Category Archives: unemployment

The robot-proof job men aren’t taking

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My Select Committee submission on the Employment Relations Amendment Bill

The regulatory impact statement on the employment law amendments by the new government says that:

The bill aims to strengthen collective bargaining through a range of measures, including guaranteed rest and meal breaks, reasonable union access to a workplace, and bringing back the 30-day rule where a new worker must be given the same conditions as a collective agreement.

MBIE officials found that the cost of the proposals would mainly fall on employers, including from higher wages and compliance costs, and from a potential fall in productivity.

The MBIE papers identified the following risks associated with the bill:

• reduced employment due to changed incentives on employers to hire new workers • an increase in industrial action and protracted bargaining due to the need to conclude agreements and include pay rates in collective agreements
• an increase in partial strikes by removing an employer’s ability to deduct pay for partial striking
• lower productivity due to less flexibility (mainly from the need for guaranteed meal breaks)

These predictions ignore the main findings of labour macroeconomics on employment protection laws and of empirical labour economics regarding the power of unions and the size of the union wage premium in the private sector.

What do employment protection laws do?

Let us begin with what are the standard predictions of the effect of employment protection laws. They lower wages and have an ambiguous effect on employment because there is both less hiring and less firing. The only unambiguous effect is on the duration of unemployment because fewer vacancies are posted but once you get a job, you keep it for longer. The unemployed must remain unemployed longer because their own fewer job vacancies posted. They must wait longer for a new vacancy suitable to their background and skills to open.

To give a summary of the literature that appears to be unknown to the junior analyst writing the Regulatory Impact Statement from this Bill, graduate textbooks in labour economics show that a wide range of studies have found that:

1. Employment law protections make it costlier to both hire and fire workers.
2. The rigour of employment law has no great effect on the rate of unemployment. That being the case, stronger employment laws do not affect unemployment by much.
3. What is clear is that is more rigorous employment law protections increase the duration of unemployment spells. With fewer people hired, it takes longer to find a new job.
4. Stronger employment law protections also reduce the number of young people and older workers who hold a job. They are outside looking in on a privileged subsection of insiders in the workforce who have stable, long-term jobs and who change jobs infrequently.

When trying to work out what the effects of the effects of this Bill on the labour market, the key consideration is the extent to which wage bargaining can undo most if not all the effects of the employment protection regulation.

Can wage bargaining cancel out the effects of employment protection laws?

Let me start with a simple example. Suppose the only employment law in New Zealand was a requirement to pay redundancy pay. If wages are flexible, a key analytical assumption that I return to again and again, wage bargaining can completely undo the effects of the redundancy payment mandate by reducing the starting wages paid by the amount of the expected redundancy payment.

Employment protection laws give rise to two costs. The first of these are severance payments, these are transfers of from the employer to the employee. The 2nd type of cost are administrative or procedure costs within the firm and payments to 3rd parties such as for litigation. Advance notice of dismissal and an obligation to find another position within the firm are both administrative costs and transfers to the employee. Administrative costs and severance payments affect employment protection in different ways depending on the presence of wage bargaining. That nuance is completely omitted from the regulatory impact statement.

As illustrated with the example of redundancy pay, if there is no involvement of 3rd parties such as arbitrating the size or eligibility of the payment, it is formula driven by tenure as an example, starting wages are lowered and just as many job vacancies are created. Even if there are some administrative costs involving payments to 3rd parties such as arbitration over the eligibility for redundancy pay or something like that, the expected cost of those payments can be offset by a lower starting wage. This illustrates the effects of employment protection in a barebones manner. The next paragraphs will flash out this analysis.

What do employment protection laws do when no wage bargaining is permitted?

When no wage bargaining is permitted because of the presence of the minimum wage or a wage floor in a collective agreement, the impact of severance pay and procedure costs are the same. They make it less profitable to create vacancies, and less profitable to let people go because of the cost of replacing them. As there are fewer vacancies, there is less employment and spells of unemployment are longer because vacancies are posted less frequently.

When wage bargaining is not permitted either at hiring or when there are productivity shocks cast doubt on the profitability of the job, they have different effects. We are currently considering what happens when there is no wage bargaining

Firing costs certainly do reduce the rate of job destruction. For example, when there is a downturn in demand or some other productivity shock and the entrepreneur believes it is a short-term affair, he can avoid paying the severance pay and administrative costs of the firing by keeping the worker on. Firing costs result in labour hoarding. Employment law protections such as severance pay and any procedure costs encourage labour hoarding. In mild downturns it is cheaper to keep people on than let them go and pay the severance pay and incur various procedural costs.

