Econ 101 theory of labour markets — not very scientific

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Lars Pålsson Syll
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Econ 101 theory of labour markets — not very scientific

OK, so what are some empirical things we know about labor markets? Here are two stylized facts that, while not completely uncontroversial, are pretty one-sided in the literature:

1. A surge of immigration does not have a big immediate negative impact on wages.

2. Modest minimum wage hikes do not have a big immediate negative impact on employment.

The first fact alone does not falsify the Econ 101 theory of labor markets. It could be the case that short-run labor demand is simply very elastic …

BUT, this is impossible to reconcile with the second stylized fact. If labor demand is very elastic, minimum wage should have big noticeable negative effects on employment:

By the same token, if you try to explain the second stylized fact by making both labor supply and demand very inelastic, then you contradict the first stylized fact. You just can’t explain both of these facts at the same time with this theory. It cannot be done.

So the Econ 101 theory of labor supply and labor demand has been falsified. It’s just not a useful theory for explaining labor markets in the short term (the long term might be a different story). It’s not a good approximation. It doesn’t give good qualitative intuition. And it’s especially bad for explaining the market for low-wage labor, which is the market that most of the aforementioned studies concentrate on.

What is a better theory of the labor market? Maybe general equilibrium. Maybe search and matching theory. Maybe a theory with very heterogeneous types of labor. Maybe something else.

But this theory, this simple Econ 101 short-run partial-equilibrium price theory of undifferentiated labor, has been falsified. If econ pundits, policy advisors, and other public-facing econ folks were scientifically minded, we’d stop using this model in our discussions of labor markets. We’d stop casually throwing out terms like “labor demand” without first thinking very carefully about how that concept should be applied. We’d stop using this framework to think about other policies, like overtime rules, that might affect the labor market.

Sadly, though, I bet that we will not. We will continue using this falsified theory to “organize our thoughts” – i.e., we’ll keep treating it as if it were true. So we will continue to make highly questionable policy recommendations. The fact that this theory is such a simple, clear, well-understood tool – so good for “organizing our thinking”, even if it doesn’t match reality – will keep it in use long after its sell-by date. That’s what James Kwak calls “economism”, and I call “101ism”. Whatever it’s called, it’s not very scientific.

Noah Smith

Lovely to see that at least some mainstream economists have the courage and intellectual guts to admit that they have been wrong.

But — sad to say — many economists will probably continue to peddle their falsified theories. It’s hard to kill your darlings …

The inverse relationship between quantity demanded and price is the core proposition in economic science, which embodies the pre-supposition that human choice behavior is sufficiently rational to allow predictions to be made. Just as no physicist would claim that “water runs uphill,” no self-respecting economist would claim that increases in the minimum wage increase employment. Such a claim, if seriously advanced, becomes equivalent to a denial that there is even minimal scientific content in economics, and that, in consequence, economists can do nothing but write as advocates for ideological interests. Fortunately, only a handful of economists are willing to throw over the teaching of two centuries; we have not yet become a bevy of camp-following whores.

James M. Buchanan in Wall Street Journal (April 25, 1996)