THE DEVELOPMENT OF THE NEOCLASSICAL TRADITION IN LABOR ECONOMICS

GEORGE R. BOYER and ROBERT S. SMITH*

This essay on labor economics examines neoclassical theory's rise to ascendancy following the second World War, with a secondary focus on the relative decline but continued influence of institutionalist eco­ nomic theory. The authors describe the evolution of institutional and neoclassical theory from the late nineteenth to mid-twentieth centuries, examine some early intellectual debates between the two camps, briefly describe the work of neoclassical labor economics pioneers, and look at major developments over the past 30 years. They argue that neoclassical economists' increasing intellectual breadth and influence in public policy have led them to pay closer attention to issues that have long been of concern to institutionalists and "neoinstitutionalists."

he field of labor economics has institutionalist approach survived, and in Tchanged dramatically in the postwar some universities continued to thrive, but period. At the end of the second World its practitioners tended to move out of eco­ War, labor economics was dominated by a nomics departments and into departments group of academics who, while knowledge­ of industrial relations or business schools. able of neoclassical theory, had their roots This essay chronicles the rise to dominance in the institutionalist approach to econom­ of the neoclassical approach to labor eco­ ics. However, the next thirty years saw the nomics. rise to dominance of an approach to labor We begin by describing the roots of the economics that was rooted in neoclassical institutionalist and neoclassical "camps" in economic theory. The same period saw a the half-century before the second World decline, within economics departments, of War. This is followed by an examination of institutionalist-based labor economics. The the state of labor economics in the first postwar decade, and of some early intellec­ tual debates between the institutional and neoclassical camps. We then briefly de­ scribe the work of four of the pioneers of *The authors are Professors in the Department of Labor Economics, New York State School of Indus­ neoclassical labor economics—H. Gregg trial and Labor Relations, Cornell University. They Lewis, Gary Becker, Jacob Mincer, and thank John Abowd, Robert Aronson, Francine Blau, George Stigler. Finally, we examine some Ronald Ehrenberg, Gary Fields, Robert Hutchens, of the major developments in neoclassical George Jakubson, Lawrence Kahn, Harry Katz, and labor economics since the early 1970s, and Marcus Rebick for their perspectives on postwar labor economics and comments on various drafts of this show how the neoclassical has been influ­ essay. enced by the institutional approach.

Industrial and Labor Relations Review, Vol. 54, No. 2 (January 2001). © by Cornell University. 0019-7939/00/5402 $01.00

199 200 INDUSTRIAL AND LABOR RELATIONS REVIEW

Our essay is an attempt to generate some Institutionalism began in the United insights into how economic thought about States at about the same time that Alfred labor issues has developed and been modi­ Marshall's Principles of Economics (1890) was fied over the past half century. It is not laying the groundwork for what we now call meant to be a survey of all aspects of labor neoclassical labor economics. Institution- economics, both neoclassical and institu­ alism's roots can be traced back to the tional. Our focus throughout is on the German historical school of economics, and development and modification of the neo­ some of its founders, such as Richard Ely, classical approach. We begin with the roots had been trained in Germany (McNulty of the two alternative approaches to study­ 1980:131-33; Kaufman 1993:30-31). Ely ing the labor market. described the economics that was taught in American universities in the 1870s and 1880s as "dry bones"—focusing entirely on The Historical "natural economic laws" and laissez faire, Antecedents of Two Traditions and seeing people as simply "instruments] During the interwar years, the entire by which wealth is created and not the end discipline of economics was characterized for which it exists" (Ely 1938:125-27). Ely by what one recent author (Yonay 1998) rejected this "barren" approach, and turned has termed a "struggle over the soul of his attention to the study of practical prob­ economics" between two fundamentally lems (including those facing the American distinct approaches toward understanding labor movement) using a variety of meth­ economic phenomena: neoclassical eco­ ods.1 In 1886 he published The Labor Move­ nomics and institutionalism. Neoclassical ment in America, which, while largely a his­ economics began in the late nineteenth torical work, is regarded by many as the first century as a challenge to the classical eco­ American labor economics text. nomics of David Ricardo and John Stuart In 1892 the University of Wisconsin hired Mill. It "replaced the individual economic Ely to be director of the newly formed agent as a sociological or historical datum School of Economics, Political Science, and by the utility-maximizing individual" History, and in 1904 he hired his former (Stigler 1969:225). Although classical eco­ student at Johns Hopkins, John R. Com­ nomics and neoclassical economics con­ mons, to teach labor economics. Com­ tained similar laissez-faire social philoso­ mons "turned the University of Wisconsin phies, the issues addressed by the two in Madison into a center of institutionalist schools were much different. Classical eco­ research, that is, of rigorous study of the nomics had focused on economic growth; evolution and practicing of various eco­ neoclassical economics focused on issues nomic organizations" (Yonay 1998:51). In of relative prices and allocation of a given 1905, two of Commons's colleagues at Wis­ set of resources. According to the English consin, Thomas Adams and Helen Sumner, economist Joan Robinson (1953:22), classi­ published a textbook entitled Labor Prob­ cal economics had been concerned with lems, which typified the institutionalist ap­ "big questions," such as the distribution of proach to labor economics. In the preface output among wages, rent, and profits. Adams and Sumner (1905:v) wrote that Neoclassical economics, on the other hand, assumed that the big questions had been "the principal aim of this book is to furnish answered, and focused on "little ques­ tions," such as "Why does an egg cost more than a cup of tea?" This new focus on prices and their underlying supply 'According to McNulty (1980:133), Ely's interests and demand conditions permitted ana­ were "so wide ... that only a fraction of the topics on lytical techniques thatwere deductive and which he wrote could be said to belong to the realm abstract, and in time this approach was to of economics." As evidence of his broad interests, become mathematical. Ely's graduate students later became professors of sociology and history as well as economics. THE NEOCLASSICAL TRADITION IN LABOR ECONOMICS 201 a convenient collection of facts that will which concerns itself with ... an institution or a facilitate the study and the teaching of the group of institutions and the consequences for American labor problem." The book had men of the operation of these institutions. two parts: "Evils" and "Remedies." "Evils" (Brissenden 1926) contained chapters on women and child In contrast to the institutional approach, labor, immigration, the sweating system, the neoclassical approach to labor econom­ and poverty. "Remedies" included chap­ ics—which emphasizes the word econom­ ters on unions, profit-sharing, cooperation, ics—is built upon posited maximizing mod­ industrial education, labor laws, and the els of firms and workers at the individual material progress of the wage-earning class. level, and it is ahistorical in nature. One In the same year Commons (1905) pub­ starts, as did Marshall, with certain funda­ lished a collection of recent papers by him­ mental principles about economic actors, self and others in a volume entitled Trade not a collection of facts, and from theoreti­ Unionism and Labor Problems, which comple­ cal analyses (often expressed and reasoned mented the Adams and Sumner text. Thus mathematically) are drawn hypotheses or emerged what was later called "institution- conclusions about labor market outcomes. alist labor economics." In its quest for analysis, this approach looks Instinationalist labor economics empha­ for general patterns rather than patholo­ sized the word labor. This approach was gies peculiar to certain institutions or mar­ kets. Put in terms of modern statistical fact-based, its methodology largely was in­ analysis, so widely used in testing hypoth­ ductive, and it generally relied on a case- eses about the labor market, the neoclassi­ study approach toward data-gathering. cal approach seeks to discover systematic From the intensive, often historical, study behavioral tendencies, and it comfortably rel­ of individual cases or events came detailed egates deviations from these tendencies to descriptions of various labor-market institu­ the "unexplained variation" of the error tions or outcomes. Followers of this institu­ term. tional approach differentiated "descriptive economics" from "economic theory," and The principal strength of the neoclassi­ saw their role as providing "data sufficiently cal approach is that it satisfies the scholarly concrete, definite, and convenient to form yearning for general principles that can a basis for analysis, discussion, and criti­ organize "mere" facts, and it is the absence 2 cism" (Commons 1905:iii). In 1926, a of general principles that was seen as a reviewer of Solomon Blum'sjust-published weakness of institutionalism. Ronald Coase institutionalist textbook, entitled Labor Eco­ summed up the work of institutionalists in nomics (which appears to be the first book this way: "Without a theory they had noth­ with these words in its title), put institu­ ing to pass on except a mass of descriptive tional economics in the following context: material waiting for a theory, or a fire" (cited in Posner 1993:206). The principal The economic drift has been and continues to criticism of the theoretic approach is that, be from the deductive to the inductive method often, too little attention is given to real­ of attack, ... from the concentration upon the ity—either in forming hypotheses about logically postulated reactions of the economic man to concentration upon groups of men cre­ labor market behaviors or in testing them ating (and being variously affected by) eco­ empirically. Again we turn to Coase, who nomic institutions. In the place of the old, wrote, "In my youth it was said that what was single, outstanding problem of the analysis of too silly to be said may be sung. In modern the economic man ... we now face, and have to economics it may be put into mathematics" deal with, a long series of problems each of (cited in Posner 1993:198-99). A neoclassical approach to labor eco­ nomics appeared poised to take hold in the decade prior to World War II with the pub­ For a recent perspective on institutional econom­ lication of two very different books by the ics, see Hodgson (1998). same title: The Theory of Wages. John Hicks's 202 INDUSTRIAL AND LABOR RELATIONS REVIEW

