The Criticality of Chronic Wage Rent

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I have become increasingly interested in how macroeconomists think, or more accurately don’t think, about wage rent. The GEM Project features the most consequential variant of that phenomenon, which it names “pure wage rent”. PWR does not require formal collective bargaining and is defined as rational labor pricing chronically in excess of employee market-opportunity costs. The Project has built a powerful case for PWR centrality in macroeconomics. It is especially important in modeling that effectively supports stabilization policymaking.

Despite being rooted in optimization and equilibrium and its consistency with available evidence,  wage rate is ignored in the New Keynesian (NK) literature. The most notable exception to wage-rent inattention is the Burdett-Mortensen (B&M) wage-dispersion theory (“Wage Differentials, Employer Size, and Unemployment,” International Economic Review, 1998). The late Dale Mortensen featured that model in his interesting book, Wage Dispersion: Why Are Similar Workers Paid Differently? (MIT Press, 2003).

Karsten Albaek has succinctly described the B&M theory: “In this general equilibrium model of the labor market, ex ante identical workers move between unemployment and ex ante identical firms, which pay different wage rates.” The action occurs wholly in the marketplace and is motivated by market frictions. B&M assume that firms cannot, given labor-market information lags, continuously match their workers’ productivity with a market wage. During the brief period of ignorance of actual labor-market pricing, some firms pay wages more or less than opportunity cost, producing some incidence of short-lived, and therefore nearly insignificant, labor rent.

The B&M model is an extension of Mortensen’s elaboration, along with Pissarides, of the venerable neoclassical labor search/match theory that has dominated NK macro theory for decades. The fundamental criticism of the Mortensen-Pissarides modeling is its inability to rationally suppress wage recontracting and thereby microfound involuntary job loss. That failure wrecks its capacity to model both macro instability and chronic wage rent.

In mainstream neoclassical modeling, employees respond to wage reductions from their market opportunity costs by quitting, voluntarily moving to alternative, now better-paying, jobs. Involuntary job loss (IJL) plays no role. Furthermore, if workers are somehow receiving wage rents, they must rationally accept any pay cut, in lieu of job loss, that does not violate their opportunity costs. Forced job separation continues to play no role. Robert Lucas’s (1981) considered assessment is relevant here: “Involuntary unemployment is not a fact or a phenomenon which it is the task of theorists to explain.” (p.243)

The introduction of IJL into general-equilibrium modeling requires the rational-behavior story to be altered in two ways. First, for whatever optimizing reason, some employees chronically receive significant wage rents. Second, firms’ capacity to offer labor-price reductions that reduce or eliminate those rents in lieu of job loss, i.e., wage recontracting, must be rationally suppressed. Meaningful wage rigidity (MWR) derived in the GEM Project to be consistent with optimization and equilibrium has two parts: downward nominal rigidity over stationary business cycles and the chronic payment of wage rent.  The core idea is not new. In a 1951 article Albert Rees, one of the best labor economists of his generation, concluded that forced job loss requires employer unwillingness to cut money wages (“Wage Determination and Involuntary Unemployment,” Journal of Political Economy (1951).

The Project’s generalized-exchange model class, armed with microfounded MWR, towers above the NK market-centric general-equilibrium theory and, more particularly, the B&M wage-dispersion model. Most notably, rational-behavior MWR modeling identifies highly specialized bureaucratic firms as the main source of both involuntary job loss and pure wage rent. It also explains why such firms experience long job tenure. It explains why laid-off workers are slow to find alternative employment and why most return to their original employer. It explains why those who are not recalled experience an extended period of intermittent labor-market search, eventually settling into jobs that pay significantly less than their original positions. It explains the limited appeal of work-sharing. Good rent-paying employment coexists with less good market-wage jobs; rational Harris-Todaro jobless queues spontaneously govern labor flows between large, highly specialized firms and their small, less complex counterparts. MWR theory explains why workers who move from bad to good jobs quickly capture existing wage rents.

The GEM story does not end there. Two-venue modeling also explains the observable existence of both intra-firm wage determination and powerful human-resource departments that design and maintain compensation policies as well as quasi-judicial workplace rules, focusing on worker perception of fair treatment by management. Generalized exchange explains why corporate leaders believe that convincing employees to adopt the firm’s objectives is crucial to their pursuit of profit. It furthermore explains why consumption is income-driven and investment is dominated by volatile expectations of pure profit. Rational MWR turns out to play a crucial role in the causes and consequences of both the 1970s stagflation, and the 1980s “rust-belt” downsizing. Wage givebacks in the real world occur when high labor rents eventually induce sufficient permanent job loss to make wage cuts acceptable to employees. Labor-price reductions are rationally long-lagged from their originating causes. PWR is a big deal that is ignored by macro theorists because it  cannot exist in mainstream market-centric general-equilibrium theory.

Blog Type: New Keynesians Saint Joseph, Michigan

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