Risk pricing in labour markets

This is a long overdue response to Nick Rowe's question about whether some kind of "taboo" makes employers less willing to exercise their right to dismiss than workers to exercise their right to leave, thus making it more difficult for them force down wages in response to adverse economic circumstances.

The argument that unemployment happens when wages fail to adjust sufficiently to changed market dynamics is a well-aired one. But explanations of "sticky wages" tend to focus on structural rigidities such as employment protection legislation. Nick wonders whether the explanation is more psychological.

Just because something is a psychological effect doesn't mean it can't be quantified. Pricing intangibles is something of a black art, but as we move into a post-industrial society it will become increasingly important; you may not even be able to explain what your asset is, let alone kick it, but you go to considerable lengths to obtain it and keep it - or, in some cases, to avoid or get rid of it.* Defining the nature of intangible assets is halfway to pricing them. In this post, therefore, I suggest a way of looking at the pricing of labour that takes into account the intangible benefits and risks of employment both for employers and employees.

Firstly, we need to acknowledge that we have a bifurcated labour market. Employers report skills shortages and complain about being unable to fill vacancies at the same time as there is high unemployment not only among the unskilled, but also among those with advanced qualifications but little work experience. It seems that employers value experience more highly than qualifications. This has serious implications for those who are currently delaying entry to the workforce by doing qualification after qualification, and becoming more and more indebted in the process, in the hope that jobs will become easier to obtain in  the future.

Relevant experience, then, is an asset that is intrinsically of more value than a Ph.D. But that does not mean that the Ph,D doesn't have value. It does - but only when combined with relevant experience. Without that experience, a Ph.D may be worthless. In fact it may even have NEGATIVE value. People can be turned down for jobs because they are overqualified. But the combination of a Ph.D with relevant experience is a highly valuable asset.

So far I'm not saying anything remotely odd. The value of the combination of a Ph.D with relevant experience can be quantified pretty easily. What cannot be quantified so easily is the cost to the employer of that person leaving. But the lengths to which employers will go to retain key staff suggests that losing workers they can't easily replace is a very significant cost to them. The right of a valued worker to leave is a business risk. Labour market flexibility at the high-skill, high-value end is definitely not something that employers want.

At the other end of the scale, people who have few marketable skills and little experience have not much in the way of valuable assets to sell to employers. This makes it harder for them to find employment, and makes them much more easily replaceable. For them, secure employment is far more valuable than it is to more marketable workers - but it is not something that employers really want to offer.

So we have two asymmetries. In the first, workers' right to leave is very likely to be exercised, since they can easily find another job, but employers' right to replace is very unlikely to be exercised except for underperformance or misconduct, because replacing the worker is difficult. In the second, workers are unlikely to exercise their right to leave, because they face unemployment, but employers may be more likely to replace on a whim, because replacing workers is easy. And this all boils down to who is holding an extremely valuable negative asset called "uncertainty".  

The negative effect of uncertainty is perhaps more obvious in the second asymmetry, so I shall talk about that first. When there is both a real risk of unemployment AND a stigma associated with unemployment (the more spells of unemployment you have, the harder it is to find work), the buyers of labour have considerably greater power than the sellers. We can say that employers have security - since workers are readily replaceable - but workers have uncertainty. We can regard that uncertainty, which is the threat of unemployment, as an extremely valuable negative asset on which employers have a put option (the power to dismiss). The value of that negative asset is inversely related to the employability of the worker. For those with little experience and/or poor skills, the threat of that option being exercised is sufficient to encourage them to accept both rubbish wages and complete insecurity. Of course the employer can exercise the option at any time at his discretion, but there is at least a delay in the exercise of that option, which creates the temporary illusion of security. For the not-very-employable, the fear of unemployment is very real.

In the first asymmetry, the skills and experience of the worker - their marketability - gives them security, but the employer uncertainty. So the power balance is reversed. The right of a skilled and experienced worker to leave can therefore be regarded as an extremely valuable "negative asset" whose price is positively correlated with the employability of the worker (the more "in demand" the worker is, the more likely they are to leave and the harder they will be to replace). This time it is the worker who has the put option, and the employer who will go to considerable lengths to prevent that option being exercised. We can say that the worker's implied threat to leave disciplines the employer who can't easily replace him in much the same way as the implied threat of dismissal disciplines less marketable workers who face unemployment.

