The defining feature of advanced economies is that most of what we consume is produced by other people. This makes it highly impractical for firms to pay their workers in kind: journalists can’t subsist on stacks of newspapers, nor can hairdressers survive on haircuts alone. The familiar solution is to pay workers in money, which they can then exchange for goods and services produced by other firms. This system allows the advanced division of labour upon which modern civilization depends, making us vastly better off than if we had to produce everything for ourselves.
The insight at the heart of John Roberts’ paper1 is that this arrangement is fragile, and that full employment of the economy’s resources depends crucially on confidence. In the model, there are two types of firms and two types of workers. Each firm can only hire one type of worker, and must sell its output exclusively to the other type. For concreteness, suppose that the economy consists of apple orchards and banana plantations, that apple-pickers only eat bananas, and that banana-pickers only eat apples.
What would happen if orchard owners were to suddenly stop hiring? (We’ll ignore for a moment why they might do so.) Apple-pickers would find themselves without jobs and wages, and therefore unable to afford to buy bananas. Plantation owners would see demand for bananas drying up, and so would want to reduce their employment of banana-pickers. If banana-pickers weren’t working and earning wages, then there would be no demand for apples, which would be a compelling reason for orchard owners to stop hiring.
Having come full-circle in this stylized example, we can see that pessimistic beliefs about the economy can be self-fulfilling: if one group of employers doesn’t expect the other to hire, it makes sense for them not to hire either. This means that workers can end up involuntarily unemployed: they are willing to work for the prevailing wage, but cannot find a job no matter how hard they try. Even though this outcome is inefficient, each firm is acting rationally given what the others are doing. As Roberts puts it,
[F]irms are unwilling to increase hiring because each forecasts that demand will be too weak to justify its increasing output, and the resultant low level of workers’ incomes generates the weak demand that makes this conjecture correct. However, if all firms increased hiring together, the additional income generated could result in enough extra demand to justify the hiring.
This kind of coordination failure simply isn’t possible in the standard model of market exchange taught in microeconomics classes (and also widely used in macroeconomics). In that model, wages and prices are set by an omniscient being known as the Walrasian auctioneer, who guarantees to buy or sell any good or service (including labour services) in unlimited quantities. This guarantee ensures that nobody has to worry about whether their favourite product will be in stock, or whether they’ll be able to find a buyer for what they want to sell.
The auctioneer’s omniscience allows him to set wages and prices such that orders and offers exactly match, so in the end his guarantee isn’t used and he just acts as a middleman. What Roberts’ model shows is that this guarantee is nevertheless essential to securing an efficient outcome. Without it, the levels of economic activity and employment depend on how confident people are, even if wages and prices are at their Walrasian levels.
In the absence of a Walrasian auctioneer to coordinate trade, it’s natural to ask whether some form of government policy could prevent the economy from becoming trapped in an involuntary unemployment equilibrium. Roberts himself identified this as a desirable extension of his model a quarter-century ago, but to the best of my knowledge no one has yet written a paper on the subject.
In a simple economy with just two different goods, a government that understood people’s preferences could in theory mandate the efficient level of employment. However, we have ample evidence from history (and present-day North Korea) that comprehensive state planning of real-world economies can have disastrous consequences. The holy grail, as I see it, is a policy that rules out the kind of involuntary unemployment identified in Roberts’ model while preserving the decentralized nature of the economy.
Michel De Vroey has argued2 that, since there are models that show a role for Keynesian policies in overcoming other kinds of inefficiency, the concept of involuntary unemployment is redundant in the macroeconomic policy debate. I’m inclined to disagree, because politicians and central bankers almost always justify stimulus policies on the grounds that they will reduce the unemployment rate. If such policies can indeed tackle the problem of involuntary unemployment, it would be nice for economists to have a rigorous model of how they work.
On the other hand, if a policy ineffectiveness proposition could be proven in a theoretical environment similar to Roberts’ model, then this might be relevant to the debate on macroeconomic policy. For example, the fact that wages and prices are fully flexible in the model suggests that monetary policy might be ineffective (or at least might not work the way it does in most New Keynesian models).3 If it could be shown that particular policies cannot rule out the kind of unemployment found in Roberts’ model, and if this type of unemployment is important in the real world, then this might provide a new account of why unemployment remains high despite central banks’ efforts to revive the economy.
John Roberts, “An Equilibrium Model with Involuntary Unemployment at Flexible, Competitive Prices and Wages”, American Economic Review 77, no. 5 (December 1987): 856–874. For those without journal access, an earlier version with the title “An Equilibrium Model with Keynesian Unemployment at Walrasian Prices” is available online as Stanford University Graduate School of Business Research Paper No. 908.↩
Michel De Vroey, “Have the Early Coordination Failures Models Achieved Keynes’s Programme?”, Revue d’économie politique 115 (April 2005): 417–436.↩
A recent working paper by Lawrence Christiano, Mathias Trabandt and Karl Walentin, “Involuntary Unemployment and the Business Cycle” shows that a surprise nominal interest rate cut reduces unemployment. However, the kind of unemployment found in their model differs from that in Roberts’, since the probability of getting a job depends only on one’s own effort (and not on macroeconomic variables like the unemployment rate). People in their model balance the costs of more intensive job search with the benefits of a higher probability of finding employment: the involuntarily unemployed are those for whom this calculated gamble did not pay off.↩