Labor economics is the branch of economics that studies the nature and determinants of employment and compensation. Particular emphasis is placed on the role played by social institutions and different types of market structures that jointly determine the pattern and mobility or speed of adjustment in the labor market where human labor inputs are bought and sold.

Labor markets are relatively slow to adjust in comparison to those markets for nonlabor inputs and commodities. For reasons best attributed to human behavior, worker movement from relatively low wage areas to high-wage locations is sluggish. Worker retraining aimed at eliminating wage differentials also requires a substantial amount of time, which is generally not the case for nonlabor inputs and commodities. As a result, the duration of wage differentials has tended to outlast those of other price differentials.

Another prominent distinction exists between internal and external labor markets. Internal labor markets refer to the determinants of pay and employment within a firm, while external labor markets refer to the determinants of pay and employment between firms or within and across industries. Many labor economists place substantial theoretical weight on these distinctions when trying to explain how labor markets work. As to the question of which type is more efficient or inefficient in the allocation of labor however, unanimity has been absent.


Almost from its inception (and especially during the post-World War II period), the analytical scope of labor economics mushroomed far outside the domain of traditional economics, making it a difficult field to define in a strict economic sense. Many labor economists caution that the word "labor" should not be understood as exclusively linked to the discipline of "economics." Instead, they advocate a more interdisciplinary approach that draws critically from insights provided by the disciplines of sociology, political science, psychology, and organizational theory and behavior. As a result, labor economics has concerned itself with a large range of topics, including race and gender discrimination; labor-management relations; demographic economics; personal or social expenditures on education, medical care, and training (referred to as human capital investments); and a multitude of issues surrounding behavior in the workplace, a subject area germane to industrial and human relations schools.

During the last two decades of the 20th century labor economics has been preoccupied with the problem of understanding and reversing a general economic productivity slowdown in the United States. As a proposed solution, a majority of labor economists and concerned others have recommended the widespread implementation of a "new" set of nonadversarial, democratic workplace industrial relations called labor-management cooperation schemes. Largely influenced by ideas gleaned from producer cooperative theory, future workplace relations under these schemes will be designed to "empower" workers in all facets of a firm's activities.

To solicit their participation in these new schemes, workers have been offered more than a token voice in shaping company policy, along with the right to exercise higher-level decision-making responsibilities formerly reserved for upper management. Labor-management schemes are also supposed to substantially reduce overall unit labor costs by eliminating management surveillance designed to detect on-the-job shirking. On the other hand, workers are expected to forego a rigid job classification system, and corresponding wage structure, and agree in turn to a more flexible job-assignment environment. The compelling argument is that worker satisfaction and motivation will increase with the challenge of learning and mastering new jobs, as opposed to the older environment of routine jobs that tended to lower morale over time. For unionized workplaces, this also means eliminating the traditional grievance procedures handled by elected union representatives in favor of nonelected joint labor-management committees that no longer have the option of turning to outside arbitrators to settle disputes.

Labor-management cooperation schemes are theoretically designed to flatten decision making so as to improve communication and spread technical knowledge without supervisory surveillance. Workers, imbued with a greater sense of self-determined voice and responsibility, should come to associate their own work efforts with their firm's success, from which individual or team rates of pay will be calculated. The influence of a more flexible job structure conducted according to democratic principles was expected to impart a long-term positive influence on productivity, but there have been problems after cooperation schemes were implemented. Because this new set of workplace relations often blurs the established, legally recognized separation between worker and management functions, a legal question has developed concerning whether these new types of relations are tantamount to "company unions," which are illegal under the National Labor Relations Act. Unions and management continue to struggle with this new environment.


