Following up on yesterday’s discussion of wage stickiness for the unemployed and the employed (Tyler, Alex).
Imagine a farmer whose farm produces 100 bushels of wheat. He hires 10 workers to bring in the wheat, paying each of them 9 bushels. Thus, each worker carries 10 bushels, the wage is 9, the wage bill is 90, and the farmer earns 10.
Now suppose that due to climate change or a swarm of locusts the farm only produces 90 bushels of wheat. If wages were fully flexible then an equilibrium exists in which each worker is paid a wage of 8 leaving the farmer with 10 bushels as before. The farmer doesn’t want to reduce everyone’s wages, however, because that will reduce morale so he fires one worker leaving nine. Each worker now brings in 10 bushels, as before, and is paid a wage of 9, for a total wage bill of 81 leaving the farmer with 9 bushels. The unemployment rate is 10%.
The unemployed worker doesn’t want to be unemployed and offers to work for less, a lot less, say 5 bushels. Even at the lower wage, however, the farmer doesn’t want to hire the worker because the worker doesn’t generate enough additional output to justify even a low wage. In fact, in this scenario the worker has ZMP.
The best the farmer can do in response to the lower wage offer by the unemployed worker is to fire an employed worker and hire the unemployed worker at the lower wage. Eventually this will restore equilibrium but it takes time to cycle through enough firings and hirings to reach full employment. Note also that in this model the farmer only has a weak incentive to do this since in the equilibrium with 10% unemployment he earns 9, almost as much as before. As an aside, also note that in my model the unemployed workers are simply unlucky (as I argued earlier). If they were to switch places with the employed, productivity would be just as high. The unemployed worker has ZMP but is not a ZMP worker.
Since the driving shock that lowers productivity in this model is a real factor (weather, locusts), this is a real business cycle model . That raises a very interesting point. The most that wage flexibility can do in this model is to restore full employment; wage flexibility cannot restore full output. Thus, the workers in this model have a very good reason to dislike wage flexibility. In the equilibrium in which wages fall the unemployed worker is better off by a lot but the 9 employed workers are all worse off than in the unemployment equilibrium. In contrast, in a Keynesian model wage flexibility can restore full output not just full employment. Thus, and somewhat surprisingly, it’s easier to justify wage stickiness in an RBC model than in a Keynesian model since the gains from wage flexibility are so much higher in the latter!
Even in a Keynesian model along the lines of the Sweeney/Krugman babysitter model it will still be the case that lower wages by the unemployed don’t get you far enough to restore equilibrium–although as noted, we will need a coordination failure story in the Keynesian model since in principle everyone would be better off in that model with wage flexibility.
You forgot to say what you were assuming about each worker’s contract with the farmer. Please use Micro 2011. Remember that in the past 10,000 years humanity has often faced negative shocks –we are stupid but I’m sure we have learnt something about emergencies that is reflected in labor contracts.
One consideration is unemployment insurance. Does it offer any incentive to keep people employed going forward? It seems like a use-it-or-lose it fund, and may present an incentive to lay people off, and not just for the worker.
Could you just explicitly state your preferred model of wage setting, instead of trying to force everyone to waste their time figuring out your pet theory? You’re not that important. Tyler and Alex run the blog with thousands of readers, you’re just a gadfly in the comments section.
Sorry, I’ll be more clear next time.
Wasn’t referring to you but the parent commenter.
David, please tell me what exactly have you learnt from Alex’s model? Hint: I learnt that in 1961 (well before RBC).
Hey Barandiaran:
Why do you talk in hints. I’m with David on this. If you have something interesting to say, just say it clearly. Your comments make you sound like an arrogant, know-it-all. Why not try giving up this holier-than-thou attitude? A wee bit of humility never killed anyone.
My comments point to how little others (in particular politicians, bureaucrats, sloppy scholars, pundits, experts) know and that often I know so little that I cannot conclude anything. In this particular case, Alex has used a simplification that eliminates the problem and all that I have said is that had he took into account what we have learnt in the past 50 years in Microeconomics (including Public Choice) he would have known why we have such a hard time understanding what is going on in labor markets.
To apply econ theory first you have to make clear your understanding of reality (the facts that you want to explain, making clear how reliable the evidence is) and then choose a theoretical model that can add value first by explaining it (by establishing causality relations between the facts –and remember this work is not CSI work) and second by predicting how different reality would have been if something else had happened. In the past x years, across countries and within countries, there have been extraordinary changes in employment (a multi-dimensional issue and therefore one that can be described in many ways) and we have a difficult time getting relevant and reliable evidence on facts, and when we focus on a “local” labor market we have a difficult time choosing the theoretical model.