The Theory of Wages, published in 1932, was retical concepts, and that stressed general a theoretical work with little attempt at principles rather than descriptive detail, empirical analysis. Hicks wrote that the were neither unknown nor awaiting discov­ purpose of his book was to restate "the ery in the 1930s. Yet the institutionalist theory of wages in a form which shall be approach to labor-market issues—dominant reasonably abreast of modern economic until then—continued its primacy through knowledge" (1932:v), and its chapters dealt the first two postwar decades. Why? with labor demand and the theory of mar­ One fundamental reason why a neoclas­ ginal productivity, the supply of labor, com­ sical approach to labor economics did not petition, and the undesirable side-effects take hold with the publication of the Hicks of governmental regulation.3 His analysis and Douglas texts was the Great Depres­ of individuals' supply of labor was influ­ sion. Unemployment rates of 25%, closed enced by Lionel Robbins's important ar­ banks, and bread lines focused attention of ticle published two years earlier, which dem­ labor-market scholars away from abstrac­ onstrated the conditions under which indi­ tion and toward policies for the immediate viduals' labor supply curves were positively amelioration of human suffering. To most, or negatively sloped.4 the market had clearly failed. It is little In 1934, Paul Douglas came out with his wonder, then, that market forces, in both Theory of Wages. Unlike Hicks, Douglas com­ theory and practice, were either dismissed bined theoretical explication with an at­ or considered social evils to be mitigated, tempt to "determine the slopes of the de­ and that labor unions, as institutions that mand and supply curves of the various com­ had become central actors in many labor modities" relevant to the production pro­ markets, were accorded such preeminence cess (Douglas 1934:xii) .5 In so doing, Doug­ in labor textbooks of the day. In the second las—who was very interested in real-world edition to his Theory of Wages, published in problems and public policy issues—tried to 1963, Hicks himself lamented that "1932 steer a middle ground between theoretical was not a lucky date for the appearance of deduction and empirically based induction. a book like this. It was the blackest year of In the preface he wrote, "The younger gen­ the Great Depression; there has been no eration of economists ... are increasingly date in this century to which the theory that turning on the one hand from the sterile I was putting out could have been more shadow-boxing which has characterized so inappropriate.... So, soon after its birth, much of dialectical economics and on the The Theory of Wages began to look like the other from the theoretical blind alley of the last gasp of an ancien regime" (1963:305). purely historical and institutional meth­ It is also noteworthy that both Hicks and ods" (1934:xii). Douglas published little in the field of la­ Thus, approaches that organized the bor economics after the mid-1930s. Hicks, subject matter of labor economics by theo- whose interests shifted to economic theory, came to believe that his Theory of Wages had "fearful gaps" and let it go out of print Hicks's book also contained a model of the bar­ "because my own views upon its subject had gaining process between labor and management that changed so much that I no longer desired is still taught in both labor economics and collective to be represented by it" (Hicks 1963:v, 306) .6 bargaining courses. Prior to Robbins (1930), most economists argued that short-run labor supply curves were always nega­ tively sloped. For example, Frank Knight (1921:117- 18) argued that "rational" men would always reduce Hicks did, however, allow the book to be re­ their hours of work when their wage increased. printed in 1963, because "it has ... been made clear to Knight's justification for this conclusion is based me that there is still a demand for it" (1963:v). Many entirely on an analysis of the income effect. modern labor economists have a high regard for The Douglas's book contained pioneering attempts to Theory of Wages. For example, Sherwin Rosen estimate labor supply elasticities. His analysis of labor (1985:1144) refers to it as a "remarkably enduring supply is extended in Schoenberg and Douglas (1937). work." THE NEOCLASSICAL TRADITION IN LABOR ECONOMICS 203

Douglas increasingly turned his energies to aborted any interest in labor economics by any public life, first as a member of the Chicago reasonably intelligent person. The central mes­ City Council (1939-42), then as an officer sage of the first was that realistic studies were in the Marines, and ultimately as a United the low road and pure theory the high road. The central message of the second was that all States Senator (after 1948). Thus, the field that needed to be known about labor econom­ of labor economics was abandoned by the ics was already known, since it was a sub-branch two prewar scholars who could have served of standard marginal analysis applied to nearly best to advance a neoclassical approach. perfect labor markets with few special charac­ teristics. (Kerr 1988:1) Labor Economics in the Early Postwar Period The distinctly ambivalent attitude toward neoclassical theory of the early postwar la­ As noted, the neoclassical and institu- bor economists is reflected in a textbook tionalist approaches to labor markets re­ published in 1941 by Princeton's Lester. flected a larger debate within the field of The book, entitled Economics of Labor, be­ economics during the 1920s and 1930s over gan by explaining to the reader that the how the study of economic phenomena text was "analytic rather than encyclopedic. should be conducted. Despite their deep The emphasis throughout the book is upon skepticism of neoclassical modeling, insti- economic principles rather than upon par­ tutionalists generally regarded themselves ticular events or ephemeral facts" (p. vii). as—and were perceived by others to be— Lester had by no means turned his back on economists (Yonay 1998:71-76). Indeed, the institutionalist approach, however, as Douglas considered Commons to be "per­ can be seen by the book's organization and haps the most magnificent economics the titles of its three major parts: "labor's teacher of my time" (Douglas 1971:35), economic problems"; "organization and and the authors of the institutionalist labor labor relations"; and "collective bargaining textbooks of the 1930s—Blum (1925), in certain industries." Moreover, Lester Carroll Daugherty (1933), Dale Yoder eschewed the very generalization that theory (1933), and Harry Millis and Royal Mont­ seeks: "Generalization is especially diffi­ gomery (1938)—all were members of eco­ cult when each problem that arises may be nomics departments in their universities. unique because it presents a slightly differ­ At a minimum, the cohabitation of in- ent combination of factors or a new set of stitutionalists and price theorists in in- circumstances" (p. 38). Carroll Daugherty, terwar economics departments meant in a 1945 paper on the labor field in the that graduate students of the day who American Economic Review, described the were interested in labor economics had ambivalence of Lester's approach in this to obtain a grounding in standard eco­ way: nomic theory. Thus, when World War II ended, the field of labor economics was in There is, in fact, no labor textbook which satis­ the hands of scholars—most notably, John factorily employs and integrates the tools of economic analysis in its discussions. The best Dunlop, Clark Kerr, Richard Lester, and thing thus far in this respect is R. A. Lester's Lloyd Reynolds—who were well-versed in Economics of Labor ... and labor teachers and neoclassical theory but deeply skeptical of writers are greatly in his debt. But Lester, after its relevance to the real world. In the words berating his competitors in front of his text­ of Kerr, book audience ... misses the trapeze in midair and is fortunate to land in the safety net of confusion, (p. 655) For nascent labor economists in the early 1930s ... the two most important recent books of special relevance were by Lionel Robbins (An Yale's Reynolds published a textbook Essay on the Nature and Significance of Economic entitled Labor Economics and Labor Relations Science, 1932) and by John R. Hicks (The Theory in 1949, and it also was largely atheoretic in of Wages, also 1932). They both carried discour­ its approach. The book's first sentence aging messages which, if followed, would have proclaimed it to be an "introduction to the 204 INDUSTRIAL AND LABOR RELATIONS REVIEW

