Two-Venue Theorem

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Involuntary job loss is at the heart of the mainstream stabilization-theory muddle. For policymakers, the socioeconomic problems of employment and income loss are central to business-cycle pathology. Many critics of modern macro modeling argue the failure of New Keynesians (NK) to accommodate forced joblessness results from rules of engagement that mandate rational behavior. The critic with the biggest megaphone is Paul Krugman: “… economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic ‘theory of everything’ is a long way off.”

Krugman is wrong. The GEM Project has shown that limitations on the NK capacity to accommodate actual joblessness do not result from the commitment to rationality. The germane problem is much less profound, grounded in the arbitrary restriction of optimizing exchange to the marketplace. Solving that fundamental problem microfounds intuitive stabilization policy while preserving the formal economic method rooted in optimization and equilibrium..

The two-venue theorem. In the necessary analysis, the central organizing proposition is named the Two-Venue Theorem:

The existence of continuous optimizing macroeconomic equilibrium providing both analytic coherence and wage rigidity sufficient to support involuntary job loss implies the coexistence of market and nonmarket equilibria, with the latter governing the dominant subset of labor pricing.

The cards are now on the table. Venues of price-mediated exchange are defined by fundamental heterogeneities in optimizing decision rules, constraints, and exchange mechanisms that impose boundaries on meaningful aggregation. The venue concept is at the core of the GEM Project, used to construct the workplace-marketplace general-equilibrium synthesis. The theorem may be best understood in conjunction with Barro’s well-known wage-recontracting critique. It is offered, not modestly, as the most consequential labor theorem in macroeconomics, mostly because it facilitates the construction of the first modern theory of wage determination. Pulling the profession’s understanding of labor pricing out of the 19th century, where it is understood by practitioners to no longer belong, turns out to be a very good thing.

Limits to aggregation are critical to the case the that modeling restricted to single-venue (marketplace) exchange cannot support stabilization-relevant macro theory. Even absent the rigorous GEM analysis, the argument rings true. The fact of forced layoffs implies the existence of wage rigidity, which in turn implies the existence of wage rents and job rationing, suppression of work-leisure substitution, nominal non-neutralities, and spillover effects that disturb other markets. Such a macro environment, surely more Keynesian than Walrasian, is an uncomfortable fit with the general market equilibrium that dominates macro thinking in the academy.

Aggregation theory.  The central goal of aggregation is macroanalytic tractability, which comes at the cost of information that is lost at each step of the process. It follows that a necessary part of aggregation methodology is the identification of the information subset that, in order for the macro model to have meaning in its proposed applications, must be preserved. Macroeconomists rarely share their thinking, or lack of it, about information loss.

A fundamental concept in the management of information loss is the economic venue. A venue of exchange is defined as a locus of optimizing decision rules plus associated constraints and transaction mechanisms that produces consistent pricing for relevant goods and services. Venues provide limits to meaningful aggregation, preserving critical heterogeneities among interacting rational agents in coherent macro modeling. A strong venue produces constant relative prices; a dominant venue produces higher prices for the same goods and services than in subordinate venues. In the GEM context, large-establishment-venue firms provide the locus of decision rules that rationally prices point-of-hire equivalent workers higher than the labor market. LEV workplaces are dominant and the marketplace is subordinate, accommodating inter-venue labor-price inconsistency associated with market failures to clear.

Generalized-exchange theory restricts the aggregation of labor pricing to the now-familiar large- and small-establishment venues. Making room for that axiomatic heterogeneity does relatively little harm to macro-model tractability, while being sufficient to coherently introduce the technological and organizational nature of complex, bureaucratic corporations into macro thinking. The powerful innovation is a wellspring of useful microfoundations, critically including rational nominal wage rigidities manifest in downward wage rigidity (DWR) and pure wage rent (PWR). A consequential outcome is involuntary job loss rationally resulting from nominal demand disturbances at both cyclical and trend frequencies.

Missing venue. The intuitive location, derived from axiomatic preferences and technology, for the Two-Venue Theorem’s nonmarket class of equilibrium exchange is the complex, highly specialized workplace. Big bureaucratic firms are broadly understood to pay close attention to nonmarket factors in their wage policymaking. Employers learned early in the past century that, in circumstances of imperfect contracting and supervision, labor prices embody information that influences workplace, distinct from marketplace, incentives.

Workplace knowledge, in vast amounts, has accumulated since “Speedy” Taylor’s (1911) time-and-motion studies and the famous 1924-32 Hawthorne experiments conducted at a Chicago factory in the midst of the global Second Industrial Revolution. The subsequent literature provides a well-documented, detailed description of intra-establishment behavior and practices that conflict fundamentally with market-centric general-equilibrium mainstream modeling of the macro mainstream. Modern theorists’ stubborn belief that labor pricing and use can be adequately understood wholly as market phenomena reflects a collective hubris that has deeply damaged their stabilization relevance.

Blog Type: New Keynesians Saint Joseph, Michigan

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