Sunday, December 23, 2007

Wages, Employment Not Determined By Supply And Demand

1.0 Introduction
One theme of this blog is that the introductory textbook model of the labor market is incorrect. Two recent papers make this point from the perspective of institutional economics.

2.0 The Impossibility of a Perfectly Competitive Labour Market
The abstract of the first paper under consideration states:
Using the institutional theory of transaction costs, I demonstrate that the assumptions of the competitive labour market model are internally contradictory and lead to the conclusion that on purely theoretical grounds a perfectly competitive labour market is a logical impossibility. By extension, the familiar diagram of wage determination by supply and demand is also a logical impossibility and the neoclassical labour demand curve is not a well-defined construct. The reason is that the perfectly competitive market model presumes zero transaction costs and with zero transaction costs all labour is hired as independent contractors, implying that multi-person firms, the employment relationship and labour market disappear. With positive transaction costs, on the other hand, employment contracts are incomplete and the labour supply curve to the firm is upward sloping, again causing the labour demand curve to be ill-defined. As a result, theory suggests that wage rates are always and everywhere an amalgam of an administered and bargained price. -- Bruce E. Kaufman (2007). "The Impossibility of a Perfectly Competitive Labour Market", Cambridge Journal of Economics, V. 31: 775-787
Kaufman states that, "Institutional, post-Keynesian, radical and other heterodox economists have for many years expressed scepticism about the theoretical and empirical validity of the competitive model of labour markets." He cites the following literature:
  • C. Kerr (1950). "Labour Markets: Their Character and Consequences", American Economic Review, V. 40 (May): 278-291
  • G. Hodgson (1988). Economics and Institutions: A Manifesto for a Modern Institutional Economics, Philadelphia: University of Pennsylvania Press.
  • D. Vickers (1996). "The Market: The Tyranny of a Theoretical Construct", in Employment, Economic Growth, and the Tyranny of the Market, (ed. by P. Aretis), Brookfield: Edward Elgar
  • W. Streeck (2005). "The Sociology of Labour Markets and Trade Unions", in The Handbook of Economic Sociology (ed. by N. Smelser and R. Swedberg), 2nd edition, New York: Russel Sage
  • S. Fleetwood (2006). "Rethinking Labour Markets: A Critical-Realist-Socioeconomic Perspective, Capital & Class, V. 107 (Summer): 59-89
As far as I can tell, none of these papers are about the Cambridge Capital Controversy, which is the basis of my favorite critique of the introductory textbook model of labor markets.

3.0 Professor Lester and the Neoclassicals
The abstract of the second paper follows:
"This article revisits what is remembered as the 'Marginalist Controversy' in light of its immediate context and object: the substantial late 1940s increase in the federal minimum wage. Richard Lester's critique of 'marginalist theory,' and its implication that the minimum wage would be detrimental to labor was founded upon empirical studies and surveys that supported an Institutionalist conception of the business firm, the labor market, and economic policy. His disputants, Fritz Machlup and George Stigler, countered his points on the basis of what they took to be 'economic theory'. By any measure, including those of their own intellectual allies, Machlup and Stigler faired poorly. Interestingly, they are collectively remembered as having been triumphant in this debate. The essay suggests that what triumphed was not their arguments but rather the Neoclassical school of economics that Stigler represented." -- Robert E. Prasch (2007). "Professor Lester and the Neoclassicals: The 'Marginalist Controversy' and the Postwar Academic Debate Over Minimum Wage Legislation: 1945-1950", Journal of Economic Issues, V. 41, N. 3 (September): 809-826."
I had not known that the context of the debate about full cost pricing included minimum wage policies. Prasch makes the point that neoclassicals often misrepresent their position as a defense of economic theory, instead of as of a specific theory. In addition to drawing on a specific school of thought, Institutionalist economics, Lester had survey data supporting his position that the typical firm does not operate in a region of increasing marginal cost. It is this sort of data, which has been repeatedly replicated, that Milton Friedman argued, in his famous paper on positive economics, should be ignored.


YouNotSneaky! said...