Firing costs also reduce labour productivity because they induce firms to keep workers at lower productivity levels are slow the rate at which workers are reallocated to new more profitable, higher productivity jobs. This reduces wages in the long-term.

Firing costs have an ambiguous impact on the unemployment rate because they combine two effects that work against each other. By favouring labour hoarding, they reduced job destruction in mild recessions and mild downturns, but they reduced job creation because the higher firing costs downgrades the profit outlook for every new hire. There are fewer jobs, but these jobs last longer. Unemployment spells are also longer because there are fewer vacancies posted.

To complicate the story even more, because unemployment duration is longer and fewer vacancies are posted, labour market tightness is reduced and in consequence the bargaining power of workers is reduced. When labour markets are tight, there are many vacancies and few jobseekers, workers can seek pay rises. But when there are few jobs and long spells of unemployment, the unemployed offer to work for less and incumbent workers fear unemployment.

In summary, when employment protection laws cannot be offset by lower starting wages or other wage negotiations, there is less employment, longer spells of unemployment, lower wages in the long term because of lower productivity, and workers have less bargaining power because of the fear of longer spells of unemployment.

What do employment protection laws do when wage bargaining is possible?

The story complicates no end when wage bargaining is possible. This is because the severance pay and administrative costs or process costs of employment protection laws have different effects. They also cut in at different times.

At hiring stage, wage bargaining could offset both the costs of having to pay severance pay and any administrative costs. But once a vacancy has been filled and the worker hired, when there is a productivity shock, administrative costs, these are payments to 3rd parties, can be avoided if the worker is kept on. Because of this, the incumbent worker might be able to ask for higher wages than otherwise as a way of splitting this saving. The fact that it will cost the employer administrative costs if there is a layoff strengthens the bargaining hand of the employee’s job is at risk.

When the worker is hired, the failure of bargaining over the starting wage incurs neither the severance nor administrative costs of employment law. The twist in the tail is that when wages are renegotiated after hiring such as in the presence of some productivity shock or demand downturn, these costs and transfers are borne by the employer if the wage renegotiation fails. How these costs and the avoidance of these costs takes place depends upon the respective bargaining power of employers and employees and in turn the tightness of the labour market in which those workers will be laid off.

This is a complicated tale. Severance pay can be undone in starting wages, but the costs of firing lends some bargaining power to employees after they hired when wages must re-renegotiated in the face of the demand of productivity shock. But, if employment protection is a particularly strong and therefore the spell of unemployment is long if you do lose your job, labour market tightness offsets any incumbency advantage in the renegotiation of wages in the face of changing economic circumstances for the employer.

What is clear is labour hoarding persists irrespective of wage bargaining options. There are fewer job layoffs so the unemployed must wait longer for vacancies to open. Employment protection unambiguously prolongs spells of unemployment.

What do trial periods do?

The impact of the introduction of trial periods on employment will be ambiguous because the lack of a trial period can be undone by wage bargaining.

  • If you hire a worker with full legal protections against dismissal, you pay them less because the employer is taking on more of the risk if the job match goes wrong. If they work out, you promote them and pay them more.
  • If you hire a worker on a trial period, they may seek a higher wage to compensate for taking on more of the risks if the job match goes wrong and there is no requirement to work it out rather than just sack them.

The twist in the tail is when there is a binding minimum wage. If there is a binding minimum wage,  either the legal minimum or in a collective bargaining agreement, the employer cannot reduce the wage offer to offset the hiring risk so fewer are hired. The introduction of trial periods will affect both wages and employment and employment more in industries that has low pay or often pay the minimum wage.

Trial periods are common in OECD countries. There is plenty of evidence that increased job security leads to less employee effort and more absenteeism. Some examples are:

  • Sick leave spiking straight after probation periods ended;
  • Teacher absenteeism increasing after getting tenure after 5-years; and
  • Academic productivity declining after winning tenure.

Jacob (2013) found that the ability to dismiss teachers on probation – those with less than five years’ experience – reduced teacher absences by 10% and reduced frequent absences by 25%.

Studies also show that where workers are recruited on a trial, employers must pay higher wages. For example, teachers that are employed with less job security, or with longer trial periods are paid more than teachers that quickly secure tenure.

If employers take on more of the risk of a job match going wrong, they will pay recruits less. They can have a promotion round 6 or 12 months where pay is topped up if there is a good match. If minimum wage laws prevent starting salaries going low enough, there will be fewer job vacancies. But higher up the wage scales, the main effect of employment protection laws is to lower wages because the employer expects a wage discount to compensate for taking on more risk of an unsuccessful job match.

