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12/7/96
The field of labour economics has long been disputed territory. On one side, there is a tradition of labour economics that rejects the idea that something as central to people's lives as labour can be analysed in an economic framework based on trade in inanimate goods. On the other is the Chicago tradition in which the logic of the market is paramount. The tools of standard economic analysis are now routinely applied to the operations of labour markets. In the process, however, the nature of economic analysis has changed. In place of the purely neoclassical interaction between supply and demand, modern economic analysis stresses the role of information asymmetries, strategic interaction and multiple equilibria, thereby creating a role for the concerns of traditional labour economics. These point are illustrated by a comparison of the market for tomatoes and the market for labour.
The field of labour economics has long been disputed territory. On one side, there is a tradition of labour economics that rejects the idea that something as central to people's lives as labour can be analysed in an economic framework based on trade in inanimate goods. In this tradition considerable stress is placed on conflict and consensus and on the role of customs and institutions. On the other is the Chicago tradition in which the logic of the market is paramount. Whatever institutions are established, and whatever customs may exist, it is argued, the inexorable forces of supply and demand will determine the outcome.
Surveying the theoretical developments of the past twenty years suggests that the Chicago tradition has been victorious. However, it has been something of a Pyrrhic victory. The tools of standard economic analysis are now routinely applied to the operations of labour markets. In the process, however, the nature of economic analysis has changed. In place of the purely neoclassical interaction between supply and demand, modern economic analysis stresses the role of information asymmetries, strategic interaction and multiple equilibria, thereby creating a role for the concerns of traditional labour economics.
These theoretical concerns relate directly to the most important economic and social policy issue in Australia today, the persistence of large-scale unemployment. A simple textbook analysis in the Chicago tradition would suggest that high unemployment can persist only if some form of monopoly or government intervention holds prices (in this case, wages) above their market-clearing level. Modern labour market theory suggests that the issues are more complex.
Are tomato markets in reality like tomato markets in textbooks ?
Before looking at labour markets, it's worth thinking a bit about fruit and vegetable markets. Fruit and vegetable markets resemble the product markets in a simple economic model in many ways. There are large numbers of buyers and sellers, prices are posted or called out, and prices adjust to clear the market. Nevertheless, the actual market for tomatoes differs from the textbook competitive market in many ways. To mix metaphors, many actual markets resemble Akerlof's (1970) market for 'lemons' more than a textbook market for goods.
Consumers want a good quality, ripe, undamaged tomato. The easiest way of estimating the quality of the fruit is to look for a tomato with a deep red colour and no obvious blemishes or bruising. The incentive this transmits to producers is to produce a robust tomato with a red colour, not necessarily a tomato that tastes good. Such a tomato can be picked and transported mechanically without suffering obvious damage. If the characteristics of the tomatoes change gradually enough, consumers may be very slow to realise what is going on. The result may easily be a Pareto-inferior equilibrium in which tomatoes look good but taste awful.
Of course, it is easy to point to a problem than to recommend a solution. It may be that, although consumers remember the tomatoes of the past with fondness, they would not in fact be willing to pay the extra costs associated with transporting them, preferring the cheap and robust, if unappetising, commodity on offer today. Even if the market equilibrium is Pareto-inferior, it is not obvious that government intervention could remedy the situation at low cost. Furthermore, the problem may be self-correcting in the long run. Eventually the divergence between the actual quality and the desired quality may become so great that it is worthwhile for a producer to invest in a reputation for good-quality tomatoes and charge a corresponding premium. The market will then jump to the Pareto-superior equilibrium where quality is kept high.
Problems of this kind have been examined using the concepts of signalling (Spence 1976) and adverse selection (Laffont 1980). In these models, the seller of a good or service has better information about its quality than the buyer. Sellers of low quality goods have an incentive to send out signals, such as red skin color for tomatoes, implying that their goods are of high quality. The only signals that can work reliably are signals that are more costly for low quality suppliers to generate than for high quality suppliers. For example, high tomato quality might be signalled by expensive packing. Since low quality tomatoes are very robust, the net benefit of expensive packing is greater for the more fragile high quality tomatoes. In some cases, it is the buyer rather than the seller who has private information. Insurance and loan markets provide examples. High-risk policyholders and borrowers will attempt to present themselves as low-risk and therefore eligible for insurance policies or loan contracts (Spence and Zeckhauser 1971).
