New Keynesian Labor Model in 514 Words

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In Job Matching, Wage Dispersion, and Unemployment (2011) Tatsiramos and Zimmermann, hereafter T&Z, provide a compact summary of NK modeling of labor behavior in highly specialized economies. What follows is a bookend to last week’s post.

Search/Match Modeling of Labor Behavior

“The flow view of the labor market is fundamental in the theory of equilibrium unemployment, as expressed in Pissarides (2000). Unemployment is a state which individual workers occupy for a relatively short period of time, as they seek rewarding long-term employment. Individual workers flow into the state and others flow out. Offsetting the flow of job finders and unemployed workers who have given up job search to take up leisure or other activities outside the labor force, is a simultaneous flow into the state of unemployment of workers who lost their jobs either through layoff of quit, and new entrants from a nonparticipation state.

“This conception of the labor market has replaced the disequilibrium theory under which employment was determined by the real wage and labor demand, and unemployment simply reflected excess supply at a real wage that was above that required to clear the labor market. The disequilibrium theory, which viewed the labor market as a spot market that meets every day to allocate jobs to workers, was inconsistent with the observations regarding the experience of individual workers over time; in particular, the fact that that a small fraction of the labor force flow in and out of unemployment each year and the typical employment relationship lasts several years. Furthermore, available jobs are heterogeneous, offering different wages, differing long-term career opportunities, and various kinds of non-pecuniary features, such as job security. These facts suggest that workers might find it in their interest to invest time and effort in the process of finding a ‘good” job, one that pays well, that might offer a challenge, good promotion prospects and consequently have a chance of lasting for a while….

“If the worker is already in a job and has the option of staying on, quitting into unemployment poses a problem that is very similar to the acceptance problem of the unemployed job seeker. The existing job is an implicit offer on the table to continue employment, the quitting alternative is a search option for an uncertain outcome. Even for jobs that have become less profitable than when they were first opened, there is a nontrivial choice to be made between continuing employment or leaving the job and seeking new job offers.

“A similar choice is faced by the firm. Should it close down jobs that have become less profitable or continue production? A large part of entry into unemployment is the result of job closure but this job closure is not necessarily the result of shocks that make the job’s overall profits negative instantly and forever. Just as there are reservation wages for unemployed workers looking for job offers, there are reservation productivities for employed workers and their firms….

“This view of the labor market formed the basis of a coherent theory of worker and employer behavior in a market in which trading opportunities are generated through search and jobs are subject to change. The theory is based on solid maximizing microfoundations under rational expectations about the future, when all gains from private trades are exploited within the constraints imposed by the market information structure.”

Critical S/M Model Flaws

The New Keynesian search/match model of labor behavior has occupied mainstream macro thinking for decades – a remarkable achievement for a theory so fundamentally flawed as to border on uselessness. What follows is a compact list of some of its most debilitating problems.

Ignored issues. A strategy often used in the defense of inadequate modeling is simply to pay no attention to its failings. The collective weight of the issues ignored in the NK market-centric analysis of rational labor behavior is fatal to its stabilization relevance. The most essential, interrelated omissions are briefly noted:

  • The rational existence and nature of involuntary job loss (IJL), which is well known to dominate the cyclical behavior of unemployment. NK search/match modeling typically ignores IJL; when noted, it is assumed as a mechanical process with no rational motivation attached. The inattention is both destructive and necessary. Rational IJL cannot exist in friction-enhanced general-market-equilibrium theory.
  • The rational existence and nature of pure wage rent, which is a necessary condition for IJL existence and the principal explanation for unemployment persistence, the high incidence of recalls in cyclical recoveries, and the long tenure of employment in particular kinds of firms. Rational PWR cannot exist in FGME modeling.
  • The rational causation from nominal demand disturbances to same-direction, evidence-consistent movement in employment and output. FGME theory does not support such causation and, as a result, cannot usefully advise stabilization policymakers.
  • The rational existence and nature of substantial human-resource infrastructures in workplaces restricted by costly, asymmetric employer-employee information. FGME modeling tells us next to nothing about actual labor management.

Selective evidence. NK theorists use of fatally flawed S/M modeling to explain labor behavior is enabled by their tacit agreement to ignore inconsistent evidence. That includes the dominance of forced layoffs in the cyclical behavior of unemployment, the central role of establishment size in the payment of wage rent, the vast literature documenting that many firms set labor prices using decision rules rooted in multiple factors of which the market is only one, and the postwar behavior of wage dispersion that is strongly indicative of a dual system of wage dispersion.

Selective literature. NK theorists reduce labor modeling in highly specialized economies to a choice between the search/match and spot-market approaches. The decision to ignore existing analyses of what goes on inside complex workplaces, i.e., efficiency-wage theory and related modeling such as Herbert Simon’s organization theory, does not result from being poorly read. Mainstream labor economists know about previous attempts to model workplaces restricted by costly, asymmetrical information. My own early work (1977, 1980, 1984) in this field powerfully  explained intra-firm labor pricing and use but was ultimately pushed aside by the general inability (at that time) to get the workplace framework to support the rational suppression of wage recontracting. Subsequent work by the GEM Project solved that longstanding problem, demonstrating that ignoring the workplace perspective is the root cause of the NK inability to rationally explain crucial macro evidence and adequately support stabilization policymaking.

Blog Type: Wonkish Saint Joseph, Michigan

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