September 5, 2014
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:
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.
This article originally appeared at Casey Mulligan’s blog, Supply and Demand (in that order)