In the absence of a method of discriminating between different quality levels, suppliers of low quality goods will be more willing to offer their goods at any given price than suppliers of high quality goods. The corresponding problem in the case of insurance is referred to as 'adverse selection.' In many cases of adverse selection, high quality goods will be driven from the market. This phenomenon was first noted as Gresham's law, that 'bad money drives out good'. If there is a wide range of possible quality variation, the market may disappear or fail to exist, because goods of any possible quality level could be driven out by lower quality substitutes. Alternatively there may exist multiple equilibria.
Information problems like that those that consumers face in estimating the quality of tomatoes mean that, even in markets for relatively simple commodities, the predictions of standard neoclassical theory may not be satisfied. In particular, competitive markets may not generate a Pareto-optimal outcome.
Partial equilibrium and general equilibrium
The basic neoclassical approach disregards questions of asymmetric information and (implicit) missing markets such as those discussed in the example above. It is useful to distinguish between general equilibrium analysis in which we analyse all markets simultaneously, with the endowments and preferences of households and the technology sets of firms taken as given, and partial equilibrium analysis, in which the existence of well-defined supply and demand curves for individual commodities is assumed.
For most of the questions we would like to answer about tomatoes markets, partial equilibrium analysis gives a fairly good answer. If we want to know the effect of a tomato sales tax on the quantity of tomatoes produced and consumed, it is reasonable to draw demand and supply curves, and trace the impact of the shift in supply associated with a tax. A 'general equilibrium' perspective is necessary only when we wish to make inferences about impacts on other markets. For example, if someone claimed that a subsidy on tomato production would be beneficial because it would create jobs in the tomato-growing and processing sectors, it would be necessary to point out that the benefits to the tomato industry would be offset by losses in other industries. However, this is not a question of general equilibrium versus partial equilibrium analysis but a distinction between correct and incorrect general equilibrium analysis.
A partial equilibrium approach may also be applied to welfare analysis. Consider a policy, such as the removal of a distorting tax, that would lead to a redistribution of income between producers and consumers in the tomato industry, with a positive net gain. Provided the deadweight cost of the tax revenue that would be necessary to compensate the losers is less than the net gain from the policy, this policy generates a potential Pareto-improvement. All governments regardless of their income distributional preferences should be willing to adopt it.
In analysing labour markets, however, a partial equilibrium analysis is inadequate. The basic problem is that whereas the tomato market is are 'small' relative to the total economy, the labour market is large. Two-thirds of total factor income goes to labour. This fact undermines the ceteris paribus assumptions on which partial equilibrium analysis is based. Consider for example, the impact of an exogenous reduction in real wages for lower-paid workers. On the basis of partial equilibrium analysis one would expect this to lead to an increase in demand for the services of those workers. However, it is necessary to take account of income effects. The reduction in wages implies a redistribution of income towards managers and owners of capital, who usually have a high income elasticity of demand for the services of skilled workers and for imported luxury items. These income effects may outweigh the direct effect of the wage reduction in increasing demand for low-paid low-skilled workers.
On the other hand, general equilibrium effects could amplify the effects predicted on the basis of partial equilibrium analysis. A slightly more complex example is that of the very large wage increases for women in 1974, associated with equal pay. A partial equilibrium analysis would suggest that these increases should reduce the demand for female labour but, ceteris paribus, increase the demand for male labour. It has been argued, however, that the general profit-squeeze effect was so dominant that equal pay for women reduced the demand for male labour.
The importance of labour in general equilibrium is related to the empirical observation that one of the staple assumptions of partial equilibrium analysis, that of the upward-sloping supply curve, is frequently not satisfied in labour markets. A partial equilibrium intuition which does carry over to the general equilibrium case is that, in such circumstances, multiple equilibria are likely to exist.