Consider, as an example, if there is a requirement to pay redundancy pay. Employers can easily undo this legal requirement by reducing wages. Another similarity is where employers pay completion bonuses on an offshore posting. They back-load compensation to make up for uncertainties about the willingness of the worker to last the posting. Because wages are lower for the duration of the posting, employees expect a big bonus. Also, there is self-selection, recruits are more likely to be those intending to stay for the whole posting. Both the employer and the employee split the greatest surplus from higher quality and longer lasting job matches arising from offering a completion bonus.

What the regulatory impact statement should have said

The regulatory impact statement should have said that many of the effects of employment law on job creation and job destruction can be undone by wage bargaining. But in the case of low paid and minimum wage workers, they have little or any ability to start on lower wages so fewer low paid vacancies will be created, few of them will be destroyed, but what is sure that the low-waged will face longer periods of unemployment.

The adverse effects of employment law on wages growth, productivity growth, and innovation come from their slowing down the rate in which workers are reallocated from old jobs to new jobs because fewer jobs are created and fewer jobs are destroyed.

What do unions still do in the private sector?

The analysis by the Ministry of the potential effects of unions is out of date. There are now doubts as to whether there is any union wage premium at all. The union wage premium is certainly withering away. Union membership was in freefall until they were saved by the passage of the Employment Contracts Act if simple correlations are to be believed.

Source: OECD Stat Extract.

What is clear is unions are dead on their feet in the private sector. Struggling to keep membership in double digits as a share of the private sector workforce both at home and abroad.

Any predictions about the effects of this amendment to the Employment Relations Act provided to you by the Ministry must be set against that background. How union so far gone in the private sector that this bill is more gesture than a real change to the economy?

We are not living in the 70s where most of the workforce are union members. The advice tended to you by officials may well have had some validity 40 years ago, but not now. Furthermore, the evidence doubting the very existence of a union wage premium is growing in jurisdictions where good data is available.

John DiNardo and David Lee compared business establishments from 1984 to 1999 where US unions barely won the union certification election (e. g., by one vote) with workplaces where the unions barely lost. If 50% plus 1 workers vote in favour of the union proposing to organise them, management must bargain for a collective agreement in good faith with the certified union, if the union loses, management can ignore that union.

Most winning union certification elections resulted in the signing of a collective agreement not long after. Unions who barely win have as good a chance of securing a collective agreement as those unions that win these elections by wide margins.

Importantly, few firms subsequently bargained with a union that just lost the certification election. Employers can choose to recognise a union. Because the vote is so close, a workplace becoming unionised was close to a random event.

This closeness of the union certification election may disentangle unionisation from just being coincident with well-paid workplaces, more skilled workers and well-paid industries. Unions could be organising at highly profitable firms that are more likely to grow and pay higher wages independent of any collective bargaining. The unions are possibly claiming credit for wage rises that would have happened anyway.

DiNardo and Lee found only small impacts of unionisation on all outcomes they examined:

  • The estimated changes for wages of unionisation are close to zero.
  • Impacts on survival rates of the unionised business and their profitability were equally tiny.

This evidence of DiNardo and Lee suggests that in recent decades in the USA, requiring an employer to bargain with a certified union has had little impact because unions have been unsuccessful in winning significant wage gains after unionisation. These findings by DiNardo and Lee suggests that there may not be a union wage premium at all since the early 1980s, at least in the USA.

In another paper DiNardo found a substantial union wage premium before the Second World War by studying the share price effects of unionisation. One of the differences back them that there was far more violence associated with strikes.

We find that strikes had large negative effects on industry stock valuation. In addition, longer strikes, violent strikes, strikes won by the union, strikes leading to union recognition, industry-wide strikes, and strikes that led to wage increases affected industry stock prices more negatively than strikes with other characteristics.

New Zealand and U.S. unions are similar in that both are on their own in bargaining with employers for a wage rise. Options for outside arbitration do not exist in New Zealand; there are some forms of compulsory arbitration in the USA The U.S. result sends a message to New Zealand that unions are a bit of a relic in terms of wage bargaining. MBIE seems to have missed that literature? When there is a literature out there saying that unions have passed into history that must be at least mentioned in passing to this Select Committee.

What the regulatory impact statement should have said

The regulatory impact statement should have said that private-sector unions are few and far between and have little bargaining power. As such, these new laws are unlikely to see a major revival of union membership. There is little evidence that unions have much power to extract higher wages in the private sector.

Summary

In summary, job protection laws reduce wages. For the low paid, they may also reduce employment rates if minimum wage rates are binding. Unions are a dinosaur that do not matter much anymore in the private sector.

Union unemployment insurance schemes were super tough on malingerers

An early role of trade unions was to provide unemployment insurance for members. Majority of British unions in 1908 provided unemployment insurance for members for 6 months or more. These union provided unemployment benefits were about 30% of the take-home pay of the time.