Many times I have said that in my view the most important event of the past 25 years it has been the integration of over 3 billion people into the world market economy and that the adjustment to this shock still is going on everywhere. How can we analyze the effects of that event on “world” labor markets, including the reactions of national governments? (Here I use “world” to refer to a collection of “national” and “local” markets with different degrees of segmentation, not to a unified market as the oil market). Some people have been trying hard to understand those effects but it is not so simple. Yes, we have to simplify, but please be sure that we still have something relevant and reliable to say about what it’s happening.
I’m sorry to sound like an arrogant, but my sins are that I know how little I know and I’m willing to challenge those that claim to know a lot –including those scholars that should know how little they know and those power-seekers that are willing to take advantage of our eagerness/stupidity to know everything.
@E. Barandiaran: again, stop trying to waste everyone’s time figuring out your pet theory.
Your reluctance to simply spell it out doesn’t suggest anything good about it.
Oh, great, finally.
I do not think you understand Keynesian-type macro modeling; the point is not to construct a Grand Unified Theory of the labor market – the point is to plausibly capture relationships between macroeconomic aggregates. If the model completely fails to capture given newfangled micro dynamics, fine. Nobody cares. One just desires to avoid Lucas-type “completely implausible that nobody picks up the $50 bill on the sidewalk”-type attacks.
Also: the rational response to ignorance is not to sit around and do nothing, for in this case we do not have an obvious null hypothesis on what is happening. There is no path is unambiguously the result of doing nothing. You may as well call for labour board regulation of all wages if you’re so damned sure that nobody knows what effects it might have: if you don’t know, how could your case against it be better than one for it? Fairly obviously, you do suspect you know what effects it could have; you just want to hold people you disagree with to an impossible standard of evidence.
David, I’m glad that you waste your time reading my comments.
You are right: I disagree with people that pretend to know too much, and therefore with the “authority” to tell/dictate others what to do.
You are wrong: since my retirement five years ago, I have been doing research on some of the many things that I don’t know and that can help me to understand how the world economy has been evolving (I don’t need to publish to survive). In addition, today old friends, acquaintances and clients that ask for my professional advice can get it free.
Everything entails telling people what to do. Property rights entails telling people what to do. Laissez-faire employment law entails telling people what to do. “That’s not yours, you have no right to it” is something that has to be dictated to people. There is no State of Nature with full employment.
So what is giving you this authority to tell people what to do? What is making you so certain when your standard of evidence is so high?
Again, thanks for wasting your time reading my comments. First, I use the words authority and dictate to make clear what I was talking about –as a professional adviser for 45 years I can tell you that the people that paid me knew that all that I offered them was an opinion (fyi, my advice was often on how to deal with a crisis). Second, in principle standards of evidence must be high, but there is always discretion to apply them depending on the urgency of taking a decision and on the prospect of getting better evidence –crisis-managers are urged and paid to take a decision yesterday, but tenured professors often believe that better evidence is coming tomorrow. Incentives matter.
EB:
Another reason your comments are annoying is a repeated appeal to authority:
“I’ve been doing this for 45 years”
“Argentina has had so many crises so we know best”
“People pay me to consult on this”
“You say this now but it’s nothing new. I already realized this in 1965″
“You guys are only academics but I did real economics”
etc.
Maybe you can tone that down a bit too? Thanks.
I clicked on that babysitter article without realizing it was Krugman. I am now much dumber for having read it.
Everything is going to be fine because we can always just print more money, eh Pauly? Thanks. Thanks a lot. You deep, deep thinker, you.
I think it is interesting, but it’s most interesting for what it doesn’t say. It’s a money supply story. It doesn’t imply that in a babysitting demand shortage we should finance more ice cream trucks.
What’s wrong with his scenario? It is, of course, not always the case; but too little currency in circulation can indeed be a problem at times?
One thing that is wrong with his scenario is that he accepts without questioning the babysitting co-op’s monopoly on currency.
Seems realistic enough when extrapolated to nations. Currency breakdown would be a catastrophic event.
Why does the farmer pay the workers per bushel, but when there is less yield one year, does not want to pay the works per bushel but instead a flat rate? who cares about worker morale? they are getting paid per bushel!
