Labor supply is the Effective Demand limit
More on the labor-market model using labor share. I want to look at productivity to make the case that the labor supply curve is actually the effective demand limit in the model. (link to previous article)
Start with the equation…
labor share = real wage/productivity
We have all seen that over the years, real wages have not kept pace with productivity. OK… we have seen the fall in labor share.
As productivity increases, labor share falls. We move down and to the right on the labor demand curve. More labor is demanded with productivity increases. Labor is relatively cheaper. More productivity would imply more employment from a demand perspective.
Yet what happens on the labor supply side? More productivity will lead to less labor being supplied. Labor is cheaper and some people choose not to supply their labor at a lower price. They may choose to be employers of labor instead.
But there is a flip-side to the labor-market model above. The flip-side is the consumption market. The labor supplied in the model above becomes the consumption demand in the consumption market. Lower labor share becomes lower demand for consumption. The upward sloping labor supply curve reflects the demand constraints from lower labor share. That is the effective demand limit.
For example, let’s say that labor share is dropping and labor demand increases to the right beyond the crossing point of supply and demand. Let’s say that increased employment gives increased production. More employment means more consumption, right? Labor demand would be happy right? Isn’t labor supplying all that the firms desire? And still, more people are being employed. Isn’t this what Krugman, Baker and others want? Don’t they want more employment in spite of the lower labor share? Are they not envisioning an unemployment rate to the right of the labor supply curve? Well, their logic implies that labor share would increase if employment was pushed beyond its natural limit. Well, ok… but the model above shows that as labor share increases, less labor would be demanded and we would return to the crossing point of supply and demand anyway. Thus, there is an effective demand limit upon employment.
In the above model, the labor supply curve is actually the effective demand limit curve.
You will not be able to have a “free-market” situation where labor is supplied to the right of the labor supply curve. Why?
Firms would be producing beyond the capacity of labor to purchase the production. Profit rates would start to drop and firms would back off from hiring the relatively cheaper labor. Production would have to decrease either by reversing productivity gains or by paying higher real wages relative to productivity. (see labor share equation above) Either way you would return to the labor supply curve. A lower unemployment rate would not manifest, unless it was war-time or some forced-labor type economy.
So productivity has its effective demand limit. Krugman and others do not see this yet.
In a related article by Yang Liu, she talks about the higher unemployment and labor shortage in China. She asks the question of how you can have labor shortage and higher unemployment together. Her answer revolves around matching efficiencies. But the model above explains the conundrum too.
China has been pushing productivity to higher and higher levels. Labor share there has fallen tremendously over the years. Basically real wages have not kept up with the productivity gains. No surprise there. So what is going on? As Chinese productivity continues to increase, China is pushing down and to the left on the labor supply curve. Unemployment will tend to increase (at least not decrease). But also you will see more people leaving the labor market. As she says in her article, there is great demand for labor. Well, yes, when labor share is low, labor demand is greater. But there is an effective demand limit in China too. There must also be many firms that are not hiring which balances in the aggregate the firms that want to hire. For all that the Chinese firms would love to have endless cheap labor, they have hit the effective demand limit of their labor supply. Profit rates will decline if they push further. This coincides with the United States currently hitting its own effective demand limit, since the United States is a large part of the Chinese economy.
My view is that China and the United States are going to trip over the effective demand limit. They are simply trying to push employment beyond labor supply’s effective demand limit. They do not see the limit. But with each passing day, they will see it within the next 9 months.
Someone once said that science is organized common sense. Well, your labor share-effective supply/demand analysis must be science since it is organized, and it is common sense. Unlike most of economics, it even makes sense.
Everyone except for highly trained economists knows: (1) People can’t work if they can’t get jobs. (2) People can’t buy things if they don’t have money. (3) Companies aren’t going to hire people to produce things if they can’t sell them at a profit. Your model seems to capture these constraints, and it explains an awful lot.
I read that article on job search inefficiencies, and it was phlogiston. As best I could tell was that there was some mysterious “training mismatch” which seems to be as bogus as it gets. (Well, maybe not. Rational expectations are even more bogus. They’re the hidden local variables of economics. They might explain things, but they don’t exist.)
Just want to acknowledge your insights.
“As productivity increases, labor share falls. ”
I think your model is based on some assumptions that depend on how you think the economy grows. If productivity increases eliminate low skilled jobs and replace them with higher skilled jobs, then labor share should increase. In Henry Ford’s day, he was able to pay his workers more to be more productive because his productivity enhancement let him sell more cars. I don’t think that is a closed model, though. Exports increased, but the economy with increased imports is being ignored.
Still thinking about this.
If you increase productivity, you don’t slide along the curve you had for the old productvity, you shift the curve.
If the government tries to fill the gap with stimulus, you don’t slide along the existing curve, you shift the curve. Or if you change the minimum wage, or eliminate the overhang of household debt, or change the preference for more schooling by reducing college tuition, or …
Response to first comment…
If you replace low-skilled workers with high-skilled workers, labor share will increase if aggregate real wages rise more than aggregate productivity. So in the example, you assume that real wages rise more than productivity.
Henry Ford had the right idea… You can offset the increasing unemployment of increased productivity by paying more to labor.
response to second comment…
During the 90s, we were sliding up the labor supply curve. We were against the effective demand limit for a number of years. Towards the end of the 90s, productivity rose with the internet.
We saw labor share drop a bit. Unemployment fell a bit. So we slid down the labor demand curve. The labor supply curve was shifting to the right. Check out end of plot on this graph.
Then at the beginning of the 2000s, labor share jumped up. The labor demand curve shifted upward. Employment rate did not change much. Productivity was rising more mildly.
What shifted the labor demand curve up at the beginning of the 2000s? My sense is to say profit taking into personal income. Profit rates dropped and the formation of the 2001 recession was happening. Employment was not going to rise in this economic state.
Then during the 2001 recession, people realized that labor was going to be less valuable with increased productivity and also off-shoring of jobs. So the labor demand curve shifted down. So for any level of labor share, there would be more unemployment. Sounds like your idea of replacing more low-skilled jobs with higher paying high-skilled jobs.
The labor supply curve has shifted to the right since then too. More people are willing to accept a lower share of the national purchasing power.
But Krugman and especially Baker and Bernstein think the labor supply curve is vertical. They expect unemployment to return to the good ol days when labor share was higher. But the labor supply curve is not vertical. A lower labor share leads to a higher natural unemployment rate. They don’t understand this… yet.