British unions had extremely tough safeguards against moral hazard. The Amalgamated Engineers forced each applicant to make his claim at the next meeting of his branch.

  • If the members present, some of whom were his fellow workmen, determined that he was not eligible for benefits, he forfeited the benefits and was “liable to such other punishment as the branch may consider the case deserves.”
  • A worker deemed eligible for benefits had to “sign … the ‘vacant-book’ of his branch once every day between certain hours” to collect relief.
  • The branch secretary would direct an unemployed member to any local firm in need of labour. A member who refused a job offer, or who did not apply for a job when informed of a vacancy by the branch secretary, would forfeit his unemployment benefit unless he could show sufficient cause for his action at the next branch meeting. This is a common theme among mutual aid societies. They use local knowledge to root out shirking.

Mutual aid societies were formed by people with a common denominator such as the same occupation or ethnic, geographic, or religious background and later, on union membership. This appears to be an attempt to both profit from advantageous selection and to deal with moral hazard by personal knowledge of new members or signs of other forms of good character such as religious fervour. Building societies and credit unions arose out of these mutual aid societies. There were burial societies, factory societies, which make provision for its employees for accident, sickness or burial, and fraternal societies that provided for widows and old-age pensions.

In 1908 Britain, 1 ½ million trade unionists were eligible for unemployment insurance through their union; four million British also belonged to the sickness societies which predated the union movement. Trade unions were superior to mutual aid societies as providers of unemployment insurance because of their greater ability to monitor the eligibility and job search of members through local branches. Few mutual aid and friendly societies provided unemployment insurance.

Friendly societies did not fail; in the UK for example, they were displaced by the National Insurance Acts of 1911 and 1948. When national insurance was first introduced in Britain, people could file claims either with the government bureaucracy or with their friendly society.

The unemployment benefits paid by national insurance were small. Most unions continued to provide insurance benefits throughout the interwar period. It was not until the post-war development of the welfare state that most unions ended their unemployment insurance policies. The 1948 Act created a government monopoly. At the time of the 1911 National Insurance Act, 9 million people were covered by voluntary insurance societies. These provided for widows and burial expenses and medical care. Some provided help in times of distress and grants to travel to new jobs.

Was @MBIEgovtnz misreported on the effects of job protection laws and unions? @EricCrampton

News reports have it that the regulatory impact statement on the new employment law amendments by the new government says that:

The bill aims to strengthen collective bargaining through a range of measures, including guaranteed rest and meal breaks, reasonable union access to a workplace, and bringing back the 30-day rule where a new worker has to be given the same conditions as a collective agreement.

MBIE officials found that the cost of the proposals would mainly fall on employers, including from higher wages and compliance costs, and from a potential fall in productivity.

The MBIE papers identified the following risks associated with the bill:
• reduced employment due to changed incentives on employers to hire new workers • an increase in industrial action and protracted bargaining due to the need to conclude agreements and include pay rates in collective agreements
• an increase in partial strikes by removing an employer’s ability to deduct pay for partial striking
• lower productivity due to less flexibility (mainly from the need for guaranteed meal breaks)

These predictions must be a misreporting of an earlier draft by a junior analyst, perhaps they were not a recruit with a background in economics. The predictions of the effects of employment protection laws and union bargaining seem to be wrong for the former and seriously out of date for the latter.

Let us begin with what are the standard predictions of the effect of employment protection laws. They lower wages and have an ambiguous effect on employment because there is both less hiring and less firing. The only unambiguous effect is on the duration of unemployment because fewer vacancies are posted but once you get a job, you keep it for longer.

To give a summary of the literature that appears to be unknown to the junior analyst writing this early draft, graduate textbooks in labour economics show that a wide range of studies have found that:

1. Employment law protections make it more costly to both hire and fire workers.

2. The rigour of employment law has no great effect on the rate of unemployment. That being the case, stronger employment laws do not affect unemployment by much.

3. What is clear is that is more rigourous employment law protections increase the duration of unemployment spells. With fewer people hired, it takes longer to find a new job.

4. Stronger employment law protections also reduce the number of young people and older workers who hold a job. They are outside looking in on a privileged subsection of insiders in the workforce who have stable, long-term jobs and who change jobs infrequently.

The impact of the introduction of trial periods on employment will be ambiguous because the lack of a trial period can be undone by wage bargaining.

  • If you have to hire a worker with full legal protections against dismissal, you pay them less because the employer is taking on more of the risk if the job match goes wrong. If they work out, you promote them and pay them more.
  • If you hire a worker on a trial period, they may seek a higher wage to compensate for taking on more of the risks if the job match goes wrong and there is no requirement to work it out rather than just sack them.

