In his classic paper “Information Costs, Pricing, and Resource Unemployment,” Armen Alchian explains how the absence of full information about the characteristics of goods and services, and about the prices at which they are available leads to a variety of phenomena that are inconsistent with implications of idealized “perfect markets” at which all transactors can buy or sell as much as they want to at known, market-clearing, prices. The main implications of less than full information are the necessity of search, less than instantaneous price adjustment to changes in demand or cost conditions, the holding of (seemingly) idle or unemployed inventories, queuing, and even rationing. The paper was originally published in 1969 in the Western Economic Journal (subsequently Economic Inquiry) and was republished in a 1970 volume edited by Edmund Phelps, Microeconomic Foundations of Employment and Inflation Theory. It is included in The Collected Works of Armen Alchian (volume 1) published by the Liberty Fund.
Alchian’s explanation of Keynes’s definition of involuntary unemployment appears in footnote 27 in the version published in the Phelps volume (23 in the version published in volume 1 of The Collected Works). Here is the entire footnote:
An intriguing intellectual historical curioso may be explainable by this theory, as has been brought to my attention by Axel Leijonhufvud. Keynes’ powerful, but elliptical, definition of involuntary unemployment has been left in limbo. He wrote:
Men are involuntary unemployed if, in the event of a small rise in the price of wage-goods relative to the money-wage, both the aggregate supply of labour willing to work for the current money wage and the aggregate demand for it at that wage would be greater than the existing volume of employment.
[J. M. Keynes, The General Theory of Employment, Interest, and Money (The Macmillan Company, London, 1936).] To see the power and meaning of this definition (not cause) of unemployment, consider the following question: Why would a cut in money wages provoke a different response than if the price level rose relative to wages – when both would amount to the same change in relative prices, but differ only in the money price level? Almost everyone thought Keynes presumed a money wage illusion. However, an answer more respectful of Keynes is available. The price level rise conveys different information: Money wages everywhere have fallen relative to prices. On the other hand, a cut in one’s own wage money wage does not imply options elsewhere have fallen. A cut only in one’s present job is revealed. The money versus real wage distinction is not the relevant comparison; the wage in the present job versus the wage in all other jobs is the relevant comparison. This rationalizes Keynes’ definition of involuntary unemployment in terms of price-level changes. If wages were cut everywhere else, and if employees knew it, they would not choose unemployment – but they would if they believed wages were cut just in their current job. When one employer cuts wages, this does not signify cuts elsewhere. His employees rightly think wages are not reduced elsewhere. On the other hand, with a rise in the price level, employees have less reason to think their current real wages are lower than they are elsewhere. So they do not immediately refuse a lower real wage induced by a higher price level, whereas they would refuse an equal money wage cut in their present job. It is the revelation of information about prospects elsewhere that makes the difference. And this is perfectly consistent with Keynes’ definition of [involuntary] unemployment, and it is also consistent with his entire theory of market-adjustment processes (Keynes, The General Theory of Employment, Interest, and Money) since he believed that money wages lagged behind nonwage prices – an unproved and probably false belief (R. A. Kessel and A. A. Alchian, “The Meaning and Validity of the Inflation-Induced Lag of Wages Behind Prices,” American Economic Review 50 (March 1960): 43-66). Without that belief a general price-level rise is indeed general; it includes wages, and as such there is no reason to believe a price level rise is equivalent in real terms to a money wage cut in a particular job.
PS There is a lot of unpacking that needs to be done in the last two sentences, but that is best left for another post.
Uneasy Money 
David,
I remember going through Alchian’s textbook and I was struck by several pages where he explained how increasing the money supply increase prices. He used the story of a housewife/butcher/distributor/rancher and explained the process from handing the housewife new money to how that resulted in increases prices.
Amazingly, he explained the resulting short run changes in inflation and output without ANY mention of stickiness, or the Phillips curve or differences between actual and expected inflation. He just used the basic price theory that he was teaching in the textbook, nothing more.
It still haunts me.
Please continue these posts on UCLA macro, they are wonderful.
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David:
An important extension of Alchian’s idea comes from the theory of Real Options. Start by recognizing that an American call option will usually not be exercised before maturity, since early exercise will normally pay less than selling the option to someone else. Next, suppose you own vacant land. This land gives you an option to build a home, a gas station, office building, etc. Once you actually build one of those things, you have exercised your option and lost the option premium. Keeping the land vacant, on the other hand, keeps your options open, and is sometimes more valuable than having the building. The implication is that it is rational to keep land unemployed in some cases. By extension, unemployment of labor is also rational.
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“The price level rise conveys different information: Money wages everywhere have fallen relative to prices. On the other hand, a cut in one’s own wage money wage does not imply options elsewhere have fallen.”
But that is money illusion. If my money wage rises by less than inflation, that says nothing about whether other money wages have risen by less than inflation. There is no explanation for a separate behavioral response to a cut in one’s observed real wage through nominal wages or prices – unless workers are observing their nominal wages instead of their real wages, i.e. money illusion .
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All well and good, in the entertaining game of explication of what Keynes _really_ meant.
However, do you think this was in fact a good explanation of high unemployment in the mid 20s and 1930s? Did it penetrate to the essence of the situation to say that the employed peers of the Jarrow marchers were responsible for maintaining real wages at an elevated level, because they refused to face the reality that the market-clearing level of wages was very much lower than they were presently being paid?
And do you think this is a good explanation of unemployment today?
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JoeMac, You are so right. There are countless examples in that textbook of the most sophisticated economic reasoning being distilled into the most basic economic concepts. That’s why I always refer to University Economics as the greatest economics textbook ever written. But it should inspire – not haunt – you. I hope to add a new post soon, either tonight or tomorrow.
Mike, Excellent point. I think that the idea predates Alchian, Hutt discussed the idea I his Theory of Idle Resources in 1939. But Alchian was able to get a lot more mileage out of it.
Satuors, You are a very careful reader. That’s what I meant by unpacking the last two sentences. I am rushed now, so I can’t go into it in detail, but Alchian distinguishes between whether there is a wage lag or there is not in his discussion of Keynes.
Cantillon Blog, I think that it is a key element of the explanation of high unemployment, because of feedback effects as the result of trading at disequilibrium prices which produces multiplier effects (or cumulative contraction via Say’s Law). Stay tuned for my next post.
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Gustav Cassel and Euro Inflation Divergence:
http://socialmacro.blogspot.com/2012/06/gustav-cassel-and-euro-inflation.html
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alchian’s university economics (1967) can still be read with profit today.
a revised edition of his universal economics (2005) is being drafted
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Cutting wages in times like this would be disastrous. This comment is meant of low and middle income families.
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Julian, Thanks for the link
Jim, It is the greatest economics textbook ever written. I didn’t know that there was an update in the works with a new co-author Don Allison. I probably knew Don Allison when I was a graduate student at UCLA, but I am sorry to say that I no longer remember him. Here is a website about the new book
http://web.me.com/donallisonjr/UniversalEconomics/web-content/Pages/Features.html
Tas. The point is not to cut wages, but to allow labor markets to operate more efficiently. Under current circumstances, I believe that inflation would promote labor market efficiency.
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Reblogged this on Utopia – you are standing in it!.
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