So the farmer is really paying the workers a flat rate of 9 bushels, on a good year the farmer may make 20 bushes, and on a bad year he may make 0 bushels, but his workers still get the constant 9 bushels. Over the long run the farmer averages 10 bushels, no one gets fired and everyone can weather the storm.
Furthermore the farmer trades options contracts on his crops to maintain consistent pricing so he can keep his workers happy, if that mattered to him.
How does the Keynesian model restore full output and full employment?
Including the effect on morale, what exactly is the marginal product of labor in this example?
Imagine I am overpaid CEO who opposes the SEC efforts to give shareholders say on pay and compensation disclosure rules. Imagine that there is a recession and the CEOs performance pay is modified to give him more income. Imagine that total compensation determines the firms output. Imagine the choice the CEO makes in deciding to reduce his comp or his employees.
How would it be better for morale to fire a worker arbitrarily than to cut all workers’ wages equally during a bad year? This model makes no sense to me unless the fired worker is more than just unlucky. Doesn’t moral intuition make any difference when it comes to economic modeling?
Jameson,
When you fire the one worker he has low morale but no longer works for you! The nine that work for you feel ok. Much better than keeping 10 and having them all upset. There is considerable evidence for this point of view from businesspeople and laborers. See
http://cowles.econ.yale.edu/books/bewley/tfb_wages.htm
Alex
Ah, now I understand better why macros fixate on unemployment.
I think Jameson is arguing about the morality whereas Alex is rebutting about the pragmatics.
I’m not getting this one, Alex. You give an illustrative example of a supply shock and at the end claim wage stickiness is more justified in a RBC than a Keynesian model. But you never gave an example of a demand shock for comparison.
Imagine a farmer whose farm produces 100 bushels of wheat. A barrel of wheat sells for $10. He hires 10 workers to bring in the wheat, paying each of them $90. Thus, each worker carries 10 bushels, the wage is $90, the wage bill is $900, and the farmer earns $100.
Now suppose that due to reduced demand for wheat a barrel now goes for $90. The farmer doesn’t want to reduce everyone’s wages, because that will reduce morale so he fires two workers leaving eight.The eight workers are able to produce 9 barrels of wheat, for a total wage bill of $720, and the farmer earns $90. The unemployment rate is now 20%.
The unemployed workers offer to work for $50. Even at the lower wage, however, the farmer doesn’t want to hire the worker because the worker doesn’t generate enough additional output to justify even a low wage. In fact, in this scenario the worker has ZMP.
I can continue to copy your story further, but obviously the point is: what difference does it make to your example whether it is a supply or a demand shock?
The difference it makes in terms of response, however, matters. If there was a supply shock due to locusts, the best policy response would be to develop a locust pesticide to kill the locusts and return the supply of wheat back to normal. In the case of a demand shock, the best response is to respond to the demand shock and perhaps print more money.
How does printing money create more demand over time?
If the lack of demand is due to a money shortage, it relieves that bottleneck. If not, ask Scott Sumner…
Remember that this is a wage stickiness scenario, just as Alex’s was. Imagine enough money were printed to create enough inflation to raise the price of wheat to $12 per bushel (or barrel, whatever) and the wage cost remains at $90 per employee. Now the two employees could be hired back at their original nominal wages even if the output remained at only 90 bushels instead of 100 and the farmer would earn $180.
In this simple scenario, increased demand raised the price of wheat but not the amount of wheat produced. In practice it would likely be a little of this and a little of that. Of course, all the employees are earning less in terms of bushels of wheat. And because the farmer is earning more than before, several of his employees wives leave them and move in with the farmer.
By the same theory, the workers cost of living adjusts instantaneously (haha). We also can’t just print money in a debt-based currency system. It’s my little pet issue, but it may actually matter.
But how may bushels are in a barrel?
Uh, one.
Ah… I screwed up my example all over the place. Barrel = bushel and I meant to say that a bushel now goes for $9 instead of $10 and the eight workers now produce 90 bushels instead of 100. Geez… I’m a ZMP commenter.
I think the real error in models like this is that they seem to ignore the management dynamics of the operation.
If I’m the farmer, I need 9 people to bring in my wheat, I do not want the 10th one around. In the real world (especially at this level of low skill employment), the management effort to direct people, the risks of theft or vandalism, the losses due to people distracting each other, and so on are high. In fact, to some limit, I might prefer to pay fewer people more so as to lower the overhead of dealing with the people.
The ZMP debate is missing a reality of the workplace. There *are* people who are ZMP people. In fact, there *are* people who are negative output people, and they can be surpriziingly hard to fire in a large org.