study of labor"—note that despite its title, it (1973). These texts, which in many ways was not introduced as a study of economics. were quite similar, had surprisingly little in The first 60% of the book was devoted to common with the textbooks of the 1940s unions (including chapters on union his­ and 1950s, or indeed even with the 1970 tory, governance, and politics), and the edition of Reynolds's textbook.8 Rees main­ chapters in the "economics" section mainly tained in his introduction that economists described practices followed by firms and trained in the "institutional tradition ... industries in setting wages. Filled with de­ have tended to move into industrial rela­ scriptive narrative on unions, government tions ... and [become] somewhat isolated regulations, and employers' practices, from the main stream of economics." He and sprinkled with a handful of tables wrote that his book "does not pretend to and charts describing trends and condi­ cover industrial relations ... Rather it will tions, the book contained virtually no concentrate on the application of economic analysis of how supply and demand affect theory and statistics to the problems of the price of labor. labor markets" (Rees 1973:viii). That Reynolds's text dominated the mar­ A glance at the tables of contents shows ket for at least the next two decades is a how different the Fleisher and Rees texts telling indication of how labor economics were from their predecessors. Gone were was taught to students during this period. the long sections on labor history, labor Between 1964 and 1970, however, Reynolds law, and union organization, and replacing revised his text to place the section called them in both texts was a single chapter "Economics of the Labor Market" first concerned only with the economic aspects rather than second. While the fifth (1970) of trade unions, such as formal models of edition maintained its original flavor—with union objectives and the measurement of collective bargaining's history, law and gov­ union-nonunion wage differentials. These ernance, tactics, and outcomes still occupy­ texts were organized by theoretical con­ ing 60% of the space—the preface noted, structs, not labor issues or institutions, and In this edition, I have reversed the previous each had chapters on the supply of labor by sequence and have placed the economic analy­ individuals, human capital investments by sis at the beginning of the book ... First, labor firms and workers, and the demand for economics is basic in the sense that the econom­ labor in competitive and noncompetitive ics of collective bargaining is included within markets and over both the short and long it ... Second, research in labor economics is shifting in a quantitative and econometric di­ rection ... The wealth of new research material warrants both enlarging the "economic" com­ ponent of this text and placing it at the begin­ ning of the discussion. (Reynolds 1970:iv) A third book, Richard Freeman's Labor Economics (1972), could also be included in this list. Freeman's More than the ordering of topics, however, book is theory-based, but it is quite short and was not intended to be a text for a full semester course in there was an increased emphasis on theory. labor economics. In contrast to just one graph included in its In 1957 Melvin Reder published a labor econom­ original edition, fully 20 theory-related ics textbook that, had it met with more success, might graphs could be found in the "economics" have served as a smooth transition between the part of the book's 1970 edition—which by "neoinstitutionalists" and the neoclassicists. The text then had chapters on demand and supply. began, as did Reynolds's, with a lengthy section on unions, but its economics section was of a very differ­ The trend that by 1970 had induced a ent flavor. As opposed to the skepticism about neo­ major change in Reynolds's text also gave classical theory of the neoinstitutionalists, Reder was birth to the first two thoroughly neoclassi­ fascinated with theory and took pains to both exam­ cal labor economics textbooks in the post­ ine critical assumptions and point out where behav­ ior was—or could be seen as—consistent with theory. war period: Labor Economics: Theory and The market for labor economics texts was clearly not Evidenceby Helton Fleisher (1970), and The ready for such a book, and it did not survive into a Economics of Work and Pay by Albert Rees second edition. THE NEOCLASSICAL TRADITION IN LABOR ECONOMICS 205

run. Both books were so devoid of descrip­ While Kerr admitted that the "revision­ tive material that neither was as long as 300 ists" focused their attention on the realism pages (Reynolds's book was by now run­ and applicability of standard theory rather ning nearly 700 pages). than suggest postulates that would extend The change made in Reynolds's text and its explanatory power (Kerr 1988:2-3), he the appearance of two theory-based com­ would later claim that the revisionists petitors suggest that the market for the achieved their greatest victory in 1963 when neoclassical approach had grown to a criti­ Hicks (in the second edition of The Theory of cal size by the early 1970s. Further, since Wages) acknowledged that social forces play textbooks tend to follow intellectual trends, an essential role, notjust a marginal one, in not lead them, their change in basic ap­ the labor market (Kerr 1994:68). A close proach by the early 1970s suggests that inspection of Hicks's 1963 book, however, during the 1950s and 1960s some very im­ reveals that it contains no mention what­ portant groundwork had been laid toward ever of any of the "realistic studies" by the a new and very different way to conceptual­ revisionists. Moreover, the seminal works ize labor economics. The next sections by the earliest of the neoclassical labor investigate various aspects of how this economists (to be discussed later), which change came about. were being published with regularity by the 1960s, made virtually no reference to the works of the early postwar scholars. It is Early Postwar Labor therefore very difficult to argue that the Economists: The End of One latter were "revisionists" in the same evolu­ Line or the Continuation of Another? tionary chain as the founders of modern Viewed retrospectively, did the work of labor economics—and relatively easy to accept labeling them as "neoinstitution- the early postwar labor economists serve as 9 a link between Hicks/Douglas in the early alists." 1930s and the neoclassical labor econo­ The early postwar scholars were all ener­ mists whose theory-oriented analyses be­ getic, trained in economics, academically gan to shape the field a generation later? respected, and persuasive enough to take Put somewhat differently, can the early on leadership roles of one sort or another postwar labor economists best be charac­ in academic or government circles. Why, terized as institutionalists who knew eco­ then, do they appear more like an exten­ nomic theory ("neoinstinationalists"), or as sion of the "institutionalist" line than, as neoclassical economists with "realistic" in­ they might have hoped, a vehicle for ex­ terests? tending neoclassical theory? Inquiring into Most likely because of their training, their the reasons for their failure to serve as a academic departments, and the perceived bridge between the institutional and neo­ obsolescence of "institutionalism," the early classical schools leads us to a consideration postwar labor economists have tended to of intellectual controversies that illustrate see themselves as being in the latter camp— both the two alternative approaches and as "neoclassical revisionists" striving to use the compelling attraction of a neoclassical the realism of the earlier institutionalists to framework for viewing the labor market. enrich standard price theory as Hicks had We start with a controversy that arose quite applied it to the labor market. Kerr, for explicitly in the 1940s. example, says that "members of the revi­ sionist group had been trained in the theory of the thirties—in Hicks, in Robinson and Chamberlain, and in Keynes ... They did not reject theory, as did the institutiona­ 9The term "neoinstitutionalists" was coined by Cain lists ... rather, they respected theory and (1976). Kerr has called the terminology "inaccurate, wanted to make it more useful in under­ even misleading" (1988:13). He coined the term "neoclassical revisionists" to refer to economists such standing practice" (Kerr 1988:13). as Dunlop, Reynolds, Lester, and himself. 206 INDUSTRIAL AND LABOR RELATIONS REVIEW

Debate on the Marginal Professor Fritz Machlup, then at the Productivity Theory of Demand University of Buffalo, sprang to the defense of neoclassical theory by arguing that Lester The concept underlying the theory of misunderstood the role of theoretical mod­ labor demand by firms is the notion that els in analyzing behavior. Machlup argued adding workers while holding capital con­ that a driver of a car deciding whether to stant increases output. These increments overtake a truck proceeding slowly in front to output ("marginal productivity") are as­ of him on a two-lane road will not explicitly sumed to diminish, however, as more and measure or calculate in a formal way all the more labor is added, and a profit-maximiz­ variables involved in making a decision ing firm is posited to stop hiring when the about overtaking the vehicle. However, if value of labor's marginal product falls be­ scientists were to model and predict this low the cost of hiring this extra labor. Thus, driver's behavior, they would have to for­ theory implies that when a wage increase mally adopt and numerically solve such a causes the costs of hiring labor to rise, firms model. Machlup argued that will cut their use of labor in order to bring the value of marginal productivity back in the explanation of an action must often include line with marginal labor costs. The concept steps of reasoning which the acting individual of diminishing marginal productivity and himself does not consciously perform (because the chain of reasoning underlying the pos­ the action has become routine) and which per­ haps he would never be able to perform in tulated profit-seeking behavior of firms are scientific exactness (because such exactness is what underlie the downward-sloping labor not necessary in everyday life). To call, on these demand curve so central to neoclassical grounds, the theory "invalid," "unrealistic" or theory. "inapplicable" is to reveal failure to understand In an article published in 1946, Richard the basic methodological constitution of most Lester took issue with the relevance of this social sciences. (Machlup 1946:535) theory of labor demand. His interviews Machlup's arguments carried the day, and with business executives (note the case study even the neoinstitutionalist texts that suc­ approach) led him to conclude that these ceeded Lester's continued to analyze the decision-makers neither thought in terms demand for labor in terms of the marginal of marginal productivity nor, as a practical productivity model. Still, the neoinstitu- matter, could explicitly calculate labor's tionalists maintained their deep misgivings marginal product with any degree of confi­ about price theory's lack of realism. dence. He therefore concluded that "much of the economic reasoning on company The Role of Theory employment adjustments to increases or in "Realistic" Studies decreases in wage rates is invalid, and a new theory of wage-employment relationships As quotations from Kerr and Lester have for the individual firm must be developed" made clear, the early postwar labor econo­ (Lester 1946:71). In essence, Lester mists felt that standard economic theory doubted the relevance of the marginal pro­ inadequately represented the complexity ductivity theory of labor demand and as­ of observed phenomena. Further, they serted that its irrelevance was caused by seemed to believe that if they could bring to simplistic or invalid deductive modeling.10