So the notion that labour market flexibility is a good thing depends on your point of view. Workers that are "in demand" are very happy with their freedom to change jobs whenever they want, not least because it gives them the power to bid up wages. But employers of these workers constantly try to reduce the elasticity of their skilled workforce - perhaps by creating contingent (uncertain) assets on the employee's side, for example by paying part of their remuneration in deferred bonuses, company shares or stock options. Or they simply pay them more to encourage them to stay - which might explain why "safe" jobs tend perversely to be more highly paid than insecure ones.

Conversely, workers that are not "in demand" don't like flexible labour markets, since losing their job is bad news for them. But employers of these workers want to be able to replace workers at a moment's notice. If employment legislation prevents employers dismissing on a whim, employers evade it by diluting the "employed" status of the worker. This last is becoming increasingly frequent, particularly for the young and the less skilled - probably, as the IFS says, because they have the least bargaining power.

The trouble is that if employers and high-skill employees get what they want, it has untoward economic effects. People who think they are going to lose their job any moment and have no idea when, or if, they will get another one don't plan for the future and don't make spending commitments. They may spend - sometimes rather a lot - but it's ad-hoc. If a lot of workers are living like this, demand is volatile. Businesses, too, find it hard to plan for the future if they are faced with the possibility of losing key staff at a moment's notice, and this is likely to depress investment and reduce risk appetite. So when the labour market (high AND low skill) is highly elastic, the pattern of behaviour from both employers and workers is driven by uncertainty and the risk of negative shocks: it's volatile and reactive. That doesn't make for a stable economy - as this paper from the ECB suggests. It finds (see p.40) positive correlation between highly elastic workforces and both frequency and intensity of financial crises.

Given the economic instability that highly elastic workforces create, it is surprising that governments are so wedded to the idea that labour market rigidities are universally bad. Tomas Hirst argued that sticky wages perhaps weren't as bad as people thought. I would add that sticky employment isn't all that bad either. Admittedly, the existence of out-of-work benefits does reduce the financial uncertainty caused by the threat of unemployment, while welfare-to-work programmes are a (feeble) attempt to address the stigma of unemployment and improve people's marketability. And I certainly don't advocate the sort of employment protection that creates well-paid jobs-for-life for older men while leaving women and the young in very insecure, poorly paid jobs. Gridlock is no better than instability. But we really need to do better than this.

There is an implied "safety asset" in labour markets just as there is in financial markets, and we are mispricing it. Consequently although we regard safe jobs as "good" jobs, we aren't paid more for doing less safe jobs. In fact many people are paid less. These days, the most insecure workers tend to have the lowest incomes. It looks as if safety is no longer regarded as valuable, but I don't think that's true. I think the problem is that it is far too valuable, so employers are restricting its availability rather than paying those with insecure jobs the value of the safety they have foregone. And because those with insecure jobs have little bargaining power, they are unable to claim fair pay for the risk they take.

In the financial world, higher returns come from taking higher risks. Applying the same logic to labour markets suggests that if employers want to benefit from flexible workforces, they should pay more for them. And perhaps high-skill workers should pay employers compensation for their right to leave. Pricing the "safe asset" correctly should nicely hedge the "uncertainty option", to everyone's benefit.

Related reading:

Buyers and sellers, bargaining power and recessions, and asymmetric taboos - Worthwhile Canadian Initiative
Weird is Normal - Pieria
Wages and the Great Recession - Pieria
Stochastic Dynamic Inefficiency, Secular Stagnation and the Natural Discounted Growth Rate - Harless
What can wages and employment tell us about the UK's productivity puzzle? - IFS (pdf)
Can intangible investment explain the UK's productivity puzzle? - Jonathan Haskell (Pieria)
Booms and Systemic Banking Crises - ECB
Why we need a minimum wage - Forbes

* Accountants please note that I am not using the accounting definition of "asset".


  1. Very well done, good of you to recognize the differing dynamics of a bifurcated labor force. Ridiculous to expect lower skilled workers to be able to maintain demand without some socially created wage stickiness, via public welfare or private wage controls.

  2. The article is very good (kudos for getting the gridlock issue that most people starting where you start miss), until the last paragraph.