In the wheat example, hiring will be driven by the size of the harvest, almost one-for-one, directly. Assuming the harvest can all be sold, and it’s not more economic to let it rot.
All discussion about sticky-wages and high-unemployment needs to factor in these other “unpriced” issues. Management bandwidth. Risks of loss. Liability. Implicitly imposed cultural costs. Social interaction costs. Let alone fear.
I don’t understand your story. You say:
“Now suppose that due to climate change or a swarm of locusts the farm only produces 90 bushels of wheat”
So, I’m assuming that by this 10 workers produce now 90 bushels of wheat (instead of 100, as before). Which means that the productivity per worker is now 9, rather than 10 (as before the shock).
Then you say:
“The farmer doesn’t want to reduce everyone’s wages, however, because that will reduce morale so he fires one worker leaving nine. Each worker now brings in 10 bushels, as before, and is paid a wage of 9, for a total wage bill of 81 leaving the farmer with 9 bushels.”
In this scenario, each worker has a producutivity of 10, as before the schock! But how is that possible? It’s only possible because the marginal productivity of 9 workers is higher than 10 workers. In fact, after the shock, the marginal productivity of ten workers is 9, and the marginal productivity of 9 workers is 10. But if this is the case, with full flexibility of wages, 9 workers would be paid by their marginal productivity, which is 10. So, it’s not possible to say if wages are stick or not, because with full flexibility they would receive the same money as before.
I’m probabling missng something here. I’d be very happy if someone could point me what are the holes in my reasoning.
Manoel
ps.: is there any capital in this model? If not, why the profit is 10 before the schock? Why not zero? If there is some capital and you say that with wage flexibility the profit would be 10 as before the shock, then you are assuming that the marginal productivity of capital is the same as before (factors receive their marginal productivity). And workers are receiving only 8, which means that the marginal productiviy of worker decreased. Thus, the shock affected only the productivity of workers, not of capital (somehow). But if this is the case, it seems to me that this would induce the farm to save labor, by using more capital and less workers, which would increase the unemployment rate, even with full wage flexibility. Not only that, if this new equiblirium is, say, 9 workers and more capital, and the total output is 90, why the profit would still be 10? It seemsn that the profit has to be the same as the wage. If not, we’re out of equilibrium in the capital/labor ratio…
and the amount of capital used doesn’t change after the shock, then we’re assuming that the marginal capital is cheaper than the marginal worker, which means that the shock is inducing a more intensive use of capital, right? But this would reduce the marginal produtcivity of capital (assuming decreasing returns) with 10 workers? So, how is it possible that the profit can be the same in the scenario with wage flexibitliy?
It makes sense if the number of bushels the farm produces is dependent on more variables than the total productivity of the workers. So if the farm only produces 90 bushels because of a supply shock, then the 10 workers are working below peak productivity. If wages were flexible, they might accept a pay cut due to their reduced productivity. But I think most people would like to work at their peak productivity and get paid more, rather than be forced to work less and take a pay cut. The problem is solved (for everyone except the umemployed worker) if the farmer just fires one of the workers.
Isn’t the real problem that these guys are not producing wheat but Ipods or movie tickets. When one of them is laid off, then the 9 still working worry that they might be next and reduce their consumption of ipods or movie tickets. This makes the Owner even less likely to hire anyone at any wage.
My just so story is as good as any. Why exactly do they call this a science?
It is easy to check such stories by evaluating household savings and household consumption during recession. If your theory is right, household savings of the employed should increase whilst they defer consumption.
Or it is shifted to supplies or other investments, like home repair, or more canned food, or car repair or gasoline.
That would not reduce aggregate demand.
The New Keynesians can generate the shock invoked here by imposing menu costs and a monetary shock – i.e., a real increase in prices for a monopolist so the profit-maximizing quantity is to only produce 90 bushels of wheat. It is not necessarily an RBC model.
I agree.
I don’t follow your comments about the farmer’s incentives
“Note also that in this model the farmer only has a weak incentive to do this since in the equilibrium with 10% unemployment he earns 9, almost as much as before”
If the farmer hires 9 workers at the old rate of 9 bushels, the farmer ends up with 9 bushels (90 harvested – 81 paid in wages)
If the farmer fires one of the 9 workers and hires the unemployed worker at a wage of 5 bushels, the farmer ends up with 13 bushels (90 harvested – 8*9 – 1*5) which is a 44.4% increase in the farmer’s profits. Isn’t that the far more relevant margin to analyze the farmer’s incentives than to compare to the 10 bushels he made the previous year?
