Friday, September 5, 2014

Some fallacies never die

Posted over a year ago as Modern Wage Economics: Too Subtle for the Blogosphere?, but some fallacies never die:

Our economy uses a lot less labor than it did 10 years ago, and for good reason people are interested in the relative importance of supply and demand factors for explaining what happened to the quantity of labor.

Naturally, a supply-demand decomposition exercise is enhanced by looking at both the quantity and price of labor, also known as the wage rate. That's why my book on the recession starts off with various indicators of wage rates and their dynamics (see chapter 2 beginning on page 9).

Three or four decades of labor economics research are of great assistance in this exercise. That research tells us that the price of labor from an employer's point of view is often significantly different than cash earnings per hour, and that a reduction in labor supply could be associated with reduced cash earnings even while it was increasing employer costs:

  1. A reduction in labor supply could reduce the quality of labor, with workers putting in less effort, or doing less to maintain their skills, or become less attached to the labor market.  This tends to reduce cash earnings per hour because each hour is less productive.  These have been major factors in the analysis of women's wages, where most economist believe that women's hourly earnings increased as a consequence of supplying more (see Becker 1985, Goldin and Katz 2002, Mulligan and Rubinstein 2008, and many others). See also some of the literature on unemployment insurance such as Ljungqvist and Sargent's paper on European unemployment.
  2. A reduction in labor supply or demand could increase the average quality of labor through a composition bias.  See p. 17ff of my book and the references cited therein.
  3. Because of fringe benefits, cash hourly earnings are not the same as employer cost.  As employer health insurance expenditure has been growing over time, the growth of cash hourly earnings has substantially under-estimated the growth of employer cost.

The Incidence of Supply and Demand Impulses.

Labor economists have also long studied the incidence of supply and demand impulses: that is, the effects of supply and demand factors on both wage rates and the quantity of labor. The consensus is that: (a) labor demand is more wage elastic than labor supply and (b) labor demand is even more wage elastic in the long run than it is in the short run.

Suppose that the reduction in the quantity of labor were 50% due to demand factors and 50% due to supply factors, and that we had overcome all of the measurement issues cited above. Result (a) means that wages would fall in the short run, because supply shifts translate more into labor quantity than into wage rates while, in comparison, demand shifts translate more into wage rates than labor quantity. In this example, it would be wrong to conclude from reduced wage rates than supply is less important than demand for explaining the change in the quantity of labor.

To put it another way, if we found that wage rates (properly measured) were constant, but didn't know the relative contribution of demand and supply factors to the quantity change, result (a) tells us that the majority of the labor quantity change was due to supply factors. With a labor supply elasticity of 0.5 and labor demand elasticity of -3 (reasonably conservative short run estimates), the constant wage rate result means that 86 percent of the quantity change was due to supply factors and only 14 percent due to demand factors. In the long run, labor demand is even more wage elastic, and the share attributable to labor supply is even closer to 100%.

To put it yet another way, if it were true that labor demand explained the majority of the change in labor quantity, then employer costs (properly measured) would have fallen dramatically.

Despite all of these lessons from labor economics, blogosphere economists attempt to dissect the hourly cash earnings data to perhaps find a small and probably ill-timed reduction and jump to the conclusion that labor supply shifts have made a trivial contribution to the change in labor quantity.


Patrick Sullivan said...

Nicely done. Noah Smith's fallacy is even more basic. When he says; 'Paying people not to work creates a supply shortage...'

That's just wrong. Shortages only appear where prices aren't free to fluctuate. Paying people not to work creates a new opportunity cost, not a 'shortage'. So he jumps from the false premise to; '...and supply shortages increase prices.'

Almost a textbook example of invalid logic.

Darragh McCurragh said...

"Our economy uses a lot less labor than it did 10 years ago." Well, that is a statement that is, taken by itself, misleading, if not even meaningless. The question is "relative to what"? If the economy used a lot less wheat than it did ten years agao, maybe it uses more rye? Tacos anyone? The labor used is often reduced (seemingly) by other factors too: when I entered high school (in Europe), 13% of pupils were doing so. We were "an elite" so to speak. Many began apprenticeships at 14 years of age and worked well beyond 60, men mostly until 65. When I left "high school" eight years later, 33% of students attended twelve to thirteen years high school, apprentices did not start until 15, most not before 16 years of age. The amount of postgrad students multiplied etc. etc. Naturally the labor supply shrank (all other factors, like population "vital statistics" being equal, which of course they weren't – families got less kids on average etc.) because even if people still worked until 65 (which they did not), they worked five to even ten years less in their lifetime. Yet many got higher wagesnot because supply shrank as such, but because their qualifications rose. I think arguing from aggregate figures like "elasticity" which rely on other aggregate figures and can hardly be measured led into the Keynesian fallcies and will not solve the underlying problems: over-regulation, cheap and subsidized this and regulated and curtailed that. No doctor could measure an Ebola patient if you brought him into a sauna and then asked him to divine the relative proportions of his fever and the sauna heat to reach an estimater of the "true fever".