Friday, November 14, 2014

Repeat After Me: The Quantity of Labor Demanded is Not Always Equal to the Quantity Supplied

I've been teaching a class on intermediate macroeconomics this quarter. Increasingly, over the past twenty years or more, intermediate macro classes at UCLA (and in many other top schools), have focused almost exclusively on economic growth. That reflected a bias in the profession, initiated by Finn Kydland and Ed Prescott, who persuaded macroeconomists to use the Ramsey growth model as a paradigm for business cycle theory. According to this Real Business Cycle view of the world, we should think about consumption, investment and employment 'as if' they were the optimal choices of a single representative agent with super human perception of the probabilities of future events. 

Although there were benefits to thinking more rigorously about inter-temporal choice, the RBC program as a whole led several generations of the brightest minds in the profession to stop thinking about the problem of economic fluctuations and to focus instead on economic growth. Kydland and Prescott assumed that labor is a commodity like any other and that any worker can quickly find a job at the market wage. In my view, the introduction of the shared belief that the labor market clears in every period, was a huge misstep for the science of macroeconomics that will take a long time to correct.

In my intermediate macroeconomics class, I am teaching business cycle theory from the perspective of Keynesian macroeconomics but I am grounding old Keynesian concepts in the theory of labor market search, based on my recent books (2010a, 2010b) and articles (2011, 2012, 2013a, 2013b).  I am going to use this blog to explain some insights that undergraduates can easily absorb that are adapted from my understanding of Keynes' General Theory. Today's post is about measuring employment.  In later posts, I will take up the challenge of constructing a theory to explain unemployment.

Ever since Robert Lucas introduced the idea of continuous labor market clearing, the idea that it may be useful to talk of something called 'involuntary unemployment' has been scoffed at by the academic chattering classes. It's time to fight back. The concept of 'involuntary unemployment' does not describe a loose notion that characterizes the sloppy work of heterodox economists from the dark side. It is a useful category that describes a group of workers who have difficulty finding jobs at existing market prices. 

The idea that the labor market is well described by a model in which a market wage adjusts to equate the quantity of labor demanded with the quantity supplied bears little resemblance to anything we see in the real world. What makes me so confident of that claim?
Figure 1: Average Weekly Hours and the Unemployment Rate
 (c) Roger E. A. Farmer

Employment varies over time for three reasons. First, the average number of hours fluctuates. Second people enter and leave the labor force and third, those people who are in the labor force flow into and out of unemployment. Figure 1 (taken from my 2013 Bank of England article) plots data from 1964 through 2012 on average weekly hours and the unemployment rate.  The blue line, measured on the right scale, is average weekly hours. The pink line, on the left scale, is the unemployment rate. The grey shaded areas are NBER recessions.

The facts are clear. Although hours do fall during recessions, the movements in hours are swamped by movements in the unemployment rate. Consider, for example, the 2008 recession. Average weekly hours fell from 34 to 33. The unemployment rate, in contrast, increased from 4% to 10%.  

The main story in the data on average weekly hours is that they declined from 39 hours per week in 1964 to 34 hours per week in 2012. As American workers got richer they collectively chose to take a larger share of their wages in the form of leisure.  These movements are important if our goal is to understand long term trends: they do not tell us much about recessions.

What about the participation rate? Recently, there has been a great deal of angst amongst policy makers  who are asking if the fall in the participation rate that occurred during the 2008 recession was cyclical or structural. Figure 2 sheds some light on that question. The graph demonstrates that there is no clear tendency for participation rates to drop in recessions. For example, participation was higher at the end of the 1973 recession than at the beginning and in a number of other post-war recessions it has remained flat. As with average weekly hours, this figure shows that movements in hours during recessions are almost entirely caused by movements in the unemployment rate.
Figure 2: Participation and the Unemployment Rate
(c) Roger E. A. Farmer
So what does cause the participation rate to vary over time? I look at Figure 2 and I see a parabola. Participation went up from 1960 to 2000 as women entered the labor force. It started to fall again in 2000 as the baby boomer generation  began to retire. These secular trends swamp business cycle movements in the participation rate  and they are largely explained  by sociology and by demographics. 

