PSST: there is no aggregate labor market

"supply and demand" is not so useful for explaining employment dynamics

Whenever you come across the phrase “the labor market,” you should activate your baloney sandwich detector. It is a concept that is not as clever as it sounds.

It sounds clever to talk about “jobs” in terms of supply and demand. But those concepts do not apply the way that they ordinarily do in economics.

Ordinary economics treats a market in terms of its equilibrium properties. When demand for light trucks increases, you observe more light trucks sold and higher prices for light trucks. When the supply of eggs is disrupted, you observe fewer eggs sold and a higher price for eggs.

We think in terms of the price adjusting to a point where no consumer wants to buy more at that price and no producer wants to supply more at that price. We say that there is neither excess demand nor excess supply. We say that the market clears. We are thinking in terms of equilibrium states.

If we thought of labor in terms of equilibrium states, we would say that the wage rate is supposed to clear the market. There should be no excess supply of audiologists in Peoria. Instead, the salary for audiologists in Peoria should fall in order to make the demand for audiologists in Peoria high enough and the supply of audiologists in Peoria low enough so that everyone who wants to be an audiologist in Peoria at that salary has a job.

But in practice we never describe labor markets in equilibrium, market-clearing terms. We instead use phrases like “unemployment” or “a lack of jobs” on the one hand, or “a labor shortage” or “unfilled openings” on the other. In the case of labor, the price-adjustment mechanism (meaning the change in wage or salary rates) works so slowly that we usually ignore that it exists. Instead of describing changes in employment in terms of movements from one equilibrium to another, we treat them as changes in disequilibrium states.

But disequilibrium is not the only flaw in talking about “the labor market.” I was very careful to use the example of “audiologists in Peoria.” That is because I want to avoid using the phrase “the labor market.” We do not have a single labor market, in which a neurosurgeon in Nashville is identical to a busboy in Biloxi. Instead, we have tens of thousands of labor markets, segmented by occupation and by geography.

Across these market segments, substitution does take place. People do move from place to place. People do change occupations. But this process is very limited, and it takes place only gradually.

What Creates Jobs?

In the conventional story, jobs are created by “demand.” In what I call the GDP-factory model, spending creates jobs and jobs create spending. This is what passes for macroeconomics in the newspaper and in freshman textbooks, but it is not really economics at all.

The economic way to think about jobs is what I call Patterns of Sustainable Specialization and Trade. The simplest model of trade is that I am better at producing one thing, and you are better at producing something else. So instead of consuming only what I produce, I exchange with you in the market.

In the real world, trade is not one-on-one. I still produce only one thing, but I exchange it for many different consumption goods. There is a complex pattern of trade, which includes not just final goods but all sorts of intermediate goods that are used to produce other goods.

These patterns of trade are sustainable if and only if there are profits earned by everyone involved. Profitability changes as a result of changes in the environment, changes in tastes, and changes in technology. So patterns are constantly changing.

The challenge for entrepreneurs and existing businesses is to adapt to the environment by creating new patterns of sustainable specialization and trade. When the new patterns that emerge from this entrepreneurial activity draw more people into paid work, we call this “job creation.”

Entrepreneurial job creation is taking place all the time, even during recessions. An economy-wide recession takes place because job destruction is unusually widespread, because several patterns of specialization and trade have become unsustainable.

I read in the news recently that Intel, the giant manufacturer of semi-conductors, was letting go of 15,000 workers. I would say that Intel decided that continued employment of those workers was unsustainable. Those workers are experiencing a recession. They will spend some time unemployed, until they can fit into other patterns of specialization and trade.

Government knows how to create jobs that are not sustainable. Unsustainable jobs provide output that cannot be sold for more than what it costs. Eventually, the economy has to stop wasting resources and get rid of those jobs.

When the government creates jobs in specific businesses, this is known as “industrial policy.” Industrial policy usually means having to subsidize the favored firms forever.

When the government tries to create jobs by telling some people “here is some money that you can have now” and telling other people “lend us money and we will pay you back later,” this known as “fiscal policy.” Fiscal policy means setting up society for future conflict, among (1) the people who are owed money by the government, (2) suppliers to the government who expect payment for services provided, (3) government clients, such as retirees, and (4) taxpayers. This conflict shows up as a large share of the budget devoted to interest payments and/or as inflation.

The TL;DR is that sustainable patterns of specialization and trade emerge from entrepreneurial activities, by start-ups or incumbent businesses. That is where jobs come from. It is best to think in those terms, rather than pretend that there is a single, aggregate demand and supply of labor.