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