Below is a mindmap outlining the causes of unemployment and the policies to reduce it. Useful for NCEA Level 2 – Internal Assessment and A Level Labour Market.
Below is a link to a very good podcast from the BBC ‘The Real Story’. Dan Damon discuss what should be done about rising unemployment in the age of Covid-19? Contributors include Australian economist Steve Keen author of ‘Debunking Economics’. Topics of debate include:
- Universal Basic Income
- Modern Monetary Theory
- How much debt can a government sustain in propping up an economy?
- Should a government subsidise companies taking-on workers?
Also features a very good interview with Daniel Susskind – author of ‘A World Without Work: Technology, Automation and How We Should Respond’
It is 53 minutes long but can take your mind off the commute to work.
When covering Labour Markets with my A2 level classes I put together an exercise which tests them on calculating MCL, MRPL etc and also showing why MCL = MRPL is the number of workers a firm should employ. There is an exercise for both Perfect and Imperfect Labour markets – see ‘Word’ document. The excel document is a model answer showing the data in a table and a graphical format. Hope it is of use.
One reason for the increasing inequality in society is the stagnant wages for the lower and middle income groups – in the USA the top 0.1% have as much wealth as the bottom 90%. Labour compensation at the very top has increased dramatically since the 1970’s.
1970’s – the top 0.1% took home less than 3% of all income
2010 – the top 0.1% took home more than 10% of all income
In the USA the top CEO’s average compensation has grown since the late 1970’s by over 900% to around $15 million a year. In contrast the lower income groups have gone up by only 10%. However when you look at hedge fund and private equity fund managers the salaries are astounding. In 2014 which was seen as not a great year for the industry 25 fund managers made at least $175 million each, and 3 made more than $1 billion.
Are CEO’s worth every cent?
In theory the demand for labour is determined by their marginal revenue product – that is the value of revenue generating by employing an additional worker. Labour markets are imperfect and a monopsony occurs in the labour market when there is a single or dominant buyer of labour. The buyer therefore is able to determine the price at which is paid for services. The monopsonist will hire workers where:
Marginal Cost of labour (MCL) = Marginal Revenue product of labour (MRPL)
Therefore it will use labour up to level of Eq which is where MCL=MRPL. In order to entice workers to supply this amount of labour, the firm need pay only the wage Wq. (Remember that ACL is the supply of labour). You can see, therefore, that a profit-maximising monopsonist will use less labour, and pay a lower wage, than a firm operating under perfect competition.
So if Goldman Sach’s CEO, Lloyd Blankfein, made $24 million in 2014, that’s because he is worth $24 million to his company. In short, you make what you deserve based on your skills, effort, and productivity, in this fairest of all possible worlds.
However this theory has little to do with how the world actually works. The idea that good CEO’s are entitled to enormous rewards is based on the belief that success or failure of the company depends on one person. According to historian Nancy Koehn, business is a team sport: not only is it impossible to quantify a single leader’s marginal revenue product; it is hard even to describe it clearly. Ultimately a CEO can appoint friends and place them on the compensation committee which recommends the CEO salary. The committee invariably proposes to pay at least as much as the median comparable company, because no board wants to admit that its company has a below-average leader. CEO’s do have key performance indicators (KPI’s) but the CEO can encourage the committee to select metrics that will be easy to satisfy. John Kenneth Galbraith describes CEO pay very succinctly – “The salary of the chief executive of a large corporation is not a market reward for achievement. It is frequently in the nature of a warm personal gesture by the individual to himself.”
Luck plays an important role in CEO’s pay. Heads of oil companies were paid more when profits increased, even when the profits were not due to their decision making but simply by a rise in the price of oil. On the contrary it is argued that some boards actually do a good job in firing under-performing leaders and that in the end, high compensation is simply the result of the market for talent – supply and demand. The financial sector tend to use the marginal revenue product of labour theory in their awarding of compensation for CEO’s. Bonuses of traders and investment bankers’ are based on the profitability of their own deals but because bonuses can never be negative, individual employees can generate enormous payouts on bets that turn out well while sticking shareholders with the losses on bets that go bad. Furthermore even if bankers do make money by buying low and selling high in the securities markets there is no value generation as there is no tangible output that anyone can consume.
In aristocratic societies such as 18th century France or 19th century Russia, wealthy noblemen who owed their riches to the accident of birth had to worry about the prospect of violent rebellion by the have-nots. By contrast in the US today the wealthy are protected by the widespread belief that their extraordinary incomes – and the inequality that they generate – are simply the product of inescapable economic necessity.
Source: Economism by James Kwak
In the September quarter New Zealand’s unemployment rate was 4.2% which was up 0.3% from the June quarter. Since the global financial crisis unemployment figures have been trending downwards since it peak of 6.7% in the September 2012. Despite the quarterly rise in unemployment, the underutilisation rate, which is a broader measure of spare capacity in the labour market, has fallen to the lowest level in over eleven years. The fall in underutilisation this quarter was driven by a drop in the number of underemployed people, those who work part time but are looking to work more hours.