them are valid, and the results are modified but not '"Lester's criticism of the marginal productivity vitiated by the presence of other forces which are at theory of labor demand was similar in some ways to work as well" (1934:95). He adds in a footnote, "The earlier criticisms made by Paul Douglas in The Theory critics of the marginal productivity theory have fre­ of Wages. However, Douglas concluded that "the quently betrayed their ignorance of the nature of forces upon which the productivity school built their scientific law. The law of gravitation, for example, theories are ... powerful. To the extent that they are had not been rendered invalid by the development of operative, the conclusions which are drawn from heavier than air airplanes" (p. 95). THE NEOCLASSICAL TRADITION IN LABOR ECONOMICS 207

light "realistic" evidence that was inconsis­ bor market issues. Another early contribu­ tent with economic theory, then others in tion to the debate about how economic the economics profession would be moti­ theory applies to "real" labor markets was vated to change standard theory as applied made by Simon Rottenberg (1956). to the labor market. A case in point was a Rottenberg directly confronted four 1948 article on money wage movements by neoinstitutionalist assertions concerning Reynolds in the American Economic Review, job choice: that "personal" reasons are which called for economists to be more cited by workers as more important than attentive to empirical reality in their model- the structure of wages when they are inter­ building. This article, like those of the viewed about their occupational choices; other neoinstitutionalists, did not attempt that workers' choices are made under con­ to construct a new theory or modify an ditions of ignorance; that workers' concern existing one to account for apparent em­ for job security dominates their sensitivity pirical inconsistencies. A neoclassical to the wage structure; and that workers do economist reading such an article could not act rationally in labor markets. Eco­ be forgiven for concluding that the au­ nomic theory, Rottenberg pointed out, thor himself saw little to be gained in posits that job choice is multi-dimensional molding standard theory to fit labor-mar­ and that predictions based on this theory ket facts. are made holding other things equal. Theory, What the neoinstitutionalists failed to he argued, does not hold that wages are the understand or acknowledge about para­ only thing that matters; rather, wages are digm changes was stated by Paul Samuelson one of the variables considered when mak­ in a 1951 paper on wage theory: "In eco­ ing a choice. Moreover, interview responses nomics it takes a theory to kill a theory; are to be distrusted, both because respon­ facts can only dent the theorist's hide" dents tend to focus on a single dimension (Samuelson 1951a:323). Samuelson's im­ when explaining choice and because they plicit view of the centrality of theory to are reluctant to admit their behavior is social analyses was elaborated more explic­ affected by materialistic motivations. Fur­ itly in 1953 by Milton Friedman. While ther, to say that information is imperfect neoinstitutionalists were inclined to think and that estimations of various job condi­ and write about the enormous complexity of tions have to be made when making a deci­ labor markets, Friedman argued that the sion under conditions of uncertainty does whole purpose of theoretical models is to not imply that workers cannot act ration­ strip away complexity so that fundamental ally. In sum, Rottenberg, Machlup, and tendencies can be more clearly seen. Friedman combined to provide important clarifications about both the role of theory Models, Friedman argued, should notbe and how to assess its usefulness in explain­ judged by the "realism" of their assump­ ing "real" labor-market phenomena. tions (as the neoinstitutionalists were wont to do), because critical behaviors necessar­ ily must be simplified by assumption if pre­ diction is to become possible in a complex The "Reach" of Neoclassical Theory world. Instead, he argued forjudging theo­ But how widely, and to what questions, ries by the quality of their predictions. Echo­ could neoclassical theory usefully be ap­ ing Machlup, Friedman argued that if a plied? Economics, like many sciences, can theory predicts behavioral tendencies of­ be divided roughly into theoretical and ten enough to find support in the data, applied fields. While theoretical fields in then it is useful even if its underlying as­ economics are abstract and in the postwar sumptions do not always and everywhere period attracted those inclined to see the hold. beauty of mathematics, the applied fields Friedman's arguments, like those of continued to attract scholars interested in Machlup, helped to intellectually justify practical problems and issues of public the approach taken by neoclassicists to la­ policy. Labor market scholars are usually 208 INDUSTRIAL AND LABOR RELATIONS REVIEW of the latter variety, and for these scholars among modern labor economists who was to become convinced that economic theory neither a colleague of Lewis while formu­ could be creatively applied to analyses of lating a seminal work nor among almost 90 important labor-market issues required that Ph.D. students he supervised over the such theory be focused both on the genera­ years.11 tion of empirically testable implications and In 1957 Lewis published a paper in which on socially interesting topics, even if here­ the secular decline in hours of work was tofore not seen as within the purview of analyzed using neoclassical economic economics. theory; that Lewis's intellectual heritage In the immediate postwar period, the was squarely in economic theory was indi­ discipline of economics had been invigo­ cated by the statement, made early in the rated by such scholars as Ragnar Frisch, Jan paper, that "our approach is orthodox: Tinbergen, and Paul Samuelson—the first mainly the theory of the demand for leisure winners of the Nobel Prize in economics— viewed as a consumption good." Lewis's who increased the degree of formalization classic book, Unionism and Relative Wages in in both theory and empirical application. the United States (1963), analyzed a tradi­ On the theoretical side of this mathemati­ tional topic in a new way. Instead of focus­ cal revolution, neoclassical theory was re­ ing on-the history, governance, and tactics cast with the use of rigorous derivations, of unions, as had the neoinstitutionalists, which spawned new interest in the field: Lewis confined his work to a question upon "While institutionalists and many neoclas- which economic theory could empirically sicists in the interwar period felt that price contribute: the effects of unions in raising theory had been completed ... the years the wages of their members relative to those 12 after World War II witnessed a flood of of nonunion workers. articles, each focusing on a certain element While Lewis's work on unions looked at of the theory, couching it in a newly born an old topic in a new way, his student (and jargon, and deriving rigorous conclusions later a colleague) Gary Becker broadened out of it" (Yonay 1998:186). the scope of issues to which economic theory On the empirical front, the field of econo­ was addressed. Becker believed that eco­ metrics—the application of statistical quan­ nomic analysis was applicable to a wide tification to tests of theoretical proposi­ range of social phenomena, not just the tions—developed and then exploded after characteristics of producers and consum­ the mid-1960s when the computer made it ers traditionally of interest to theorists. In possible to perform highly complex calcu­ his view, the applications of economic lations in minutes (and, later, seconds). theory were better defined by methodology These changes in economics at large helped than by topic: "The combined assumptions attract to the field of labor economics some of maximizing behavior, market equilib­ innovative pioneers who could envision the rium, and stable preferences, used relent­ application, and empirical testing, of neo­ lessly and unflinchingly, form the heart of classical theory in a variety of "realistic" the economic approach as I see it" (Becker labor-market contexts. 1976:5). Becker's writings and his attitude One such pioneer was H. Gregg Lewis, were fundamental to the development of who has been called the "father of modern modern labor economics. labor economics." Lewis was greatly influ­ enced by theorists at the University of Chi­ cago, where he was both a student and "Lewis served on the faculty supervising commit­ professor. While he authored a "classic" tee of the doctoral dissertations of Gary Becker, Glen book and several important articles, his Cain, Thomas Finegan, Marvin Kosters, Robert Lucas, Walter Oi, Donald Parsons, Albert Rees, Sherwin contribution to the field was "achieved more Rosen, and Finis Welch, among others. through teaching and criticism than , Lewis continued to study the issue and published through publication" (Rees 1976:83-84). a second book on the union wage effect more than It is difficult to think of an early leader two decades later: see H. G. Lewis (1986). THE NEOCLASSICAL TRADITION IN LABOR ECONOMICS 209

