Neil Irwin’s Shame, Part III

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This post is the third installment bashing Neil Irwin’s hobby-horse that the economy is too complicated for human comprehension. He has been mounting his soapbox and arguing that economists are fooling themselves and trying to fool everybody else. In so doing, he has been misusing  the New York Times to open the door to crackpot ideas. He should be ashamed.

Readers of this Blog know that the true problem is less know-nothing. Mainstream macro theories about which Irwin makes fun are constructed for an earlier age, prior to the Second Industrial Revolution. They are not up to the task of explaining modern, highly specialized economies. Thankfully other, readily available models powerfully explain Irwin’s “incomprehensible” macro-problem agenda, focusing on the interrelated phenomena of wages, inflation, and unemployment. The NYT failure is simply that Irwin, who should be finding out if better models exist, would rather preach than do his job.

If Irwin decided to do some reporting, he could discover that the debilitating problem with mainstream thinking is paying exclusive attention to decisionmaking in the marketplace. Especially since the Second Industrial Revolution, a great deal of consequential economic decisionmaking occurs inside large, bureaucratic firms. Once that second venue is included in macro analysis, Irwin’s incomprehensible economy becomes comprehensible. What follows outlines the basics of the two-sector modeling capable of usefully explaining wages, inflation, and unemployment.

Market Venue

Firms in the market venue are characterized by effective direct supervision of worker on-the-job behavior, i.e., ŹK=ŹmK. (The notation is defined in the previous posts.) These businesses populate mainstream macro theory. Rational worker choice is restricted to the marketplace; workers cannot influence their own behavior on the job. Profit-seeking firms must price labor hours to equal employees’ market opportunity costs.

The market-wage-taking venue recalls Lloyd Fisher’s “structureless labor markets”, to which he assigned four characteristics. There are no unions; there are no formal or informal work rules; workers tend to be unskilled; and relatively little capital or machinery is employed. Clark Kerr (1977, p.24) described wage policies of firms operating in Fisher’s structureless environment: “The employer prefers one worker to another only if he accepts a lower … rate. Rates vary greatly over time, but at any moment of time are uniform over space. There are no structural barriers to the mobility of workers and to the fluidity of rates. The only nexus is cash.”

In small, nonunion establishments, worker behavior beyond quitting is little affected by variations in the wage received. That insensitivity does not result from the employees’ disinterest in fair treatment (which generalized-exchange modeling identifies as an axiomatic worker preference). Rather, it is rooted in nature of the production process, which places a much smaller premium on the close coordination of work tasks, generates relatively little firm-specific human capital, and makes direct supervision or piece rates efficient means of preventing employee dissatisfaction from adversely affecting productivity on the job. Those characteristics are reinforced by high labor turnover (in workplaces with little specific human capital) that hinders the building of stable interpersonal and intertemporal reference standards; ҜK collapses to workers’ market opportunity cost (Ҝk={Wa}).

For the kth small firm, characterized by cost-effective workplace supervision and diminishing returns, rational labor-price dynamics are familiar from textbook treatments of nominal wage optimization in competitive markets:


where wm is the growth rate of the market wage, rm denotes the growth in firm marginal labor productivity, and pm is the firm’s product-price inflation. Management decision-making is restricted to adjusting the firm’s labor hours (influencing rm). There is no endogenous firm influence on wm, which reflects employees’ market opportunity costs.

The generalized-exchange model posits coherent price-discovery and matching frictions, introduces government constraints, and aggregates labor pricing in the small-establishment venue:

wmK(t)=γmK(t)+pmK(t)+a1(UN–U(t))+a2Δμt, such that a1>0, a2>0,

where w is the growth rate in the nominal wage, γm denotes aggregate marginal labor-productivity growth, pm is the rate of change of the Kth-sector’s product price, U is the jobless rate, UN denotes the natural rate, and Δμ represents change in government labor-market intervention.

Variations in unemployment are associated with incidence and propagation of real and nominal disturbances, as wages respond quickly, but not immediately, to changes in labor-market conditions. In the labor-pricing literature, short response lags are typically attributed to various price-discovery and matching costs, rooted in costly market information or administrative charges.

