Labor Responses, Regulation and Business Churn in a Small Open Economy

Dr Anthony Savagar

by Marta Aloi, University of Nottingham, Huw Dixon, Cardiff University and Anthony Savagar, University of Kent. Discussion paper KDPE 1804, February 2018.

Non-technical summary:

A long-standing debate in macroeconomics is whether labor hours initially increase or decrease across the economy following a technology improvement. We develop a theory that reconciles both outcomes by observing that:

1. New firms enter the economy slowly after a technology improvement. That is, entry is not instantaneous as often assumed.

2. At the firm-level labor can be employed with increasing or decreasing returns in production. Therefore, the division of labor across units (firms) affects its efficiency, which is not the case with constant returns, as often assumed.

Given these observations, an improvement in technology has the following effect. Firms already in the economy benefit from the technology. Output per firm and profit per firm increase without the firms changing anything in their production process due to the direct effect of a better technology. Aggregate labor will also respond instantaneously.

We ask: is this initial aggregate labor response greater or less than the level labor will settle down to over time?

The initial profits that incumbent firms earn from the technology improvement encourages entry by new firms. This takes place slowly because there are dynamic costs associated with entering, which can create an incentive for potential entrants to delay entry until a cheaper time. Slow entry means that for a short-while incumbents can enjoy high profits, and expanded output. But over time, entry takes place and as each new firm enters it will steal business until profits are at a level that does not make entering worthwhile for new firms due to the entry cost. As firms enter labor per firm decreases. If labor at the firm-level has increasing returns, then each new firm decreases labor efficiency, reduces wages and reduces hours. Therefore after the initial labor response, subsequent entry decreases labor. Hence there is short-run overshooting. Vice-verse for decreasing returns. If labor has constant returns then entry decreasing labor per firm does not affect its efficiency, so the initial response of aggregate labor persists forever.

Finally we show that the speed which firms adjusts depends on regulation of the entry process. A deregulatory policy will hasten the speed of firm adjustment, which makes the initial response of labor less persistent.

You can download the complete paper here.