First Fundamental Neoclassical Tenet

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E.K. Hunt and Mark Lautzenheiser (2011, p.434) nicely capture three fundamental tenets of mainstream neoclassical theory: “… the faith that the invisible hand of the competitive market harmonizes all interests through free exchange, creates rational prices, and leads to an efficient allocation of resources; the faith that the free market will automatically create a full-employment equilibrium; and the belief that the wage rate is equal to the value of the marginal product of labor and that the profit rate (or interest rate) is equal to the value of the marginal product of capital – hence, by implication, each social class gets the value created by the factors it happens to own.”

Neoclassical general-market-equilibrium thinking has been fully realized for a long time, during which its micro-coherent macro branch has become dominant in the academy. That status is being challenged by the emergence of the GEM Project’s generalization of rational exchange from the marketplace to workplaces restricted by costly, asymmetric information and routinized jobs. That powerful model class mandates the coexistence of the marketplace and workplace venues of optimizing exchange, both organized by general decision-rule equilibrium but with distinct objective functions, constraints, and exchange mechanisms.

It is enlightening to work through how two-venue modeling impacts the fundamental tenets of market-centric neoclassical theory outlined above. This post takes an introductory look at how GEM innovations alter the first tenet, My critique, which could go in many directions, focuses on the competitive labor market’s capacity to rationally price labor services. The next two weeks will, in turn, illustrate the substantial effects on the second and third neoclassical tenets.

Competitive Labor Market

The textbook marginalist narrative on labor-market outcomes, maximizing employer profit and  employee utility, ostensibly microfounds Keynes’s Second Classical postulate, i.e., that nominal wages paid must  equal workers’ market opportunity costs. That demonstration is perhaps the most familiar in neoclassical economics and need not be recounted here. Our purpose is instead to elaborate on familiar circumstances, mentioned above, that economists generally understand wrecks the competitive labor market’s capacity to price worker hours in line with their opportunity costs: costly, asymmetric workplace information. In such circumstances, efficient labor pricing cannot occur in the market and must be conducted inside the firm.

My focus here is a particularly consequential outcome of intra-firm optimizing behavior: the chronic labor rents that are rationally paid in the large establishment venue (LEV). The GEM Project has demonstrated that wages variably exceeding market opportunity costs are a requirement of LEV profit-seeking. (Chapters 2 and 3) The Project derives from axiomatic model primitives the workplace exchange relation (WER) that is sufficiently nonconvex to make chronic rent (WnWm>0) a necessary outcome of optimizing behavior, as illustrated in the Figure. The particular WER is a long-missing fundamental economic law. Chronic wage rent is rooted in rational choice by employers and employees, is broadly consistent with relevant evidence, and presents an extraordinary opportunity for economic theorists willing to consider the consequences of obvious workplace information asymmetries.




Accommodating Wage Rents

Microfounded MWR substantially alters the textbook microeconomic story, making it more recognizable to non-economists. Chronic rents imply that most workers are pushed off their neoclassical labor-supply schedule. Rent-paying jobs for which SEV (small-establishment venue) employees are qualified are rationed, and weekly hours for LEV employees are fixed by management. The labor market is in chronic disequilibrium. Critical on-going labor flows occur in both directions between LEV and SEV firms, periodically switching direction. Inter-venue dynamics are governed by the well-known Harris-Todaro mechanism. Cyclical and chronic labor-market disequilibrium spills over into other markets, damaging beyond repair the analytic usefulness of knife-edge neoclassical market-centric equilibrium.

Two-venue general decision-rule equilibrium provides the organizing impulse that effectively replaces the neoclassical market-centric Walrasian equilibrium. Labor rents cannot be ignored by rational workers,  introducing big changes in their behavior that sharply enhance the capacity of textbook theory to explain the relevant evidence. It will be comforting to mainstream theorists as they come to grips with the necessity of workplace modeling that, after accommodation of the fundamental GEM innovations, much of the textbook neoclassical narrative remains intact.

Many policy implications follow. Most important is that labor-related policymaking must be supported by models that feature rational labor rents. Their absence in mainstream market-centric thinking has damaged policy advice for far too long. An illustrative example is payroll taxation. Textbook neoclassical modeling puts all workers on their knife-edge work-leisure margin, arguing that a significant economic cost to higher payroll taxes is the lost income and output that results from the jump voluntary job quits. In the GEM analysis, featuring significant wage rents, a jump in quits in response to an increase in the payroll tax rate is not rational; the losses do not occur.

In closing, I want to call attention to an especially difficult, almost always ignored, policy conundrum uniquely identified by the more powerful GEM analysis. Income-support programs for workers who lose rent-paying jobs are commonplace. Such programs are a rarely questioned response to both layoffs and job-downsizing. There is, however, no symmetric attention to the welfare loss affecting workers who are unable to get rationed high-wage jobs in the first place. Programs that enhance the human capital of excluded workers, enhancing their general capacity to access better-paying employment, have always played second-fiddle to income-support programs that seek to replace a significant part rent-enhanced wages lost in involuntary job reductions.

Blog Type: New Keynesians Saint Joseph, Michigan

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