Econ 101 theory of labour markets — not very scientific

3 December, 2016 at 18:39 | Posted in Economics | 4 Comments

OK, so what are some empirical things we know about labor markets? Here are two stylized facts that, while not completely uncontroversial, are pretty one-sided in the literature:

1. A surge of immigration does not have a big immediate negative impact on wages.

2. Modest minimum wage hikes do not have a big immediate negative impact on employment.

The first fact alone does not falsify the Econ 101 theory of labor markets. It could be the case that short-run labor demand is simply very elastic …

BUT, this is impossible to reconcile with the second stylized fact. If labor demand is very elastic, minimum wage should have big noticeable negative effects on employment:

By the same token, if you try to explain the second stylized fact by making both labor supply and demand very inelastic, then you contradict the first stylized fact. You just can’t explain both of these facts at the same time with this theory. It cannot be done.

So the Econ 101 theory of labor supply and labor demand has been falsified. It’s just not a useful theory for explaining labor markets in the short term (the long term might be a different story). It’s not a good approximation. It doesn’t give good qualitative intuition. And it’s especially bad for explaining the market for low-wage labor, which is the market that most of the aforementioned studies concentrate on.

What is a better theory of the labor market? Maybe general equilibrium. Maybe search and matching theory. Maybe a theory with very heterogeneous types of labor. Maybe something else.

But this theory, this simple Econ 101 short-run partial-equilibrium price theory of undifferentiated labor, has been falsified. If econ pundits, policy advisors, and other public-facing econ folks were scientifically minded, we’d stop using this model in our discussions of labor markets. We’d stop casually throwing out terms like “labor demand” without first thinking very carefully about how that concept should be applied. We’d stop using this framework to think about other policies, like overtime rules, that might affect the labor market.

Sadly, though, I bet that we will not. We will continue using this falsified theory to “organize our thoughts” – i.e., we’ll keep treating it as if it were true. So we will continue to make highly questionable policy recommendations. The fact that this theory is such a simple, clear, well-understood tool – so good for “organizing our thinking”, even if it doesn’t match reality – will keep it in use long after its sell-by date. That’s what James Kwak calls “economism”, and I call “101ism”. Whatever it’s called, it’s not very scientific.

Noah Smith

Lovely to see that at least some mainstream economists have the courage and intellectual guts to admit that they have been wrong.

But — sad to say — many economists will probably continue to peddle their falsified theories. It’s hard to kill your darlings …

buchC6The inverse relationship between quantity demanded and price is the core proposition in economic science, which embodies the pre-supposition that human choice behavior is sufficiently rational to allow predictions to be made. Just as no physicist would claim that “water runs uphill,” no self-respecting economist would claim that increases in the minimum wage increase employment. Such a claim, if seriously advanced, becomes equivalent to a denial that there is even minimal scientific content in economics, and that, in consequence, economists can do nothing but write as advocates for ideological interests. Fortunately, only a handful of economists are willing to throw over the teaching of two centuries; we have not yet become a bevy of camp-following whores.

James M. Buchanan in Wall Street Journal (April 25, 1996)



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  1. Imagine the difference we would have seen in the “darling” theories of economists over the last century had labor unions been the primary source of endowed chairs in economics, rather than industrialists.
    Economic theories do not grow in a garden; they grow on a farm.

  2. Main issues in current ad-hoc economic reasoning based on demand/supply and equilibrium are due to partial variables used without considering boundary conditions(i.e. income/expense identity constraints).

    One accounting identity related to labor market is:

    GDP=GDI = Wages + CFC(Consumption of Fixed Capital)+NOS (NetOperatingSurplus)+Tariffs – Subsides.

    PE(Payroll Employment) = Population* ParticipateRate*(1- UnemploymentRate)
    LP(Labor Productivity) = (NOS + Tariffs -Subsides)/PE
    LC(Labor Compensation) = Wages/ PE
    CC(CFC Cost) = CFC/PE
    ULC(Unit Labor Cost) = LC/LP
    UCC(Unit CFC Cost) = CC/LP

    Thus, we can derive more meaningful forms of original accounting identity to lock up all related variables in one identity equation:

    (1) P*Q = POP*PR*(1-UR) *(LC + CC + LP)

    (2) P*Q = POP*PR*(1-UR) *(1 + ULC + UCC) * LP

    To illustrate the problem in ad-hoc economic reasoning, I insert these variables into following narrative descriptions for your reference

    For example,
    (1) (Phillips Curve) inverse relationship between unmemployment rate(UR) and inflation(P) ?

    (2) A surge of immigration (POP) does not have a big immediate negative impact on wages(LC and ULC) ?

    (3) Modest minimum wage(LC and ULC) hikes do not have a big immediate negative impact on employment(PE)?

    None of above is a correct logic for economic reasoning since they implicitly assume “all else equal”. These identities can explicitly tell us what are all other factors or variables needed to be considered in what relationships.

  3. I am saddened that pontus hasn’t thought to come to this post and lecture us on how rigorous neoclassical economics is.
    I do not find a lot in Noah Smith’s treatment to cheer, beyond the sarcasm of We will continue using this falsified theory to “organize our thoughts” He’s shown us that the Econ 101 story of supply and demand in the labor market results in contradictory and inconsistent ad hoc just so stories. He doesn’t quite say why economists like these stories: that, as Michael Robinson indicates in his comment, they serve the interests of the powers that be, among other reasons.
    You can say it is a bad theory because it doesn’t “fit the facts” but why doesn’t it “fit the facts”? Is it that we need to go back to the neoclassical drawing board? Or do we need a better drawing board? Noah Smith doesn’t quite commit himself on this critical point.
    What is wrong with this conceptual apparatus? We are going to need a conceptual analytic apparatus of some kind and we need acquaintance with facts to highlight what is wrong with this Econ 101 apparatus. Where does it go wrong? How does an argument so airtight to a genuinely smart man like Buchanan become a groundless prejudice? Surely, it is not simply a matter of collecting a sinecure from the TPTB on payday.
    I would humbly submit, contra the honorable pontus, that there is no rigor in Econ 101. The theory invokes a conceptual apparatus that is completely faulty and the faults are excused. “Elasticity” of demand or supply is pseudo-physics; there’s no sound analytic reason for supposing that there are things in being in the world called demand or supply, let alone ones that have a property akin to the properties of an alloy in metallurgy. Here’s a bigger one: there’s no “labor market”. With rare exceptions, people buying and selling labor do not meet and ask and bid the wage; people are employed under contracts with prominent contingencies and indefinite terms. And, does the implicit model of production make any sense? Is a production function an adequate theory of production? (Hint: a production function is not a mathematical function and it is a theory of income distribution, not production, so no.)
    Economists using the rhetoric of Econ 101 supply and demand to “organize their thoughts” are practicing idiocy. But, it never seems to stop. Sadly, I do not imagine Noah Smith has had an epiphany here.

    • The conceptual apparatus is down to the metaphorical nature of our thinking. It’s the kind of thing that people do not even realize is a thing.

      I am beginning to wonder about another metaphor: are universities the monasteries of the 21st Century? The preserve Enlightenment knowledge but must be emptied to make way for a next paradigm?

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