And once the farmer sees the unemployed worker willing to work at a much lower wage, he has even more incentive to fire one of the remaining workers and hire back the unemployed worker because there is a strong possibility that the recently fired worker would make a similar offer and the farmer could increase his profits again by going through the fire/ hire cycle.
Bill Woolsey responds to Tyler on sticky wages for the unemployed.
And then the employed lambaste the unemployed for their laziness and unwillingness to accept less for their unemployment while praising themselves for their hard work and productivity and declare it is a structural problem and the unemployed need to find new sources of jobs.
Isn’t this a result of assuming an aggregate production function that has an upper limit to output regardless of labor employed? If you allowed a more standard production function (e.g. Cobb Douglas) then allowing wage flexibility in the context of a negative real shock would restore ‘full output’ (if you take ‘full output’ to mean output at full employment) which would be greater than the diminshed output under sticky wages.
If I understand your model correctly, it assumes away any impact on output by holding it fixed exogenously.
The fixed upper limit is a simplification but not critical. If there is a productivity shock you will still get reduced output relative to before.By full output I do not mean output at full employment but the same output as before the shock.
David says;
It is easy to check such stories by evaluating household savings and household consumption during recession. If your theory is right, household savings of the employed should increase whilst they defer consumption.
you mean like this?:
http://www.calculatedriskblog.com/2011/03/personal-saving-rate-and-income-less.html
Add unemployment compensation. The real shock hits, one is laid off, the other 9 get 9 bushels each. There is a 10% “payroll” tax to a fund. With 9 workers get 9 each, the fund has 8.1 bushels. Those go to the unemployed guy. The after-tax wage is 8.1 bushels for each of the 9 workers. The unemployed worker gets 8.1 in benefits, and so prefers his unemployed status of benefits without work. The unemployed worker has no incentive to cut his offer wage to get employment.
In that case, full employment sounds better. Each worker gets 8 bushels, all 10 are employed, the payroll tax is zero, and the after-tax wage rate is only trivially lower than with unemployment plus payroll tax. Plus the farmer gets 10 bushels, much better than with unemployment.
The welfare state boosts the case for wage flexibility, even though it may reduce the willingness of the unemployed to cut their offer wages. And it is the capitalists who want wage flexibility, not the unemployed who could be employed at lower wages.
Would adding money to this model help understand the current situation? Can monetary expansion help reverse the impact of the shocks on employment (but not aggregate output)?
Can you add fiscal expansion to the model?
Would adding unionization matter to the model? Minimum wages? What about mandatory health insurance?
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Wouldn’t a better outcome in this scenario be to reduce everyone’s hours and pay by 10%? Now each worker brings in 9 bushels and is paid 8.1, leaving the farmer with 9. Hours can be increased once production is able to increase again in the future with a better harvest or new seeds that yield more bushels.
Perhaps if there were more periods of deflation this problem would be solved. What if cost of living wage changes went both ways.
Open Books Management seems to work to keep employees from being laid off. People mostly choose to have their wages reduced rather than take a chance at the company failing, they even choose lower wages over laying off workers.
BTW I have always thought that there are dangers to too much success of the federal reserve.
> Thus, the workers in this model have a very good reason to dislike wage flexibility.
I just don’t get this. Ex post, if you let me condition on being a winner in some economic lottery (and I’ve taken econ 101 so assume I’m also entirely selfish), I’ll presumably not be in favor of anything that flattens the outcome space or re-rolls the dice. Is that what you are saying because it doesn’t seem interesting -?
But if you are thinking about preferences ex ante, which does seem the right question, I don’t see the argument. Under normal utility models and assuming no particular insight as to whether you will be the one axed, wouldn’t one normally prefer an economic regime that allows pain sharing more easily rather than face a proportionate chance of complete poverty.
This works equally well as a demand story. If consumer preference reduces the demand to 90 bushels, then the farmer has no incentive to harvest the last 10 bushels. Everything else remains the same in the story.
A supply shock that doesn’t affect worker productivity also seems unlikely. To take the farming example, the labor quantity is going to be proportionality to the number of acres planted and harvested, not the number of bushels produced. If locus eat 10% of the grain in each acre, it doesn’t change the number of acres that need to be harvested or the total labor required to do it but it does reduce the productivity per unit labor. You have to invoke a very selective supply shock (locus eat 100% of the grain in 10% of the acres) to not affect worker productivity, which does not seem like a representative supply shock.
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