Taking Important Evidence Seriously

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What will it take for mainstream New Keynesians (NK) to take available, consequential evidence seriously? The approach generally used today is to cherry pick macro facts, recognizing only those that align with consensus friction-augmented general market equilibrium (FGME) modeling. That practice is nowhere more evident than in market-centric theorists treatment of the treasury trove of Behavioral Economics (BE) findings.

What follows is organized around Morris Altman’s “Insights From Behavioral Economics on How Labor Markets Work” (2014). Since much of the BE action occurs outside the marketplace, the more appropriate titular question would have been “How Does Labor Actually Behave in Highly Specialized Economies”. From Altman’s abstract: “I discuss some key issues raised by behavioral economics for better understanding the working of the labor market. Amongst the key points in this paper are: (i) a revised modeling of the labor supply curve, with a specific focus on the target income approach, (ii) elaborating on the importance of effort variability for understanding labor supply, including a narrative on efficiency wage and x-efficiency theory (includes the importance of fairness), (iii) building upon x-efficiency and efficiency wage theory to better understand the demand side of the labor market, (iv) discussing some of the cognitive/informational/institutional factors affecting decision-making, including modeling the role of errors or biases in labor market decisions for both the supply and demand side of the labor market, (v) insights of experimental economics for labor market behavior, (vi) the importance behavioral economics for better understanding the stylizing facts of labor markets. This paper also compares conventional to behavioral theoretical approaches labor markets, their different underlying assumptions, and analytical predictions, with implications for public policy and institutional design. Also compared are the errors and biases and the bounded rationality approaches labor market analysis. They produce different analytical predictions as well as having different implications for public policy and institutional design.”

This post will consider Altman’s summary points in turn. First, his focus on the market-focused target-income theory of labor supply is interesting but may be dismissed in this post. It does not have much to do with the GEM Project’s fundamental introduction of workplaces restricted by information asymmetries as a necessary companion venue to the competitive marketplace. Targeted income could, of course, be easily incorporated into generalized-exchange modeling but would add little to the power of the analysis. Given that the large-establishment venue (LEV) features chronic wage rent, hours at work are rationed.. Employees receiving market rents take all the work they can get.

Altman’s second summary point, the “importance of effort variability for understanding labor supply including a narrative on efficiency wage and x-efficiency theory (includes the importance of fairness)”, is much more relevant to this essay’s larger point. Long before the boom in BE research that notably featured the Ultimatum Game, those ideas  have been at the core of generalized-exchange theory. Recall that the original efficiency-wage literature roots variable effort in optimizing labor-management intra-firm behavior organized by general decision-rule equilibrium. Workers’ strong preference for equity (suppressed in market-centric analysis) is shown to motivate rational behavior in information-challenged workplaces. NK market-centric modelers provide no room for variable effort and its attendant wage rigidities, choosing to ignore involuntary job loss and other crucial instability facts that are easily produced by the workplace-marketplace synthesis.

Third is the foundational BE roles of “x-efficiency and efficiency-wage theory”. Decades ago, my generalized-exchange modeling became  (along with Solow) the original efficiency-wage theory. Its revival has motivated the second (workplace) venue of rational exchange in highly specialized economies that is necessary for the adequate explanation of macro facts. The second venue and its attendant macro facts ae simply ignored by mainstream market-centric New Keynesians. The consequences are debilitating.

Fourth is the “better understanding [of] the stylizing facts of labor markets”, which collects the message of Altman’s final three bullet points and extends well beyond the Behavioral Economics literature. Here the workplace-marketplace synthesis excels. It robustly explains involuntary job loss (both temporary layoffs and permanent downsizing as the rational outcomes of stationary and nonstationary adverse disturbances in nominal demand), chronic wage rent (consistent with the literature on the labor-pricing effects of firm size) that rations LEV jobs and hours on those jobs, that such rationing compromises the optimization of the work-leisure trade-off for both SEV and LEV workers, that LEV wages dominate  marketplace labor pricing and consequently push SEV (small establishment venue) workers into chronic labor-market disequilibrium, the good (rent-paying) jobs coexist with bad (market-paying) jobs, that Harris-Todaro good-job-seeking queues exist, that pure profit (the firm’s residual revenue once the factors required in production are paid) exists and plays the crucial role in business capital spending, that cyclical unemployment is rationally persistent, that job seniority and worker reference standards are important in within-firm wage setting, that the incidence and nature of wage givebacks are also important, the human-resource departments exist and are important, that the Second Industrial Revolution and its advent of large, bureaucratic work establishments provides a critical demarcation in the development of macroeconomics, and more.

That’s a lot for NK theorists to leave on the table. But it’s not all. The second venue passes the eyeball test. Nobody questions that information-challenged workplaces exist and are inherent to complex, bureaucratic firms. Akerlof’s “market-for-lemons” persuasively argues unbalanced-information workplace labor pricing is deeply problematic to general market equilibrium.

How long can market-centric NK theorists get away with blatantly ignoring well-known, important evidence? The existence of alternative generalized-exchange modeling, rooted in optimization and equilibrium, that is consistent with the shunned evidence makes the damage caused by the mainstream macroeconomists’ cherry-picking egregious.

Blog Type: New Keynesians

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