Becker made several major contributions ties, clean living spaces, and the like. The that were particularly significant to the cost of time at home is measured by for­ emergence of neoclassical labor econom­ gone earnings; thus labor supply and house­ ics. In 1957 he published The Economics of hold decisions are intertwined. Becker's Discrimination, in which he posited that a work on household production, along with person with a "taste for discrimination" will Mincer's 1962 paper, "Labor Force Partici­ act "as if he were willing to pay something, pation of Married Women," represented either directly or in the form of a reduced attempts "to place the theory of labour income, to be associated with some persons supply in the context of family decision­ instead of others" (Becker 1957:14). Based making, combining non-market household on this concept, Becker provided a frame­ behaviour with market behaviour" (Blaug work with which to analyze and measure a 1985:165). Mincer (1962a) found that social problem that is too important to be married women's participation rates were poorly analyzed and understood. negatively related to their family's income Becker also was one of the pioneers, (the "income effect") and positively related along with Theodore Schultz (1963) and to their own wage rates, holding income Jacob Mincer (1962b), in the development constant (the "substitution effect"). Lewis's of the theory of human capital. In Human (1957) earlier study of trends in work hours, Capital (1964), he argued that education along with Mincer's careful measurement and on-the-job training should be viewed as and empirical estimation of income and forms of investment, and that individuals' substitution effects, marked the beginning and firms' decisions concerning the amount of "modern research on labor supply" to invest are based on a comparison of costs (Pencavel 1986:5). The work on labor sup­ with the expected future returns to these ply by Becker and Mincer permitted and investments. Further, as a much-cited ar­ encouraged widespread analysis of the ris­ ticle by Walter Oi (1962) pointed out, em­ ing labor force participation of women and ployers' decisions concerning the use of the labor supply effects of social welfare overtime and layoffs in response to product programs. demand fluctuations are critically affected by their prior (and expected future) invest­ George Stiglerwas another path breaker. ments in the hiring and training of work­ In the early 1960s, Stigler (1961, 1962) ers. Human capital theory was extended to developed the economic theory of infor­ mation and its labor sub-field, the theory of the issue of migration by Larry Sjaastad 15 (1962), opening up a rich literature on job search. He argued that information is both the causes and effects of geographic and job mobility. Taken together, these theoretical developments opened up seri­ More recently, Becker has generalized his theory ous study of employee and employer behav­ of household production to include various aspects iors that critically affect job stability, the of family behavior. In A Treatise on the Family (1981), acquisition of skills, and locational choice— he analyzes "marriage, births, divorce, division of and hence the level of individual wages, the labor in households, prestige, and other nonmaterial distribution of earnings, and the demand behavior with the tools and framework developed for material behavior" (p. ix). for formal and informal schooling (which Other major studies of labor force participation together create the skills that constitute published in the 1960s include Cain (1966) andBowen over half of our stock of national wealth). and Finegan (1969). The labor supply effects of income maintenance programs are analyzed in Cain and Watts (1973). Becker's third major contribution has The theory of j ob search was first suggested by W. become known as the theory of household H. Hutt (1939:59-60), who maintained that an unem­ production. In his 1965 paper, "A Theory ployed worker who is actively searching for a job "is of the Allocation of Time," Becker viewed really investing in himself by working on his own account without immediate remuneration. He is household activities as the combination of prospecting... . He judges that the search for a better time and goods to produce commodities opening is worth the risk of immediately foregone that yield happiness: meals, leisure activi­ income." 210 INDUSTRIAL AND LABOR RELATIONS REVIEW

a valuable resource that is costly to obtain. analyzed like any other market, as Hicks An unemployed person looking for work, had claimed, the persistence of unemploy­ "unless his degree of specialization is patho­ ment seemed to constitute a major contra­ logical," faces "an immense number of po­ diction of an important theoretical impli­ tential employers" and needs to determine cation; indeed, in the words of institution- "how to acquire information on the wage alist Dale Yoder (1933:119), "Unemploy­ rates, stability of employment,... [and work­ ment must be regarded as deviation away ing conditions] which would be obtained from what might be expected to be the from every one of these potential employ­ normal condition." ers" (Stigler 1962:94). Information is ob­ One characteristic of the neoclassical tained by engaging in the costly activity of labor economists—and one that sharply job search, and Stigler argued that a maxi­ distinguished them from the neoin­ mizing worker will continue to search "un­ stitutionalists—was their dogged determi­ til the expected return equals the marginal nation to find maximizing behavior and cost of search" (1962:96). Because search equilibrium outcomes throughout the la­ is both necessary and often cheaper when bor market. Stigler's insights on search one is unemployed, and because the pres­ made it possible for at least some share of ence of unemployment insurance effectively overall unemployment to be seen as both subsidizes continued search, Stigler's con­ voluntary and a characteristic of equilib­ tributions opened up new insights useful to rium. If search is cheaper when a worker is the analysis—and to some extent, the not encumbered by a job, and if it is not remediation—of unemployment. always optimal for an unemployed worker While Stigler's work on information and to take the first job offered, then job seek­ search costs had relevance to unemploy­ ers could be seen as rationally choosing un- ment, it also could be used to address a employment under certain conditions. phenomenon that had contributed to the Armen Alchian (1970:29-30) described neoinstitutionalists' deep suspicion of stan­ such unemployment as "self-employment dard theory: the existence of wage differ­ in information collection." The economic entials in markets where the "law of one theory of job search was further developed price" was predicted to hold. Indeed, the by Dale Mortensen (1970a, 1970b) and J. J. issues of unemployment and wage differen­ McCall (1970), whose work demonstrated tials nicely illustrate the very different mind­ that "search unemployment" was an equi­ sets of the neoclassical labor economists librium outcome of voluntary behavior on and their neoinstitutionalist predecessors— both sides of the labor market. These pa­ a topic to which we will shortly turn. pers set the stage for an explosion of theo­ retical and empirical research in the 1970s and 1980s on the economics of search in Intellectually Coping the labor market.16 with Inconvenient Facts It had long been observed by both insti­ One fundamental tenet of basic price tutional and neoclassical economists that theory is that the forces of demand and cyclical declines in the demand for labor supply drive all markets into market-clear­ ing equilibrium. If a price is set above equilibrium, for example, supply will ex­ ceed demand, and the responses of profit- maximizing firms and utility-maximizing This enormous body of research is surveyed in worker/consumers will eventually drive the Devine and Kiefer (1991). Another view of "volun­ price down toward equilibrium. The lower tary" unemployment arising from (utility) maximiz­ price will increase the quantity demanded ing behavior was suggested by Lucas and Rapping (1969); in this model, some workers withdraw their and reduce the quantity supplied, with the labor supply—for the purpose of consuming leisure— result that the excess supply is reduced or when their individual wage falls below its normal (or eliminated. If the labor market can be "permanent") level. THE NEOCLASSICAL TRADITION IN LABOR ECONOMICS 211 did not lead to declines in wages by enough (1976) found that "most workers who are to clear the labor market, as predicted by laid off are subsequently rehired by their economic theory. Rather, firms tended to original employers," and concluded that temporarily lay off workers during down­ "because workers remain with the same turns. The absence of market-clearing employer through several spells of unem­ wages and the use of layoffs seemed to be ployment, the frequency and duration of further proof that neoclassical labor eco­ temporary layoffs must be regarded as part nomics was not realistic. In the mid-1970s, of the total package of compensation and Costas Azariadis (1975), Martin Baily conditions.... Although any particular lay­ (1974), and Donald Gordon (1974) inde­ off may be involuntary, the general pattern pendently developed the theory of implicit of temporary layoffs may be an explicit part contracts, which provided an economic ra­ of labor contracts" (1976:937-38). In sum, tionale for temporary layoffs. According to it is the view of neoclassical labor econo­ implicit contract theory, because workers mists that layoff unemployment is not in­ 17 dislike risk while firms are risk-neutral, consistent with economic theory. a mutual gain is available to employers and How neoclassical labor economists dealt employees ... [compared] to a world of purely with the issue of wage differentials is per­ auction labor markets. Employees will, to some haps even more instructive. Elementary degree, prefer a lower expected wage with a economic theory strongly implies that work­ smaller variance to a larger more uncertain ers who have equivalent skills and jobs with income. In the interest of getting cheaper the same nonpecuniary characteristics will labor, employers can enter into implicit long- receive identical wages.18 This one price term quasi-contracts with their employees by guaranteeing them some reasonable security. should prevail, because if it did not, either (Gordon 1974:78) workers in lower-paying jobs would migrate to the higher-paying ones, or the higher- The original implicit contracts models as­ paying employers would be driven by com­ sumed that all workers in a firm were iden­ petition in the product market to reduce tical, and that any layoffs that occurred their wages. Therefore, an implication of were therefore random. Because the share simple theory is that, absent temporary dis- of workers laid off even during serious down­ equilibria, observed wage differentials turns was relatively small, and the average should be related empirically only to the duration of temporary layoffs was short, supply (that is, human capital) characteris­ contracts containing "sticky" wages and lay­ tics of workers or the nonpecuniary aspects offs offered more income security than con­ of their jobs—and not to the industry, size, tracts in which firms responded to down­ or "ability to pay" of their employers. The turns by cutting all workers' wages. The problem for labor economists is that this existence of unemployment insurance implication is contradicted by the data, made contracts containing temporary lay­ which suggest the existence of persistent offs even more attractive to both firms and wage differentials among firms hiring from workers (Feldstein 1976). the same labor market. Indeed, the prob- A similar line of reasoning can be used to explain why implicit contracts exist in the real world where workers are not identical. Firms with long employer-employee job attachments may be encouraged by older "Implicit contract theory is surveyed in Rosen workers' risk aversion to engage in senior­ (1985). Burdett and Mortensen (1980) provide a ity-based layoffs rather than wage cuts for synthesis of search and implicit contract theory. all workers. Younger workers may be will­ The theory of wage differentials that compen­ ing to accept such contracts if they know sated for nonpecuniary differences in jobs, originally that layoffs are temporary and that they will outlined by Adam Smith, was fully developed by Sherwin Rosen (1974) in an influential paper thatwas eventually attain enough seniority with the seminal to a burgeoning empirical literature on com­ firm to become "older" workers. Feldstein pensating wage differentials. 212 INDUSTRIAL AND LABOR RELATIONS REVIEW lem of wage differentials was a cornerstone price theory it is cause for concern, and that an of neoinstitutionalists'distrust of economic explanation is in order. (Reder 1962:276) theory: "It is the apparent failure of local rates to equalize which has long been seized To Reder and others of the same stripe, upon by critics of competitive theory as neoclassical theory was innocent until their prime exhibit" (Reder 1962:312).19 proven guilty, and like good defense law­ The neoinstitutionalists had explained yers, they readily marshaled plausible alibis these theoretically embarrassing wage dif­ and mitigating circumstances when the facts ferentials in a number of ways that they looked damning. On the topic of why believed undermined the neoclassical interindustry wage differentials did not model. Reynolds, in his 1970 text (pp. 101- show signs of disappearing over time, as 17), pointed to a numberoipotential expla­ theory suggested should happen, Reder nations: wages that were downwardly in­ invoked two defenses that were to become flexible, internal labor markets, discrimi­ fairly standard: the data observed might nation, "anti-pirating" agreements among inadvertently be from periods that exhib­ employers, unionism, poor information, ited short-run disequilibria, and the studies restricted entry to occupational training might not have controlled for all the vari­ programs, the failure of firms to maximize ables that influenced the observed outcome profits, and sheer tradition. While these (in this case, possible changes in the geo­ scholars were clearly seeking generaliza­ graphical distribution of firms and the oc­ tions, none cast their analyses in terms of cupational skill mixes within industries). neoclassical theory (that is, using a sparse While Reder did concede that the persis­ model of maximizing behavior in the face tence of interindustry wage differentials of competition and constraints). could imply that the competitive hypoth­ Melvin Reder, at Stanford, was among esis was wrong, the internal logic of el­ the first of the "modern" labor economists ementary neoclassical theory was clearly to directly address the issue of wage differ­ compelling enough to prevent his theoreti­ entials apparently associated with employer cal hide from being easily dented by mere (including industry) characteristics. In a facts. He reasoned that, "to be sure, there 1962 paper on the topic of demand-side is a tendency for out-of-line wages to be wage differentials he revealed an attitude corrected as soon as the 'opportunity pre­ very characteristic of the neoclassical labor sents itself,' but it is also true that large economists: firms are more dilatory about correcting Most discussions of interindustry wage differen­ overpayment" (Reder 1962:285). He im­ tials proceed without much explicit consider­ mediately allowed that this dilatory behav­ ation of economic theory. The literature ior was "not explained by the competitive abounds in ad hoc hypotheses, some of which hypothesis," but undaunted, he concluded are consistent with economic theory but many his paper by arguing that the competitive of which are not. However, these various hy­ hypothesis had not been disproved. He potheses are usually treated as being equally reasoned that "it can hardly be said to be plausible, a priori; consistency with the implica­ firmly established as an explanation of wage tions of price theory has counted for very little in appraising the merits of a theory. Our atti­ phenomena even for long periods; but it tude is somewhat different; we believe that if a has at least survived (reasonably well) the theory is inconsistent with the implications of tests to which it has so far been put" (Reder 1962:298). Thus, Reder's attitude, like that of other neoclassicists, was essentially that models assuming maximizing behavior can explain labor-market phenomena if only 19Reder's views of the early 1960s are echoed today researchers are well-enough endowed with by Kaufman (1994:146), who says that "the single data and methodologies to apply the ap­ most important empirical issue in labor economics is propriate empirical tests. the degree to which labor markets are competitive." Reder's unswerving allegiance to neo- THE NEOCLASSICAL TRADITION IN LABOR ECONOMICS 213

