Arnold Kling  

Macroeconomics Doubtbook, Installment 3

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This discusses labor markets. I also discussed them in my macro lectures, and I may want to integrate more of that material here. The full installment is below. This was the previous installment. Here is an excerpt of the current installment:


Often, when someone moves from one region to another, he or she already has people to contact, a community in which to live, and job opportunities to pursue. People ordinarily move with the expectation that they will rapidly become integrated into the social and economic environment of the new region.

However, when circumstances produce a massive flood of refugees, the situation is more chaotic. People fleeing ethnic strife, natural disasters, or political brutality are focused on survival. They may arrive in such overwhelming numbers and with such little advanced planning that rapid integration into the social and economic environment is impossible. People who had high incomes and valuable skills in their former country can have difficulty establishing themselves in their new homeland.

Similarly, I would suggest that a recession creates a flood of refugees in the job market. In ordinary times, the job transitions that people undertake are ones for which they have done some preparation and planning. The market is able to absorb job losers and new labor force entrants fairly routinely, just as a region can absorb fairly routinely the normal ebb and flow of population. However, just as a community cannot quickly absorb a sudden flood of refugees, labor markets cannot absorb a large influx of unemployed workers.

Labor Economics

In a textbook competitive market, there is no excess supply. When an excess supply threatens to appear, the price falls, increasing demand and reducing supply in order to restore balance.

Unemployment can be viewed as an excess supply of labor. Evidently, the labor market does not act like a textbook competitive market. Macroeconomists are tempted to ask why the labor market does not act as a textbook competitive market and whether it would be better if the labor market were more like a textbook competitive market.

One question is why an individual firm chooses to dismiss workers rather than reduce wages. In theory, if a firm finds that it is paying a wage that is higher than the marginal product of the last worker, it could reduce its wage until either it falls to the level of the marginal product or enough workers quit that the marginal product of the remaining workers is at least as high as the wage rate.

We are brought back to the issue of why wages are sticky in some labor markets. I believe that from the standpoint of an individual firm, the answer comes from a combination of factors.

1.The marginal contribution of workers is often very difficult to measure. The elasticity of demand for labor at any one firm tends to be low.

2.When a firm is reducing its demand for labor, managers would rather choose which workers to let go than lower wages and leave that decision to workers.

3.Worker morale and productivity are higher when there are fewer workers earning higher wages than when there are more workers earning lower wages.

In textbooks, a firm knows the marginal value product of each worker. In reality, most firms have only a vague idea of the marginal value of what a worker produces. If eight software developers develop an update to the inventory tracking system, how would you compute the marginal product of one of the people working on the project? What is the marginal product of the accountant who works on part of a disclosure statement for the Securities and Exchange Commission? What is the marginal product of a marketing executive who is developing a strategy for the firm to use social media? What is the marginal product of the human resources executive in charge of a particular training program?

Garett Jones of George Mason University, in unpublished comments (on Twitter, if you must know), suggests nowadays firms hire workers to produce organizational capital, not widgets of output. At many firms, a lot of labor is overhead labor. However, the amount of overhead is variable.

The size of the accounting department depends less on the volume of output than on the overall status of the firm. If the financial condition is perilous, management will try to get by with a skeleton accounting staff. If the firm is in the process of entering new markets, it will be expanding its accounting department in order to ensure that controls and information management systems are in place to manage growth prudently..

The typical firm does not make its hiring decisions on the basis of calculating marginal product. Instead, based on their financial condition and the market environment, firms make a determination of whether they need to add capabilities, maintain the status quo, or retrench.

If the financial condition of a firm takes a turn for the worse, it needs to hold down or reduce its labor compensation. If all of its workers were equally valuable and interchangeable, then it might make sense to reduce labor costs by cutting wages, leaving it up to employees to decide when the wage is too low to warrant staying on. However, when managers believe that some workers are particularly valuable, they would rather make the choice themselves. Managers choose which workers to retain and which workers to let go.

After a cutback in staff, the workers that are retained by the firm are less likely to have their pay cut. The firm needs its remaining staff to maintain their productivity--indeed, it may require additional effort to make up for the workers who were let go. A pay cut would send workers a very adverse signal about the prospects for the firm, leading the firm's best workers to seek jobs in other firms. The relationship of wage cuts and morale/productivity will come up again when we discuss the path of behavioral economics.