The twist in the tail is whether there is a binding minimum wage. If there is a binding minimum wage,  either the legal minimum or in a collective bargaining agreement, the employer cannot reduce the wage offer to offset the hiring risk so fewer are hired. The introduction of trial periods will affect both wages and employment and employment more in industries that has low pay or often pay the minimum wage.

Trial periods are common in OECD countries. There is plenty of evidence that increased job security leads to less employee effort and more absenteeism. Some examples are:

  • Sick leave spiking straight after probation periods ended;
  • Teacher absenteeism increasing after getting tenure after 5-years; and
  • Academic productivity declining after winning tenure.

Jacob (2013) found that the ability to dismiss teachers on probation – those with less than five years’ experience – reduced teacher absences by 10% and reduced frequent absences by 25%.

Studies also show that where workers are recruited on a trial, employers have to pay higher wages. For example, teachers that are employed with less job security, or with longer trial periods are paid more than teachers that quickly secure tenure.

If employers take on more of the risk of a job match going wrong, they will pay recruits less. They can have a promotion round 6 or 12 months where pay is topped up if there is a good match. If minimum wage laws prevent starting salaries going low enough, there will be fewer job vacancies. But higher up the wage scales, the main effect of employment protection laws is to lower wages because the employer expects a wage discount to compensate for taking on more risk of an unsuccessful job match.

Consider, as an example, if there is a requirement to pay redundancy pay. Employers can easily undo this legal requirement by reducing wages. Another similarity is where employers pay completion bonuses on an offshore posting. They back-load compensation to make up for uncertainties about the willingness of the worker to last the posting. Because wages are lower for the duration of the posting, employees expect a big bonus. Also, there is self-selection, recruits are more likely to be those intending to stay for the whole posting. Both the employer and the employee split the greatest surplus from higher quality and longer lasting job matches arising from offering a completion bonus.

The analysis by the Ministry of the potential effects of unions is out of date. There are now doubts as to whether there is any union wage premium at all. The union wage premium is certainly withering away.

John DiNardo and David Lee compared business establishments from 1984 to 1999 where US unions barely won the union certification election (e. g., by one vote) with workplaces where the unions barely lost. If 50% plus 1 workers vote in favour of the union proposing to organise them, management has to bargain for a collective agreement in good faith with the certified union, if the union loses, management can ignore that union.

Most winning union certification elections resulted in the signing of a collective agreement not long after. Unions who barely win have as good a chance of securing a collective agreement as those unions that win these elections by wide margins.

Importantly, few firms subsequently bargained with a union that just lost the certification election. Employers can choose to recognise a union. Because the vote is so close, a particular workplace becoming unionised was close to a random event.

This closeness of the union certification election may disentangle unionisation from just being coincident with well-paid workplaces, more skilled workers and well-paid industries. Unions could be organising at highly profitable firms that are more likely to grow and pay higher wages independent of any collective bargaining. The unions are possibly claiming credit for wage rises that would have happened anyway.

DiNardo and Lee found only small impacts of unionisation on all outcomes they examined:

  • The estimated changes for wages of unionisation are close to zero.
  • Impacts on survival rates of the unionised business and their profitability were equally tiny.

This evidence of DiNardo and Lee suggests that in recent decades in the USA, requiring an employer to bargain with a certified union has had little impact because unions have been unsuccessful in winning significant wage gains after unionisation. These findings by DiNardo and Lee suggests that there may not be a union wage premium at all since the early 1980s, at least in the USA.

In another paper DiNardo found a substantial union wage premium before the Second World War by studying the share price effects of unionisation. One of the differences back them that there was far more violence associated with strikes.

We find that strikes had large negative effects on industry stock valuation. In addition, longer strikes, violent strikes, strikes won by the union, strikes leading to union recognition, industry-wide strikes, and strikes that led to wage increases affected industry stock prices more negatively than strikes with other characteristics.

New Zealand and U.S. unions are similar in that both are on their own in bargaining with employers for a wage rise. Options for outside arbitration do not exist in New Zealand; there are some forms of compulsory arbitration in the USA. These US result sends a message to New Zealand that unions are a bit of a relic in terms of wage bargaining. MBIE seems to have missed that literature?

In summary, job protection laws reduce wages. For the low paid, they may also reduce employment rates if minimum wage rates are binding. Unions are a dinosaur that do not matter much anymore.

 

Yesteryear’s robots came for many more jobs

PRECARIOUS WORK AS THE FLIP SIDE OF EFFICIENCY WAGES

Efficiency wages were put forward as a cause of what is now called precarious work. The efficiency wage hypothesis breathed considerable new life into the old theory of dual labour markets (Katz 1986; Dickens and Lang 1985).