classical theory was testimony to the intel­ book expanded on earlier studies by lectual appeal of a simple, internally consis­ Reynolds, Kerr, and Dunlop.20 Reynolds tent model of behavior. To a neoclassical (1951) had concluded from his study of economist, the logic of price theory was so labor markets in a medium-sized New En­ utterly convincing—especially in the ab­ gland city that "each company employment sence of a competing theory—that logic office is really a distinct market for labor" itself was called upon to settle what ap­ (p. 42). He found that wage dispersion peared to be empirical disputes. Paul across firms was "very substantial," and that Samuelson, for example, had this to say in "nonwage terms of employment... tend to the 1951 edition of his textbook: accentuate wage differences rather than to offset them" (pp. 221-22). Kerr (1954), in The fact that a firm of any size must have a wage his famous paper on the "balkanization" of policy is additional evidence of labor market labor markets, developed the concept of imperfections ... But just because competition "institutional" labor markets that were gov­ is not 100 per cent perfect does not mean that it must be zero. The world is gray, not black or erned by formal and informal rules rather white ... If you try to set your wage too low, you than by economic variables. These institu­ will soon learn this. At first nothing much need tional labor markets "create truly happen, but eventually you will find your work­ noncompeting groups." The rules set sharp ers quitting a little more rapidly than otherwise "boundaries between the 'internal' and 'ex­ would be the case. (Samuelson 1951b:598) ternal' [labor] markets and define more precisely the points of entrance.... Workers In this passage, Samuelson is dealing with inside the market... are not in direct com­ the empirically based charge that small petition with persons outside." The term changes in wages do not always cause work­ "internal labor market" was coined by ers (or customers) to immediately move Dunlop (1966), who maintained that both from poorer opportunities to better ones, unionized and nonunionized employers as posited by elementary theory. Instead of "tend to develop an elaborate set of prac­ arguing that elementary theory is inad­ tices or rules relating to promotions, trans­ equately realistic, however, or presenting fers, layoffs, and retirements for various empirical data to show that market behav­ groups of job classifications; they confine ior actually is consistent with theoretical entry from outside the organization ... to predictions, Samuelson reasons from sheer a limited number of classifications" logic: even if labor-market mobility is re­ (1966:32).21 stricted for some reason, it must surely be the case that in the long run employers Doeringer and Piore (1971:2-3) defined who depart from paying market wages an internal labor market as "an administra­ will be punished. He might have added, tive unit, such as a manufacturing plant, "What other outcome could there be?" within which the pricing and allocation of Without another theory that was equally labor is governed by a set of administrative appealing in terms of its logic, those with rules and procedures." This internal labor an analytic inclination could imagine no outcomes other than those implied by price theory.