Partial equilibrium approaches are also inadequate for welfare analysis of labour markets. Labour income is so large in relation to total output that there is, in general, no feasible method of compensating the losers for the impacts of policies involving substantial shifts in the demand for labour. The suggestion that the distributional effects of such shifts will wash out in the long run appears to be based more on wishful thinking than on any serious analysis. Hence, alternative labour market policies are unlikely, in general, to be Pareto-comparable.
Let us now consider the implications of all of this for wages policy at the aggregate level. Partial equilibrium analysis suggests that the underlying cause of unemployment is excessive real wages, and that the appropriate response is to reduce real wages. General equilibrium considerations regarding profitability effects and the demand effects of income redistribution lead us to qualify this conclusion, but not necessarily to overturn it. Even when all these factors are taken into account, it seems reasonable to conclude that lower wages will, on average, be associated with higher levels of demand for labour. However, the relationship is likely to be much weaker, and more uncertain, than the relationship between the price of tomatoes and the existence of an excess supply of tomatoes. The recent debate over the impact of US minimum wage laws illustrates this point. Although the econometric issues remain undecided, a number of recent studies suggest that increases in the US minimum wage have had no net impact on employment. However, if the issue were as clear-cut as a partial equilibrium analysis would suggest, there would be no need for a complex econometric debate.
Even if a negative relationship between real wages and employment exists, the analysis presented above suggests that the elasticity of employment in response to changes in wages is likely to be low. The conclusion of empirical studies, such as that by Gregory (), suggesting that a real wage cut of 30 per cent, or even more, would be required to restore full employment is not surprising. The low-wage, high hours, high employment equilibrium associated with such a cut (if it were feasible) would not be Pareto-comparable with our current situation, nor would there exist any set of tax and welfare policies that would compensate the losers. In particular, over the medium-term, the reduction in the frequency of unemployment would not be sufficient to compensate low-wage workers for the reduction in real wages experienced under such a policy.
A more general policy implication is that there is no basis for proposing a separation of targets and instruments, in which some policy instruments are applied without regard for their employment implications with other targets being specifically directed towards improving employment. Like the widespread use of a distinction between efficiency and equity instruments, such an approach is unsound both in theory (Quiggin 1995) and in practice.
Non-neoclassical theories and the operation of labour markets
Even in a world of neoclassical general equilibrium, results derived from partial equilibrium supply and demand analysis are a poor guide to the behavior of labour markets. We have already seen, because information is not perfect, even simple markets, such as the market for tomatoes, differ in important ways from the neoclassical ideal. The importance of these differences is magnified in the case of labour markets. Here, sellers are supplying their own labour services rather than a physical commodity. The presumption that they are better informed than the buyers about the quality of those services, that is, about their own abilities and attitudes is overwhelming.
The non-neoclassical character of labour markets has been examined in a number of different frameworks and research programs. Three of the most important are efficiency wage theories, the theory on contracting and hierarchies, and X-efficiency theories.
Efficiency wage theories
Efficiency wage theories have developed to explain two puzzling observations in labour markets. First, some firms appear to pay higher wages than others for apparently identical workers. In particular, large firms appear to pay more than small firms. Second, workers who appear to have reservation wages below the market wage for a given occupation remain unemployed even though other, apparently identical workers are earning the market wage. In both cases, a neoclassical model would suggest that the employers could impose wage cuts, if necessary replacing their current workers with outsiders willing to work for less.
The original efficiency wage literature related to labourers in less developed countries. Here the idea was that the wage needed to be high enough to permit workers to gain adequate nutrition, and therefore put forth the optimal level of effort. In the more recent literature on efficiency wages in developed countries (Akerlof 1984; Greenwald and Stiglitz 1988; Stiglitz 1985; Yellen 1984), the underlying idea of paying high wages in order to elicit high effort levels is retained, but the primary focus is on information and incentives.
To illustrate the modern version of the efficiency wage idea suppose that a risk-neutral employer hires a risk-averse worker, to undertake a task. There is uncertainty in the outcome of the worker's efforts. This may be represented by the occurrence of one of two states of nature 'Good' and 'Bad'. The worker can allocate his effort so as to determine the output in the two states of nature, but it is more costly to increase effort in the Bad state than in the Good state. If the employer could observe the state of nature and/or the worker's effort level, it would be possible to sign a fixed-wage contract in which the worker put forward the optimal level of effort, produced the optimal state-contingent output and received his reservation utility level. A situation where the worker received more than his reservation utility would be inconsistent with profit-maximisation by the employer.