Inside-the-Firm Venue

GEM innovations in wage determination are concentrated in large, specialized establishments offering routinized (Class-I) jobs. In those circumstances, rational behavior unbundles Ź and mandates labor pricing that both demonstrates limited downward flexibility and variably exceed market-opportunity costs. The LEV is home to optimizing decision rules, constraints, and mechanisms of exchange that differ fundamentally from the rules, constraints, and exchange mechanisms that govern choice in the marketplace. Practitioners learned long ago that employees resent being treated as a commodity governed by the arbitrary interaction of supply and demand and want, instead, to be taken out of the market. LEV workers have been shown to possess sufficient on-the-job latitude to enforce that preference.

Bureaucratic establishments offering routinized jobs cannot measure individual employee’s unbundled labor input, Źij. As a result, profit-seeking firms play the averages and invest in the indirect management of workplace exchange. In the more structured environment, firm boundaries relative to the market are more broadly drawn, making its employees a noncompeting group. Outsider access to jobs within the establishment is typically limited to specific ports of entry, often the less desirable positions; existing employees have first claim on better jobs via promotion or transfer. Significant training occurs on the job as part of the general process of workplace socialization, featuring the acquisition of formal and informal firm-specific human capital and increasing the cost of labor turnover to the firm. Due-process rules, governing the on-the-job interaction between employees and management, are characteristic of structured workplaces and “effectuate standards of equity that a competitive market cannot or does not respect.” Kerr emphasized that his “structured” and “unstructured” wage-determination processes describe fundamentally different activity sets.

The so-called American model of labor management further restricts workplace exchange with narrow job classifications, labor pricing attached to those classifications, and substantial firm latitude (subject to seniority) to lay off employees. The Japanese model, by contrast, features broad job classifications with wages attached to individuals (paying close attention to age profiles), enhanced (although still incomplete) job security, and more flexible rules governing labor deployment. A variety of rent-paying workplace organizations, as long as they are constructed on limited ports of entry and designed to encourage acceptance of management objectives, can be accommodated by the large-establishment venue in generalized-exchange analysis.

Recall from above that baseline (durable-Ҝ) continuous-equilibrium LEV modeling is consistent with the following discrete-time wage dynamics:


The growth rate of the nominal reference wage (Wn) is denoted by wn; rn is the real-wage growth rate consistent with the reference-standard (Ҝ) dynamics pioneered in the GEM Project; pc is consumer price inflation; ķ is the rational arrangements catch-up lag modeled above; and J denotes the aggregated workplace venue.

Meaningful wage rigidity is consistent with the absence of labor-market variables in LEV wage determination. The noncyclical dynamic path of the real (consumer-prices) efficiency wage is motivated by rn, which as noted is governed by Ҝ. Nominal cyclical dynamics are rooted in the powerful lagged catch-up adjustment for price inflation, denoted by pcķ(t). As demonstrated earlier in this chapter, expectations play no rational role in labor pricing.

The equation immediately describes the high-wage sector. To better utilize the GEM aggregate-supply model’s capacity to introduce structure into both wage determination and the propagation of macro shocks, further define price inflation: p(t)=βpD(t)+(1−β)pI(t), where D represents the prices of domestically produced goods and services, I is imports, and β is the relative weight of domestic products in the index of total consumer prices; and pD(t)=σpn(t)+(1−σ)pm(t), where σ denotes the relative weight of LEV product prices in overall domestic prices. For ease of presentation, p will also represent consumer prices. Similarly, define the sectoral composition of trend productivity growth: γ(t)=Φ(t)γnT(t)+(1−Φ(t))γmT(t), where Φ represents the relative size of the LEV.

Combining the definitions yields descriptions of nominal wage dynamics in the specialized sector:


What’s Next

The stage is now set for next week’s specification of the two-venue model that makes Neil Irwin’s incomprehensible economy comprehensible.

Blog Type: Wonkish Chicago, Illinois


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