Freeman

ARTICLE

Recycling Labor

The Process of Layoffs and Hiring Is a Sign of Economic Health

APRIL 01, 1999 by CHARLES W. BAIRD

In 1998 Boeing and MCI WorldCom, to mention only two, announced plans for massive layoffs. Boeing actually cut 48,000 jobs. Throughout 1998 there were many announcements of intended mergers—for example, Exxon with Mobil and Chevron with Shell—most of which included plans for substantial job cuts. Total layoff announcements in the United States in 1998 exceeded 600,000.

To those who received such announcements it must have seemed that their personal fortunes were ruined and the economy was falling apart. No one wants to leave a job involuntarily, and when one hears of it happening, one is naturally sympathetic. The perceived instability of employment in free-market economies is a major reason why many Americans support government intervention in the labor market.

Yet in any market-based economy there will always be layoffs and there will always be hires. Moreover, this is to be celebrated. It is a sign of economic health. Given the pace of change in what we know, in what is discovered to be possible, in consumer tastes and preferences, and in the extent of competition, labor, like all productive resources, must constantly be recycled.

The popular press always stresses the downside of the recycling of labor. Bad news sells better than good news and each plant closure or massive layoff is easy to capture on videotape. The upside of recycling—the hiring—is more diffuse and less visible. Nevertheless, most of the time the upside outweighs the downside.

From December 1997 to November 1998, in spite of all the layoffs and downsizing that occurred, entrepreneurs in the American economy created over a million and a half net new jobs. That’s an average of 131,916 more jobs created than lost each month. And 1998 was not unusual. Table 1, column 2, shows this net job creation (December to November, seasonally adjusted) in each year starting in December 1992. Column 3 shows the 12-month diffusion index of employment change for the same periods. A diffusion index of 50 percent indicates an equal number of American industries adding and decreasing jobs.

TABLE 1

Year Net New Jobs Diffusion Index
1992 1,106,000 62.9
1993 2,293,000 69.2
1994 3,362,000 66.6
1995 672,000 63.5
1996 2,543,000 69.1
1997 2,825,000 72.9
1998 1,583,000 n.a.

Source: http://www.bls.gov/news.release/empsit.toc.htm (Bureau of Labor Statistics Employment Situation Report)

In every year net new jobs were created, and more industries added than eliminated jobs. Clearly, layoffs and downsizing do not mean the American economy is falling apart.

Moreover, the personal fortunes of most people who receive layoff notices are not ruined. Most find new jobs at better pay after a job search and relocation. Table 2, column 2, shows the American unemployment rate, and column 3 shows the median duration of unemployment in November for each year from 1992 to 1998. Column 4 shows the private-sector employee total compensation index for the third quarter of each year. For example, in the third quarter of 1998 total compensation paid to private-sector employees was 38.7 percent higher than in the second quarter of 1989. Total compensation includes wages and salaries plus all benefits such as health insurance and paid vacations.

TABLE 2

Year Unemployment Rate(%) Median Duration (in weeks) Compensation Index (1989/2=100)
1992 7.4 9.0 114.7
1993 6.6 8.3 118.9
1994 5.6 9.1 122.8
1995 5.6 8.1 126.1
1996 5.4 7.8 129.7
1997 4.6 7.8 133.7
1998 4.4 6.7 138.7

Source: http://www.bls.gov/news.release/empsit.toc.htm

Using Bureau of Labor Statistics (BLS) data, the Employment Policy Foundation concluded that in the last five years, average annual employment growth in the highest paid one-third of new jobs was 3.2 percent. In the same period, employment growth averaged just over 1 percent in the lowest- and middle-paying thirds. This means that over 60 percent of all employment growth occurred in jobs in the top third.[1] Since 1983, job growth in the top third has been 50 percent, which is one-and-a-half times more than in the lower third.[2] It seems clear that for most people who receive layoff notices, unemployment is temporary and a bridge to a better job.

The unemployed fall into four categories: job losers, job leavers, re-entrants, and new entrants to the labor market. The job losers are those who are fired, those who receive layoff notices, and those who have completed a temporary job. Job leavers are those who choose to quit a job either to take or to seek another job. Re-entrants are people who were employed in the past but who dropped out of the active labor force for some time to pursue other activities, such as school or homemaking, and who then take up an active job search. New entrants are those who are engaging in active job search for the first time.

Table 3 shows the percentage distribution of the unemployed in each of the four categories in November in the years 1992 to 1998. Job losers are the largest group, followed by re-entrants.

TABLE 3

Year Job Losers Job Leavers Re-Entrants New Entrants
1992 55.2% 10.5% 24.0% 10.3%
1993 52.5 11.9 25.2 10.4
1994 48.0 9.5 34.5 8.0
1995 47.6 11.1 33.4 7.8
1996 45.9 11.4 34.6 8.1
1997 45.6 10.3 35.2 8.8
1998 45.0 10.7 35.4 8.9

Source: http://www.bls.gov/news.release/empsit.toc.htm

Job leavers and new entrants together make up roughly 20 percent of the unemployed. In November 1998 the seasonally adjusted number of unemployed people was just over six million. So there were about 2.7 million job losers, three-quarters of a million job leavers, over 2 million re-entrants, and over half a million new entrants. They were all actively involved in the labor recycling process.