- Both Doeringer and Piore were students of John Inside the Firm and Work Dunlop at Harvard. Groups: Neoclassical Approaches In an earlier paper, Dunlop (1957:135) presented to Neoinstitutionalist Interests a table of the average hourly wages for unionized truck drivers in Boston in July 1953. The table showed In 1971 Peter Doeringer and Michael that the wages varied sharply across industries. How­ Piore published an important book, Inter­ ever, wages for truck drivers within a "wage contour" (basically an industry) tended to be equal. He con­ nal Labor Markets and Manpower Analysis, cluded that these wage contours had developed over that in many ways picked up where the early time, and that they demonstrated that a "perfect postwar neoinstitutionalists had left off. The labor market" did not exist (pp. 135-37). 214 INDUSTRIAL AND LABOR RELATIONS REVIEW market was distinguished from the exter­ The literature on internal labor markets, nal labor market, "where pricing, allocat­ and the seeming inconsistencies of impor­ ing, and training decisions are controlled tant labor-market outcomes with the pre­ directly by economic variables." Movement dictions of simple neoclassical theory, chal­ between the two labor markets lenged neoclassical labor economists to expand their analyses of wage determina­ occurs at certain job classifications which con­ tion beyond their traditional focus on mar­ stitute ports of entry and exit to and from the ket tendencies—and to regard as worthy of internal labor market. The remainder of the analysis the wage setting practices by indi­ jobs within the internal market are filled by the vidual employers. Moreover, at least partly in promotion or transfer of workers who have al­ ready gained entry. Consequently, these jobs response to the neo-neoinstitutionalist lit­ are shielded from the direct influences of com­ erature, neoclassical economists have be­ petitive forces in the external market. gun to widen their "homo economicus" (Doeringer and Piore 1971:3) view of economic agents as narrowly self- serving and autonomous, to include con­ Doeringer and Piore (1971, Chapter 8) siderations of social interdependency and also examined the implications of dual la­ context. bor market theory, originally developed by For example, the theory of efficiency Piore (1969). This theory postulates that wages offers explanations based on maxi­ the labor market is divided into primary mizing behavior both for the existence of and secondary markets. Jobs in the primary wage differentials for workers with similar sector are high-paying, with good working characteristics and for the payment of wages conditions, employment stability, and in excess of market-clearing levels. Accord­ chances for promotion. In contrast, jobs in ing to this theory, higher wages affect the the secondary market are low-paying, with net productivity of workers by reducing high turnover, poor working conditions, their propensity to quit and by increasing and little chance for promotion. Disadvan­ their levels of effort. Profit-maximizing taged workers "are confined to the second­ employers are willing to pay above market- ary market by residence, inadequate skills, clearing wages, because such a strategy in­ poor work histories, and discrimination" creases labor productivity more than it in­ (p. 166). Primary sector jobs are associated creases costs (Akerlof and Yellen 1986). with internal labor markets; some second­ Efficiency wage theory offers an explana­ ary jobs are "completely unstructured," tion for wage dispersion and for dual labor while others are attached to internal labor markets: the "wage-productivity nexus" is markets, although they include few, if any, more important in some sectors of the of the privileges typically associated with economy than in others. In the primary such labor markets. sector, where the wage-productivity nexus Further analysis of internal labor mar­ is assumed to hold, workers are paid above kets and dual labor markets has been done market-clearing wages; in the secondary by Bennett Harrison (1972), David Gordon sector, where above-market wages are not (1972), Lester Thurow (1975), Edwards, profitable, labor markets clear (Yellen Reich, and Gordon (1975), and Paul 1984:201). Bulow and Summers (1986) Osterman (1975, 1984), among others. constructed a model of dual labor markets These studies examine individual firms' based on the causal relationship between hiring and pay practices, the reasons for wages and productivity, and used it to ex­ the existence of internal labor markets, plain interindustry and intraindustry wage and the consequences of internal labor differentials, discrimination, and involun­ markets for the distribution of earnings tary unemployment. and differential economic opportunity. A recent version of efficiency wage theory, Given the influence of Dunlop and Kerr on the "fair wage-effort hypothesis" (Akerlof these scholars, one is tempted to refer to and Yellen 1990), contends that workers them as "neo-neoinstitutionalists." will withhold effort if they are paid a wage THE NEOCLASSICAL TRADITION IN LABOR ECONOMICS 215

below what they consider to be fair. It is issues that were so important to the possible that the fair wage exceeds the neoinstitutionalists are being addressed by market-clearing wage (1990:255-56). The price theorists.23 "fair wage-effort hypothesis" is one possible In recent years, neoclassical economists explanation for the interindustry wage dif­ have begun to model several other labor- ferentials (for workers with similar skills in market characteristics or outcomes that similar jobs) found by the neoinstitu- seem at first blush to be inconsistent with tionalists—for example Slichter (1950) — the predictions of neoclassical theory. Ed­ and by Dickens and Katz (1987) andKrueger ward Lazear (1979,1981), for example, has and Summers (1987, 1988). According to dealt with the issue of why older workers Akerlof and Yellen (1990:265), "if firms might be paid more than their marginal must pay a high wage to some groups of products. Lazear and Sherwin Rosen (1981) workers—perhaps because they are in short and Rosen (1986) raised the issue of why supply or perhaps to obtain high quality— small differences in productivity among top demands for pay equity will raise the gen­ executives can lead to huge differences in eral wage scale for other labor in the firm, who would otherwise see their pay as un­ pay, while James Brown and Orley fair."22 Ashenfelter (1986) took a new look at an older issue raised by Dunlop: why firms The importance of fairness in labor mar­ (and their unions) have latitude within kets was also discussed by Nobel laureate which they can design their internal com­ Robert Solow in his book, The Labor Market pensation structures. Indeed, a new text­ as a Social Institution (1990). Solow con­ book by Lazear, entitled Personnel Economics tended that "the fundamental reason for for Managers (1998), now applies the prin­ believing that fairness is a factor in labor ciples of rigorous economic reasoning to a markets is what we know about our own variety of human-resource management is­ society and culture.... Once you admit to sues (hiring, training, paying, motivating, yourself that wage rates and employment and promoting workers) of long-standing are profoundly entwined with social status interest to the neoinstitutionalists (see also and self-esteem you have already left the Lazear 1995). Unlike the neoinstitution­ textbook treatment of the labor market alists, however, neoclassical labor econo­ behind" (pp. 9-10). Robert Frank argued mists have built their studies of firm behav­ in his book, Choosing the Right Pond: Human ior upon models of maximization in the Behavior and the Quest for Status (1985), that face of constraints (Baker, Gibbons, Murphy individuals place a value on status in their 1994; Holmstrom and Milgrom 1994). local reference group, and that this can explain why within-firm differences in indi­ Neoclassical Labor viduals' wages are often smaller than differ­ Economics and Public Policy ences in their marginal products. The pub­ lications discussed above all encompass By the early 1970s, neoclassical econo­ social interdependencies in a theoretical mists had become prominent enough that model, thus allowing concerns for "fair­ they substantially contributed, both philo­ ness" and status to be associated with maxi­ sophically and empirically, to the national mizing behavior in a context of markets debate that ended military conscription in and constraints. Finally, it could be said, the United States (President's Commission

Katz and Summers (1989) offer another expla­ "Neoclassical economists' interest in fairness is nation for interindustry wage differentials: workers not new, although one could argue that it has been in certain industries are able to extract rents—in the suppressed for some time. In 1883 Alfred Marshall form of wages in excess of their best alternatives— wrote a paper entitled "A Fair Rate of Wages." The from their employers. paper is reprinted in Marshall (1925:212-26). 216 INDUSTRIAL AND LABOR RELATIONS REVIEW

onan All-Volunteer Armed Force 1970). It later 1960s, also became an object of study was increasingly recognized that economic by analytical labor economists; Ashenfelter's theory and the measurable implications that (1978) analysis of the effects of govern­ could be derived from it were useful for ment training programs on the post-train­ understanding the effects of labor market ing earnings gains of trainees is an early institutions and policies. Neoclassical la­ example of a study examining the costs and bor economics thoroughly adopted econo­ benefits of public sector training. metric techniques as a means of extending Other policy-related areas of research "dry bones" theory into the real world of that attracted neoclassical scholars touched institutions and government programs. on issues of immigration, gender, and race. One of the areas to which neoclassical Barry Chiswick (1978), and later George labor economists turned their attention Borjas (1985, 1987, 1990) and David Card was labor supply behavior, spawned in part (1990a), contributed analyses of the eco­ by the negative income tax experiments of nomic effects of immigration.25 The sharp the late 1960s and the 1970s. Significant increase in female labor force participa­ advances in the way in which labor supply tion since World War II was mirrored by an models were econometrically specified and increase in research on women in the work­ estimated were made early on by Orley place. Early studies measuring the size of— Ashenfelter and James Heckman (1974) and offering explanations for—male-female and Heckman (1974), with later additions earnings differences were undertaken by by Heckman and Thomas MaCurdy (1980), Ronald Oaxaca (1973), Jacob Mincer and MaCurdy (1981), Ashenfelter (1983), and Solomon Polachek (1974), and Francine Joseph Altonji (1986), among others. Blau (1977), while Blau and Lawrence Kahn Heckman (1979, 1980) developed a now (1996, 1997), Claudia Goldin (1990), and widely used statistical technique to correct Blau and Ehrenberg (1997) offer more re­ for the selectivity bias that occurs when cent perspectives of the problems and individuals in one group (for example, progress experienced by the female labor workers) differ from those in the other force. Following the lead of Gary Becker, (those choosing not to work) in ways that neoclassical labor economists also sought are not easily measured. to measure and explain the economic dis­ Research in the area of human capital advantages faced by the African-American mushroomed, with an early focus on the labor force. Early work by Ashenfelter rates of return to personal and social edu­ (1970,1972) and the authors in Ashenfelter cational investments (Hanoch 1967; and Rees (1973) was followed by a robust Griliches 1970). These early interests, cen­ literature summarized in Donohue and tral to issues of educational policy, led di­ Heckman (1991). rectly to new empirical techniques to deal The study of unions, long of interest to with possible problems of "ability bias" and government policy-makers and labor econo­ self-selection associated with estimating the mists alike, was broadened beyond the esti­ returns to schooling, and to more recent mation of unions' wage effects. The model studies of the effect of school quality on of labor-management bargaining and strike student achievement and future earnings.24 activity originally postulated by Hicks (1932) Job training programs, which were part of was expanded to include union leadership President Johnson's Great Society in the and rank-and-file as separate parties and statistically tested by Ashenfelter and George Johnson (1969) and Henry Farber (1978). Empirical tests of the asymmetric-

