacy. This is usually done by giving the opposite party lists of choices; the answers to the choices would reveal information of the opposite party.
Another approach is signaling, where the party who knows more gives solid credentials (such as a diploma) to prove the party's skill in a specific area (in the case of a diploma, it's education).