Arthur Okun’s Forgotten Contribution

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 I knew Arthur Okun. In the late 1960s and 1970s, Washington economists working at agencies variously tasked to stabilize the economy considered him to be the town’s preeminent macro theorist. He understood that  then-mainstream Keynesian modeling was centrally constructed both on nominal wage rigidity, sufficient to suppress labor-price recontracting, and stabilization policymaking rooted in the discretionary management of total demand. Drawing on the work of the early ILM theorists, featured in most recent posts on the GEM Blog, as well as other economists looking inside large firms, he almost succeeded in microfounding Samuelson’s Neoclassical Synthesis before his untimely death  in 1980.

Prices and Quantities

I most admired Okun’s refusal to shrink from hard problems. In his posthumous Prices and Quantities (1981), he tackled the exceptionally challenging labor-microfoundations issue by investigating rational workplace exchange, organizing his thinking around a class of implicit contracts he wonderfully named the “invisible handshake”. Hindsight permits interpreting Okun’s intra-firm analysis as a path-breaking effort to model what frustrated efficiency-wage theorists were beginning to set aside, i.e., the meaningfully nonconvex WER class illustrated in the GEM Project’s keystone diagram:



GEM Blog - Modern Labor Supply - Panel A


At the time of his death in 1980, Okun was writing about the nature of modern, specialized economies, explicitly working in the Keynesian tradition of market price-quantity disequilibrium. In Prices and Quantities, he  identified the “big new element” in the General Theory to be “the assumption of downward inflexibility of wage rates”. He understood that flexible pricing, allowing economies to adjust quickly to macro shocks, eliminates most of the real-world problems that macroeconomists are asked to solve. His instinct was to look inside bureaucratic large firms for what it is about modern economies that engenders downward labor-price rigidity.

As already noted, Okun got close to making macro theory simultaneously micro-coherent and stabilization-relevant. He posited employee-satisfaction dependence on fair treatment and, given costly, asymmetric workplace information, motivated agents to consider the distributional consequences of wage decisions. From Okun (1981, p. 81): “The world of employer-worker attachments creates a complex optimization problem for the firm’s personnel management. The firm is not only required to minimize the wage costs of a given employment but also to develop effective mechanisms to promote and assess productivity, and to build a reputation that will both enhance the supply of willing applicants and hold down quit rates.” He separated career from casual employment and emphasized the role of trust in facilitating rational exchange among persons who transact repeatedly. He focused on the critical Early-Keynesian issue, implicitly asking why in the real world wage recontracting does not prevent involuntary job loss.

Prices and Quantities assembled his workplace analyses and made substantial progress toward policy-useful formal macroeconomics, while remaining an intermediate work that did not yet derive involuntary job loss consistent with optimizing, continuous equilibrium. Okun was in the vanguard of the research effort to generalize rational exchange from the marketplace to the bureaucratic workplace. However, given that he was unable to extend and defend ideas that ran counter to mainstream theorists’ deep partiality to macro modeling restricted to market exchange, his work is today little taught or read. More generally, absent his insight, standing, and powers of persuasion, generalized exchange failed to win much acceptance in the aftermath of the book’s posthumous publication and has endured a protracted period of inattention in the academy.

Generalized-Exchange Macroeconomics

Okun understood that costly, asymmetric intra-firm employer-employee information mandated two-venue macro analysis. He made significant progress identifying the separate nature of workplace mechanisms of exchange, objective functions, and technological constraints. With his untimely death, however, the crucial microfounding of the large-establishment labor-input schedule (the Figure below) was postponed for a generation. The GEM Project has revived Okun’s legacy by deriving the necessary on-the-job behavior from axiomatic preferences and technical constraints. (Chapter 2)

The second Figure, which differs from the first diagram only in the reversal of the X and Y axes, captures a powerful theory that enables macroeconomics to simultaneously micro-coherent and stabilization-relevant. It is critically consistent with what is known about routinized-job wage-setting in the class of large, bureaucratic firms that became ubiquitous in the aftermath of the Second Industrial Revolution. The baseline input-supply schedule depicts an implicit contract that optimizes employer profit and employee utility and, consequently, determines the rational wage on its own. (Chapter 2.) That may startle economists, but it describes observable actual practice in large specialized firms. This is how labor pricing over stationary business cycles is actually done. Large-establishment optimization equilibrates the employers’ efficiency wage, minimizing unit labor cost, and employees’ reference wage, satisfying their axiomatic preference for equitable treatment by management.



GEM Blog - Modern Labor Supply - Panel B


The diagram captures essential properties of rational labor management and pricing in large specialized establishments. Labor rents are paid. And, over stationary business cycles, demand-independent labor pricing is consistent with downward inflexibility of nominal wages. The labor-input-schedule discontinuity at the unit-cost-minimizing feasible wage orients baseline labor-pricing dynamics around preventing cuts from the efficiency/reference wage.

Final Word

Why have Prices and Quantities and the other important contributions of Arthur Okun been forgotten? I blame Okun’s colleagues at the Brookings Institution. They long ago gave up on his insights. Given the plentiful evidence that his intra-firm modeling reflected actual behavior, notably including the large-establishment reluctance to cut nominal wages over stationary business cycles, Brookings macro scholars’ shoddy treatment of Okun’s legacy must have been rooted in a shared belief that microfounding a nonmarket theory of intrafirm rational behavior was simply too difficult. If so, the advent of generalized-exchange theory provides Okun’s colleagues who remain active a second chance. They are invited to use the GEM Project to revive Okun’s legacy. They are invited to do the right thing.

Blog Type: New Keynesians Saint Joseph, Michigan

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