On ability bias and selection bias, see, for ex­ ample, Griliches (1977), Willis and Rosen (1979), Ashenfelter and Krueger (1994), and Card (1995). On the effects of school quality, see Hanushek (1986) 25See also the papers in Abowd and Freeman (1991) and Card and Krueger (1992). and Borjas and Freeman (1992). THE NEOCLASSICAL TRADITION IN LABOR ECONOMICS 217

information model of strike activity were The energy and frequency with which undertaken by Joseph Tracy (1987) and theory was being applied by labor econo­ David Card (1990b). mists to issues of social and economic policy In 1984, two neoclassical labor econo­ raised the question of whether the modern mists, Richard Freeman and James Medoff, approach could go very far beyond the published a book entitled What Do Unions walls of academe and be widely useful for Do?, in which they argued that neoclassical policy purposes. John Dunlop thought not: economists had produced "very little quan­ "Tests of the elegance, coherence, and gen­ titative evidence concerning the impact of erality of economic and industrial relations U.S. unionism on outcomes other than models and theories are intellectually ex­ wages," and that they generally ignored the citing and challenging, but their relevance neoinstitutionalists' view that unions often and application to policy making is scarcely raise productivity and induce better man­ within the reach of most researchers" agement. Freeman and Medoff used newly (Dunlop 1977). available computerized data files, which contained vast amounts of information on Neoclassical labor economists (Ehren­ thousands of individuals, establishments, berg et al. 1977) strongly demurred, argu­ and companies, to statistically analyze "many ing that the Carter administration's policy of the nonwage effects of trade unions" decision to tax unemployment insurance (pp. 4-5). Their results indicated that benefits was but one contemporary example many of the neoinstitutionalists' observa­ of the influence on public policy of neo­ tions concerning unions were correct. In classical analysis (which had demonstrated particular, they found that unions raised that higher benefits encourage longer spells productivity in many sectors of the economy, of joblessness). By the 1980s neoclassical largely as a result of lower rates of turnover labor economists had become so intimately under unionism and of "improved manage­ involved with policy analyses—for the Coun­ rial performance in response to the union cil of Economic Advisors; the Department challenge" (pp. 21-22). While the conclu­ of Labor; the Department of Health, Edu­ sion that the positive aspects of unionism cation and Welfare; the Equal Employment usually outweighed the negative (mo­ Opportunity Commission; international nopoly) aspects remains open to question development agencies; the Congressional (see Hirsch 1991), the issue is one that has and Executive Budget Offices; and even the important policy implications for a society CIA—that they were forced to give more that still debates whether the government attention to issues raised by the institution- should take a more (or less) active role in alists. encouraging the growth of union power. The greater interest of neoclassical labor economists in public policy issues, and their In addition to interests in the growing influence, forced three major longstanding policy issues regarding changes in the field. First, because one unions, discrimination, education, and cannot understand public policy issues with­ immigration, neoclassical labor econo­ out a thorough grounding in institutional mists began attempts (following Rosen detail, neoclassical labor economists neces­ 1974) to identify and measure market sarily became more institutional in their failures as they related to the relatively interests. Seemingly small administrative new "social" regulation of workplace details about how unemployment or work­ safety (see Smith 1979; and later, Viscusi ers' compensation insurance premiums are 1993). In addition, the "adverse incen­ set, for example, have huge implications tives and distributional anomalies" of the for the layoff or safety behavior of employ­ U.S. system of unemployment compensa­ ers; labor economists wanting the ear of tion noted by Feldstein (1974) were exam­ policy-makers had to know these details. ined by Ehrenberg and Oaxaca (1976), Moreover, institutions have histories that Hamermesh (1977), Brechling (1977), Topel both reflect and affect behavior; the (1983), and Burdett and Wright (1989). ahistorical approach of pure theory might 218 INDUSTRIAL AND LABOR RELATIONS REVIEW yield behavioral tendencies, but usually a besides their colleagues, labor economists larger context is required if sensible poli­ had to use ordinary English instead of jar­ cies are to be promulgated. Daniel gon. Congressman Lee Hamilton recently Hamermesh's 1977 book on unemployment wrote: "For me, the most important quality compensation, which was aimed at an audi­ for economists to have when they are testi­ ence much wider than professional econo­ fying or advising policy-makers is the ability mists, was but an early example of the kind to express their ideas on important policy of attention that is now routinely given to issues clearly and simply, without jargon" institutional details by neoclassical labor (Hamilton 1992:61). economists studying welfare programs, im­ Recentyears, therefore, have seen move­ migration, workers' compensation, inter­ ment away from some of the more academi­ national comparisons of job training, and cally insular features of "pure" neoclassical many other labor market issues. analyses of the labor market toward includ­ Second, along with greater prominence ing some "realistic" characteristics of the in public policy came greater responsibility institutionalist approach. More research­ for the accuracy and credibility of empiri­ ers are collecting their own data, and more cal results. Few in society care in the ab­ are now relying on case studies (often, "natu­ stract about whether capital and labor are ral experiments") involving some exog­ used under conditions of constant elastic­ enous economic or policy change to create ity of substitution in the mining of coal, but the comparisons needed for hypothesis test­ 26 if the implicit tax of the Black Lung Ben­ ing. Even controlled experiments have efits Program is being debated, the condi­ been run, both inside and outside the labo­ tions under which coal is produced matters ratory. very much because real jobs are on the line. Thus, the stated mission of the The quality of one's data, and the statistical neoinstitutionalists—causing simple price specifications and methods used, began to theory to adapt to the unique realities of really matter when the answers started to the labor market—seems to be on its way to affect lives instead of "dry bones" abstrac­ fulfillment. Neoclassical labor economists tions. Interestingly, the lively disputation are now—at long last, some would say— over the findings of David Card and Alan addressing some of the issues that had so Krueger (1995) relative to the minimum consumed the interest of neoinstitution­ wage'have mostly focused on the quality of alists, and they have turned out to be simi­ data and the replicability of statistical esti­ lar to their neoinstitutionalist predecessors mates (Neumark and Wascher 1997; Card in the fundamental desire to understand and Krueger 1997). how employers and employees really be­ Third, greater policy prominence re­ have. While "dry bones" neoclassical theory quired labor economists to write for new provides the skeletal framework for mod­ audiences—people who are intelligent but ern analyses, empirical flesh and blood still not necessarily schooled in the use of eco- provides labor economists with the motiva­ nomicjargon or patient with complex equa­ tion. Early empirical work using large data tions. In the 1990s, for example, various sets and advanced computing techniques issues of the Economic Report of the President provided general support for some theo­ addressed labor-market topics requiring retical implications but offered disappoint­ non-technical treatments of such concepts ing results regarding others; further scien­ as labor supply theory (1992:148), com­ tific advances therefore required taking pensating wage differentials (1993), the more sophisticated account of social and natural rate of unemployment (1994), the returns to human capital investments (1996), and distinguishing labor demand 26 from labor supply shifts as explanations of See, for example, Card (1990a) on the labor market effects of the Mariel boatlift, and Meyer, growing wage inequality (1997). When Viscusi, and Durbin (1995) on supply responses to their research began to matter to others changes in workers' compensation benefits. THE NEOCLASSICAL TRADITION IN LABOR ECONOMICS 219

institutional idiosyncrasies. If the new ar­ of science, then the neoinstitutionalist in­ eas of inquiry within neoclassical labor eco­ terests may permanently fuse with the neo­ nomics are in fact driven by the imperatives classical approach.

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