Three Necessary Models Are Missing

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In one of the earliest contributions to what was later named efficiency-wage theory (EWT), a diagram was constructed in the attempt to capture practitioner descriptions of labor pricing in workplaces restricted by costly, asymmetric information. It portrayed the on-the-job behavior (OJB) of employees in the space relating labor price (denoted by W) and labor productivity (Ź); Wm denotes the market wage, and Źɱ the productivity floor consistent with direct employee supervision.

The functional relationship between the wage paid and worker productivity over the range of feasible labor pricing  (W=WnWm) was critically posited to be nonconvex, implying that unit labor costs are minimized by paying the available wage consistent with the upper-limit radius vector: the efficiency wage (Wn). I named the function the Workplace-Exchange Relation and reasoned that its nonconvexity, if consistent with optimization, equilibrium, and the evidence, must play a central role in actual wage determination when constrained by problematic direct OJB supervision.

Background. WER nonconvexity was sufficiently aligned with the evidence in the mid-1970s that it was used it to help guide important policy research. I was head of the unit at the Federal Reserve tasked with explaining the mechanics of, and the Fed’s proper response to, stagflation. We had our hands full, particularly wrestling with the macrodynamics of the puzzling price-wage spiral (simultaneously occurring with high unemployment) that was generally believed to have initiated the crisis. We searched the literature and concluded that the most useful explanation of WER nonconvexity was provided in the middle-century work of a loosely organized school of hands-on labor economists, named by Clark Kerr “neoclassical revisionists”.

NR theorists pioneered the economic analysis of rational employer and employee interaction in large, highly specialized, bureaucratic firms that became ubiquitous after the Second Industrial Revolution. Informed by their on-site investigations, Kerr et al. descriptively modeled labor pricing and use in workplaces inherently restricted by costly, asymmetric information and consequently limited OJB oversight. Their work turns out to be fundamental to understanding WERs, efficiency wages, and – ultimately –  highly specialized economies.

Macroeconomists learn early in their careers that pricing and allocation decisions in the context of buyer-seller unbalanced information are inadequately explained by market-centric theory. That precept long ago became an unhappy paradox – both indisputable and almost always ignored. Leading theorists fail to recognize the damage caused by pushing aside the significance of rationally nonconvex WERs rooted in employer-employee information asymmetries. The necessity of introducing the analysis into textbook theory is the central message of this post.

The missing models. Once workplace modeling of the sort done by the Neoclassical Revisionists is ignored, explanation of aggregate labor behavior that is both microfounded and evidence-consistent is doomed. Common reliance on the venerable friction-augmented general-market-equilibrium (FGME) framework badly constricts theorists’ capacity to account for consequential intra-firm features of highly specialized economies. Ignored or misrepresented phenomena have been shown to include involuntary job loss, persistent cyclical unemployment, continuous-equilibrium joblessness, good and bad jobs, the distribution of firm revenues among production factors, the existence and role of pure profit, the determinants of capital spending, the determinants of household consumption (reviving the insightful 1971 analysis of Barro and Grossman is a happy outcome of the enriched EWT), job tenure, worker reference standards, wage givebacks, firm downsizing, Harris-Todaro job transfer, the centrality of nominal-demand management in stabilization policymaking, the relative importance of the Federal Reserve’s real-side objective, the existence and importance of large human-resource departments in complex firms that account for a substantial share of total labor income, the criticality of Nobel Laureat Herbert Simon’s maxim that profit-seeking management must invest in convincing employees to adopt the firm’s objectives as their own, management recognition of the importance of equitable treatment in employee satisfaction, and the endogeneity of effective worker supervision.

The nonconvex WER points the way to much improved understanding labor behavior. For starters, adding a second (workplace) venue of rational exchange enables resolution of the debilitating shortcomings listed above. Also important, the second venue makes sense. Information-challenged workplaces exist and are inherent to highly specialized firms, which are frequently large and bureaucratic. I have elsewhere (somewhat loosely) named this sector the large-establishment venue (LEV). Remaining workplaces, effectively relying on direct worker supervision, are characteristic of smaller, less complex firms that cede much of their decision-making to the marketplace. They are named, also loosely, the small-establishment venue (SEV).

Revived LEV research has reinvigorated EWT by simultaneously microfounding three interrelated labor-behavior models:

  • On-the-job behavior (OJB) in the circumstances of information asymmetries, axiomatic worker preferences, and imperfect workplace supervision;
  • Labor pricing that is chronically in excess of market opportunity costs, named pure wage rent (PWR); and
  • Nominal wages that are meaningfully downward rigid over stationary business cycles.

Each of those theories is a big deal. Taken together, they force a fundamental reconstruction of textbook labor and, consequently, macro modeling. The payoff is being able to explain a lot more of the important evidence.

Blog Type: Wonkish Saint Joseph, Michigan

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