Labor demand: comparatively analyzing the impacts of labor market regulations

Introduction

Labor demand is an economic field where still remains a significant amount of open questions, particularly in terms of identifying the most important variables affecting the unemployment. The relationship between both labor market regulations (hereafter LMRs) and productivity growth on the labor demand has been a field plenty of research and academic discussions. By the other hand, such a level of research has not been found regarded to capital stocks and other Keynesian variables explaining the unemployment (Stockhammer, 2010). Nonetheless, in terms of academic evidence supporting the impact on labor demand, both productivity changes and capital stock seem to reach a higher consensus about their negative relationship with unemployment. The empirical evidence for LMRs does not reach the same level of consensus and the probability for finding contradictory outcomes is not lower, particularly in regard to minimum wage´s impact.

This work intends to set how determinant are LMRs, productivity changes and capital stock over unemployment by comparatively analyzing the empirical evidence obtained from economical research. Before facing the comparatively analysis, a brief review of labor demand theory is done as well as an extensive review about what is said by the theory in terms of how LMRs, productivity changes and capital stock affect the unemployment. On this point, a distinction between both classical and Keynesian theories explaining the labor demand performance is done. Finally, this work offers some conclusions about the several impacts over unemployment ascribed to three of variables under study by analyzing and comparing the empirical evidence obtained from economical research.

Labor demand Theory

Labor demand can be defined as set of decisions that the employers must take in relation to their workers in terms of hiring, wages, ascents and training (Hamermesh, 1993). In neoclassical terms, the labor demand would have like objective to identify the principles that explains the amount of workers demanded by the companies, the type of workers required and the wages that they are prepared to pay to these workers. The labor demand, in this sense, should be understood like a derived demand because is a factor, between others, into a productive process for goods and services (Hamermesh, 1993).

According to classical economics, the labor demand is unable to get the plenty employment because external rigidities operating into the economy, for instance, government policies and the relative power of the unions. The classical economist thought that just for eliminating the external rigidities of the labor market would be possible to eliminate the unemployment, because the wages (employment"s price) could become completely flexible (Bellais, 2004; Hellwig et.al. 1999). After economical crisis on 1929, when the classical economics was seriously questioned, the Keynesian economics provided us a theory which the full employment depends on the full aggregate demand, it means, a demand level considering both consumption and investment. According to Keynes, getting full employment will not be possible just for increase the aggregate consumption but also the investment rate should be equal to the difference between the disposable income and the aggregate consumption (Stockhammer, 2009). With such a point of view, even though the wages could become absolutely flexible, this is not enough in order to eliminate the unemployment, which depends on the investment decisions as well. In summary, for the Keynesian model, the only important thing about labor demand is the rigidity of nominal wage which is not feasible to overtake on the short run (Stockhammer, 2009).

In terms of elasticities, a negative relationship between wages and employment level (own price elasticity) has been the core of classical economics; however such a relationship has shown contradictory outcomes in the empirical research (i.e. Card and Krueger, 1994), arising some voices claiming that a downward sloping curve is not needed at all (Stockhammer, 2009). By the other hand, because the labor is not the unique productive factor, we need to think the labor demand as being affected by the price of other factors, therefore, crossed price elasticity between labor and capital is usually measured (Hamermesh, 1993). If such elasticity is negative, labor and capital are complementary factors to each other, but if this relationship is positive, labor and capital are substitutes. Thus, the main assumption behind the relationship between capital stock and unemployment is considering the elasticity of substitution to each other as being negative (Arestis et.al. 2007). Finally, by reviewing use-product elasticities, a positive relationship between level of output and labor demand is assumed by both classical and Keynesian economics (Hamermesh, 1993).