Up until the period of the Great Depression and World War II, the study of labor economics was confined to the dominant orthodox framework of pure neoclassical economic theory. Analytical concepts familiar to micro and macroeconomists were the guiding precepts. A fundamental theoretical conclusion emerged which held that in a labor market where the competitive forces of supply and demand operated, a uniform industry-wide wage would prevail for laborers with similar skill or occupational characteristics. Any aberrations were thought to be short-lived and generally dismissed. This established theory remained unquestioned until a comprehensive empirical research project conducted by the War Labor Board yielded opposite conclusions. It found that wage rates for similar occupations varied greatly within and across many of the same labor markets. The most ironic finding of the report involved unions. According to established theory, the forces of free competition were thought to be least active in unionized labor markets, which represented the antithesis of neoclassical free competition. The study showed that, in reality, it was only in these unionized markets that anything approaching a uniform industry wage prevailed. Faced with this split between reality and theory, postwar labor economics developed into two schools of thought. The orthodox neoclassical school continued to push ahead with the development of theoretical models, while the institutionalist school conducted empirical research whose results typically clashed with the prevailing conclusions reached by theorists. The following sections will explore the history of the theoretical movement and then detail the key institutionalist beliefs.


Labor economics as a separate branch of economics emerged out of the political turmoil swirling around two major theoretical traditions and their competing theories of wage determination. On one side stood classical political economy, on the other neoclassical or marginalist political economy. In general, answers to two key questions divide the two traditions. First, do capitalist market forces function to guarantee that workers will receive their "fair share" of the output they generate? Second, if not, is it possible through collective/union efforts to gain a larger share, given the constraints imposed by capitalist market forces?

Classical political economy, which flourished and dominated the field of economic theory and analysis from the 18th century until the middle of the 19th, would have answered no to the first question and, under certain conditions, yes to the second. The field found its most cogent expression in Adam Smith's (1723-1790) Wealth of Nations in 1776, which is popularly demarcated as the founding work of modern political economy. The tradition extended through other major figures such as David Ricardo (1772-1823) and Karl Marx (1818-83); these three brought the field to its highest development. Marx developed his labor theory of value and exploitation to demonstrate how workers received only a portion of their product, with the remainder forming an economic surplus appropriated by capitalists for the maintenance of their consumption and investment activities.

For reasons more political than economic, neoclassical theory displaced classical political economy in the 1870s, and has remained the dominant framework for conducting formal economic analysis ever since. The works of utilitarian social philosopher Jeremy Bentham (1748-1832), were highly influential in the formation of early neoclassical economics. Bentham maintained that all human motivation could be reduced to a single principal: the individual's desire to maximize utility or satisfaction. Contrary to the class-conflict conclusions reached by classical political economy, utilitarianism espoused an economic doctrine of class harmony where the satisfaction of individual preferences informed all economic decisions. The appeal to class harmony resided in the "rational" notion that if capitalists and workers were brought to understand that they each received only a portion of what they had jointly created, then social justice would prevail. Several early attempts at constructing an economic theory of value and exchange on the basis of a utilitarian approach failed. Only with the separate publication of economic texts by William Stanley Jevons (1835-82) and Carl Menger in 1871, and by Leon Walras three year later, did neoclassical theory emerge as an internally coherent theoretical tradition. A short time later, the work of Alfred Marshall (1842-1924) provided additional support of neoclassical theory.

Neoclassical wage theory developed in response to Marx's critique and in reaction to a burgeoning, often hostile, trade union movement. Its overriding concern was to try to affirm that capitalist market forces were capable of paying workers their "rightful share" of the net product. With that in mind, John Bates Clark's influential book, The Distribution of Wealth, did just that. In his book, Clark argued that workers received wages that were equivalent to the value of their marginal labor product. From there, it followed that wage differentials simply reflected individual differences in skill and ability and the nonmonetary advantages and disadvantages between numerous jobs. Any of the factors that caused the productivity of labor to increase, thus shifting the demand curve for labor upwards, would be met with appropriate wage increases. Clark and other neoclassical labor economists concluded that Marx was wrong and that unions were unnecessary. In fact, they argued that successful union strategies that raised wages above the value of their marginal product would have a negative effect by lowering employment within unionized sectors while increasing the labor supply and lowering wages in nonunion sectors.

