Bryan Caplan  

Sorrow and Anger

Learning About the Economy: St... Revealing Sentence on Higher E...
On Thursday, Casey Mulligan lectured on his The Redistribution Recession at GMU.  Lots of interesting, neglected evidence on the spike in labor market distortions since 2007.  Yet the talk was marred by Mulligan's commitment to a market-clearing model of labor markets.  When pressed, he was quite insistent that given the expansion of the safety net, the unemployed do not want to work at the current market wage.

To be fair, Mulligan explicitly disavowed the view that the unemployed are happy about their situation.  But in his view, the unemployed would be even less happy to keep doing their old jobs for prevailing rates of compensation.  Unemployment's bad, but so are wage cuts.

Why should you reject Mulligan's view?  There's the obvious fact that wages don't fluctuate like stock prices, even in the face of large shocks to the labor market.  The best argument, though, is introspection.  Ask yourself:

When someone gets laid-off, what is his main emotional reaction likely to be? 


When someone gets a nominal wage cut, what is his main emotional reaction likely to be? 


In Mulligan's model, lay-offs and wage cuts are two sides of the same coin, and workers should respond identically.  But of course they don't.  Part of the reason is that - especially during recessions - labor markets don't clear.  People who keep their jobs are lucky, earning above the market-clearing wage.  The rest are unlucky, and often struggle for months or even years to find a remotely comparable position. 

Yet there's more psychology going on.  When you're laid-off, you feel exiled from your group.  You're rejected, unfit, unworthy.  Many people in this situation break down and cry.  When you face a pay cut, in contrast, you feel betrayed by your group.  You're insulted, snubbed, scorned.  You might weep, but you're more likely to crumple up the memo explaining the pay cut and hurl it in the trashcan.  Especially during a recession, you probably won't be brave enough to quit in retaliation; instead, you'll shave the quality of your work to extract a petty revenge.

Most Keynesians will probably see Mulligan's market-clearing model as an excuse to reject everything he says.  But this is hasty and unfair.  There's no reason why we can't (a) admit that labor markets don't clear during recessions, yet (b) insist that expanding the welfare state seriously retards the labor market's naturally sluggish adjustment mechanism.  Keynesians' benign view of governments' "response" to the Great Recession is not implied by their model.  Indeed, the Keynesian model specifically implies that Keynesians should look upon new labor market distortions with anger, or at least sorrow.

Update: Check out Mulligan's EconTalk podcast with Russ Roberts.

COMMENTS (7 to date)
Eli writes:

Yeah, I listened to the Econtalk with Casey Mulligan. When Russ pressed him on magnitudes, I didn't find the answer compelling. Since United States welfare spending is so low in the first place, I doubt that the increases in recent years have that significant a role in keeping the unemployment rate high.

Koz writes:

Bryan's counterexample is interesting but not conclusive imo. Without intending to endorse a perfectly clearing model of labor markets during a recession, I think there is more to Mulligan's point about the lack of desire of the unemployed to work in the current labor market.

Specifically, I think role of psychological expectations is an important component of compensation and that affects employed labor and unemployed labor much differently.

Ie, for both the employed and the unemployed, the perception of being on an upward career path or at least having a real of it is an important motivating factor in labor.

For an employed person taking a pay cut, he loses cash compensation and also his quasi-equityholder relationship with his employer. In a lot of cases, he can probably fade the former ok but not the latter. That's where the anger comes from.

For an unemployed person, that factor cuts in the opposite direction. For as long as he is unemployed and relying on the social safety net (or savings if he has any), he can believe that he is only one phone call from resuming his prior career path. And the energy he puts in the labor market is probably geared around hoping for or engineering that phone call. But once he actually accepts new employement he will start evaluating much differently, based on a reasonable extrapolation of the new role he accepts. And if the prospects there are not good, it's at least plausible won't take the job and keep his hopes instead, reasonable or otherwise.

