GEM Project innovations, especially microfounded meaningful wage rigidity (MWR) and same-direction causality from nominal demand disturbances to employment and output, have motivated an ambitious research agenda that reworks a substantial portion of mainstream market-centric general-equilibrium economics. I’ll admit it has been fun.
This Blog has reported on many of interesting revisions mandated by the generalization of rational exchange from the marketplace to the large-establishment workplace. Today’s post pushes the reconstruction further along by looking at how the macro profession has, for almost fifty years, overlooked the true significance of John Harris and Michael Todaro’s 1970 article, “Migration, Unemployment, and Development: A Two Sector Analysis”. To be sure, their paper has long been known and admired. It was honored as one of the “Top 20” articles published during the first century of the American Economic Review. Although it was not clear what “top” signifies, there can be no doubt that inclusion in that list is very impressive. But what’s interesting to me is the selection committee apparently had little grasp of the full, more fundamental contribution of labor-transfer analysis. In the GEM Project, the H-T model is shown to be an essential component of coherent, stabilization-relevant macro theory.
Original H-T model. Starting with a basic model rooted in labor point-of-hire homogeneity, H-T posit two venues of economic exchange, described as subsistence agriculture and an industrial enclave. Associated production heterogeneities are assumed to cause the more capital-intensive sector to pay wage rents, the existence of which implies the most desired jobs are rationed. Further positing that high-wage job search is mutually exclusive with holding a low-wage job, H-T then investigate the nature of rational labor transfer between the two venues. They plausibly demonstrate that workers’ searching for a rent-paying job rationally invest in spells of unemployment that are increasing in the size of the wage premium and the perceived likelihood of obtaining preferred employment. Optimizing labor behavior yields continuous-equilibrium unemployment in excess of textbook market-centric frictional joblessness.
Given modern consensus macro rules of engagement, the H-T paper would never have been published by the editors of the American Economic Review. It is a minor miracle that an article that derives its critical results from the assumption of meaningful wage rigidity is remembered today with anything but scorn. After all, prohibiting the consequential use of assumed MWR is what much of the 30-year macro-methodology war was about. I believe that H-T gets a pass from today’s microfoundations police because the authors made clear that their analysis was restricted to elaborating on Sir Arthur Lewis’s practitioner-respected, Nobel-prize-winning two-sector model explaining how economies rise out of subsistence conditions. Modern market-centric DSGE theory has difficulty with that fundamental question, and mainstream gatekeepers appear generally content to go easy on New Neoclassical Synthesis rules for Lewis-class theorists.
GEM enrichment. The Project demonstrates that confining H-T labor transfer to the Lewis-class problem has buried its substantial, much more general power to explain labor-market behavior in highly specialized economies. From the perspective of the axiomatic generalization of rational exchange, it becomes clear that the stabilization-relevant modeling of labor markets has been badly compromised by the absence of rational transfer.
In the GEM Project, H-T labor transfer assumes its proper, more robust role of linking the marketplace and large-establishment workplace venues. The mechanism now governs two-way flows that constitute a considerable share of rational labor-market activity in modern economies. An important example of market activity, which the mainstream coherent market-centric model class is unable to accommodate, is the class of joblessness that reflects the time-varying queue of workers seeking employment, for which they are qualified, that pays wage rents. Exchange generalization identifies the subset of reservation-wage unemployment (ÛƦ<UƦ) associated with the inter-venue, two-way labor transfer required by continuous-equilibrium MWR and the consequent rationing of rent-paying jobs. (Chapter 6) The rational-search decision to join the good-job-seeking queue (ÛƦ) is governed by perceived high-wage employment growth and wage-rent size, a process that is rooted in H-T and little influenced by match technology. It substantially alters the textbook narrative by making market labor supply to the large-establishment venue elastic. Moreover, if workers can compete effectively for LEV jobs while being employed in the low-wage sector, queue-related unemployment can be partly disguised, greatly expanding the actual labor pool available to highly specialized firms.
In another significant example, rational two-way labor transfer in GEM modeling permits the effective introduction of job downsizing into macro modeling. By definition, downsizing involves the permanent loss of a rent-paying job. (Chapter 5) Rational workers’ response to that class of unemployment includes extended periods of price discovery as they attempt to identify their true opportunity costs, typically featuring short-duration jobs paying market wages before they settle into more long-lasting positions. Job downsizing an important, policy-relevant phenomenon, necessary to adequately explain readily available labor-market evidence, that is inherently excluded in mainstream market-centric DSGE theory.
Parting word. It is a pleasure to work with a coherent macro model that features rational MWR. It is especially enjoyable to work through the existing literature, rehabilitating the large number of models that have been shortchanged or simply tossed in the dustbin by mainstream theorists. I recognize that they are stuck with the unenviable task of defending market-centric general-equilibrium thinking that many know, deep down, to be a deeply flawed description of highly specialized economies. H-T labor-transfer modeling is an instructive example of that unhappy state of affairs. Restricted to filling out the Lewis growth model, it has garnered honors but has little relevance in the great macro issues of the day. Its arbitrary restriction to explicating subsistence economics has been lifted by the coherent, stabilization-relevant macroeconomics that is rooted in the axiomatic generalization of rational, price-mediated exchange from the marketplace to the large-establishment workplace. H-T labor-transfer goes from being a very good model playing a heavily proscribed role to a crucial one on a much larger policymaking stage. It deserves much greater attention than it has received so far. I hope Harris and Todaro take note.
Blog Type: Wonkish San Miguel de Allende, Mexico