In the efficiency wage literature, however, it is assumed that the employer cannot observe effort, but only the output level. Faced with a fixed wage contract, then, the worker would have an incentive to shirk, putting forward a low level of effort and reporting the occurrence of the bad state of nature to explain the low level of output. If the worker were risk-neutral, and there were no constraints on the set of payments the employer could make, the optimum response would be a piece-rate contract.
In practice however, these conditions are not satisfied. In particular, even where there does not exist a legislated minimum wage, there is a lower bound to the feasible set of wages that may be paid in the bad state of nature. The employer may be able to dismiss the worker without pay but she will not in general be able to make the worker compensate her for all losses incurred in the bad state.
In these circumstances, the optimal second-best contract may allow the worker to receive more than reservation utility. The intuition is that it is more important for the employer to give incentives for high output than it is to pay the minimum amount for which the worker would sign on. This intuition may be pushed further when we think about the contract being extended in time. If the penalty for excessively low output is dismissal, the worker will be motivated to put forward high levels of effort if the wage for the job in question is more than he could get in the outside labour market.
The likelihood of such an outcome is greater, the greater is the difficulty of monitoring and the greater is the cost to the employer of bad outcomes. These conditions seem more likely to be satisfied in large enterprises than in small ones, and for capital-intensive as opposed to labour-intensive enterprises.
Long-term contracts
Our understanding of the contractual structure of firms and other hierarchical organisation has been greatly enhanced by the observation, due to Coase (1937), but developed most in recent years by Williamson (1975, 1981) that the firm is a nexus of contracts, and contracts are alternatives to markets. Hence the fact that most hiring of labour goes on within firms rather than in markets is important to understanding why labour is special. Indeed, the boundary between the firm and the market may be seen as the boundary between labour (defined in the broadest possible way as the exertion of human capacity) and goods. In any situation where the product of labour is an unambiguously defined good or service with a known market price, the return to labour is uniquely determined by the market price. In this situation there is no need for the production of the good or service to be integrated with the activities of any other enterprise. Any firm can buy the good (or contract out the provision of the service) in the market.
In any long-term relationship one or both parties must make investments that are specific to the relationship. Once such an investment has been made, the relationship between the parties takes on an element of bilateral monopoly. The division of the surplus (relative to the situation where the relationship is terminated) is a bargaining problem. The vital employee may threaten to leave unless she receives payments equivalent to the whole of the surplus. Conversely, the employer may demand that employees accept wages no higher than the next-best alternative (which will normally have been reduced by the time spent in acquiring firm-specific skills). The way in which the parties anticipate this bargaining problem will be resolved will determine their ex ante willingness to engage in firm-specific investments. Thus, it is desirable for both parties to commit themselves in advance to an agreed partition of the benefits. The problem is that, in general, it will be difficult to make a credible and binding commitment.
For example, employers wishing workers to invest in firm-specific skills may promise to pay them above-market wages. But once the investment has been made, the employee is in a weak bargaining position. The problem is further complicated if the employee also has private information (for example, concerning her ability or motivation).
Various devices may be used to overcome these commitment difficulties. For example, a lifetime employment policy, or a Last On, First Off retrenchment policy would in general appear to be efficient but they reduce the employer's ability to renege on implicit contracts. In most long-term contractual arrangements, workers will not be paid their current marginal product, but rather a wage which takes into account past and expected future performance.
The effectiveness of such commitment devices depends on the economic environment. Unpredicted changes in economic conditions may enhance the incentives and ability of one or other of the parties to repudiate implicit (or even explicit) contracts. For example, a sustained economic downturn leads employers to value the capacity to dismiss existing staff at will more than the ability to induce new workers to undertake firm-specific investments. In these circumstances, employers may collectively lobby for legislative devices, or may individually resort to devices such as takeovers or (particularly in the United States) bankruptcy to void long-term contracts. In buoyant economic conditions, the boot is on the other foot. Unions will favour unrestricted open market bargaining, and will seek to eliminate implicit or explicit contractual obstacles.