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The notion of a segmented labour market, of a primary and a secondary labour market, each with distinctly different wage setting mechanisms, was very much a fringe idea prior to the 1980s:

Efficiency wage theory provides a rare common meeting ground for mainstream and radical economists, because the far left in U.S. economics has taken the lead in developing theories of dual labor markets and for setting-out policy proposals for higher minimum wages based on the assumed validity of the efficiency wage approach (Gordon 1990, p. 1157).

The workers privileged enough to hired by firms paying an efficiency wage would enjoy job security, low job quit rates, good working conditions, career advancement, training and higher pay (Akerlof 1982, 1984; Bulow and Summers 1986; Dickens and Lang 1993). The remaining equally productive workers who were unlucky enough to be priced out of these good jobs by the job rationing implicit in an efficiency wage must fend for themselves in a secondary labour market; in precarious work with high quit rates, harsh workplace discipline, few promotions, little training and poor pay (Akerlof 1982, 1984; Katz 1986; Dickens and Lang 1985). Efficiency wages do not motivate greater employee effort unless the prospect of precarious work in this secondary labour market looms large in the back of their minds as their main alternative source of employment for those lucky enough to be employed in the good jobs in the primary labour market (Katz 1986; Bulow and Summers 1986).

Those workers crowded into these bad jobs in the secondary labour market find it to be a slow and difficult process to break into these better paying good jobs in the primary labour market. There are queues for the good jobs because they are paying above-market wages; many of those crowded into the bad jobs are women and minorities (Bulow and Summers 1986; Dickens and Lang 1985, 1993).

Akerlof, in his Nobel Prize lecture on behavioural macroeconomics, contended that the good and bad jobs caused by paying efficiency wages is central to explaining involuntary mass unemployment:

The existence of good jobs and bad jobs makes the concept of involuntary unemployment meaningful: unemployed workers are willing to accept, but cannot obtain, jobs identical to those currently held by workers with identical ability. At the same time, involuntarily unemployed workers may eschew the lower-paying or lower-skilled jobs that are available. The definition of involuntary unemployment implicit in efficiency wage theory accords with the facts and agrees with commonly held perceptions. A meaningful concept of involuntary unemployment constitutes an important first step forward in rebuilding the foundations of Keynesian economics (Akerlof 2002, p. 415).

Living wage activists already doubt that the market can provide steady wages growth and stable employment. Efficiency wages are a leading New Keynesian macroeconomic explanation for that. The living wage movement cannot pick and choose from what the efficiency wage hypothesis says about how well the labour market functions for those who are and are not in efficiency wage jobs.

Living wage activists are unwittingly following a course of action that leads to more job rationing, more precarious work and more unemployment. Those priced out of council jobs by a living wage such as the 17 parking wardens are left to take their chances in the rest of the local labour market. These workers must take bad jobs while queueing for the good jobs in the primary labour market. Instead of being sources of opportunity in their communities, councils through a living wage policy risk becoming drivers of labour market segmentation and the fostering of a precariat.

The fair-wage effort hypothesis is a theory of mass low-skilled unemployment

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Living wage advocates make much of the demoralising effects of pay inequality on workplace productivity. In common with the efficiency wage hypothesis, this is another example of what Nozick (1974) called normative sociology; the study of what the causes of social problems ought to be. Again, living wage activists misconstrue what the fair-wage effort hypothesis was seeking to explain.

The fair-wage effort hypothesis aimed to fill gaps in the efficiency wage hypothesis by explaining why unemployment is so much higher among the lower skilled (Akerlof and Yellen 1988, 1990). Under the fair-wage effort hypothesis, workers slack off if paid less than they think they deserve:

The motivation for the fair wage-effort hypothesis is a simple observation concerning human behavior: when people do not get what they deserve, they try to get even (Akerlof and Yellen 1990, p. 256).

Lazear (1989, 1991) contends that employers too may want greater pay equity to temper over-competitiveness in teams. If pay and promotions in a team are linked to the relative performance of its members, large pay differentials may undermine co-operation and might encourage sabotage:

Very large pay spreads induce high effort, but they also create a work environment in the firm that is not very pleasant… individuals who are competing with one another can either seek to outperform others, or they can contribute to the failure of others. Such incentives can result in collusion (Dye, 1984) or in sabotage (Lazear, 1989). Thus, pay structure must strike a balance between providing incentives for effort and reducing the adverse consequences associated with this kind of industrial politics (Lazear and Shaw 2007, p. 95).