Another way to think of employment and unemployment is as percentages of the total civilian noninstitutionalized population aged 16 or over (hereinafter, the population). The unemployment rate reported above is the number of unemployed divided by the active labor force. The active labor force is the sum of the employed and the unemployed. Only people who are out of work and who are actively seeking work are counted as unemployed. Many people in the population are not in the active labor force. The labor-force participation rate is the active labor force divided by the population. Table 4, column 2, shows the labor force participation rate in November of the years 1992–1998. Column 3 shows the ratio of the employed to the population. The difference between columns 2 and 3 in any year is the ratio of the unemployed to the population. Those ratios are shown in column 4. In November 1998, for example, only 3 percent of the entire population was unemployed. The other 97 percent were either employed or were not seeking employment. Since 1994, when the BLS began to collect the data, only 0.5 percent of those out of the labor force were discouraged about finding work. The rest were out of the labor force by choice.[3] Typically the discouraged job seekers are those whose skills have become obsolete and who need retraining.

TABLE 4

Year Participation Rate Employed/Population Unemployed/Population
1992 66.3% 61.4% 4.9%
1993 66.3 61.9 4.4
1994 6.8 63.0 3.8
195 66.5 62.8 3.7
1996 67.0 63.4 3.6
1997 67.1 64.0 3.1
1998 67.1 64.1 3.0

Source: http://www.bls.gov/news.release/empsit.toc.htm

The Market Process

The labor market, like any other market, is a process of interaction between forces of demand and supply. The buyers of labor are employers, and the sellers of labor are job seekers and job holders. When employers “buy” labor, they hire the productive services of workers. Labor is employed, along with materials, supplies, and the services of capital goods, to produce output that employers in turn sell to customers. Workers supply labor services to employers in exchange for wages, salaries, and benefits.

The maximum amount that an employer is willing to pay for a worker’s services is called his demand price for the labor. It depends on the increment to output that the services make possible and on the prices for which the employer can sell the additional output to customers. Suppose that employer expects that an additional worker makes possible the creation of ten additional units of output per day, and that when those units are sold, the employer will receive $120 of extra revenue net of all other incremental costs. The hiring cost is the sum of compensation paid to the worker and employment taxes paid to government. The employer would not be willing to pay $120 per day or more for the worker’s services, but at any hiring cost less than $120 per day, the employer would increase profits by hiring the worker. From the employer’s point of view, the lower the hiring cost the better so long as he can hire the quantity and quality of labor he wants. The lower the hiring cost, the more eager the employer will be to hire additional workers if he can get them.

If workers’ productivity declines because of, for example, a change of technology that makes their services less important, or if the prices that the employer receives from customers decline because, for example, the customers decide they want to buy different products, the employer would have to cut labor costs by layoffs or by reducing rates of compensation (or both). The latter is likely to cause many workers to quit because they have no reason to think that the reduced compensation is the best they can do. Both those laid off and those who quit will begin a process of job search.

The minimum compensation that an employee will accept from an employer is called his supply price for the job. It depends on his perception of his alternative employment (and unemployment) opportunities. Other things equal, the better his alternatives the higher his supply price. If you know you can get $15 per hour from Employer X for doing a job, you will not accept anything less from Employer Y for doing the same job. If your alternative to working for Employer X is to be unemployed (a very unlikely situation), you will have a higher supply price if your family will support you during unemployment than you will if your best alternative is to become homeless.

So there is an upper limit on what an employer will pay and a lower limit on what a worker will accept. The actual rates of compensation depend on the relative strengths of two types of competition in the relevant labor market—competition among employers to hire and competition among employees to be hired. For a given level of competition among employees, the more intense the competition among employers to hire, the greater the pay. Conversely, for a given level of competition among employers to hire, the greater the competition among employees, the lower the pay. Every hiring of every worker is an employment contract based on voluntary exchange. Every employer and every employee enter into such contracts because they expect to be better off than they would be if they did not do so.

From an individual worker’s point of view, the best of all possible situations is to be the only one who can do a particular kind of work and to have hundreds of employers competing to hire someone who can do the job. Such a worker would have tremendous bargaining power, and any one employer would have almost no bargaining power. Similarly, from an individual employer’s point of view, the best of all possible situations is to be the only buyer of a particular kind of labor service and to have a plethora of workers competing to do the job. Such an employer would have tremendous bargaining power, and any one worker would have almost no bargaining power. Bargaining power in any market depends on the alternatives available to the actors therein.