Labor demand performance and its determinants

As a consequence of all of above, by testing the elasticities presented in terms of both own and cross prices, we can better understand how the labor demand works. Further, by discussing these theoretical issues in terms of unemployment´s determinants, we can say that there has been a historically considerable agreement about two of the most important variables: (1) labor market regulations or institutions and (2) changes in both productivity and output levels (i.e. premises from Okun"s law). In addition, on last two decades, in light of LMRs" deficiencies to properly explain the unemployment, a third variable has been arisen: (3) capital stock (Hellwig et.al. 1999; Stockhammer et.al, 2010). In spite the agreement reached in terms of these variables as affecting labor demand performance, there is not a consensus about which of these determinants has the greatest effect on the unemployment.

3.1 Labor demand and labor market regulations

According to classical economics and NAIRU paradigm, labor market institutions should be the most important variable affecting unemployment because they can alter the market equilibrium (which is supposed being feasible to reach without any external regulation according to efficiency markets theory) through exogenously imposing higher cost on labor (Baker et.al 2002). However, as it will be seen soonly, the empirical evidence is not conclusive in order to confirm this theoretical assumption (Arestis et.al. 2000, 2007; Stockhammer, 2009, 2010; Karanassou, 2008; Kee, 2005).

How would LMRs be affecting labor demand? Even though the theoretical response to this question depends on the specific type of regulation, there is an academic consensus in order to think of all of LMRs´impact on labor demand as being affected by three most important variables (Squire et.al. 1997): (1) strength of elasticities for both labor supply and labor demand, (2) the market structure for a particular country and (3) strength level of the labor market and economic institutions. Thus, the overall effect of LMRs on labor demand depends on the interaction between all of these variables because: "even if the regulations are binding, the relevant elasticities of supply and demand may be so low that the impact of the regulations on efficiency is small. And, even if the regulations are binding and the elasticities are sizable, compliance may be low" (119).

How do these three assumptions work to determine labor demand? Firstly, the key thing is related to market structure. For standard competitive models of the labor market an increase on the unemployment rate will be predicted because an introduction of any regulation, i.e. minimum wage, which would obligate to companies to pay over the labor marginal productivity (Boeri et.al. 2008; Ni et.al, 2011; Baker et.al, 2002; Gorostiaga et.al, 2007; Montenegro et.al, 2003). The theory also predicts that there would be effects over wage dispersion which could become lower (Dolton et.al, 2010). On the other hand, in models including some form of modern monopsony or other market imperfection, minimum wages redistribute the rent without necessarily affecting employment (employees do not have any chance for getting another better job in a particular market) because the firms set the wage of equilibrium where marginal cost is equal to marginal revenue (Boeri et.al. 2008; Baker et.al, 2002; Gorostiaga et.al, 2007; Montenegro et.al, 2003)..

Even though the theory claims the importance of market structure as determining a downward sloping or upward sloping relationship wage-demand for both competitive market and monopsony respectively, there is a strong consensus about the role played by levels of labor and economic institutions" strength in any country. The main assumption behind, mostly related to developing countries, is that weaker laws enforcement, large informal sector, underdeveloped capital markets, and informal credit and insurance networks imply higher levels of noncompliance of labor regulations, consequently, could be much more difficult to forecast the effects of the LMRs on the labor demand because the wide myriad of variables that need to be controlled (Boeri et.al. 2008).

The range of labor market institutions studied and its impact on labor demand is wide. Minimum wage is so far the most studied variable. Dismissal protection also has been widely studied. Other LMRs shuck as mandated benefits, unemployment insurance benefit systems and working hour regulations has been less researched (Boeri et.al. 2008). This work focuses on minimum wage (hereafter MW) and dismissal protections because their significant amount of empirical research.

Theoretically, whereas MW is expected to behave as it was described above in terms of market structure (competition and monopsony) in the case of dismissal protections such a distinction does not work, being expected a downward sloping curve in most cases (Boeri et.al. 2008) and its importance determining unemployment is expected to be central: "OECD and the International Monetary Fund have blamed high and long-lasting unemployment benefits employment protection legislation and similar regulations for persistently high unemployment in many European countries" (Stockhammer et.al. 2010, pp. 438). In order to estimate the impacts of dismissal protections on labor demand is necessary to take into consideration the probability of remaining in a job, the advance notice to a worker that has been i years with a firm, the probability that the economic difficulties of the firm are considered a justified cause of dismissal, the mandated severance pay for i years at the firm, and finally, the payment to be awarded to a worker with tenure in case of unjustified dismissal (Boeri et.al. 2008).

