In economics, the term underemployment has at least three different meanings. All three of them involve underutilization of labor that is missed by official definitions and measurements of "unemployment."

1. Underutilization of skills

In one usage, it describes the employment of workers with high skill levels in low-wage jobs that do not require such abilities. For example, someone with a college degree may be tending bar or driving a cab. Alternatively, a skilled machinist may be working at a fast-food outlet.

This may result from the existence of unemployment, which makes workers with bills to pay (and responsibilities) take almost any jobs available, even if they do not use their talents. This can also occur with individuals who are being discriminated against, lack appropriate certification (such as a high school or college diploma), or have served time in jail. Some types of skills -- such as those associated with doctorates in literature or philosophy -- are valued very poorly by the marketplace, so that people often end up taking jobs that do not employ their education.

A related kind of underemployment refers to "involuntary part-time" workers, who could (and would like to) be working for the standard work-week and can only work a fraction of this.

These kinds of underemployment arise because labor markets typically do not "clear" using wage adjustment. Instead, there is non-wage rationing of jobs.

2. Underuse of economic capacity

The term can also be applied by regional planners to describe localities where economic activity rates are unusually low. This can be induced by a lack of job opportunities, training opportunities, or services such as childcare and public transportation. Such difficulties may lead residents to accept economic inactivity rather than register as unemployed or actively seek jobs because their prospects for regular employment appear so bleak. (These people are often called discouraged workers and are not counted officially as being "unemployed.") The tendency to get by without work (to exit the labour force, living off of relatives, friends, personal savings, or non-recorded economic activities) can be aggravated if it is made difficult to obtain unemployment benefits.

Relatedly, in macro economics, "underemployment" simply refers to excess unemployment, i.e., high unemployment relative to full employment or the NAIRU. Thus, in Keynesian economics, reference is made to underemployment equilibrium. Economists calculate the cyclically-adjusted full employment unemployment rate, e.g. 4% or 6% unemployment, which in a given context is regarded as "normal" and acceptable. Sometimes, this rate is equated with the NAIRU, also known as the natural rate of unemployment. The difference between the observed unemployment rate and cyclically adjusted full employment unemployment rate is one measure of the societal level of underemployment. By Okun's Law, it is correlated with the gap between potential output and the actual real GDP. This "GDP gap" and the degree of underemployment of labor would be larger if they encorporated the roles of underemployed labor, involuntary part-time labor, and discouraged workers.

3. Underuse of employed workers

The third definition of "underemployment" describes a polar opposite phenomenon: to some economists, the term refers to "overstaffing" or "hidden unemployment," the practice of businesses or entire economies employing workers who are not fully occupied i.e. who are currently not being used to produce goods or services. This may be because of legal or social restrictions on firing and lay-offs (e.g. union rules requiring managers to make a case to fire a worker or spend time and money fighting the union) or because they are overhead workers, or because the work is highly seasonal (which is the case in certain accounting firms). Note that this kind of underemployment does not refer to the kind of non-work time done by (say) firefighters or lifeguards, who spend a lot of their time waiting and watching for emergency or rescue work to do; this kind of activity is necessary to ensure that if (e.g.) 3 fires occur at once, there are sufficient firefighters available.

This kind of underemployed workers may exist for structural or cyclical reasons:

• For example, in Western economies, some firms become insulated from fierce competitive pressures and grow inefficient; they may employ more workers than necessary, and carry the resultant excess costs and depressed profits. In some countries, labour laws or practices (e.g. powerful unions) may force employers to retain excess labour. Other countries (e.g. Japan) often have significant cultural influences (the relatively great importance attached to worker solidarity as opposed to shareholder rights ) that result in a reluctance to shed labour in times of difficulty. In centrally-planned economies, lay-offs were often not allowed, so that many workers did not actually do much work on the job.

• Cyclical underemployment refers to the tendency for the capacity utilisation rate of firms (and therefore of their demand for labor) to be lower at times of recession and/or depression. At such times, underemployment of workers may be tolerated — and indeed may be wise business policy — given the financial cost and the degredation of morale from shedding and then re-hiring staff. Alternatively, paying underused overhead workers is seen as an investment in their future contributions to production. This kind of underemployment has been given as a possible reason why Airbus gained market share from Boeing. Unlike Airbus, which had more flexibility, Boeing was unable to ramp up production fast enough when when prosperous times returned because the company had dismissed a great part of its personnel in lean times. Another example is the tourism sector, which is notoriously cyclical in areas where attractions are weather-related.