Lazear’s (1989, 1991) theory about the industrial politics arising from pay inequality stressed how sizable rewards to individual members of a team could lead to a lack of team play and lower team output. If the prizes were smaller for superior relative performance, the pay rise after a promotion or the annual performance bonus, there may be more teamwork (Lazear 1989, 1991). Akerlof and Yellen (1990) were correct in their insight that their hypothesis about fair-wage effort applies more to workers on lower wages with fewer chances of moving up promotion ladders and pay scales.

The fair-wage effort hypothesis is but another Keynesian macroeconomic theory of unemployment:

The hypothesis explains the existence of unemployment. Unemployment occurs when the fair wage w* exceeds the market-clearing wage. With natural specifications of the determination of w*, this hypothesis may explain why skill and unemployment are negatively correlated. In addition, it potentially explains wage differentials and labor market segmentation (Akerlof and Yellen 1990, p. 256).

The fair-wage effort hypothesis was developed as a descendant of the efficiency wage hypothesis because the latter cannot explain why wages are high for everyone working in high-paid industries:

All workers in better-paid industries tend to receive positive wage premia. That is, the wages of secretaries and engineers are highly correlated across industries. Ease of supervision and the magnitude of turnover costs might well be correlated across industries for a given occupation explaining, for example, why, say, skilled machinery operators receive positive wage premia in most industries. But there is no obvious reason why, say, secretaries, should be harder to supervise in the chemical industry where pay is high, than in the apparel industry where pay is low (Akerlof and Yellen 1988, p. 44).

The efficiency wage hypothesis also offered “no natural explanation” for why unemployment rates [JC1] are much higher among the lower-skilled (Akerlof and Yellen 1990). Skilled workers are probably more difficult to monitor than the unskilled so their unemployment rates should be higher than for the low-skilled as a worker discipline device but the contrary is the case (Akerlof and Yellen 1990).

The fair-wage effort hypothesis aimed to fill gaps in the efficiency wage theory of unemployment by explaining why low skilled unemployment is much higher both in recessions and in better times. Living wage activists must accept that their demands for workplace pay equity increase low-skilled unemployment under a Keynesian theory which they embrace with considerable enthusiasm.

If high wages are paid to the more skilled to attract the best applicants, demands for pay equity by their less skilled co-workers could price some of them out of the market leading to unemployment (Akerlof and Yellen 1988, 1990). In addition, pay equity norms are unlikely to respond quickly enough to fluctuations in aggregate demand so wages can be too high in recessions causing mass unemployment of the low skilled (Akerlof and Yellen 1988, 1990; Summers 1988). The unemployed cannot successfully offer to work for less than existing workers do in a recession because they cannot make a credible commitment to eschew fairness considerations once hired (Akerlof 2002).

An important premise of New Keynesian macroeconomics is demands for pay equity come at a price. At a price that is high enough for the efficiency wage and fair-wage effort hypotheses to be put as a comprehensive New Keynesian explanations of involuntary mass unemployment (Gordon 1990).

Both the efficiency wage hypothesis and the fair-wage effort hypothesis are attempts to flesh out a theory of extensive labour market dysfunction leading to mass unemployment. Living wage activists are using Keynesian theories of why wages are too high to argue for even higher wages.

An efficiency wage is a theory of persistent mass unemployment

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Shapiro and Stiglitz (1984) first put forward their theory of an efficiency wage to explain large-scale involuntary unemployment. It was the very real threat of a prolonged spell of unemployment (rather than a morale boosting pay rise) that motivated employees to put in more effort to keep their jobs:

To induce the worker not too shirk, the firm attempts to pay more the “going rate”; then, if the worker is caught shirking and is fired, he will pay a penalty. If it pays one firm to raise its wage, it pays all firms to raise their wages. When they all raise their wages, the incentive to shirk again disappears. But as all firms raise their wages, the demand for labour decreases, and unemployment results. With unemployment, even if all firms pay the same wage, a worker has an incentive not to shirk. For, if he is fired, an individual will not immediately obtain another job. The equilibrium unemployment rate must be sufficiently large that it pays the workers to work rather than take the risk of being caught shirking (Shapiro and Stiglitz 1984, p. 435).

The unemployed offer to work for less pay than existing employees but they are not hired because their labour productivity is not assured at this lower pay (Akerlof 1982, 1984; Katz 1986, 1988; Yellen 1984). There is involuntary mass unemployment because of the prevalence of efficiency wages:

If there is involuntary unemployment in an equilibrium situation, it must be that firms, for some reason or other, wish to pay more than the market-clearing wage. And that is the heart of any efficiency-wage theory (Akerlof 1984, p. 79).

Direct parallels were quickly drawn between the efficiency wage hypothesis as a worker discipline device eliciting greater effort and the old Marxist concept of the reserve army of the unemployed:

… it pays each firm to increase its wage to eliminate shirking. When all firms do this, the average wage rises and employment is reduced. In equilibrium, all firms pay a wage above the market clearing level, creating unemployment. Since jobs are scarce and rationed, the loss of a job can involve a lengthy spell of unemployment. The reserve army of the unemployed acts as a discipline device making shirking costly (Katz 1986, pp. 240-41).