3.2 Labor demand and Productivity Changes

Real wage aspirations of workers could explain the observed inverse relationship between productivity growth and unemployment (Slacalek, 2005) and the recent dynamics of the trade-off between inflation and unemployment (Grove, 2003). According to Slacalek (2005) there are two lines of research explaining how expected wages affect this negative relationship (where unemployment is mainly measured as NAIRU variation). Firstly, there would be a mismatch between the perceptions of productivity growth by workers and firms which would not permit a fast adjustment of salaries and, therefore, a non equilibrium state of employment level would happen when a productivity shock comes.

Secondly, there would be two competing effects which would determine the direction that the productivity – employment relationship eventually takes (Slacalek, 2005): when a work capitalization effect occurs (mainly determined by higher labor productivity) the unemployment is expected to decline because the firms will increase the work value. By the other hand, when creative destruction effect occurs, the old jobs are destroyed and replaced by new ones. In words of Slacalek (2005), the correlation between productivity growth and labor demand (employment rate) depends on the relative size of these two effects.

Methodologically, VAR is mostly used model in order to test the relationship between productivity growth and unemployment because the impulse response functions summarize the effect that has a purely transitory deviation on the variables included in the model with respect to its initial values of balance and forecasting the effect that this non permanent shock (impulse) would have through the time. On this path, Slacalek (2005) gives us the following equation in terms of geometric lags:

where p is labor productivity, u is the unemployment rate, ??p is the change in nominal price inflation and z includes labor demand shift variables. In this rendering, unemployment depends on current productivity growth and also on the difference between last period's productivity and the weighted sum of productivity further in the past.

3.3 Labor demand and Capital Stock

According to the Keynesian point of view, it is not possible to solve the unemployment phenomena for using policies and tools operating only from labor market, especially when we find ambiguous outcomes from the literature concerned to the impact of labor market institutions on labor demand (Arestis et.al. 2007). On this path, we should explain the unemployment as a good market related issue because the most important components of the aggregate demand are coming from there, for instance, consumption and investment (Stockhammer, 2010; 2011).

In this sense, Arestis et.al. (2007) suggests that there is a robust negative relationship between capital accumulation and unemployment and he gives as a explanation the lower elasticity found between capital and labor when the degree of substitutability was expected to be higher from the classical economics between both of them variables. The main idea involved in this assumption is related to the insufficient capital formation could be a cause of unemployment (Stockhammer, 2010) and this impact is described firstly as the nature rate of unemployment being affected by the investment level. In addition, Stockhammer et.al. (2010) offer us a second channel of impact in terms of the unemployment as reducing the ability of workers to push up wages and then an insufficient capital stock would require a higher unemployment rate to equilibrate income claims of workers and employers.

Methodologically, there would be a tendency to examine the influence of capital stock on unemployment by using single unemployment rate equations and proxy variables such as real interest rates, real balances or investment ratios (Karanassou et.al. 2008). For instance, Stockhammer (2011) offer us the following equation where LMI, ACCU and MS represent labor market institutions, capital accumulation and macroeconomic shocks, respectively. C represents other control variables to be specified later. FEt and FEj are crosssection and period fixed effects, respectively.

However, according to Karanassou et.al. (2008) this trend for using single-equation estimation of the unemployment rate brings implicitly tow main problems: (1) the above proxies could not capture the effects of capital accumulation of other influences due to often the influence of capital stock is hidden behind noncontroversial accounts of the unemployment upturns due to rises in interest rates or financial crises.(2) Since the unemployment rate is a nontrended variable, single equation models have to use exogenous variables that do not display a trend. This would not the case with multi-equation labor market models.

Finally, we can summarize all has been seen above in the figure 1 which relates labor demand elasticities with studied variables.

Figure 1

Summary of expected impact of variables being studied on labor demand.