I should emphasize that cutbacks and expansions within firms are happening all the time, not just during recessions and booms. A thriving firm may still choose to cut a division or department whose performance is disappointing. Even within an economically depressed industry, one can often find small firms that are expanding.

The economy as a whole will reflect the staffing decisions of all firms, some of which are adding capabilities, some of which are maintaining the status quo, and some of which are retrenching. It is important not to confuse the gross level of staff reductions with a rise in unemployment. Unemployment increases only when the net of new hires minus layoffs is less than the increase in the labor force. One hospital can shut down its brain surgery unit without necessarily causing unemployment among brain surgeons. If the overall market is strong, those brain surgeons will be hired elsewhere.

Similarly, it is important not to confuse a theory of wage stickiness at a single firm with an explanation for market-wide or economy-wide failure of labor markets to clear. Even moreso, we are not ready to explain why these failures occur at particular times, called recessions.

For several decades, macroeconomic textbooks have taught students to distinguish among frictional unemployment, structural unemployment, and cyclical unemployment. Frictional unemployment is defined as the normal short-term unemployment that is caused by the "friction" involved in changing jobs. In between the time someone leaves a job and takes a new job, that person is unemployed. Structural unemployment is defined as long-term unemployment due to a mismatch between skills demanded and skills supplied. Cyclical unemployment is defined as medium-term unemployment due to changes in aggregate demand.

These distinctions may be less helpful than they appear. Manufacturing workers on temporary layoff, who expect to be recalled when demand recovers, fit the notion of cyclical unemployment1. Otherwise, however, it is difficult to classify an unemployed individual using these categories. If it takes a long time to find a job, that might be due to "friction," but it might easily result from cyclical or structural factors.

One characteristic of labor markets is that there are significant transaction costs involved in adding workers. Try to picture a group of people milling around in a parking lot early Monday morning. A car drives up. The driver rolls down the window and says, "Here's some work if you want it. I've got a hospital that needs three brain surgeons to operate today through Friday. They're paying twenty-one thousand for the week. Any takers?"

This picture is comical, because of the absurdity of imagining a spot market for labor being used to hire brain surgeons. In principle, however, spot markets would seem to guarantee full employment and flexible wages. Why do we observe relatively few spot market transactions in labor, and how important is this for explaining recessions?

There are examples of labor markets that seem close to spot markets. You cannot find brain surgeons milling around in a parking lot looking for daily or weekly employment, but you can hire manual laborers that way. Routine clerical help can be obtained through temporary agencies. You can hire someone to do freelance writing, editing, or graphic design by using an advertisement on a Web site.

What I call the dishwasher story assumes that there is a spot market for hiring workers to wash dishes. Suppose that, due to some change in insurance regulations, the demand for brain surgeons falls. This leads some brain surgeons to become dishwashers. The wage rate for dishwashers falls, but full employment is restored. Nonetheless, the economy is still poorer than it was when brain surgeons were using their skills.

In fact, if brain surgeons lost jobs, they probably would spend a lot of time searching for new jobs doing brain surgery rather than immediately take jobs as dishwashers. That is, they would spend time looking for a match for their skills.

Many economists believe that it is fruitful to study the labor market as a "matching market." There is a voluminous literature that adopts this perspective. It is tempting to describe good economic times as periods when it is easy to match worker with vacancies and to describe bad economic times as periods in which matches are difficult to make. However, such stories do not fit with the sense that we have that recessions involve a general excess supply of labor, not just a matching problem.

I think that it may be useful to think of movement in labor markets as analogous to regional population movements. Ordinarily, most people remain where they are, because of the high psychological and financial costs of moving. However, there are always people who are moving from one region to another, as they respond to changes in the environment, technology, and institutions. Within the United States, in the early 19th century, we saw cities grow up around the intersections of major rivers. Later in the century, railroads helped shape population patterns. Other well-known factors that caused population shifts included the discovery of gold in California, the introduction of the automobile, and air conditioning.

The United States as a whole has experienced large and variable immigration flows. When political or economic conditions in other countries became dire, many people attempted to make new lives in this country.

Over time, many population shifts represent changes in "vintages." Young people gravitate toward one region, and older people in another region gradually die off.

There are a number of similarities with labor markets. First, most people prefer not to move very often or very far. In the case of work, moving "far" could mean making a significant career change, even if the geographic location is nearby. Whether movement represents changing firms, changing cities, or changing careers, high psychological and financial costs deter most people from moving frequently.

Second, notwithstanding these costs, there is always some movement taking place. Just as some regions expand and others fade, some firms and industries expand while others decay.