What do I take away from these data? There are three reasons why employment fluctuates over time. People vary the average number of hours worked per week. Households send more or less members to look for a job. And those people looking for jobs find it more or less difficult to find one. The first two reasons for fluctuating employment could perhaps be modeled as the smooth functioning of a market in which the demand and supply of labor respond to changes in market prices.  I cannot see any simple way to model unemployment fluctuations as the operation of a competitive market for labor in the usual sense in which economists use that term. 

Repeat after me: the quantity of labor demanded is not always equal to the quantity supplied.


  1. See for a nice discussion of unemployment as an equilibrium phenomena

  2. See too From one to many islands : the emergence of search and matching models at

  3. Bob, This is the way labour markets work: v(s, y, λ) max{λ, R(s, y) min[ λ, β ∫ v(s′, y, λ) f(s′, s)ds′]}. Ed

    Robert Lucas went on to explain in his professional memoir about this exchange in the early 1970s that:

    we had agreed on notation: s stood for the state of product demand at a particular location, y stood for the number of workers who were already at that location, R(s, y) was the marginal product of labour implied by these two numbers, and v(s, y) stood for the present value of earnings that one of these workers could obtain if he made his decision whether to stay at this location or leave optimally.

    Other features of the equation were as novel to me as they are (I imagine) to you…a single parameter—Ed’s λ—stood for two different things: the present value of earnings that all searching workers would have to expect in order to leave a location and the present value that a particular location would need to offer to receive new arrivals…If I had to pick a single day to represent what I like about a life of research, it would be this one.

    Ed’s note captures exactly why I think we value mathematical modelling: it is a method to help us get to new levels of understanding the ways things work.About these ads

    1. Thanks for your comments Jim. I am a fan of labor search models and I will explain why in future posts. But there is more than one way to add search to an otherwise neo-classical model. If done correctly (see my 2010 book, Expectations Employment and Prices) search provides a microeconomic foundation to Keynes' idea of multiple steady state equilibrium unemployment rates. If done incorrectly, search dramatically fails to explain the facts (see Rob Shimer's original paper that later commentators dubbed the 'Shimer puzzle'.

  4. Roger,

    You have just stepped on the nerves of the framework of the economics.
    The labor market never completely clears as long as the existance of the unemployed labors.

    I would encourage you to expand your analysis to the entire microeconomics and macroeconomics. Because the existence of inventories, markets never clear. There is no such thing as market equilibria in reality.

    I reached the same conclusion from a very different angle. Please take a look:

    Current economics is psedoscience: why are 60% current economic theories and models wrong?

    Popular DSGE models are probably intellectual dead ends, and the right forecasting models for macroeconomics are the IBS+ accounting models.

    1. @ a jwinterpretation Yes, I may have stepped on a nerve. But the techniques introduced by Bob Lucas, Ed Prescott and the entire Minnesota school are here to stay. And that is a plus. It is possible to use the techniques of search theory to explain all of the phenomena you mention. We should not let arguments over technique obscure arguments over substance. By using ideas from search theory correctly (see my 2010 book and the papers linked in my post) we can maintain the spirit of Keynes without losing the rigor of equilibrium arguments. My beef is not with the equilibrium concept. It is with the tendency of some economists to exclusively search for models with unique equilibria in which the equilibrium is Pareto efficient.

  5. Unlike say DVDs, people do not have one set purpose/function for existing. There is not an "overstock of labor" sitting on a shelf somewhere. I work to live, I don't live to work. Or in cruder terms, I won't get off my butt just to do mindless work for someone else's profit.

    The whole model of labor seems ... Irrelevant to reality.