By the mid-1940s, neoclassical economists felt secure within their long-run equilibrium interpretation of wage determinants. At that time, however, empirical economists attempting to reconcile real-life labor market phenomena with neoclassical theory encountered unsettling data. When confronted by a growing number of studies suggesting flaws in their theories, neoclassical economists reacted by simply developing several ad hoc explanations to account for these exceptions. Empirical economists, on the other hand, found themselves shunning theoretical models constructed to guide them in their research. Without any theoretical structure to inform their work, they also resorted to ad hoc explanations. As a result a growing schism emerged within labor economics between theory and practice.


In order to address the widening gulf between theory and reality, a new breed of "Institutionalist" labor economists arose at the end of World War II. Recognition of four major economic developments largely explained why this happened. First, the disturbing impact of the Great Depression rattled every branch of economics related to the theories of pure competition and general equilibrium. Second, the publication of John Maynard Keynes's (1883-1946) General Theory and its insightful analysis of effective demand posed intriguing questions that were difficult to reconcile with standard neoclassical theory. Third, industrial unions were being formed at an unprecedented pace. Fourth, the development of the theory of imperfect competition in the 1930s seemed better suited to account for the fact that labor and capital markets reflected very large powerful bargaining units that were fewer in number, as opposed to the very large number of small powerless markets assumed by the neoclassical theory of perfect competition.

One of the earliest postwar institutionalists to attempt to explain inter-industry wage differentials based on real economic conditions was John Dunlop. In 1948, he proposed four reasons for their existence: unequal productivity levels; the proportion of labor to total costs; the relative degree or absence of competitive product market pressures; and an industry's changing skill and occupational composition of the workforce. Similar institutionalist studies soon followed. Though their points of emphasis varied, all those studies significantly departed from the prevailing neoclassical theory of perfect competition tied to marginal productivity.

Not content to sit on the sidelines, upholders of neoclassical orthodoxy criticized institutionalist theory on methodological grounds. Institutionalist theory, they claimed, was overly dependent on short- as opposed to long-run determinations. Institutionalists replied that orthodox neoclassical theory had yet to explain the widespread and persistent pattern of inter-industry wage differentials between workers with nearly identical productivity characteristics, an undeniable fact uncovered repeatedly by institutionalist research.

Neoclassical theory appeared to be vindicated with the publication in 1964 of Gary Becker's book on human capital theory. Becker's human capital approach, for which he was awarded a Nobel Prize in economics in 1993, argued that workers could upgrade their economic status if they made the rational individual choice to invest in more education and skill training. Once completed, their marginal productivity would increase and competitive pressures within the labor market would operate to raise their income. If they chose to do otherwise, it signaled that they somehow preferred the existing distribution of wages and were willing to live with its consequences, no matter how inequitable. Armed with human capital theory, confident neoclassical labor economists entered the realm of empirical research intent on explaining the persistence of inter- and intra-industry differentials among workers with identical productive characteristics. They anticipated the restoration of marginal productivity theory to its former prominence, arguing that wage differentials simply reflected individual differences in skill and effort, hence productivity. Liberal economists also jumped on the bandwagon, viewing human capital theory as a means for justifying larger government expenditures on training programs for the poor and disadvantaged.

Not long after the rise of human capital theory, real problems revealed its promises to be empty. Despite human-capital-inspired government programs, the continued fragmentation of the economy into low- and high-wage sectors proved intractable, as did wage differentials between black and white, and male and female workers. According to the logic of human capital theory, the economy's competitive pressures should have operated to eliminate those discriminatory forces, yet with the passage of time they had grown more pronounced. Closer empirical scrutiny of human capital theory raised serious questions concerning the use of average years of schooling as the critical variable used to explain wage differentials. Other factors such as large-scale manufacturing, on-the-job training, and reliance upon studies that separated production from skilled workers offered more credible explanations.