Third, many of the economy-wide changes in the labor force involve the turnover of "vintages." Over the past fifty years, we have seen many workers with only a high school education retire out of the labor force, with new entrants tending to have higher levels of education.

What does this analogy with population movements say about recessions? Often, when someone moves from one region to another, he or she already has people to contact, a community in which to live, and job opportunities to pursue. People ordinarily move with the expectation that they will rapidly become integrated into the social and economic environment of the new community.

However, when circumstances produce a massive flood of refugees, the situation is more chaotic. People fleeing ethnic strife, natural disasters, or political brutality are focused on survival. They may arrive in such overwhelming numbers and with such little advanced planning that rapid integration into the social and economic environment is impossible. People who had high incomes and valuable skills in their former country can have difficulty establishing themselves in their new homeland.

Similarly, I would suggest that a recession creates a flood of refugees in the job market. In ordinary times, the job transitions that people undertake are ones for which they have done some preparation and planning. The market is able to absorb job losers and new labor force entrants fairly routinely, just as a region can absorb fairly routinely the normal ebb and flow of population. However, just as a community cannot quickly absorb a sudden flood of refugees, labor markets cannot absorb a large influx of unemployed workers.

Remember that economic activity consists of patterns of specialization. Many patterns persist, but there are always old patterns that are breaking down and new patterns that are emerging. In general, the new patterns that emerge provide more wealth than the old patterns that break down. People shift to the new patterns in response to improved opportunities.

The refugee problem arises when, instead of gradually giving way to a new pattern, an old pattern of specialization simply breaks down. A business model becomes obsolete. This in turn adversely affects related business models. The result is a flood of unemployed workers. Like a flood of new refugees, these unemployed workers cannot be rapidly absorbed by the economy. Instead, there is a long process of adaptation and adjustment. Some workers change jobs, some workers get retrained, and some workers retire and are replaced by workers of newer vintages. The time that it takes to restore full employment depends on the severity of the breakdown and the nature of the adaptations required.

This raises the question of how one pattern of specialization can break down without another pattern available to replace it. Ordinarily, one would think that if a business or industry becomes obsolete, that is because another business or industry has emerged that is even more lucrative. How can one pattern of specialization disappear without having been displaced by a better pattern? That question leads us to other paths.


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COMMENTS (8 to date)
Lord writes:

I would put employment somewhat more simply. Everything a firm knows or can know about productivity is incorporated in wages. Thus when a firm experiences reduced demand, everyone's productivity at the firm is reduced and the firm reduces its workforce to restore the productivity of those remaining. Managers use all manner of criteria to discriminate among workers except productivity because that has already been equalized to the best of their ability. They may try to minimize the number laid off, the capabilities lost, loss of institutional knowledge, disruption to more profitable areas, maximize opportunities for improvement, sociability, or classical discriminatory attributes. While workers may expect less likelihood of wage cuts or further layoffs, the more astute recognize this as a warning and time to begin seeking other opportunities.

Fergus O'Rourke writes:

Er, why is commentary on Twitter "unpublished" ?

azmyth writes:

Garrett Jones is a master of the medium. He is able to summarize in 140 characters what takes others 5 pages to say.

Pareto writes:

Are you ever going to publish your thoughts on macro, Arnold?

Chris Koresko writes:

I like Lord's picture. It seems to capture most of the important effects in one shortish paragraph.

I take his point that managers will generally try to equalize the productivity of their employees to mean maintaining an equal relationship (in some as yet unspecified sense) between the wages of each worker and his marginal productivity. Is that right?

Rebecca Burlingame writes:

One more thought on labor markets. People sometimes move to rural areas in the mistaken belief that lower home prices can be adequately paid by local work, when in fact the home prices are lower because the work simply is not there. In this case people just end up with extra long commutes to where the work is.

rhhardin writes:

People with underwater mortgages can't move to new jobs.

Theoretically they could - what has to happen is that they swap mortgages with somebody else underwater where they want to go who wants to make the reverse move - but there's no paperwork path to that result. Something like underwater money is needed to mediate finding multi-party matches.

After all, they still own one house worth of house, which ought to swap even for another house worth of house, even if both have fallen in money value; and they need a house where they're going.

So that's another labor stickiness factor.

EclectEcon writes:

When the wage rate falls, that leads to an increase in the quantity demanded (not demand) and a decrease in the quantity supplied (not supply). Or do you not accept this distinction?

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