Vacancies, Discouraged Workers and Labor Market Dynamics

Abstract

This paper presents a theory of labor market dynamics and shows how the discouraged worker effect can lead to overshooting, oscillations and even unstable wage movements in response to exogenous disturbances. The main source of the potential for these unusual dynamics is the possible misinformation conveyed to the wage-setting agent by cyclical variations in measured labor force participation-variations which the wage-setter may misconstrue as fundamental shifts in the labor supply schedule. The present work views the discouragement decision in a search theoretic framework. In their search process, individuals face a two stage problem. First they must search over employers for vacant positions. Then they must search over vacant positions to find a particularly high wage. Recent works by Parsons [9], Barrn [1], n , and Barrn and McCafferty [2] have shown that variations in the difficulty of finding job vacancis are an empirically important determinant of individuals' job search behavior. Therefore, one would expect that the higher the vacancy rate, the greater the returns to search, and therefore for given wage levels, the less likely it would be that there would be a large number of discouraged workers. The standard wage adjustment mechanism assumes that the rate of change of the average wage level is proportional to the level of excess demand. However, suppose individual firms set wages. These firms can directly gauge the level of demand because they know their own hiring plans. However, they can only infer the level of supply by observing the number of labor market participants. To capture the possible effects of this misinformation, the present work postulates a wage adjustment mechanism in which the rate of change in the average wage rate is proportional to the difference between the number of job vacancies and the number of active job searchers (the measured level of unemployment). This wage mechanism is formally similar to those proposed by Dow and Dicks-Mireaux [3], Hansen [4], and Lipsey [5]. However, the present work explicitly accounts for labor market dynamics and for fluctuations in labor force participation during periods of disequilibrium. The present work then proceeds to show how the combination of this type of wage adjustment mechanism and the discouraged worker effect can lead to the unusual dynamics described above.