Noah Smith: Supply and Demand Does a Poor Job of Explaining Depressed Wages

Noah Smith: Supply and Demand Does a Poor Job of Explaining Depressed Wages: “The standard framework that economists traditionally used to understand job markets is just supply and demand…

…But… even very large, sudden waves of low-skilled immigration didn’t hurt the wages of native-born Americans, as the theory suggested should happen when there’s a positive shock to labor supply. Adjusting the model to match this reality wasn’t too hard. Economists just had to assume that immigration produces a positive shock to labor demand as well as supply—immigrants buy things locally, creating jobs for the native-born. But the minimum-wage effect posed more of a problem to the theory—no matter how you slice it, price controls should lower employment in a competitive market. The likeliest reason that this doesn’t happen is that employers have market power—that it’s so costly and difficult for workers to find new jobs that they simply accept lower wages than they would demand in a well-functioning market. If employers have market power, modest minimum-wage rise will tend not to increase unemployment, because they force companies to move back toward the wage levels that would prevail if competition were working the way it should. In that model, a small increase in minimum wage could even increase the number of jobs.

New evidence is showing that employers have more market power than economists had ever suspected…. José Azar, Ioana Marinescu, and Marshall Steinbaum… Efraim Benmelech, Nittai Bergman, and Hyunseob Kim…. Together with the evidence on minimum wage, this new evidence suggests that the competitive supply-and-demand model of labor markets is fundamentally broken…. Textbook writers and instructors should respond by changing the baseline model of labor markets that gets taught in class. Students ought to start with a model of market power, in which a few companies set wages below levels found in a competitive market unless prevented from doing so. That model is about as easy to work with as the traditional supply-and-demand setup, but matches the data much better.

In any scientific discipline, theories should evolve as new evidence comes in. That’s true both of what gets used in research and what gets taught in class. The evidence on labor markets has evolved, and the dominant theories need to change with the times…