It is very difficult to determine ex ante the desirable degree of flexibility in adherence to long-term contracts of this kind. The issues go to the heart of the dispute between Posner, Buchanan and others regarding the nature of property rights. It is even more difficult at any point in historical times, with a large variety of existing contractual arrangements, to determine how, if at all, policy should be changed in response to changing circumstances.
For example, it seems unlikely that the Japanese lifetime employment system, in its present form, can be sustained indefinitely. The system is really only feasible against a background of strong long-term economic growth. But whether it would be preferable to repudiate the system outright, to 'grandfather' existing employees, or to seek to make the system more flexible without fundamentally changing it is very difficult to tell. The answer will certainly involve both social and economic considerations. Similar considerations apply to labour market reform in Australia.
Dynamic effects and X-efficiency
The view that labour is special is not held only by advocates of intervention. A common theme in advocacy of microeconomic reform is the idea that, in addition to the (relatively modest) benefits that general equilibrium models suggest may be attained as a result of, say, tariff reform or the elimination of monopoly, there are much larger dynamic gains. It is argued that, once enterprises are opened up to competition, they will respond by eliminating internal inefficiencies. This argument may be seen as a version of Liebenstein's (1966) X-efficiency hypothesis. Although X-efficiency ideas have been influential at an informal level, they have had little theoretical development since the publication of Liebenstein's original article. Some possible ways in which the idea may be made more rigorous are therefore suggested.
The X-efficiency idea is necessarily an idea about labour markets. The prospect of scrappage cannot make an engine work more efficiently or a ton of iron ore yield more steel. Hence, if the X-efficiency hypothesis is to be made explicit, it must represent a claim that labour markets work more efficiently when product markets are competitive. There seems to be plenty of anecdotal experience, arising for example from the experience of tariff reform in the manufacturing sector to support the idea that the pressure of external competition may lead to a breakdown in internal rigidities and an improvement in efficiency.
To pursue this idea a little further, suppose that there are two possible contracts, one of which involves considerable dissipation of resources in the process of dividing the associated rent and one of which does not. In a situation of limited competition and high profits, both contracts are consistent with the continued existence of the firm. When competition becomes more stringent, the second contract is sustainable but the first is not. The X-efficiency argument might then be reformulated as saying that, under competition, firms with inefficient internal equilibria will be winnowed out.
The idea of X-efficiency has been criticised by neoclassical writers such as Stigler (1976). Stigler argues that what is represented as a gain in X-efficiency is in fact simply an increase in the intensity of labour or, equivalently, a reduction in on-the-job leisure. At an empirical level, Stigler's critique has a great deal of force. In many of the recent cases where labour productivity has increased following competitive reforms, it is easy to produce evidence of increased work intensity. Even where formal evidence is not available the connection between reform and increased work intensity has become part of our common-sense knowledge.
However, this merely shows that claims of increased X-efficiency in any particular instance should be assessed sceptically. To refute the X-efficiency hypothesis at a general level on the basis of Stigler's argument it is necessary to show that the labour market for a particular enterprise has a unique equilibrium. If this is true then changes in external conditions will flow through to changes in the derived demand for labour and therefore to the equilibrium contract, but there will be no X-efficiency gain. On the other hand, if there are multiple equilibria, it is entirely plausible that an external shock might lead to a jump from a Pareto-inferior to a Pareto-superior equilibrium, corresponding to a gain in X-efficiency. It seems equally possible, however, that a shock might generate a jump in the other direction, moving to a Pareto-inferior equilibrium and worsening the prospects for survival of the enterprise.
The claim that competition enhances efficiency is more problematic than is often recognised. In particular, it is important to note that this claim embodies a rejection of neoclassical partial equilibrium analysis and of the comparative static propositions it generates. For example, if firms a forced to achieve increased efficiency by being exposed to import competition, it would appear that gains could also be obtained by imposing taxes or other cost burdens on domestic producers, thereby forcing them to be even better than their competitors.
