Phillips Curve Part III: Melding GEM Labor Pricing

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The crucial contribution of generalized-exchange macroeconomics is its intuitive extension of rational price-mediated exchange from the marketplace to workplaces restricted by asymmetric employer-employee information. Early and New Keynesian theorists have never grasped that the primary missing element in their market-centric modeling is fundamental firm heterogeneity.

Small-establishment venue.  Firms characterized by effective direct supervision of worker on-the-job behavior (ŹK=Źm) populate the small-establishment venue (SEV). Given bundled Ź, rational worker choice is wholly governed by the marketplace, while profit-seeking firms must price labor hours in line with employees’ market opportunity costs.

Market-wage-taking SEV firms 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 little capital or machinery is employed. Clark Kerr (1977, p.24) described labor pricing 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.”

The generalized-exchange model’s central point here is that, in small, nonunion establishments, worker behavior beyond quitting is unaffected by variations in the wage received. Insensitivity does not result from the employees’ disinterest in fair treatment, which the GEM Project has identified as an axiomatic worker preference. Rather, it is rooted in nature of the production process that makes direct supervision the most efficient means of preventing employee dissatisfaction from adversely affecting productivity on the job. That outcome is reinforced by high labor turnover that hinders the building of stable interpersonal and intertemporal reference standards (Ҝ), which 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 derivations of nominal wage optimization in competitive markets:


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

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

                            wK(t)=γK(t)+pK(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. Market frictions induce short lags in the wage response to changes in labor-market conditions that are consistent with rational behavior.

Reiterating an earlier point is probably useful here. No rational market friction effectively suppresses wage recontracting  in a way that involves involuntary job loss. At issue is the inherent immediacy and power of the choice between continued employment and maintenance of existing wage rent. General market equilibrium, no matter how friction-enriched, cannot accommodate either meaningful wage rigidity or evidence-sized forced job loss. The point has been most forcefully made by Robert Barro (1989, p.14): “As a theoretical matter, it has long been known that direct costs of adjustment could explain some stickiness in prices. However, the basic misgiving about menu [or recontracting] costs is that the direct costs of adjusting prices are typically trivial relative to the losses from choosing inappropriate quantities.”

Many New Keynesians agree: “… nominal rigidities can only go so far. To take an example, if fluctuations in demand lead to unemployment and if being unemployed is much worse than being employed, it is hard to see why individual workers do not take a cut in their wages to gain employment.” (Blanchard and Fischer, 1989) Indeed, the Barro critique (1977) – part of the successful New-Classical challenge to Early Keynesian thinking – has long been accepted by the NK macro academy as one of the rules of the game. From Robert Gordon (1990, p.1137): “No New Keynesian wants to build a model with agents that Barro could criticize as failing ‘to realize perceived gains from trade’.”

Large-establishment venue. GEM innovations are concentrated in large, specialized firms offering routinized jobs. In such establishments, rational behavior unbundles Ź and mandates labor pricing that demonstrates baseline downward inflexibility and chronically exceeds market-opportunity costs. The LEV is home to workplace optimizing decision rules, constraints, and mechanisms of exchange that differ fundamentally from the rules, constraints, and exchange mechanisms that govern the marketplace. Practitioners learned long ago that workers resent being treated as a commodity subject to the whims of supply and demand, wanting instead to be taken out of the market. LEV workers have sufficient on-the-job latitude to enforce that preference.

LEV establishments cannot accurately measure individual employee’s unbundled labor input (Źi). Profit-seeking firms play the averages, investing in the indirect management of workplace exchange. Outsider access to jobs within the establishment is typically limited to specific ports of entry, often less desirable positions; existing employees tend to have first claim on better jobs via promotion or transfer. Significant training occurs on the job becoming part of the general process of workplace socialization, featuring the acquisition of formal and informal specific human capital that increase the cost of labor turnover to the firm. Due-process rules, governing on-the-job interaction between workers and management, are characteristic of structured workplaces and “effectuate standards of equity that a competitive market cannot or does not respect.” (Doeringer and Piore 1971)

Recall that baseline (durable-Ҝ) continuous-equilibrium LEV theory. previously named the human-resources model, is consistent with the following discrete-time wage dynamics:


The dynamic path of the nominal reference wage (Wn) is denoted by wJ; rn is the LEV real-wage growth rate consistent with the inactive-Ҝ (reference-standard) dynamics of Chapters 2 and 3; pc is consumer price inflation; ķ is the rational arrangements catch-up lag modeled above; and J denotes the aggregated LEV workplace venue. Downward wage rigidity is consistent with the absence of labor-market variables in the equation. Cyclical wage dynamics are motivated by the rational catch-up to price inflation.

The equation describes the rent-paying venue. To utilize the GEM model’s capacity to introduce greater 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)=σpJ(t)+(1−σ)pK(t), where σ denotes the relative weight of LEV product prices in overall domestic prices. For ease of presentation, p also represents consumer prices. Similarly, define the sectoral composition of trend productivity growth: γ(t)= Φ(t)γJT(t)+(1−Φ(t))γKT(t), where Φ represents relative LEV size. Combining those definitions yields a description of nominal wage dynamics in the highly specialized sector:


Melding LEV and SEV labor pricing provides a rational-behavior application of the flex- and fix-price aggregate-supply modeling of John Hicks. Using the great theorist’s macro analysis to provide literature roots for generalized-exchange theory is more than a presentation convenience. Hicks (1974) explicitly motivated his fix-price sector with an intuitive Workplace-Exchange Relation rooted in his reading of the Neoclassical Revisionist labor literature: “Employers were reluctant to raise wages, simply because of labor scarcity; for to offer higher wages to particular grades of labor that had become scarce would upset established differentials. They were reluctant to cut wages, simply because of unemployment; for if they did so they would alienate those whom they continued to employ. The ‘stickiness’ is not a matter of money illusion; it is a matter of continuity.”

Combining labor pricing in large- and small-establishment venues identifies the respective determinants of baseline (inactive ҜJ) nominal wage change:



This equation provides the content for the GEM Phillips Curve presented in the next post.

Blog Type: Phillips Curve

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