    In the financial world, higher returns do *not* come from taking higher risk. The idea is totally discredited and your less sophisticated readers should not be mislead into believing it. Please, please, read "The Missing Risk Premium" from Eric Falkenstein, or any of the now copious stack of academic papers on the same topic.

    Then on the idea that employers should "price" job safety: under competition, individual employers *cannot* do that, they'd just be competed away. It's a sticky stable equilibrium which is hard to move out of.

    Policies that would help should make it easier for low/wrong skill workers to get high demand skill, basically trying to get a more "equal skill" workforce (in demand adjusted terms, which fortunately doesn't require everybody to become a brain surgeon). You can try from both ends: making the training/bootstrap experience system better (which is hard, unfortunately), and making it cheaper for workers to be able to afford retraining/adapting.

    A universal basic income would probably help here, giving more leeway for people to retrain and blurring the line/stigma between employment and unemployment status, thus diminishing employers' bargaining power. (It reduces the "spread" between work and non-work.)

    1. Cig, yes I agree, my comment is too simplistic. Really the question of risk versus return in labour markets is a whole post on its own anyway (and there is an academic paper on it that someone sent me after reading this). However, I completely agree with you about UBI. Funny how all roads seem to lead in that direction at the moment.

    2. It's all about the bargaining power (not the

    3. It's all about the bargaining power (not the risk versus return or anything else), which is why UBI is so relevant. One important caveat, however: UBI by definition is offered with no strings attached, so the UBI recipient cannot legally be required to work as a condition of receiving a particular level of UBI. (Nor can the recipient legally be required not to work, as in the “benefits trap”.) However, the legal right to quit is not enough to change the balance of bargaining power; for that to happen, the UBI also needs to be large enough that quitting waged work is a more realistic option than it would be without UBI. In other words, the UBI needs to be livable.

      Any UBI large enough to change the balance of bargaining power is known as Unconditional Livable Income (ULI). The ULI would be expected to increase wages and decrease the labor supply. The Marxian “industrial reserve army of the unemployed” would cease to exist as such, even though the “unemployed” would be more numerous, since they would no longer be desperate to find work. Instead, the lowest-paid workers would become a “people's industrial reserve army of the employed”, perpetually ready to quit and rely on UBI alone if abused or underpaid, forgoing the additional income from wages. Worker discipline would be replaced by employer discipline. All workers would enjoy the bargaining-power advantage that presently belongs only to the highest-paid. Their pay might even begin to correlate with the value of what they produce, rather than with their survival needs. In effect, ULI would serve as a rolling strike fund for the entire population, making labor strikes on an individual basis a practical possibility.

      By contrast, an inadequate UBI (below the level of ULI) would be worse than useless. Instead of offering workers the option to quit, the inadequate UBI would allow employers to pay workers less for the same work. The entire amount of the UBI would be captured by employers as a subsidy to wages, just as occurs with stingy welfare-type benefits under the current regime (such as food stamps for Walmart employees). I would expect to see a U-shaped or even V-shaped relationship between the level of UBI and the lowest level of prevailing wages, with a relatively sharp change of regime (in the engineering sense) as inadequate UBI, subject to employer subsidy capture, shaded into empowering ULI.

      ULI is the only kind of UBI worth considering, and quantitative analysis of its approximate minimum is of vital importance for any plan to implement UBI.

  3. Excellent post. The value of this implicit safety asset is very significant, but generally overlooked.

  4. Universal basic income funded by location value taxation http://wealthoflabour.wordpress.com

  5. Re: "Employers report skills shortages and complain about being unable to fill vacancies at the same time as there is high unemployment not only among the unskilled, but also among those with advanced qualifications but little work experience."

    Perhaps that is the case on your side of the pond but in the US there is significant unemployment and even more UNDERemployment among the skilled and experienced. I speak from experience as a 57 year old mechanical engineer.

    Anecdotal claims from employers about having difficulty finding "good people" should be taken with a grain of salt. Every employer I worked for complained about how hard it was to find "good people," yet there was never a shortage of applicants with the desired qualifications -- it's just that the applicants were not perfect enough to suit the employer.

    In the US, JOLTS data showing the number of unemployed vs. the number of job openings for each job category dispels the myth that there is a shortage of STEM workers, for example.

    To sum things up, skilled workers experience unemployment and UNDERemployment, too, and skilled workers need job creation programs and economic security, too.

    That not the main point of your post but nonetheless I felt obliged to point it out.


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