Implications for industrial relations policy
Consider first the implications of the analysis presented above for issues such as the desirability or otherwise of minimum wages and working conditions, the attitude of governments towards trade unions and the involvement of governments and courts in determining aggregate wage outcomes. The terms 'industrial relations policy' and 'labour market reform' are widely used as code for competing policy positions in this area. A more neutral term might be 'institutional labour market policy'.
The main implication to be drawn from the analysis presented above is that it is difficult to determine in advance what labour market outcome would be generated by any given set of institutions, let alone what the optimal outcome would be or what institutions would achieve it. Advocates of arbitration assumed that it would lead to the elimination of industrial disputes, or at least to a great reduction in their frequency. In fact, arbitration merely changed the setting within which industrial disputes took place. Advocates of labour market reform have assumed that it would lead to large reductions in unemployment, but the experience of the United States and more recently New Zealand is not very encouraging.
To the limited extent that the United States has experienced lower unemployment than other OECD countries, it appears to be the produce of an extremely tight welfare system, which leaves unemployed men few alternatives other than crime, beggary or starvation, rather than of the efficient workings of its labour market. Although it is too early to tell for sure about the New Zealand experiment, similar comments appear to be applicable there. On the positive side, few economists predicted the successes of the Prices and Incomes Accord and even today, it is difficult to explain why this policy succeeded (at least in its own terms) where other similar policies have so frequently failed.
Implications for unemployment policy
Unemployment is the biggest problem facing Australia today. The social loss associated with large-scale unemployment (including hidden unemployment and underemployment) is greater than the combined losses from all of our mistakes in microeconomic policy (Quiggin 1996). Hence if the problem of high unemployment could be resolved through adjustments to our labour market institutions, it would be worth overcoming almost any obstacles to achieve this.
The analysis presented above concerning the complexities of the operation of labour markets do not preclude the possibility that unemployment could be greatly reduced through improvements in the operation of labour markets, but they do suggest that it will be very difficult to identify those improvements. In particular, the simple recommendation, derived from partial equilibrium analysis, of the adoption of policies to cut real wages, will yield at most a modest reduction in unemployment, and will reduce the welfare of most low-income workers, even when unemployment effects are taken into account.
In these circumstances, it seems reasonable to focus on aggregate-level policies aimed at enhancing the demand for labour. This view is reinforced by the observation that the only sustained period of full employment in Australian history was achieved within just such an aggregate framework, that of Keynesian macroeconomics. However, the traditional Keynesian approach had defects that ultimately proved fatal, most notably its inflationary bias. Moreover, such a policy is essentially unworkable in a fully open economy, because aggregate demand expansion necessarily generates a current account deficit, which is typically accompanied by capital flight and adverse currency speculation.
In Langmore and Quiggin (1994), an aggregate policy based on the idea of demand switching is proposed. The object is to increase the share of demand allocated to labour-intensive services, and hence the derived demand for labour associated with any given level of aggregate demand. The core proposal is to raise the share of GDP allocated to community services, such as health, education, and police services. Such an increase must be financed by increased levels of taxation and, where feasible by increased private payments for such services.
More generally the policy proposals of Langmore and Quiggin (1994) are based on the premise that sustained reductions in unemployment should be the pre-eminent goal of economic policy. Thus, even though we suggest that the elasticity of labour demand with respect to wages is relatively small, we argue that, where government policy adds to wage costs, it should be modified. This leads to a proposal for the abolition of payroll tax and its replacement by a combination of higher general rates of company taxes and taxes on other inputs, notably carbon-based fuels.
The pursuit of an aggregate policy of this kind implies that the primary concern of institutional labour market policy must be with aggregate outcomes and in particular with the aggregate growth of nominal wages. For this reason, we support the retention of a substantial role for centralised wage setting, arguing that the role of enterprise bargaining should be limited to the formulation of agreements on local variations to a central award structure.