Source: Author´s own summary

Evidence: a comparative analysis

By comparing the empirical evidence we can shape some conclusions about the capability of our studied variables to explain the unemployment. However, since many several econometric techniques have been used and theories underlying the empirical research have moved between classical and Keynesian explanations on labor demand performance, such a comparison is highly complex. As a consequence, firstly, the collected evidence for each variable will be discussed and compared each other, and then, this study will finish showing some relevant methodological issues eventually explaining the outcomes obtained.

The real impact of LMRs on labor demand is at least a controversial issue. There is not conclusive evidence about this relationship. Whereas many studies give a real importance to LMRs as a determinant of labor demand (Boeri et.al. 2008; Baker et.al, 2002), many other claims that such a relationship is not independent of other macroeconomic determinants. Stockhammer et.al. (2010), for instance, aims that for isolating changes in unemployment due to labor market institutions from those due to macroeconomic policy, is possible to find that the evidence supporting the LMRs effects on the unemployment is inconclusive.

4.1 Minimum wages: From the theory, a negative effect of the MW on the employment level is expected for competitive markets, however, there is some important evidence in contrary (Kaufman, 2010; Ni et.al, 2011; Williams, 2001). In general, it can be said that the evidence trends to confirm the assumptions in the case of monopsonies (an observed MW effect on employment as being zero or even positive), but is not definitive in the case of competitive markets (negative effect of MW increase on employment) (Kaufman, 2010; Ni et.al. 2011). For instance, the classical studies of Card and Krueger (1994) found evidence supporting a positive effect of the MW over the employment level for fast-food restaurants in New Jersey and Pennsylvania, both of them as being considered competitive markets.

These kinds of results, however, can be explained from others research streams widely developed: (1) impact of several age / skillness groups and (2) impact of enforcement and compliance strength. Regarding to the first one, the evidence trends to confirm that youngest and/or unskilled workers not only would suffer an increase in their unemployment level but also the unemployment duration would be longer (Pedace et.al, 2011; Williams, 2001). About the second one, the degree of compliance, enforcement, penalties for non-compliance, and existence of uncovered sectors (often called informal labor markets) are issues much more likely to be weaker in developing countries, affecting the real impact of minimum wages (Boeri et.al, 2008). It has been detected, for instance, that modest penalties for paying wages below the MW do not permit to trust in results showing positive or null effect on unemployment (Boeri et.al, 2008; Squire et.al, 2011).

Gavrel et.al- (2010) introduces another two variables in order to explain the existence of non conclusive evidence about MW´s impact. The first one, gap between MW and average wage, states that two effects happen at the same time when a MW is introduced: a job creation reduction and an increase in job search intensity. If AW is significantly higher that MW, the second effect dominates the first one. On the contrary, for high values of the MW regarding AW, the reduction in the creation of jobs leads to an employment cut. Secondly, Gavrel (2010) explains the results obtained by Card and Krueger (1995) for introducing a distinction between short and long term, saying that in the short term a minimum wage increase will raise employment by shortening the expected duration of vacancies. Unfortunately, there is not a significant amount of research doing the distinction between short, medium and long term, nonetheless, the available evidence aims that a MW does not affect the unemployment on the long term (Dalton, 2010).

4.2 Dismissal Protections: From the theory, a negative effect of dismissal protections on the employment level is expected. This assumption has been usually confirmed in developed countries (Boeri et.al, 2008; Squire et.al, 2011) although almost there are not studies separating the dismissal protections from other regulations. Few studies doing this separation found the existence of this impact but in lower rates (Squire et.al, 2011). About developing countries, even though the negative relationship between dismissal protections and labor demand has been weakly found, this impact is quite difficult to test because the massive presence of non compliance levels and weak policies of enforcement.

