Guest Post: Arindrajit Dube on ZMP Unemployment.

This is a guest post by friend of the blog Arindrajit Dube, Assistant Professor of Economics, UMass Amherst, on the ongoing econoblog debate on unemployment and now the Zero Marginal Product unemployment hypothesis.

Zeroing in on Unemployment?

Zero is so in these days. At least in the world of macro-economics blogosphere. So we now have a renewed discussion of “Zero Marginal Product” (ZMP) of labor as an explanation for the persistently high unemployment rate.

Most flippantly, this is probably a macro-economic version of Godwin’s Law.  If you talk about unemployment long enough, someone will eventually bring up marginal product being lower than the wage.  Usually, it takes the form of blaming minimum wage for unemployment: if wages could fall enough, employment would reach equilibrium.  But the minimum wage prevents equilibriation. [As it turns out,  careful research on minimum wage does not find disemployment effect, even during high unemployment spells in the United States (forthcoming Industrial Relations) ; for evidence on minimum wage more generally – see here].

Somewhat surprisingly then, the most recent discussion about ZMP seems to have bypassed the minimum wage and gone straight for the zero.   Less importantly, I think there is a little bit of “zero envy” going on here – wanting to promote ZMP as an alternative to the “zero lower bound” on interest rates as an explanation of our economic malaise.  More importantly, I think the ZMP argument (as it has been made) is fraught with numerous logical difficulties.

First, it has been suggested by Tyler Cowen that we can understand ZMP as labor hoarding – in a world where firms don’t actually hoard labor.  I think this argument really gets it wrong.  Fundamentally, it confuses between firm-level and market-level notions of marginal product.

Labor hoarding occurs when a firm chooses to pay a wage above marginal productivity for a period of time because there are adjustment costs in hiring.  So a worker’s marginal product at a particular firm may be lower than the wage, and yes, in some cases may be zero, though that’s an extreme case.   But the operative phrase is at a particular firm . It doesn’t mean that the person’s maximal marginal product (across all possible jobs) is suddenly really small … It just means that (say) Ford might keep the worker around even if production is happening at 50% of usual rate because it’s costly for them to let her go and then rehire her. If they were to let her go, it’s not the case that her marginal product at her next best alternative job is suddenly zero or really small.

The second – and more fundamental – point is this.  The marginal product of labor is not well defined in the presence of aggregate demand externalities. This is almost a tautology, and is true in any New (or old or Post) Keynesian model that I am aware of. The reasons are simple to explain.  Let’s say I’m a restauranteur. I don’t want to hire additional waiters because their marginal product is less than the wage I would have to pay them (whatever it may be – including zero!). However, if other firms (say other restaurants,  grocery stores, department stores etc.) all hired more people as well, then suddenly the marginal product of that server I was thinking of hiring just rose.  And I might just hire her.  This is the fundamental point in any model with aggregate demand externalities.

14 years ago, I wrote a short paper (with Ethan Kaplan) on how such externalities may shape labor supply decisions and worker discouragement in the presence of heterogeneous labor.  (“Aggregate demand externalities and labor supply decisions: Worker discouragement and market inefficiency,” Economic Letters, Sep 1997, pdf link)  We showed how in the presence of demand externalities, a wage subsidy (such as the earned income tax credit) financed by a tax on profits can be Pareto improving by encouraging employment of workers who otherwise might (inefficiently) stay out of the labor market. In light of the healthy profits earned by US corporations these days, it is particularly useful to think about employment friendly policies financed by profits. And the reason for that is not limited to “populist” sensibilities. There are “hard headed” rationales based on the desire to make our economy work better.

But don’t take my word for it – the entire 2 volume set of New Keynesian Economics (Mankiw, N. Gregory, and David Romer, eds. New Keynesian Economics.2 vols. Cambridge: MIT Press, 1991, link)  is full of papers that imply that the marginal product of labor is a function of aggregate demand. Take as an example “Imperfect Competition and the Keynesian Cross”, by N. Gregory Mankiw. Or “Monopolistic Competition and the Effects of Aggregate Demand” by  Olivier Jean Blanchard and Nobuhiro Kiyotaki. So that makes me wonder – what’s the real explanatory power of the ZMP argument, when well argued explanations show that the marginal product depends on fiscal and monetary policies?

I think the question of why we are seeing high and persistent unemployment is terribly important. And we should welcome explanations of all sorts as we try to figure out the answers.  However, I don’t see an appeal to zero marginal product of labor a particularly enlightening explanation for our troubles.