You'll have to pry supply and demand from my cold, dead hands (from the archives)

Good old supply and demand still has a lot to teach us, even about labor markets 😱

Many of our favorite newsletters are from the early days of Economic Forces. We had been mulling over how to do economics for years, discussing with each other, and finally had a different outlet than the journal articles.

Unfortunately, those early posts only got in front of a few people. The newsletter below—our first, sent out 3 years ago—arrived in 374 mailboxes. Since you’ll still have to pry supply and demand from my cold, dead hands, here it is ICYMI:

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I’m kicking this shindig off with a simple defense of (the increasingly scoffed at by the loudest voices online) supply and demand. It seems silly to need to defend supply and demand within economics circles. But it is 2020…

tl;dr We can’t forget how much supply and demand explains about labor markets, especially when teaching students in their first economics course.

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I teach my intro economics students supply and demand. And I’m not afraid to say it!

Here’s the kicker: I even use supply and demand when talking about labor markets, even though all the hip labor economists are using monopsony models 🤷‍♂️ Am I not hip?!

The fact that PhD economists within any subfield have moved beyond the benchmark tells me almost nothing about what I should teach first-years. Macroeconomists are using heterogeneous agent DSGE models, IO economists are doing dynamic entry, and theorists are doing… well let’s not worry about the theorists.

There is always a trade-off between realism (which complicates the model) and tractability (which simplifies the model). After years of practice with formal models, realism becomes relatively cheaper, so the producers of models optimally choose more of it. But I guess if we haven’t taught our students about standard, competitive producer theory—trading off inputs while taking competitive prices as given—they may not be able to see this 🤔

But if the specialists are using one model, I—a mere theorist—feel the need to argue for why I focus on supply and demand so much when teaching about labor markets. I see four key results that are easy to show Econ 101 students without the complication of monopsony.

1. People respond to higher wages predictably, aka labor supply curves slope up.

2. Wages reflect productivity, aka demand curves for labor shift out with increased productivity.

3. Technology raises the productivity of workers who use the technology, aka the falling cost of a complementary good shifts out the labor demand curve for certain workers.

4. Higher returns to skills increase the demand for those skills, driving up the price of things like college.

There are lots of qualifications/subtleties that we can debate about these results. But this is 101 people! We need to establish the baseline before we attack it.

Supply Slopes Up

To start things off simple, I take a little time to assure my students that labor markets are similar to what we have studied so far. Despite the theoretical intrigue of backward bending labor supply curves and the fun dreaming of getting paid $1 million per hour and working for a minute each day, for real people on the relevant part of the wage distribution, they respond in predictable fashions to wages: when they get paid more, they work more. Supply curves slope up.

(Graphs come from a wonderful talk by Kevin Murphy.)

When my students are managing workers in 15 years, I hope they can remember that to get their employees to work more or harder, they made need to pay them more. Yes, that’s common-sense, but let’s start easy: workers respond to price incentives.

Higher Productivity Increases Demand

We can also say a lot about the demand for labor, using the standard model. For example, we can show that wages are not arbitrary. There are economic forces (see what I did there?) that tie together a worker’s wage and productivity for the company. Now, it need not be perfectly tied, as in competitive markets, for supply and demand to be helpful in understanding the broader point.

The key is that the demand curve for labor comes from the worker’s ability to produce goods. When a worker is more productive, her wages increase.

Notice I am not saying that ONLY productivity affects wages. One doesn’t need to be an absolutist about the most basic example of the perfectly competitive model. Other things matter: preferences, bargaining power, etc. But no serious economist is going to suggest that an increase in the productivity of the marginal worker will not increase wages. That comes out of supply and demand; I don’t need anything fancier.

Complements Affect Productivity

Productivity is not only determined by how hard someone works, how much they slack off. There is a myriad of other factors that make workers more or less productive. Two deserve mention here: capital and technology.

As societies accumulate more capital and tools for working, workers become more productive. My father, when he still farmed, could harvest more corn in an hour than his father, not because he worked harder, but because he had modern equipment. That equipment raised his productivity. In jargon, the tractor was a complement to his labor.

More than physical capital, the long-run increases have come from technological advances. Society has learned through trial and error how to better produce things.

But this technology and capital may not increase everyone’s productivity identically. Take the example of a modern laptop (a combination of both capital and technology). A computer makes an engineer much more productive. It does little for a janitor. This will play out in wages. If we think education roughly corresponds to “likeliness to have a job that uses computers”, the wage gains will go to higher education people, which we do see. That means the premium of a college education over high school will increase. And what do you know?👇

Markets are Connected

The real power of supply and demand comes from studying across markets. Give me any data about price and quantity in the labor market and I can come up with a story of how the curves shifted to rationalize that. And I’m not even a creative economist.

But the real insight is not about the single market graphed, but what it can tell you about other markets. Since we are all trying desperately to be relevant to our students. What’s more relevant than understanding the cost of education?

Suppose I observe the returns to college increasing. I don’t even need to know why. What does that do to the demand for college? Demand shifts out. What happens to the price? The price goes up 🤯 It’s all, everybody in unison now, “SUPPLY AND DEMAND!”

So I can quickly explain two major developments in labor markets (the growing returns to education and the growing cost of education) with good old supply and demand. There are interesting questions about how market power plays into this, but is someone really going to look me in the eye and say these are bigger trends than technological change?

Now I could explain these phenomena with a more complicated model, such as monopsony. But why complicate it? Why?! It’s not necessary. Students already get confused with two curves. I don’t need to add a third curve for no payoff. That’s probably why I’ve found no intro textbook that talks about shifts of the curves in a monopsony model. Basically, all the monopoly/monopsony model in an intro textbook does is say “this is why the price may not equal marginal cost.”

That’s important to remember. And it is why I teach monopoly and monopsony. But few 101 students can “use” that model to derive any additional results.

So I’ve been able to explain the major labor market development of the last forty years—growing inequality across the wage distribution—with supply and demand. That seems like a good use of time in the classroom. ✅ Oh, and I’ve explained why college is so damn expensive, which seems relevant to my students. ✅✅

If other professors think the effects of minimum wage laws on employment numbers is the most important take away from economics 101, fine. Start with the monopsony model 👍 I just beg, please, first ask what are the important economic ideas that I want to convey to students and THEN how can I make the model simple enough (but not too simple) to convey that idea.

-Brian

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