It's a similar phenomenon to the dotcom bubble of 2000, where some firms at least lost valuation at the exact time where they started making money. As long as a firm could be perceived to be dialed into the New Economy, it was worth the moon. But as soon as it became a profit-making concern it was evaluated as one, to the detriment of the stockholders.

Jim Rose writes:

Alchian (1969) lists three ways to adjust to unanticipated demand fluctuations:
• output adjustments;
• wage and price adjustments; and
• Inventories and queues (including reservations).

Alchian (1969) suggests that there is no reason for wage and price changes to be used regardless of the relative cost of these other options:
• The cost of output adjustment stems from the fact that marginal costs rise with output;
• The cost of price adjustment arises because uncertain prices and wages induce costly search by buyers and sellers seeking the best offer; and
• The third method of adjustment has holding and queuing costs.

Long-term contracts including implicit contracts thus arise to share risks and curb opportunism over sunken investments in relationship-specific capital. These factors lead to queues, unemployment, spare capacity, layoffs, 'shortages', inventories and non-price rationing in conjunction with wage stability.

Alchian and Woodward’s 1987 'Reflections on a theory of the firm' says:

“… the notion of a quickly equilibrating market price is baffling save in a very few markets.

Imagine an employer and an employee. Will they renegotiate price every hour, or with every perceived change in circumstances?

If the employee is a waiter in a restaurant, would the waiter’s wage be renegotiated with every new customer? Would it be renegotiated to zero when no customers are present, and then back to a high level that would extract the entire customer value when a queue appears?…

But what is the right interval for renegotiation or change in price? The usual answer ‘as soon as demand or supply changes’ is uninformative.”

Alchian and Woodward then go on to a long discussion of the role of protecting composite quasi-rents from dependent resources as the decider of the timing of wage & price revisions.

Alchian and Woodward explain unemployment as a side-effect of the purpose of wage and price rigidity, which is the prevention of hold-ups over dependent assets. They note that unemployment cannot be understood until an adequate theory of the firm explains the type of contracts the members of a firm make with one another.

Benjamin Klein’s theory of rigid wages in American Economic Review in 1984 is one of the few that explored rigid wages as an industrial organisation issue.

Klein treated rigid wages as a response to opportunism and hold-up problems over specialised assets and are forms of exclusive dealership or take-or-pay contracts.

Marc writes:

Back in 2009 I was working for a small division of California based tech company. Due to economic uncertainties caused by the financial crisis, management decided to reduce staff salaries 10% and management salaries 15% across the board.
I don't remember anyone being angry at the time. The press portrayed the cuts as effective action by a smart, decisive CEO, but I don't remember anyone with those thoughts either.
However, I do remember 5-6 months after the cuts running into an old co-worker. It turned out, I was part of the first wave of a massive staff turnover, and that turnover had just resulted in the reinstatement of everyones salary level, some raises, and, a nervous management, extending full time status to contract workers.
Anyway, I just mentioned it as there is a 3rd reaction -- something like -- 'then I'll work for someone else'

Ritwik writes:

Tenured professor. Introspecting. About modal blue collar job loss. Ok.

Like what you write usually Bryan, but this is just delicious.

simon... writes:

Employers sure know about productivity losses with direct pay cuts. That is exactly why you don't see them that often.
But there are forms of indirect cuts - benefits (large portion of employer's expenses) cuts are less obvious and usually met with less anger. Employers can always fire people with higher salaries and replace them with people with lower salary requirements and more motivated. It not about either the labor markets clear or not, it's about how fast they move towards a clearing point.

Jim Rose writes:

Bryan, I recently went through a workplace restructuring where my pay and that of others was cut on a take-it-or-leave basis. This happened to friends elsewhere with other employers. unionised workplaces all.

everyone involved was well aware of the weak state of labour demand in the local labour market.

Alchian (1969) argued that in a recession, employers and workers do not immediately know that demand has fallen elsewhere as well as in their own local markets and recognise the need to adjust to their poorer prospects everywhere, and it is also not known how long the drop in demand will last. workers look for another job at the same pay rather than accept a pay cut.

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