The Inadequacy of the Pricing Mechanism in solving Skills Deficiencies – AKA Why You Should Be Concerned With Your Government’s Role in Address Skills Challenges

Friday, July 20, 2012
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The view that skills deficiencies are ephemeral and disappear as labor markets adjust is widely held (See for example Hay, Faruq et al. 2011). Underpinning this view is a belief that the pricing mechanism, exercised through expected wage returns and premia that motivate individual investment in particular types of skills and the ability of firms to increase extrinsic pay to obtain particular skills, leads to allocative efficiency within labor markets. However, persistent skills deficiencies over the last decade reported in several countries that began instituting national skills surveys in the early 2000s challenge the assumption that skill deficiencies are short lived and the effectiveness of the pricing mechanism in reducing the occurrence of deficiencies (Shah and Burke 2003; Paterson, Visser et al. 2008; Education Analytical Services 2010; Shury, Winterbotham et al. 2010).

The cobweb theory explains how labor market adjustments related to professions requiring training that delays labor market entry might mitigate the effect of the pricing mechanism on skills supply and complicate reaching market equilibrium. Shifts in the underlying supply of and demand for skills require time to reestablish market equilibrium due to the lag in time it takes to develop particular skills. For example, in analyzing the markets for lawyers and engineers, Freeman (1975; 1976) finds that the duration of the training period to obtain particular labor market skills and accompanying lag in labor market entry due to the training period can result in cyclical shortage-surplus cycles in professional labor markets. Freeman employs the cobweb model to show that supply of particular labor market skills is highly related to the economics of a profession, such as expected salary, and other forces that signal ongoing job opportunities and the state of the market such as R&D, output levels, and competition from others with similar skills. An important finding of Freeman’s model is that forces signaling professional opportunity and market health are more influential in motivating the supply of particular skillsets than salaries. Various factors are at play that signal increasing demand for a particular skillset, but the supply of individuals with those skills is delayed by the amount of time training to acquire a particular skills set takes. The time lag between the duration of the training period and labor market entry may potentially explain how labor market adjustment caused by adaptive expectations could potentially lead to endogenous cyclical cycles of skills shortages. While there is no similar theory regarding skills gaps, empirical studies also cast doubt on the pricing mechanism as a corrective measure to eliminate internal skills deficiencies. In skills surveys across a number of countries, firms consistently rank increasing pay or relying on the market mechanism amongst the least used measures to overcome skills gaps (Young and Morrell 2006; Management 2009; Shury, Vivian et al. 2009; Education Analytical Services 2010; Shury, Winterbotham et al. 2010).

Given the questionable role of price adjustment in remedying immediate labor market skills deficiencies, such as skills gaps, ensuring conceptual clarity, understanding the causes and consequences, and considering potential solutions is critical. Rather than an ephemeral shock, skills gaps have been a persistent issue immune to corrective market forces that affect the workforce of firms in many countries.

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