Thursday, March 20, 2014

Labor Markets Don't Clear: Let's Stop Pretending They Do

Beginning with the work of  Robert Lucas and Leonard Rapping in 1969, macroeconomists have modeled the labor market as if the wage always adjusts to equate the demand and supply of labor.

I don't think thats a very good approach. It's time to drop the assumption that the demand equals the supply of labor. 

Why would you want to delete the labor market clearing equation from an otherwise standard model?  Because setting the demand equal to the supply of labor is a terrible way of understanding business cycles.

Hours spent in employment varies over time for three reasons.

First, people enter or leave the labor force.  Second, some people lose jobs and others find jobs. Third, people work longer or shorter hours. Most economists confound all three reasons by using only one data series; hours spent in paid employment. That's not a good idea.

Here's data on participation in blue on the right axis against unemployment in red on the left axis. The grey areas are recessions. Participation is smooth; it trends up until 2000 and then trends down.   All the action during recessions is in the unemployment rate.

Participation and Unemployment
Perhaps its variation in hours that explains demand and supply variations?  Nope.  Here is data on average weekly hours (in blue on the right scale) and the same series on unemployment for comparison.

Hours and Unemployment

Why is this a big deal? Because 90% of the macro seminars I attend, at conferences and universities around the world,  still assume that the labor market is an auction where anyone can work as many hours as they want at the going wage.  Why do we let our students keep doing this? 


  1. "Why do we let our students keep doing this?"

    Because economists who assume "full employment" never have to suffer the consequences of their assumption?

    No, it's worse than that. Economists get away with ridiculing those who DON'T assume full employment. It's a tribal thing.

    Thirteen years ago I wrote a book chapter called "The 'lump-of-labor' case against work-sharing" and followed it up seven years later with a journal article titled "Why economists dislike a lump of labor," I have comprehensively documented the fraudulence of the fallacy claim. Does it matter? Of course not. Economists continue to trot out the old libel as if it was Holy scripture. Does anyone call them on it? Only me.

    1. Sandwichman
      It takes a long time to change a consensus. There has been a lot of recent work on search theory and that work is now becoming integrated into the macroeconomics mainstream. However, there are currently several competing versions of reach theory and they have very different implications for economic data.

  2. Here's a matching model based on job openings and unemployed:

    The total number of unemployed U relative to NGDP seems to be related to the price level, but only as a bound [graph at link]

    CPI ≥ k NGDP/U

    It doesn't explain the discrepancy, though.

  3. Amen to that. But the first step to achieve this goal is to remove the market-clearing model from our textbooks and replace it with the search model. The problem is that the cost of switching building blocks and re-writing macroeconomic theory may be higher than any single economist wants to undertake. Perhaps this is another example of path dependency, where history has locked us in a sub-optimal "technology".

    1. Constantine
      You are right. But before a successful textbook incorporates the search model; the profession needs to agree on which search model to adopt.

  4. If the labor supply is scarce, the wage always adjusts to the demands of the work force
    glass blowers in Medieval times
    or farmers after the black plague
    or ,,,,well since the XVI century the slave trade make the wage's more flexible

    if the wage always is a big word.... adjusts to equate the demand and supply of can yes you can drop the wages till the people starve

    the english since 1815 had periods of low wages and of course famine and chronic unemployment, and the corn laws or bylaws that make the low wages a thing of pure bliss.....and for four years the low wages are nice,,,after this you have the peterloo massacre and a steady rise of ....what is the word? ah wages

  5. Looking at the last graph, there appears to be significant anti-correlation between unemployment and the average weekly hours. Can you check whether it's real?

    Of course, this need not mean much, as one should really look into trends (1st derivative) not the actual values of unemployment and the hours.

    1. Branko.
      Yes: there is a negative correlation between unemployment and hours during recessions. People lose jobs and they work fewer hours when firms can't sell goods. But the magnitude of hours declines during recessions is small relative to the loss of employment caused by job loss. In the Great Recession unemployment doubled from 5% to 10%. Average weekly hours went down by about 45 minutes a week.

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

    Alchian (1969) suggests that there is no reason for wags 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.

    There is a tendency for unpredicted price and wage changes to induce costly additional search. Long-term contracts including implicit contracts 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 and price revisions.


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