Illustration: Glen Le Lievre.

Illustration: Glen Le Lievre.

The world is full of economists who, though they know little of the specifics of labour economics, confidently propose policies for managing the labour market based on their general knowledge of the neo-classical model. All markets are much the same, aren't they?

I fear this is the best we'll get from the Productivity Commission's inquiry into regulation of the labour market. So a test of the commission's report will be whether it displays knowledge of advanced thinking on how labour markets actually work or is just another neo-liberal rant about free markets.

In their efforts to bone up on the topic, the commissioners could do worse than start with a quick read of Nobel Laureate Robert Solow's 90-page classic, The Labor Market as a Social Institution.

Since the book was published in 1990, it should be old hat to economists, but I doubt it is. If so, it shows how little effort most economists - even academic economists - have put into studying the labour market.

Solow starts by reminding economists of a glaring problem they prefer not to think about: if the market for labour is just a market like any other market, and so is capable of being adequately analysed by the economists' standard tool kit of demand and supply - prices adjust until demand and supply are equal and the market ''clears'' - how come the labour market never clears? How come we always have high unemployment, which shoots up during downturns and stays very high for years before falling only slowly?

To put it another way, if the labour market works like any other market, making wages just a price like any other price, why don't wages fall and keep falling as long as the supply of labour exceeds the demand for it? Why do nominal wages almost never fall? Why is it the closest we ever get is nominal wages not rising as fast as ordinary prices, so wages fall a bit in ''real terms''?

In a country with Australia's history of many minimum wages, carefully specified in awards and agreements, it's easy for economists to claim wages can't fall because they're being held up by legal minimums. But this doesn't wash. In reality, many if not most wages are well above the legal minimum, meaning the minimum isn't ''binding'' and so isn't stopping actual nominal wages from falling back to the minimum. But they don't - and nor do they in America, where the minimum wage is kept so low it's almost never binding.

Overseas, some extreme neo-classical economists have tried to escape this problem by arguing most unemployment is voluntary rather than involuntary. It just so happens that, when economies turn down, a lot of people decide now's the time to take unpaid holidays and stay on them for many months. Yeah, right.

Solow says a more credible line of explanation is to admit the obvious: there must be something about labour markets that makes them different from other markets (such as the market for cars, or the market for bank loans) and so renders economists' usual analytical tools inadequate.

And it's not hard to think of what that something could be. Other markets are for the purchase and sale of inanimate objects, whereas every unit of labour bought or sold comes with a real live human attached. Every human is different - some are smart, some aren't; some work hard, some don't; some are co-operative, some aren't - and bosses turn out to be humans, too.

The thing about humans is they have egos and feelings and moods. One apple doesn't care about the other apples in the barrel, but a human cares about how they're being treated by their human boss, as well about how they're being treated relative to all the other humans working for the boss.

Hence the title of Solow's book. Unlike other markets, the labour market is also a social institution. Only an economist could imagine you could analyse the labour market successfully without taking account of the human factor.

So maybe it's the social dimension of labour that explains why wages are inflexible and the labour market doesn't clear. Solow uses the work of some woman whose name seems vaguely familiar, a Janet Yellen, and her Noble prize-winning husband, George Akerlof, to outline a possible explanation of the conundrum, ''the fair-wage-effort hypothesis''.

The ''efficiency-wage theory'' says that in the modern economy workers often have some control over their own productivity. They produce more when they are strongly motivated to do so. ''One way for an employer to provide more motivation is by paying more than other employers do; another is to threaten to fire the excessively unproductive if and when they are detected,'' Solow says.

If that sounds obvious, note the radical implication: a firm's physical productivity depends not just on how much labour (and capital) it uses, but also on how well the labour is paid. If so, wages won't fall just because unemployment rises.

Yellen and Akerlof's version of efficient-wage theory says workers who believe they're being paid ''a fair day's wage'' feel a social obligation to deliver ''a fair day's work'' in return.

A different approach is ''insider-outsider theory''. This says the people already working for a firm (insiders) are likely to be more productive than those who aren't (outsiders) because they understand the peculiarities of how the firm works. If so, the insiders are helping to generate ''economic rent'' for the firm and thus are able to share this rent by negotiating higher wages. An outsider may be prepared to work for the firm for a smaller wage, but the boss won't want to risk reducing his productivity by switching from insiders to outsiders.

Whichever of those theories you find more persuasive, the point is the workings of real-world labour markets are far more complicated than most economists realise. Let's hope the Productivity Commission does.