Arnold Kling  

Labor Market Puzzle

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The latest labor market data show that aggregate hours worked fell again in August. This means that LUCY, my indicator of labor capacity utilization, also dropped.

The longer that this productivity-cushioned recession continues, the more of a puzzle it presents to macroeconomists. The issue is this: if productivity is rising much faster than real wages, why aren't firms hiring more workers?

Let me sketch a couple of possible answers briefly.

The one-sector model

If we think of the economy as consisting of a single labor market, then I believe that the only way to explain recent economic behavior is to stress the distinction between average productivity and marginal productivity. That is, one can argue that even though average productivity is rising, marginal productivity is falling.

Consider a typical industry with new-economy characteristics, which means that a lot of labor goes for research, trial-and-error, marketing, and other expenses that do not contribute to output in the short run. The perceived marginal product of these activities may have fallen, because corporations have changed priorities.

With the stock market down, firms may place a higher value on retained earnings, which would lead them to reduce overhead. Another factor may be Sarbanes-Oxley, the bill that made corporate boards and executives more accountable for certifying earnings. I have been accumulating some anecdotal evidence that this is having a real dampening effect on the risk-taking of companies. Workers that are involved in experiments to build a better mousetrap, or to come up with marketing strategies for such a mousetrap, are now seen as expendable.

The two-sector model

The two-sector model is one in which in one sector of the economy has productivity growing faster than demand, while in another sector demand is growing only as fast as productivity. The first sector is shedding workers, while the second sector is standing pat. On average, productivity goes up and labor demand goes down.

For Discussion. What empirical evidence would you look for to examine the validity of either of these models?


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CATEGORIES: Macroeconomics



COMMENTS (6 to date)
Matt Young writes:

Civilian industries are in no mood to increase new production facilities until the ratio of goverment and private sector re-balance. They fear future interest rate increases, as well as the risk you outlined.

This behavior fits the first model, increasing hours with the existing plant and reducing new plant and R&D.

Tom Dougherty writes:

“The issue is this: if productivity is rising much faster than real wages, why aren't firms hiring more workers? … If we think of the economy as consisting of a single labor market, then I believe that the only way to explain recent economic behavior is to stress the distinction between average productivity and marginal productivity. That is, one can argue that even though average productivity is rising, marginal productivity is falling.”

Draw a graph of the marginal and average product of labor. The marginal product of labor rises faster than the average product, reaches a peak, and then falls intersecting the average product of labor at the average product's peak. The marginal product of labor is the labor demand curve.

What you say is that firms are hiring labor at some point on the marginal product curve between its maximum point and the point where it intersects the average product curve. This is where marginal product is falling and average product is rising.

In this range, total wages would exceed the total revenue generated. The total wages would equal the wage (determined on the labor demand curve) X the quantity of labor. The total revenue generated would equal the average product of labor X the quantity of labor. Therefore, on the part of the labor demand curve where the marginal product exceeds the average product, firms expenses would exceed revenues and would do better shutting down than operating.

Mats writes:

Another model might emphasize advertising and distribution. If these sectors increase their efficiency to make prodcuts and consumer tastes coincide, productivity would leap:

http://blogofpandora.blogspot.com/2003_08_01_blogofpandora_archive.html#106206502532252593

Arnold Kling writes:

Tom,
"What you say is that firms are hiring labor at some point on the marginal product curve between its maximum point and the point where it intersects the average product curve. This is where marginal product is falling and average product is rising. "

Is that what I'm saying? Maybe, but I don't think so. When I talk about the marginal product of labor falling, I mean that it is falling over time. It was X a few years ago, and it is less than X now.

What I am suggesting is that when you have people doing R&D, as opposed to production, the marginal product is in the eye of the beholder. If the firm values your research, your marginal product is high. But if it doesn't value your research, it doesn't need you. I'm suggesting that the perception of the value of research has changed.

Randall Parker writes:

The two-sector model: But you offer no explanation for why the sector that is increasing in productivity isn't hiring. So that just leaves you with the explanation already offered for the one sector model but applied to that sector in the two sector model.

I have another hypothesis: firms are increasing their hiring but not in the United States. Take a bunch of US multinationals and figure out whether their workforces are growing more rapidly abroad than at home. My guess is that the answer is YES.

Lawrance George Lux writes:

One must always go back to Basics, when there is a seeming incontinuity. Average Productivity is rising because of technological advance, along with greater pressure on the individual laborer to produce. Business face decreasing Sales, or more expensive marketing of Sales. Corporate management face increasing Stockholder pressure to consistent Dividends. This Management feels pressure to drop greater Profit-risk ventures, while under no real compulsion to raise Productivity.
lgl

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