The early 1970s saw another institutionalist theoretical upsurge intended to explain the persistence of race and gender wage discrimination and the growth of a newly emergent "working poor" category. Reviving and building upon a previous institutionalist concept of internal labor markets (ILMS), two "new institutionalist" labor economists, Peter Doeringer and Michael Piore (1942-), led the effort to tackle those issues. They emphasized two major theoretical issues pertinent to ILMS theory: the growth of job-specific skill training and the notion of a modern "dual economy." In support of their job-specific skill approach, they argued that the development of large manufacturing firms provided the impetus for stable internal labor markets. So structured, firms could minimize the rising costs associated with skill training and worker turnover. Being somewhat sheltered from competitive external labor market pressures, firms could develop mutually beneficial internal job ladders. These would allow experienced workers to reap seniority benefits, be more inclined to stay within the firm, and train new workers.

Advancing a more detailed version of the dual economy approach first put forward by Robert Averits in 1968, Piore and Doeringer also argued that the labor market was divided into a primary and secondary market. Jobs in primary markets were distinguished by sophisticated technologies, skilled and semi-skilled labor, high wages, good working conditions, chances for advancement, employment stability, fairness, and due process in the administration of work rules. On the other hand, jobs in the secondary markets were subject to external competitive pressures; lacked technological sophistication; were performed by unskilled labor; and featured low wages, little or no fringe benefits, high labor turnover, absenteeism and tardiness, higher levels of petty theft, little chance of advancement, and typically autocratic and capricious supervisors.

Proponents of ILMS argued that the existence of dual labor markets, especially its primary component, did not fit well within the orthodox model of pure competition determining wages. The idea that labor mobility would lead to a reduction in wage differentials was flawed, if not altogether wrong, because of the discriminatory barriers that faced blacks, other ethnic minorities, and women. When it came to the subject of unions however, Piore and Doeringer's ILMS model encountered difficulty in explaining how supposedly secondary labor markets were able to transform themselves into primary markets through unionizing efforts. Nor were they ever able, like older institutionalist labor economists, to ultimately reject the overriding authority of marginal productivity theory.

In the more liberal academic environment of the 1970s, radical and Marxian ideas began to spread in labor economics. Drawing upon a rich historical legacy of industrial organization under capitalism, Harry Braverman's groundbreaking 1974 publication, Labor and Monopoly Capital, painstakingly detailed the de-skilling effects of modern capitalism. Consistent with Karl Marx, Braverman argued that this course was undertaken so that capitalist-inspired management could take control of the labor process away from skilled workers in order to raise the level of exploitation. Influenced by Braverman, many radicals took issue with the assumed connection between highly capital-intensive modem technology and the high skill levels said to be found in the high-wage primary labor markets, which was a primary part of the dual labor market theory. Others rejected the harmonious view of the labor process held by the new institutionalist school, especially when frequent strikes and productivity slowdowns seemed to indicate a lack of harmony. Most radical labor market theorists did not entirely reject new institutionalist reasoning, however. Instead, they insisted that dual market structures arose from class struggle over the internal organization of the labor processes. They called this labor segmentation theory.

Though essentially restatements of imperfect competition theories from the 1930s, the new Marxist and radical versions of monopoly capital were advanced to explain how market power served to prop up longstanding, above-average rates of profit. These rates were considered to be the sustaining lifeblood separating high-wage, primary markets from low-wage secondary markets. Interestingly, while reviving the importance of class struggle (once the centerpiece of classical political economy), many radicals were either ignorant of, or rejected outright, Marx's theory of the law of value. Marx considered this law as absolutely critical—it held the key to understanding the objective limits of a theory of inter and intra-industry profit and wage differentials tied to his dynamic theory of capitalist accumulation. With the lone exception of Howard Botwinick's contribution, Persistent Inequalities, no radical or Marxian work in labor economics has systematically broken away from the underpinnings of neoclassical theory, in either its perfect or imperfect versions, to formulate a theory of wage differentials consistent with Marx's law of value.