  6. Roger. You won't be surprised if I say I agree!

    But one very small point: when I eyeball that participation rate curve, I think I see that participation rate does fall temporarily, *relative to trend*, during a recession. But because participation and unemployment are measured on different scales, the fluctuations in participation relative to trend look smaller, relative to fluctuations in unemployment, than they really are.

    But yes, the fluctuations in unemployment are still bigger. And the "discouraged worker" explanation says they are just different parts of the same thing: in a recession it gets harder to sell your labour for money. So more people are trying harder for longer, and more people give up.

    And if we model this in a search model with heterogenous jobs and workers, it doesn't really make much difference. The Marshallian supply and demand curves are just the limiting case. Instead of it being harder than normal to find a job it a recession, it becomes impossible instead of perfectly easy.

    1. Thanks Nick. Of course you are right. In my view, search theory is the only game in town if we are looking for a coherent explanation of labor market dynamics. But there is more than one way to add search to a DSGE model.

  7. My two cents: The labor market does not work like a potato market. On the labor market, supply & demand are not independent.

    The price mechanism in the potato market doesn’t exist on a macroeconomic basis, because supply & demand are interrelated on the labor market.

    One person’s spending is another person’s income. The world as a whole cannot improve its competitiveness.

    We need to distinguish between micro and macro level. The government cannot slash spending like a private household, because its revenues are not met.

    The problem is that we cannot apply to macro level from a micro level. What works on a micro basis doesn’t work on a macro basis. The simple price mechanism fails in the labor market.

    High unemployment is considered by neoclassical school as the sign of oversupply of labor. Hence, the lack of jobs is the best evidence that the price on this market (namely the wage) is too high. Therefore the wages must be reduced in order to clear supply and demand. This is the view which is derived from the neoclassical theory. This is the policy that Europa currently trying to apply, unfortunately.

    The level of employment in the economy is not determined by the wage, but by the level of output.

    Keynes was the first to argue that involuntary unemployment represented a failure in the product market, not a failure in the labor market as Peter Temin and David Vines note in their current book “Keynes – Useful Economics for the World Economy”.

    1. Wow. There is a lot to respond to here. The rational expectations revolution changed the way that macro economists (including yours truly) go about our business. And that change led us to look at many of the old arguments through a different lens. My principal response to your comment is the same as my response to some the previous comments on this post. Take a look at my book Expectations Employment and Prices. There, I provide a foundation to Keynesian macroeconomics that is very different from the familiar defense that Keynesian economics relies on sticky prices. It doesn't.

      As for Temin and Vines. They are simply repeating a familiar defense of Keynesian economics that stems from Samuelson's misleading, but highly successful, attempt to bastardize Keynes by squeezing his ideas into a neo-Walrasian framework.

  8. Thanks Roger, 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.

    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.

    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.

  9. Forgive the naive question, but isn't it possible that hours dropped not because people wanted leisure but because the jobs available were not full-time?

    1. @Cathy O'Neil
      Yes that's possible. And in favor of that view is the fact that many people are working multiple jobs.

      On the other hand, in nineteenth century England, it was not uncommon for laborers to work six days a week for 10 hours or more hours a day. And in very poor countries today, the poor work long hours for low wages. I do think that there is something to the argument that, as we get richer, average hours fall because of a wealth effect on labor supply. It is important to separate the trend from business cycle effects caused by the recession.

  10. Roger

    You might like to look at John Quiggin's take on search theory:


    His conclusion: if generally-accepted numbers on the number of jobs rejected are accurate, then "the search theory of unemployment is utterly baseless". It is telling, though, that there seems to be very little empirical research into how people actually do find jobs.

    1. Thanks for your comment Peter. John and I disagree on this. I'm guessing John hasn't read my book Expectations Employment and Prices which takes a very different view from mainstream search models.

  11. Hi Roger
    Can you can tell me what kind of labor i you mentioning
    Brain Hoshowski

  12. Brian
    I think your comment was cut off. Can you repost it?


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