The Joy of Market-Clearing Wages By Bryan Caplan

When people compare the U.S. and Europe, they often conclude that the U.S. is richer and more economically efficient, but that Europe is happier because they don’t measure everything in dollars and cents (or even Marks and Pfennings). One of the prime examples people often point to: America’s less regulated, more flexible labor markets versus Europe’s highly regulated, highly rigid labor markets. (Exceptions: The UK and Holland). The U.S. sure looks more efficient, but many think of the European system as more humane.

There is a broad consensus among economists that European-style labor market regs are the main reason why European unemployment is so much higher than that in the U.S. Everyone from me to Paul Krugman agrees.

Still, you might argue that the European approach makes people happier. There is some increased risk of unemployment, but workers get higher earnings. If labor demand is inelastic, it seems like this could make most people better off. (Even this needs lots of qualifications, but I’ll buy it for the sake of argument).

So what? Well, if you delve into the life satisfaction literature, you learn two fun facts.

1. Once you reach a modest standard of living, additional income does not increase life satisfaction very much. Marginal utility of wealth decreases rapidly – maybe even more rapidly than you thought. (Having been a happy grad student on $6000/year, it’s not more rapid than I thought).

2. Unemployment per se has a large effect on life satisfaction. If you compare two people with equal incomes, one employed, one unemployed, the unemployed one is typically a lot less happy.

Just to get a feel for these results, Donovan and Halpern report (Chart 11) that about 80% of people in almost every occupational category is “fairly” or “very” satisfied with their lives. Manual laborers and white collar workers are nearly equal in satisfaction. Managers are a bit higher, around 90%. But the unemployed are fully 20 percentage points less likely than most workers to be satisfied with their lives.

Suppose, then, that labor market regulation could raise the incomes of manual laborers up to the level of white-collar workers. That’s a big change, but the extra income would probably add at most 1 percentage point of life satisfaction. If a side effect of the regulation was increasing the unemployment rate by 5%, however, this gain would be exactly balanced by the decreased satisfaction of the unemployed. And this is true even if we ignore all of the other side effects of the regulation – from extra taxes to pay for extra workers on the dole, to higher prices from restricted supply.

If you think this is remotely accurate, you will flee in terror from any regulation that might marginally push up unemployment. Flexible labor markets are more than just efficient. Contrary to popular prejudice, they also make a lot of people happy by making it easy to find a job.