Leftist criticisms of radical segmentation theory were several. On theoretical grounds, it was argued that segmentation theory was overly dependent upon ad hoc explanations and lacked theoretical clarity. Even results from empirical studies were contradictory, indicating that overall patterns of working class division and segmentation were broadly diffused, tending to transcend neatly compartmentalized boundaries. This was true not only for the United States, but especially in Europe where significant numbers of immigrants gained entrance into primary labor markets in Germany, France, and Italy instead of entering the secondary markets as segmentation theory would have expected. Moreover, when it came to the historical development of dual economic structures, more attention was paid to capitalist' s motivations than to those of workers, especially unionized ones.

Beginning in the late 1970s, primary sector industries such as the automobile and steel industries suffered huge losses and went through periods of labor upheaval. In response to falling profit rates, which were once virtually guaranteed by near monopoly power, former primary market high-wage firms were behaving much like secondary ones. Tactics included forcing concessions in wage and working conditions, threatening to or actually relocating firms to low-wage areas, defeating strikes through the use of "scab" labor as permanent striker replacements, actively lobbying for passage of trade pacts that threatened high wages, and instituting two-tier wage packages for the same job.

Faced with these difficulties and criticisms, many radical labor economists unceremoniously abandoned ship. Indeed, by the 1990s, many leading radical proponents were no longer touting class struggle as a determinant factor. They had instead joined forces with the orthodox consensus on the need for joint labor-management schemes designed to counter the slowdown in productivity.


As the 20th century came to a close, a development called "efficiency wage theory" was gaining popularity. Efficiency wage theory was initiated by neoclassically oriented labor economists who acknowledge the failure of their traditional competitive framework to explain persistent real-world inter- and intra-industry wage differentials for workers with identical productive characteristics, as well as its inability to account for the growth of chronic unemployment. Efficiency wage theory has elicited considerable unanimity among the previously feuding groups of radical, institutional, and orthodox neoclassical labor economists.

Though many different versions abound, the central premise of efficiency wage theory is that the payment of wage rates above the assumed market equilibrium wage will result in a profit-maximizing outcome and permit capitalist firms to minimize total unit labor costs. Accordingly, above-equilibrium wage rates are thought to induce increased effort and productivity and a reduction in worker shirking; reduced turnover costs; perceived greater costs of termination; improved worker morale; and the attraction and retention of better quality personnel.

In the long run, if all firms pursue a similar higher-than-equilibrium wage strategy, unemployment will result. And neither is there reason for firms to lower wages, since this will slacken worker effort and increase unit labor costs. The prospect of an extended period of unemployment is posited as the safeguard against employee shirking. This approach to employee motivation, however, depends on the fostering of a long-time employer-employee relationship, which in turn creates a new set of factors for labor economists to consider.

Depending, then, on the conditions unique to each industry or firm, different levels of efficiency wages will be necessary so that workers with identical productive characteristics will not receive the same wage. With this logic in mind, orthodox labor econmists apparently have a plausible answer to the puzzling question of how above-equilibrium wage firms manage to survive in a competitive economy.

SEE ALSO : Economic Theories

[ Daniel E King ]


Botwinick, Howard. Persistent Inequalities: Wage Disparity Under Capitalist Competition. Princeton, NJ: Princeton University Press, 1994.

Ehrenberg, Ronald G. Modern Labor Economics: Theory and Public Policy. 6th ed. Reading, MA: Addison-Wesley, 1997.

Lippit, Walter, ed. Radical Political Economy. Armonk, NY: M.E. Sharpe, 1996.

Reynolds, Lloyd George. Labor Economics and Labor Relations. 1Ith ed. Upper Saddle River, NJ: Prentice Hall, 1998. Tilly, Chris. Work Under Capitalism. Boulder, CO: Westview Press, 1998.

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