Enterpreneurship

Entrepreneurs are the key actors in all markets. The role of an entrepreneur is to discover and grasp profit opportunities. Every problem that emerges in a market is a profit opportunity for an entrepreneur who first notices how to solve it and undertakes the solution. Successful innovations by entrepreneurs elicit imitation, and imitation by more and more people means that, in free-market settings, problems inevitably give way to solutions. Entrepreneurs do what they do in pursuit of profit; but when they are successful, and therefore make profit, the rest of us benefit from their innovations.

Entrepreneurship involves creating new products, creating new technologies, creating new productive resources, assembling new combinations of productive resources to produce old and new products, adopting new forms of organization, and entering new markets and exiting old ones. Buyers and sellers in all markets must keep abreast of more innovation now than ever before. In today’s markets, successful innovation at one place rapidly affects most other places. Entrepreneurship, and responses to entrepreneurship, lie behind the recycling of labor (and of other productive resources).

Suppose that the proposed merger of Exxon and Mobil takes place. In the face of falling prices for petroleum and its products (which itself is due to successful innovations in the discovery, production, and refining of crude oil as well as the discovery and implementation of alternative energy sources), the decision-makers in the new firm will have to cut out duplicative operations. This means that many employees of the merged firm will receive layoff notices. Perhaps some will be able to stay on by agreeing to accept cuts in compensation, but most will quite reasonably think that it is possible to find other satisfactory jobs that pay as much or more as the ones they have lost. While searching for alternatives, they will be counted by the BLS as unemployed. Some will find new employment quickly; others will not. As noted, the median duration of unemployment in November 1998 was 6.7 weeks. If after some initially planned search period, some job seekers find no satisfactory new jobs, they will reevaluate their prospects and lower their supply prices. Or perhaps they will become convinced that their best strategy is to undertake retraining so they can find different sorts of jobs.

Employers in markets for new products and products for which customer demand is rising also engage in search. They search for new employees who can do what needs to be done. They could attract a lot of applicants right away by offering very high pay and benefits, but most will reasonably think it would be cost-effective, at least for awhile, to offer normal compensation and spend some time sampling the workers that apply. Recycling labor is not a simple matter of throwing all applicants into a common bin. They must be sorted according to abilities, interests, and costs. If after some initially planned period of search the employers do not find enough satisfactory employees, they will then offer better compensation to attract more applicants.

The key insight is that every unemployed worker who wants to work is a potential profit opportunity for an entrepreneur who discovers ways of employing him. Even workers who have a hard time finding new work are potential profit opportunities. They are likely to be available at modest levels of compensation, making it cost-effective to hire and train them. And when they are trained they acquire additional bargaining power with their employers and with potential new employers. This is why, in a market-based economy, layoffs do not usually result in a growing number of unemployed people and falling average rates of compensation. Unemployment is like a pipeline. There are always people entering the pipeline, but there are always people exiting too. Even if the number of people in the pipeline at any moment were always the same, the faces on those people would be constantly changing.

Entrepreneurs, like all people, make mistakes. Some entrepreneurs think they perceive profit opportunities and hire additional labor to try to grasp those opportunities. When losses instead of profits emerge, they have to pass out layoff notices. However, the historical record suggests that under normal circumstances, entrepreneurial successes more than make up for entrepreneurial failures. After all, entrepreneurs are self-interested and therefore keenly motivated to avoid mistakes and the losses that result.

Of course, there are occasional periods during which unemployment increases relative to employment, but these are the result of faulty government policies that cripple the labor recycling process. If, for example, the government inflates the money supply and thus distorts the price signals to which entrepreneurs respond, lots of entrepreneurs will hire labor that later, after the market corrects the distorted prices, they will have to lay off. Excessive taxation and regulation are other ways in which government can cripple the labor recycling process.

Government Doesn’t Create Jobs

It is entrepreneurship in the context of freedom, not government, that creates increasing employment opportunities. Try to imagine what would happen to the labor-recycling process if entrepreneurs had to get permission from some government authority before they could enter or exit markets, expand or contract employment, create new products, change technologies, or alter their organizational structures. The pattern of production would become less and less consistent with the pattern people want. Innovation would shrivel. Lots of people would continue to be employed doing what they always did, but they would increasingly produce things for which there would be no demand. There would be few job opportunities for new people in the labor force. Production would be aimed at keeping government authorities, not customers, happy.

American presidents like to assert that they are elected to “run the economy.” We should be grateful that that is merely their conceit. No one runs a successful economy. Its success depends on no one’s being in charge of it all. At the same time, its success depends on everyone’s being in charge of his own production and exchange activities, dealing with others on the basis of voluntary exchange.


Notes

  1. The American Workplace 1998 (Washington, D.C.: Employment Policy Foundation [www.epf.org], 1998), p. 24.
  2. Economic Bytes, Employment Policy Foundation, November 2, 1998.
  3. http://www.bls.gov/news.release/empsit.toc.htm, Table A-10.

ASSOCIATED ISSUE

April 1999

ABOUT

CHARLES W. BAIRD

Charles Baird is a professor of economics emeritus at California State University at East Bay.

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