The field of labor economics is involved with the study of the labor market, including the determinants of employment, unemployment, and wages. The labor market developed as societies moved from feudal to capitalist processes. The development of capitalism in turn led to powerful capitalist owners and an industrial workforce that was concentrated in factories. Conditions of work became, by present Western standards, dirty, demanding, and dangerous. As a result, workers organized unions and began to demand better pay and working conditions, and they set up political organizations like the Labour Party in the United Kingdom. Over the years, organized labor managed to achieve many of their goals, as legislation was introduced in many countries to provide minimum wages, poverty relief, unemployment benefits, and pensions, and to ensure safe working conditions.
The labor market consists of employers, workers, and a government that provides an institutional and legal framework. The distinctive features of labor as a commodity are: (1) except for a slave society, people can only buy and sell labor services; (2) the quality of the labor services provided depends not only on the innate ability of the workers but also on their attitudes to work, to their fellow workers, and to their employers; (3) most employment contracts last for a fairly long time, so there are not frequent repeat purchases of this “commodity”; (4) there is asymmetric information in the labor market about the “quality” of labor services; and, (5) there is an unequal power relationship in the labor market.
Labor markets are different from other markets. As Arthur Okun points out in Prices and Quantities (1981), they are not auction markets that clear instantaneously, but are influenced by “custom and practice.” For example, firing is usually based on last in, first out, and seniority is often given special privileges. There are many interrelated labor markets, differentiated by geography, occupation, industry, and often by gender and race. Analyses of segmented labor markets (primary and secondary markets) provide an interesting window into the role of “power” in labor markets, as demonstrated in the work of Peter Doeringer and Michael Piore (1971). Robert Solow, meanwhile, has emphasized the idea that the labor market is a social institution, and that it is therefore important to consider issues of equity and fairness in labor markets (1990). The labor market is different from other markets because the commodity being traded (labor) is capable of reasoned thought. Hence, the way employers treat workers, and the way other workers treat each other, influences their behavior and productivity, as well as wages.
Labor economics was once an interdisciplinary (institutionalist) study that included historical analysis, industrial relations, sociology, and political science. In the early literature, Adam Smith, David Ricardo, and Karl Marx employed versions of the labor theory of value, which states that the determinant of the value of a commodity is the amount of labor embodied in it. Marx pointed to the “exploitation” of labor, believing that workers produced “surplus value.” Subsequently, at some point in the post-World War II era, labor economics became a narrow economics subdiscipline in terms of methodology that used neoclassical economic theory (assumptions of maximizing behavior in atomistic, mainly, competitive markets) to analyze various aspects of the labor market, including aspects of employment, unemployment, wages, gender and race discrimination, and immigration. It expanded its boundaries in terms of subject matter, exploring areas of demography, crime, health, marriage, and social relationships (“economics imperialism”) under the guidance of the Nobel Prize-winning economist Gary Becker.
Econometric methods have been used on time-series, cross-section, and panel or longitudinal data to study labor economics and the evaluation of government policies on the labor market. Thus, under the influence of another Nobel Prize-winning economist, George Akerlof, modern labor economics has moved full circle—it now studies labor markets in an interdisciplinary framework (although with formal economic models) that includes concepts of psychology, anthropology, industrial relations, and management theory. Modern labor economics has developed new econometric methods to analyze social safety policies by using controlled experiments, “matching” techniques, and panel estimation techniques with fixed and random effects. Since the mid-1990s, labor economics has embraced “experimental economics” methods devised by innovative economists such as Ernst Fehr and Simon Gächter (2000). In these studies, the concepts of fairness, reciprocity, and equity in the labor market are investigated.
The Great Depression of the 1930s led to studies of unemployment, including long-term unemployment, the impact of unemployment on society, and human degradation caused by unemployment. Much work was done to explain the massive rise of unemployment in terms of “rigid wages” (classical economics), and of inadequate aggregate demand (Keynesian economics). The big increase in unemployment following the “oil shocks” of the 1970s led to theories of “stagflation.” Subsequently, explanations of unemployment pointed to imperfectly functioning markets, with regulated labor market institutions being blamed. Theories then moved on to using concepts of search in a labor market with imperfect information, as described by Edmund Phelps (1970) and Dale Mortenson and Christopher Pissarides (1999). In these models workers are looking for a job when they receive wage offers which follow a normal distribution; some are good and some are bad. They have to decide whether to accept the offer or reject it. If they reject the offer, they are unable to return to it if the subsequent offers are worse.
