Wednesday, December 24, 2008

Economics Lesson from the University of Chicago’s U.S. Senator

Copyright, The New York Times Company.

President-elect Barack Obama was not the first University of Chicago professor to serve in the United States Senate. More than 50 years prior, a professor from my department named Paul Douglas became a United States senator representing Illinois.

In his life as an economics professor, Professor Douglas wrote about the supply and demand for labor. Some of his techniques can lead us to a surprising conclusion about today’s recession: The recent decrease in employment may be less due to employers’ unwillingness to hire more workers, but more to workers’ unwillingness to work.

As you’ve probably heard, employment has been falling over the past year. After peaking in December 2007, employment fell 1.4 percent over the next eleven months. Hours per employee were down, so that total hours worked were 4.7 percent below its upward trend over the prior 36 months. Explanations for the decline — like most everything in economics — can be classified in two ways: supply or demand.

In many recessions, the demand for labor gets much of the blame. The demand explanation says that, with orders for their products down, many employers have trouble finding productive uses for their employees. Some employees are then let go. In this view, productivity – the amount produced per hour worked – should decline because reduced productivity is one of the driving forces of layoffs. Gross domestic product thereby declines for two reasons: fewer workers and less productivity per worker.

Indeed, hourly productivity did decline in the 1981-82 recession, falling three of four quarters for a cumulative peak-to-trough decline of 2.3 percent. Productivity fell faster and longer during the Great Depression.

The second type of explanation is reduced labor supply.

Suppose, for the moment, that people were less willing to work, with no change in the demand for their services. This means that each worker who remains employed would have to be more productive because employers have to produce with fewer workers.

Of course, people have not suddenly become lazy, but the thought experiment gives similar results to the actual situation in which some employees have bad incentives to take jobs and some employers have bad incentives to create them.

Professor Douglas gave us a formula for determining how much output per work hour would increase as a result of a reduction in the aggregate supply of hours: For every percentage point that the labor supply declines, productivity would rise by 0.3 percentage points.

As mentioned above, in 2008, labor hours have fallen 4.7 percent below trend. According to Professor Douglas’s theory, this means productivity should rise by 1.4 percent above trend by the fourth quarter.

So let’s take a look at the numbers. Unlike in the severe recessions of the 1930s and early 1980s, productivity has been rising. Through the third quarter of 2008, productivity had risen six consecutive quarters, with an increase of 1.9 percent over the past three, or 0.7 percent above the trend for the prior twelve quarters.

Because productivity has been rising – almost as much as the Douglas formula predicts – the decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire).

Why would some persons have worse incentives to take jobs (and employers worse incentives to create them) in 2008 than they did in 2006 or 2007?

I will tackle that question in my next [New York Times] post, but even without a specific answer we learn a lot about today’s recession from the conclusion that labor supply – not labor demand – should be blamed. First of all, it suggests that a fundamental solution to the recession would encourage labor supply (perhaps cutting personal income tax rates, so people can keep more of their wages), rather than tinker with demand.

Second, the recent supply reduction may be more short-lived than the demand reductions of past severe recessions. In particular, as people adjust to the reality of depleted retirement accounts and vanished home equity, many of them will decide to make up for some of the shortfall by working more and retiring later.

On another note, the Department of Economics at the University of Chicago does not conform to stereotypes: Professor Douglas ran for senator on the Democratic Party ticket and was occasionally accused of being a socialist. I teach his formula frequently and with admiration.


LetUsHavePeace said...

Senator Douglas also served with the First Marine Division on Okinawa and Peleliu, after enlisting in the Corps as a private at the age of 50. He earned two Purple Hearts; the wound from the second left his left arm permanently disabled. It took him 13 months in Bethesda to recover.

PLW said...

Wow.. not a very popular piece at among the NYT commentators. Hopefully it led a few of things to think about things a little more carefully, though.

Anonymous said...

Professor, wouldn't it be the case that, with labor heteregeneity, if there's a drop in labor demand, the workers that are going to be let go will be those that are less skilled, less productive and those with least firm-specific human capital, and therefore average productivity will go up?

fscond said...

My experience with layoffs:
The recent "reduction in force" has given our company the opportunity to fire people that they had wanted to fire for years but had not put together the necessary performance files. With management turnover and the onerous task of detailing performance failures, it is extremely difficult to fire anyone. In addition, upon firing, there is a high possibility of a lawsuit based on some alleged discrimination.
At least with the early rounds of layoffs, productivity would naturally increase. Labor laws and lawyers have prevented discrimination but has also protected unproductive employees.

Richard H. Serlin said...

The conclusion that, "the decreased employment is explained more by reductions in the supply of labor (the willingness of people to work) and less by the demand for labor (the number of workers that employers need to hire).", is based here on extremely flimsy evidence and simplistic reasoning that takes literally a few simple models with grossly unrealistic assumptions. Simple models can be great for understanding, but you have to interpret them properly. They usually just teach how a few factors work by looking at them carefully in isolation. They aren't exactly equal to reality, and should not be interpreted as such. You should always ask – with any model – are there important other factors that the model assumes away that I should still consider. Unfortunately, however, taking the models literally and cranking out technical publication after technical publication with great speed and workaholism can get you tenure at an Ivy League school.

A decrease in demand and involuntary layoffs – with no decrease in the desire to work – does not have to lead to a decrease in productivity. There are many strong factors here that move in different directions, most of which your argument wrongly assumes don't exist.

If firms are very reluctant to layoff workers in the face of a demand decrease they may keep some on who have little productive work to do, and spend a lot of time just sitting around waiting for something to do. This would decrease productivity. It does fit your argument. But, there are also ways productivity could increase, like if firms are less reluctant about laying off workers in the face of a slowdown -- something you would expect with today's less worker concerned culture – then layoffs will be swift and abundant, and the first let go are the least experienced and productive workers. This raises substantially the average productivity of the workers left. Also, those left will have more capital per worker, raising their productivity. And then there are other factors which can raise productivity, like the coincident great technological advance in computers, communication, and globalization. And what about underemployment? the engineer forced to take a job at Wal-Mart. This is grossly inefficient, but it would result in a lower official unemployment rate and an increase in the average productivity of Wal-Mart workers.

For good reason the vast majority of top economists don't profess that a decrease in desire to work is the primary, or even a large cause, of the current great increase in unemployment.