During 2019 the labour market appears to have tightened but it does appear to lag behind the growth cycle meaning that with the slowdown in growth in 2019 higher levels of unemployment will be apparent early this year. It is interesting to note that as labour becomes more scarce with lower levels of unemployment wage growth usually follows – see graph.
Annual wage growth is at its highest level since the 2008 global financial crisis, after which wage growth remained largely flat. The percentage of wages that increased is at its highest level since March 2015, at 59%. This shows there has been more broad-based wage growth across the Labour Cost Index* (LCI). Salary and wage rates for the public sector increased 3.0 percent annually, the highest rate since June 2009. This compares to a 2.2 percent increase in the year to the June 2019 quarter. Public sector wage rates have been driven by collective agreements for teachers, nurses, and police over the past year. With these three largest occupations excluded, public sector wages would have increased 1.8 percent annually.
*The labour cost index (LCI) measures changes in labour costs. These costs consist of base salary and ordinary-time wage rates, overtime wage rates, and non-wage labour-related costs. The index essentially covers all employees aged 15 years and over, in all occupations, and in all industries except domestic services.
Department of Statistics NZ
Westpac Quarterly Overview – November 2019
Marginal Revenue Product refers to the amount of revenue generated by an additional worker. This is a theory of wages where workers are paid the value of their marginal revenue product to the firm and is based on the assumption of a perfectly competitive labour market. Therefore an employer will hire workers up to the point where the value of the marginal product of labour equals the wage that is being paid. The demand curve for labour can therefore be represented by the value of the marginal product curve – see graph below and a revision mindmap.
It is unavoidable that recessions are part of the economic environment that we live in. In tackling the impact of recessions it has become apparent that one cannot solely rely on expansionary monetary policy of the central bank. Economic conditions have changed, as if an economy was to fall into recession in this low interest environment monetary policy options are far more limited than they were post the GFC. Add to this a higher debt level and you put further pressure on the banking system. A publication this year entitled “Recession Ready – Fiscal policies to stabilise the American economy.” (Published by the Hamilton Group – Washington Center for Equitable Growth) suggests that governments should assist in ensuring that the recovery phase is much quicker than it has been by ensuring confidence amongst businesses and households so they resume investing and spending again. They focus on antirecession programmes known as “automatic stabilisers.”
Automatic stabilisers are the automatic increases in revenues and decreases in expenditure in the government budget that occur when the economy strengthens, and the opposite changes that occur when the economy weakens.
Increase in GDP growth = the government will receive more tax revenues – people earn more and so pay more income tax. As it is assumed that unemployment decreases the amount of money spent on unemployment benefit decreases.
Reduction in GDP growth = lower incomes – people pay less tax. As unemployment increases the government spends more on unemployment benefits. This increase in benefit spending and lower tax collection helps to limit the fall in aggregate demand.
One of the chapters written by Claudia Sahm proposes a direct payment to individuals that would automatically be paid out early in a recession and then continue annually when the recession is severe. During a recession consumer spending (C) declines sharply – see graph – and as it makes up above 70% of most countries aggregate demand – C+I+G+(X-M) – this can lead to employment losses and reduced output. Consumers therefore are integral to boosting aggregate demand and direct stimulus payments to individuals should become part of the system of automatic stabilisers as additional income translates quickly into additional spending.
Trigger to start automatic stimulus payments.
The idea behind this is for direct payments to individuals after a 0.5% in the quarterly unemployment rate. If you look at each recession since 1970 the stimulus trigger of an increase in 0.5% unemployment meant that payments would have been triggered within three months of the start of the past six recessions (USA). But there are some concerns with using unemployment data:
- Unemployment rate tends to lag the business cycle as unemployment tends to peak after the recession ahas ended.
- The rise in unemployment doesn’t necessarily mean you are in recession – two consecutive quarters of negative GDP.
Lump sum v Tax cuts
There is an argument that a one-off lump sum payment is much effective in boosting spending than changes in income tax which would be spread fiscal stimulus throughout the year. Even if the Marginal Propensity to Consume (MPC) was the same for both lump sum and tax cuts it would not be until early in the next year that the full spending occurred under the tax cut option. The delay in spending from lump sum payments would be three months thus the overall stimulus boost would be both larger and more rapid – see graph below.
Direct stimulus payments would quickly deliver extra income to millions of households at the start of a recession and maintain income support until the recession has subsided. This should generate more aggregate demand and thereby reducing the impact of the recessionary phase.
Source: “Recession Ready – Fiscal policies to stabilise the American economy.” (Published by the Hamilton Group – Washington Center for Equitable Growth)
Marginal Revenue Product of Labour
Marginal revenue productivity (MRPL) is a theory of wages where workers are paid the value of their marginal revenue product to the firm.