The rise of rational expectations led to the concept of the “natural rate of unemployment” (Friedman 1968), and to a Keynesian variant, the non-accelerating inflation rate of unemployment (NAIRU), which was supposed to be constant and immutable. However, econometric work has found this concept to be ill-defined and poorly estimated. More important, it was found that there is “hysteresis” in the behavior of unemployment and in the so-called natural rate. The current rate of unemployment depends on the past evolution of the unemployment rate. Hence the “natural rate” is not a constant to which the unemployment rate will gravitate.
Much has been made about the role of “monopolistic” unions in raising wages above market-clearing wages and causing unemployment. Several studies have compared the differences between the wages of union and nonunion members. In an important book published in 1984, Richard Freeman and James Medoff argued that unions have a positive impact on the functioning of labor markets.
The post-1960s literature on labor economics moved from macroeconomic analyses of labor markets and industry-level studies to the study of microeconomics (on a firm and individual/household level) of the demand and supply of labor. The development of the human capital approach to analyzing the investments of rational maximizing individuals in education and skills, as outlined by Gary Becker in Human Capital (1964), led to a better understanding of labor supply. Given that investment in human capital is irreversible, work done in the 1990s treated the acquisition of skills as an “investment option” under uncertainty.
The growth of computer usage, and the subsequent development of large data sets, has led to an explosion of econometric analyses. Most of the research to explain wage rates (or earnings) has used earnings functions. Thus, the logarithm of wages (earnings) was explained by human capital, work experience, and various other control variables. Although most studies have found human capital variables to be significant, the explanatory power of these equations is very low. Yet the role of human capital in explaining economic growth has had important policy implications. Minimum wage policies have been analyzed to see if they have helped the poor and led to a fall in employment. David Card and Alan Kreuger’s 1995 critical analysis of the data for the United States suggested that minimum wages had little impact on unemployment. This conclusion led to a huge controversy that has continued into the early twenty-first century. The re-introduction of minimum wages in the United Kingdom in 1998 was found by Alan Manning (using monopsonistic models in 2003) to have had no significant impact on employment.
There have been significant advances in the study of the determinants of labor supply and demand using modern econometric techniques and panel data. In studies of labor supply, individuals are assumed to maximize lifetime utility, subject to given budget and time constraints, where they choose an optimal amount of education, work, and leisure. Tax and welfare policies are studied in this framework and have important implications for the policy analysis of negative income taxes and social security benefits. Labor demand is studied for firms that maximize present values of profits by choosing optimal amounts of labor. Labor is treated by firms as a “quasi-fixed” input, according to Walter Oi (1962), and it is analogous to investing in physical capital goods. Advanced studies suggest that firms choose wages to maximize the efficiency of labor (Akerlof and Yellen 1986), or else choose an appropriate sequence of wages to maximize present values (Lazear 1995).
Labor economics has made significant theoretical and empirical strides in understanding the workings of labor markets. Econometric analyses of various tax, welfare, and active labor-market policies have helped to develop new policies for improving the functioning of the labor market and helping the unemployed and the poorer segments of society. However, there is still much work to be done to truly understand the nature of unemployment and poverty.
SEE ALSO Demography; Economics, Neoclassical; Employment; Human Capital; Information, Asymmetric; Labor; Labor Demand; Labor Force Participation; Labor Market; Labor Market Segmentation; Labor Supply; Labor Union; Labor, Marginal Product of; Labour Party (Britain); Marginal Productivity; Marx, Karl; Minimum Wage; Ricardo, David; Slavery; Smith, Adam; Solow, Robert M.; Surplus Value; Unemployable; Unemployment; Unemployment Rate; Unions; Wages; Wages, Compensating
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P. N. Junankar