It is misconceived for living wage activists to use a theory of lengthy unemployment to justify a large living wage rise but argue that there will be little unemployment because of the efficiency wage effects. This is the exact opposite of what the efficiency wage hypothesis is about. The leading Keynesian macroeconomists of their generation were striving to explain mass unemployment:

… the economists who developed the theory of efficiency wages (including Shapiro and Stiglitz, Akerlof and Yellen and Yellen) had no illusions that they were helping business firms to discover a new way to increase profits. The economists who developed efficiency wage theory were trying to explain persistent unemployment. Hence the title of Janet Yellen’s famous survey, Efficiency Wage Models of Unemployment.

The question that motivated efficiency wage theory was not why firms should raise wages but why firms don’t cut wages when they should. The answer they gave was that firms don’t cut wages despite unemployment because they fear that workers will respond to lower wages with reduced productivity …

In the original efficiency wage literature, there is no wishful thinking–no idea that we can have more of everything that we want without trade-offs. Instead of being desirable, the efficiency wage is a problem because lower wages would reduce unemployment and be better for the economy … the efficiency wage theorists took it for granted that to the extent that firms can increase profits by raising wages they have already done so (hence the persistent unemployment) (Tabarrok 2015).

Gordon was blunt about why efficiency wage arguments were popular and with whom

If any development in the microeconomics of labor markets could be called the “rage of the 80s,” it is efficiency wage theory, based on the hypothesis that worker productivity depends on the level of the real wage. When there is such a link between the wage rate and worker efficiency, firms may rationally pay a real wage rate that exceeds the market-clearing level. Firms may refuse to reduce the wage to hire members of a pool of unemployed workers who may be available at a lower wage, fearful that a reduction in real wages for existing workers may reduce productivity by more than the gain in lower wages (Gordon 1990, p. 1157).

Living wage activists have it the wrong way around about the social benefits of paying an efficiency wage. The efficiency wage hypothesis is a theory of why wages are too high and employment is too low (Akerlof 1982, 1984, 2002; Yellen 1984; Katz 1986, 1988; Stiglitz 2002). Living wage activists are using a well-respected theory of why wages are too high to argue that wages are too low.

The compassion of unions towards the minimum waged

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Source: page 451 and page 828 of the 3rd edition (1972) of University Economics by Armen Alchian and William Allen; the first part of the quotation is Question #30 at the end of Chapter 22. via Bonus Quotation of the Day… – Cafe Hayek

Robert Lucas on the voluntary and involuntary unemployment distinction

Robert Lucas in a famous 1978 paper argued that all unemployment was voluntary because involuntary unemployment was a meaningless concept:

“The worker who loses a good job in prosperous time does not volunteer to be in this situation: he has suffered a capital loss. Similarly, the firm which loses an experienced employee in depressed times suffers an undesirable capital loss.

Nevertheless the unemployed worker at any time can always find some job at once, and a firm can always fill a vacancy instantaneously. That neither typically does so by choice is not difficult to understand given the quality of the jobs and the employees which are easiest to find.

Thus there is an involuntary element in all unemployment, in the sense that no one chooses bad luck over good; there is also a voluntary element in all unemployment, in the sense that however miserable one’s current work options, one can always choose to accept them.”

I agree that we all make choices subject to constraints. To say that a choice is involuntary because it is constrained by a scarcity of job-opportunities information is to say that choices are involuntary because there is scarcity. Alchian said there are always plenty of jobs because to suppose the contrary suggests that scarcity has been abolished.

Lucas elaborated further in 1987 in Models of Business Cycles:

A theory that does deal successfully with unemployment needs to address two quite distinct problems. One is the fact that job separations tend to take the form of unilateral decisions – a worker quits, or is laid off or fired – in which negotiations over wage rates play no explicit role.

The second is that workers who lose jobs, for whatever reason, typically pass through a period of unemployment instead of taking temporary work on the ‘spot’ labour market jobs that are readily available in any economy.

Of these, the second seems to me much the more important: it does not ‘explain’ why someone is unemployed to explain why he does not have a job with company X. After all, most employed people do not have jobs with company X either. To explain why people allocate time to a particular activity – like unemployment – we need to know why they prefer it to all other available activities: to say that I am allergic to strawberries does not ‘explain’ why I drink coffee.

Neither of these puzzles is easy to understand within a Walrasian framework, and it would be good to understand both of them better, but I suggest we begin by focusing on the second of the two.