There is also the well known The Impossibility of Reading the Cambridge Journal of Economics for Free or at a Low Price which makes me really scratch my head as to how exactly the author makes the following sentence sensical, in the light of the fact that the supply and demand for labor are two completely different things having nothing to do with each other other than occasionally intersecting:

"the labour supply curve to the firm is upward sloping, again causing the labour demand curve to be ill-defined"

The labor supply can't do anything to labor demand nor vice versa.

Is this Steve Keen type of stuff?

Robert Vienneau said...

I consider graceless the off-topic, question-begging reference to Steve Keen. As far as I know, factor demand curves are derived under the assumption that firms take prices, including the prices of factor services, as given parameters.

Blogus Pokus said...

This is an unrelated discussion, but I was hoping that maybe you (or someone else reading this forum) could help me with a question that may also be of interest to you.

How does a standard neo-Walrasian CGE (computational general equilibrium) model predict economic losses from trade liberalisation?

I understand the logic behind the two goods and country case where welfare gains can be made through the elimination of trade barriers if there exists a comparative advantage (assuming the standard assumptions of perfect competition, constant returns to scale etc.), but how does the logic work with more than two countries and goods?

Is the answer simply that those countries which do not have a comparative advantage (in any or critical goods), experience welfare losses, because they are now importing more (due to lower prices abroad) and exporting less (trade is being diverted to other countries)?

Most (if not all) countries when getting the CGE treatment with full liberalisation scenarios, seem to make welfare gains. Is this because most countries have at least some comparative advantage in some goods, and the theory neglects any adjustment and transaction costs?

Some background on this question: I'm not an economist by trade, but rather study development studies, for which I'm writing a Master's Thesis. My strategy has been to use the Lakatosian methodological framework for studying the hardcore assumptions behind general equilibrium analysis. This has led me to study for example Keen's work, and Fabio Petri's (on the capital controversies) among others. Since I'm not concentrating on heuristics (and I'm not particularly mathematically inclined), I'm not familiar with all the implications of the standar neo-Walrasian theory (e.g. Arrow-Debreu) that the criticism, quite rightly it seems, is able to destroy by attacking its inconsistent or absurdly narrowed assumptions. To the standard unacquainted reader (for example my supervisor) it is however perhaps not only enough to attack the assumptions, but also be able to reduce the theory via its implications. I'm thinking that for a conclusion, I could write up a kind of characterisation of what the theory implies in the narrow sense and a wish list of what problems a perfect economic theory would be able to cover and account for as a contrast (perhaps a distant dream, but why not?)

Any ideas on the above would be appreciated..

YouNotSneaky! said...


With more than two countries and more than two goods, in general the pattern of comparative advantage can become indeterminate. However this does not imply that gains from trade do not exist, nor that there will be loosers from trade. If some country does not have a comparative advantage in anything then, just like in the standard 2x2 model, it will simply not engage in trade.

"How does a standard neo-Walrasian CGE (computational general equilibrium) model predict economic losses from trade liberalisation?"

It doesn't unless there's distortionary taxes or externalties or monopoly power.

Blogus Pokus said...


Thanks for your answers. It confirms my intuition on the standard theory, although I'm puzzled how the CGE-models then are able to account for economic costs in the applied models moving from distortionary to free trade. Would you know of a good reference on this topic?

A possible complication, which may be my own confusion, for the more than two countries and two goods case, is that what happens if a country has no comparative advantage in production, but would like to buy cheaper from abroad given the arising situation of free trade?

Is this scenario forbidden in the neo-Walrasian GE-framework, because the framework begins with the assumption that each country has a set of goods endowments that it produces and consumes? Thus the definition of comparative advantage incorporates both production and consumption possibilities. A country cannot consume in international markets despite cheaper prices if it cannot produce for those markets.

Wait hold on... I see now. I realise I've been asking the wrong question presuming autarky as a starting point. Obviously CGE-models analyse a situation of global economic integration with trade distortions as a starting point. In this context it seems that losses are possible, when a country benefitting from trade barriers now loses, when a more efficient producer is able to exploit the new market situation. This can thus lead the less efficient producer to become a country with no comparative advantage within international markets, and therefore it can't trade. This registers as an economic loss. Does this sound right?