There is No Labor Shortage

The laws of supply and demand say that wages must increase

Recent talk of a labor shortage leads me to reprint one of the first essays that I posted to the Web, in December of 1997. I have not changed a word in what follows.

"Two main lessons derived from [my experience as an economist] are:

1. Economists do not know very much

2. Other people, including the politicians who make economic policy, know even less about economics than economists do."

--Herbert Stein, "Washington Bedtime Stories", p. xi

Economics professors reveal most of our knowledge to first-year students. Not much is held back for later courses.

Certainly, no one has to wait for an advanced course to be exposed to the proposition that supply and demand curves intersect. Nonetheless, in the media and government, non-intersecting supply and demand curves are drawn with disturbing frequency.

For example, in the 1970's the public was told to expect a chronic shortage of oil. Graphs depicted "demand" for oil increasing indefinitely, getting further and further away from "supply," which was shown increasing less rapidly, or perhaps falling. Thus, an "energy crisis" was proclaimed.

In contrast, the proposition that supply and demand curves intersect implied that there was a price that would eliminate the oil shortage. When the market mechanism was tested by the Reagan Administration, it proved to work.

Today, one hears talk of a "labor shortage," or a "skilled labor shortage." For example, the attendees of a recent conference for the staffing/recruiting industry were told that for the next 20 years the challenge would be to find job candidates. The speaker showed graphs of "demand" for workers growing faster than "supply."

The causal factor in this analysis is the proposition that demographic trends imply slow labor force growth in the U.S. relative to overall population growth. The baby boomers will reach retirement age, while a smaller cohort enters the working age.

If we want, we can add another demographic hypothesis to this analysis. We might suppose that until they do retire, baby boomers will be saving at higher rates, thereby increasing the supply of capital.

Now we are ready to pose the question for our first-year economics students: describe the new equilibrium in an economy in which the supply of labor falls and the supply of capital increases.

The answer, of course, is that the wage rate increases and the rate of return on capital declines. At higher wages, people will supply more labor (although perhaps not much more), and firms will demand less labor. With these market mechanisms working, there will not be any shortage.

What is surprising is that these adjustments in wage rates and the return on capital seem to be occurring slowly. In fact, Paul Krugman, a leading economist of my generation, has been quoted as saying something to the effect that the most striking feature of the "new economy" is the low wage rate.

In the financial press, such as Business Week, we instead read about how the high rate of profitability of U.S. corporations is due to brilliant management. Skeptics like Krugman and myself are unconvinced. If we are correct, then sooner or later wages will start to rise and perceived management genius will start to fall.

Fortunately, a foolish prediction of a 20-year labor shortage probably will not cause the staffing industry to make any mistakes over its relevant time horizon, which probably is closer to 20 days. More ominous are the rumblings from the Department of Commerce, which recently published a study purportedly showing that the U.S. faces a future scarcity of skilled labor.

The prediction of a skilled labor shortage gives one the feeling that we are being softened up for some foolish policy initiatives: perhaps a crash program to develop "synthetic nerds," or maybe an underground facility to store network engineers as a "strategic reserve."

Suppose that we took a survey of all employers and asked, "At a salary of $30,000 per year, how many Java programmers would you hire?" Adding up the answers, one might obtain a somewhat larger total than the number of people willing to supply Java programming skills at that salary. But that shortage would disappear if we surveyed employers and programmers assuming a salary of $300,000 a year. Somewhere between $30,000 and $300,000 is a salary that will balance demand and supply.

One prediction is that wages for computer programmers will rise too slowly in the "Dilbert" sector of the economy (government agencies, financial services companies, telecommunications companies, and other firms whose primary business is not software, but who currently maintain large software development organizations). Consequently, the best programmers will leave the Dilbert sector to join companies whose sole focus is software development. This is a healthy economic process, but it may be widely interpreted as a shortage.

The natural economic tendency is for resources to move to where they are most productive. Market prices act as signals to bring about these shifts. The market price for computer programmers has soared in recent years. Small, specialized software companies are more effective than the Dilbert sector at using programmers. Thus, they can afford to pay programmers higher wages, while the Dilbert sector cannot. The more complaints that one hears from such firms of a shortage of technical workers, the more confident one can be that market forces are working to allocate technical workers to their most productive uses.

Although most economists would share my confidence that the market can take care of a labor shortage, there is much that we do not know. We do not know how far away the current wage rate is from the one that is consistent with no excess demand for labor. We do not know if the process of wage adjustment will be inflationary (nominal wages rising) or deflationary (prices falling relative to wages). We do not know how long the process may take.

Noneconomists, who forecast a chronic labor shortage as if there were no equilibrium wage rate, know even less than economists do.