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Daniel Hamermesh - Labor costs

Daniel S. Hamermesh, Editor-in-Chief at IZA World of labor, discusses labor costs.

By how much does employment fall when labor costs increase?
It’s a very hard question to figure out how much employment will respond to a rise in labor costs, and it clearly depends on the kind of worker. For high skilled workers, a rise in labor costs doesn’t make much difference. For lower skilled workers, employers are more responsive and will cut back employment more. On average, my best guess is, ten per cent rise in labor costs. Everything else the same, nothing else changes, will lead to about a three per cent drop in employment in hours.

How rapidly do employers adjust to an increase in labor costs?
Clearly there’s an initial response that takes quite a while for things to be fully realised. For lower skilled workers, the evidence is very clear, the responses are fairly quick: a quarter or two quarters. For higher skilled workers, it takes much longer. I mean think about professors, it’s very hard, even if their wages rise and their costs rise, to get rid of them. It takes a long time before some will retire, and you don’t hire their replacements. So it depends very, very much on the skill. On average, perhaps half of any adjustment would be made up in six months.

How do employers choose whether to cut employees or hours? 
Remember that total work is the product of the number of workers times the number of hours. Now think about, it if you’re a smart employer, you spend a lot of money training workers, searching for workers, and if you fire them you’ve got to pay them unemployment compensation. So typically, the first response is to cut the hours of existing workers. It’s only after you’ve cut hours somewhat that it pays you to start thinking about getting rid of workers, and even then, you won’t get rid of workers, you’ll just stop hiring workers when others quit. So if hours are the first margin of response, employees are the second margin of response, and within that margin you’ll work off the margin of non-replacement rather than firing people.

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