4.3 Factors productivity: Even though some research state that impact of TFP (total factors productivity) on unemployment depends on how new technology is embodied in new jobs (Pissarides and Vallanti, 2006), most of studies has found evidence about productivity changes as affecting negatively several steady-trends of unemployment rates, especially about the NAIRU (Ball & Mankiw, 2002; Restrepro, 2008; Slacalek, 2005), specially when new technologies are assimilated for the jobs (Pissarides and Vallanti 2006), and few research has not found this relationship (Gruber, 2003).

Nonetheless, such a relationship could be depending on speedy of productivity changes and its adjustment on the time. The empirical evidence indicates that the workers are not able to adjust their wages expectations when they face faster productivity growth and, therefore, the labor market absorbs more workers which implies the NAIRU becomes lower (this is, without a higher inflation), but just on the short run because in the long term the workers will adjust their wages expectations (Ball and Mankiw, 2002). Similarly, has been reported that in USA, for example, the NAIRU rose when productivity growth slowed in the 1970"s, and, in the 1990s, the NAIRU fell when productivity growth sped up (Ball and Mankiw, 2002). Even though there is some studies reporting opposite results in the sense of showing that several productivity shocks have increased the unemployment on the short run (Restrepo, 2008), the dominant empirical evidence is in favor of a negative relationship between productivity changes and unemployment in the short and medium run.

4.4 Capital Stock: Robust evidence confirming the inverse relationship between unemployment and capital accumulation has been found (Arestis et.al. 2007; Stockhammer 2010; 2001; Karanassou et.al. 2008). Stockhammer (2010), for instance, compares the effects of labor market institutions and capital accumulation separately on unemployment level, concluding that "labor market institutions do have an effect on unemployment, but it is a comparatively minor one. Macroeconomic variables have a much greater impact and among these capital accumulation (…) and the real interest rate are the most important ones" (pp. 455).

In a cross Nordic countries study, Karanassou et.al. (2008) found that capital stock explains around 30% of the increase in unemployment in Denmark whereas in Sweden, capital accumulation contributes to 50% of the unemployment upsurge during the 1990s. Finally, they state that in Finland the unemployment would have been 5 percentage points lower in the absence of the 1992 permanent drop in its capital stock growth rate. The same trend was found by Kee et.al. (2005) who aim that empirically capital accumulation in the export sector explains most of the decline in Singapore"s unemployment rate.

Nonetheless of robust evidence confirming the positive impact of capital stock on employment, other research offer alternative explanations. Malley and Moutos (2001), for instance, say that impact of absolute growth rate of capital stock in OECD-European countries has been less determinant that relative evolution of capital stock to other countries because an increase in the domestic capital stock relative to the foreign capital stock would allow to domestic firms to compete more effectively by capturing market shares at the expense of foreign firms. However, there are not enough studies testing this assumption. By the other hand, Kapadia (2005) also confirms the negative impact of capital stock on unemployment but its study limits this impact over a certain range.

Table 1

Summary of evidence found for each variable studied and its impact on labor demand.

Source: Author´s own summary

Conclusions

The impact of LMRs on labor demand has been widely questioned on last two decades, especially because the relative incapacity to explain the remaining unemployment rates even in presence of favorable macroeconomic performances (lower inflation and lower real salaries for many European countries) which contradicts the main theoretical assumptions related to own price elasticities, at least in the context of competitive markets. The empirical evidence has been more contradictory related to minimum wages than dismissal protections, even though in both of them variables such as enforcement and compliance levels seem to play a determinant role. Methodologically, the wide range of econometrics models has made more difficult the comparison of evidence.

In the case of productivity growth and capital stock, the evidence seems to be more robust than theoretical explanations. Whereas in both of them cases a positive relationship on labor demand is found, still remain a considerable amount of open questions underlying the relationship. For instance, in the case of labor productivity, whereas some research state that it would better to divide the total factors productivity in order to test separately both labor and capital productivities, many others highlight the central importance attributed to TFP (total factors productivity). In the case of capital stock, the lack of research does not still allows to define precisely which is the channel underlying the impacts on labor demand.

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Autor:

Student: Rodrigo Valdivia Lefort

Literature Review – MA Business Economics

Module Leader: José Sanchez Fung

London, May 2011