The Economics of Labor Adjustment: Mind the Gap

By Russell Cooper and Jonathan L. Willis
August 2001 
RWP 01-06
Research Division 
Federal Reserve Bank of Kansas City 

Abstract

We study the inferences about labor adjustment costs obtained by the "gap methodology" of Caballero and Engel [1993] and Caballero, Engel and Haltiwanger [1997]. In that approach, the policy function of a manufacturing plant is assumed to depend on the gap between a target and the current level of employment. Using time series observations, these studies reject the quadratic cost of adjustment model and find that aggregate employment dynamics depend on the cross sectional distribution of employment gaps. We argue that these conclusions may not be justified. Instead these findings may reflect difficulties measuring the gap. Thus it appears that the gap methodology as currently employed, may be unable to: (i) identify the costs of labor adjustment and (ii) assess the aggregate implications of labor adjustment costs.

JEL classification: E24, J23, J6.

Jonathan L. Willis is an economist at the Federal Reserve Bank of Kansas City. The authors are grateful to seminar participants at Boston University, the University of British Columbia, the University of Haifa, the University of Texas at Austin and the 2000 CMSG conference at McMaster University for comments and suggestions. Discussions with John Haltiwanger, Daniel Hamermesh, Peter Klenow and Christopher Ragan were much appreciated. The authors thank the NSF for financial support. The views expressed in this paper are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Kansas City, the Federal Reserve Bank of Minneapolis, or the Federal Reserve System.

Cooper E-mail:  rcooper@bu.edu
Willis E-mail: jonathan.willis@kc.frb.org

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