The MRP theory outlined below is based on the assumption of a perfectly competitive labour market and the theory rests on a number of key assumptions that realistically are unlikely to exist in the real world. Most labour markets are imperfect, one of the reasons for earnings differentials between occupations which we explore a little later on.
- Workers are homogeneous in terms of their ability and productivity
- Firms have no buying power when demanding workers (i.e. they have no monopsony power)
- There are no trade unions (the possible impact on unions on wage determination is considered later)
- The productivity of each worker can be clearly and objectively measured and the value of output can be calculated
- The industry supply of labour is assumed to be perfectly elastic. Workers are occupationally and geographically mobile and can be hired at a constant wage rate
Marginal Revenue Product (MRPL) measures the change in total output revenue for a firm as a result of selling the extra output produced by additional workers employed. A straightforward way of calculating the marginal revenue product of labour is as follows:
MRPL = Marginal Physical Product x Price of Output per unit
Therefore the MRP curve represents the firm’s demand for labour curve and the profit maximising condition is where:
MRPL = MCL (Marginal Cost of Labour) where the revenue generating by employing an additional worker (MRPL) = the cost of employing an additional worker (MCL).
Mind Map below adapted from Susan Grant’s book CIE A Level Revision Guide
Chris Giles of The FT wrote a very good article explaining the output gap using Goldilocks and the three bears. As you may know in the story Goldilocks found the first bowl of porridge too hot, the second bowl too cold but the third bowl just right. We can use this analogy with regard to the economy:
- running too hot – a positive output gap – the economy is overheating and higher interest rates and less government spending is needed to slow the economy down.
- running too cold – a negative output gap – the economy has a lot of spare capacity and needs to be stimulated by dropping interest rates and increasing government spending.
- running just right – no gap – there is neither a requirement for an expansionary monetary and fiscal policy nor a contractionary monetary and fiscal policy.
Just as Messrs Friedman and Phelps had predicted, the level of inflation associated with a given level of unemployment rose through the 1970s, and policymakers had to abandon the Phillips curve. Today there is a broad consensus that monetary policy should focus on holding down inflation. But this does not mean, as is often claimed, that central banks are “inflation nutters”, cruelly indifferent towards unemployment.
If there is no long-term trade-off, low inflation does not permanently choke growth. Moreover, by keeping inflation low and stable, a central bank, in effect, stabilises output and jobs. In the graph below the straight line represents the growth in output that the economy can sustain over the long run; the wavy line represents actual output. When the economy is producing below potential (ie, unemployment is above the NAIRU), at point A, inflation will fall until the “output gap” is eliminated. When output is above potential, at point B, inflation will rise for as long as demand is above capacity. If inflation is falling (point A), then a central bank will cut interest rates, helping to boost growth in output and jobs; when inflation is rising (point B), it will raise interest rates, dampening down growth. Thus if monetary policy focuses on keeping inflation low and stable, it will automatically help to stabilise employment and growth.
However policymakers rely on estimates of the output gap – which compares actual GDP with a country’s full capacity when all resources are fully employed. The concern that the Bank of England have is that official data shows that the UK economy is showing sluggish growth rates with a tight labour market.
Almost all employment indicators suggest the economy close to overheating – recruitment difficulties and industry facing capacity constraints. This is in contrast to economic growth which suggest that there is room for expansion. Add to this the uncertainty about Brexit, the reliability of the output gap even more dubious. Current techniques might correctly measure the output gap but what about the contribution of potential capital projects which are underway?
Some economists have suggested that output gaps are inherently political and chosen to rationalise existing policies, rather than to set the correct prescriptions. However for economists is there an alternative to taking the temperature of an economy.
Although not in the A2 syllabus we have had some great discussions in my A2 class on Modern Monetary Theory – MMT. It has its roots in the theory of John Maynard Keynes who during the Great Depression created the field of macroeconomics. He stated that the fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. When you get this situation it is the government that can get the economy moving again by putting money in people’s pockets.
MMT states that a government that can create its own money therefore:
1. Cannot default on debt denominated in its own currency;
2. Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
3. Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
4. Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
5. Does not need to compete with the private sector for scarce savings by issuing bonds.
Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.
How does it differ from more mainstream monetary policy – see table below.
Those against MMT are dubious of the idea that the treasury and central bank should work together and also concerned about the jobs guarantee. They argue that if the government’s wage for guaranteed jobs is too low it won’t do much to help unemployed workers or the economy, while if it’s too high it will undermine private employment. They also say that trying to use fiscal policy to steer the economy is a proven failure because politicians rarely act quickly enough to respond to a downturn. They can’t be relied upon to impose pain on the public through higher taxes or lower spending to quell rising inflation.
Below is a video from Stephanie Kelton, an MMTer who was the economic adviser on Vermont Independent Senator Bernie Sanders’s presidential campaign in 2016.
The Economist – Free Exchange – March 16th 2019
Wikipedia – Modern Monetary Theory