Employment is a fundamental economic variable that is relied on as both a gauge of the current state of the economy and a measure of societal wellbeing. In light of its central role, it is essential that policymakers understand the factors that drive this important variable so that they can reliably update their forecasts of economic activity and estimate the likely outcome of a policy change or unanticipated economic disturbance.
At its most basic level, employment is the market clearing quantity implied by the intersection of labour supply and demand, so the literature has either focused on the factors that drive supply or demand. This paper concentrates on the factors that drive labour demand. It adds to a number of recent Australian studies by updating estimates of key labour demand parameters and clarifying their interpretation.3
This project is the first part of a larger research effort with the ultimate goal of modelling short- and long-run labour demand on both a heads (that is, the number of persons employed) and total hours worked basis. For ease of exposition, we have limited this paper to modelling heads which allows us to avoid complexity associated with measuring total hours worked.
Following the broader aggregate labour demand literature, we derive a conditional long-run labour demand equation via a representative firm-level profit maximising problem, where production takes place according to a constant elasticity of substitution production function4. This theoretical framework is augmented by cyclical explanatory variables to form an error correction model, which is then estimated using standard econometric methods.
Our estimates of important labour demand parameters, such as the elasticity of substitution between capital and labour, are consistent with previous Australian studies.
We add to the current stock of knowledge by demonstrating that the typical strategy of identifying labour-augmenting technical change via a deterministic time trend is at odds with observed data. We do this by showing that model-based estimates of the growth rate of labour augmenting technical change greatly exceed the prediction of theory that it be equal to the trend growth rate of observed productivity and/or real wages. We go on to demonstrate that despite this weakness this strategy remains a valid approach to estimating all other key labour demand parameters.
The remainder of this paper is organised as follows: section 2 derives the long-run labour demand relationship; section 3 describes the data used in estimating the labour demand equation; section 4 provides details of the econometric method and reports parameter estimates; and section 5 summarises the analysis and outlines plans for future work.
3 See, for example, Debelle and Vickery (1998), Dungey and Pitchford (1998), Downes and Bernie (1999), Lewis and MacDonald (2002, 2004), Dowrick and Wells (2004), Dixon, Freebairn and Lim (2005) and references therein.
4 See, for example, Lucas and Rapping (1970), Altonji (1982), and Hamermesh (1986).