By contrast, current labour market policy would appear to presuppose a monetarist policy framework, in which acceptable price stability is achieved by adherence to a monetary growth rule. If such a policy framework were valid, there would be no need for concern about the rate of growth of nominal wages. The recent evolution of monetary and labour market policy in Australia appears to involve inherent contradictions. On the one hand, labour market policy is formulated on a basis which eliminates any scope for control over nominal wage outcomes. On the other hand, monetary authorities appear to adopt a 'fine-tuning' approach in which signals such as the aggregate nominal wage outcome play a major role in determining interest rate policy.
Concluding comments
Traditional labour economics embodied two main objections to the application of standard market analysis to labour. First, labour is too important to be left to the ebb and flow of market forces. Second, in analysing conditions of wages and employment we are dealing with people, not with inanimate objects. On the whole, these objections have been overcome, at least at a theoretical level. The economic forces affecting labour markets are not, after all, qualitatively different from those operating in other markets. Furthermore, the development of general equilibrium analysis overcomes, at least in principle, the argument that labour markets are too important in the economy as a whole.
In a sense, however, the traditionalists have had the last laugh. In developing analytical tools to cope with the complexities of labour markets, economists have come to adopt much more complex theories about the operations of markets in general. The simple partial equilibrium analysis of introductory textbooks has been replaced with a more complex analysis involving strategic interaction, reputation building and multiple equilibria. Indeed, in analysing any market we are dealing, as in labour markets, with interactions between human beings who will not accept the role of passive price-takers if they can avoid doing so.
Of course, none of this means that labour markets, or other markets, are immune from the forces of supply and demand. As a first approximation, these forces will operate in much the same way as is suggested in introductory textbooks. However, because of the importance of labour in the economy as a whole, and of informational considerations, this will only be a first approximation. General equilibrium effects will usually be important, and valid analysis of welfare can only take place in a general equilibrium context.
Neither policies that ignore the role of supply and demand forces in labour markets nor policies that assume that those forces will operate in a simple textbook fashion are likely to be effective. In particular, there is no guarantee that institutional labour market reforms will lead to a substantial reduction in unemployment. Policies that act directly to increase the demand for labour are a more appropriate solution.
References
Akerlof, G. A. (1984), 'Gift Exchange and Efficiency-Wage Theory: Four Views', American Economic Review 74(2), 79-83.
Akerlof, G. (1970), 'The market for 'lemons' : Qualitative uncertainty and the market mechanism', Quarterly Journal of Economics 84(3), 488-500.
Coase, R. (1937), 'The nature of the firm', Economica 4, 368-405.
Greenwald, B. and Stiglitz, J. E. (1988), 'Pareto Inefficiency of Market Economies: Search and Efficiency Wage Models', American Economic Review 78(2), 351-55.
Gregory, R. (1993), 'Aspects of labour force living standards in Australia and the US: The disappointing decades 1970-1990', Economic Record
Laffont, J. J. (1980), Essays in the economics of uncertainty, Harvard University Press, Cambridge, MA.
Langmore, J. and Quiggin, J. (1994), Work for All: Full Employment in the Nineties, Melbourne University Press, Carlton, Victoria.
Liebenstein, H. (1966), 'Allocative efficiency vs X-efficiency', American Economic Review 56, 392-45.
Quiggin, J. (1996), Great Expectations: Microeconomic reform and Australia, Allen and Unwin, Sydney.
__________ (1995), 'The suboptimality of efficiency', Economics Letters 47, 389-92.
Spence, M. (1976), 'Informational Aspects of Market Structure: An Introduction', Quarterly Journal of Economics 90(4), 591-97.
Spence, M. and Zeckhauser, R. (1971), 'Insurance, Information, and Individual Action', American Economic Review 61(2), 380-87.
Stigler, G. (1976), 'The Xistence of X-Efficiency', American Economic Review 66(1), 213-16.
Stiglitz, J. E. (1985), 'Equilibrium Wage Distribution', Economic Journal 95(379), 595-618.
Williamson, O. E. (1981), 'The economic organisation of work: A comparative perspective', Journal of Economic Behavior and Organisation 1(1), 125-39.
__________ (1975), Markets and Hierarchies, The Free Press, New York.
Yellen, J. L. (1984), 'Efficiency Wage Models of Unemployment', American Economic Review 74(2), 200-205.
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