Archive for the 'Alchian' Category

Alchian on Money Illusion and the Wage-Price Lag During Inflation

At the end of my post a couple of days ago, I observed that the last two sentences of the footnote that I reproduced from Alchian’s “Information Costs, Pricing, and Resource Unemployment,” required a lot of unpacking. So let’s come back to it and try to figure out what Alchian meant. The point of the footnote was to say that Keynes’s opaque definition of involuntary unemployment rested on a distinction between the information conveyed to workers by an increase in the price level, their money wage held constant, and the information conveyed to them by a reduction in their money wage, with the price level held constant. An increase in the price level with constant money wages conveys no information to workers about any change in their alternatives. Employed workers are not induced by an increase in prices to quit their current jobs in the expectation of finding higher paying jobs, and unemployed workers are not induced to refuse an offer from a prospective employer, as they would be if the employer cut the money wages at which he was willing pay his current employees or to hire new ones. That subtle difference in the information conveyed by a cut in real wages effected by rising prices versus the information conveyed by a cut in real wages effected by a cut in money wages, Alchian explained, is the reason that Keynes made his definition of involuntary unemployment contingent on the differing responses of workers to a reduced real wage resulting from a rising price level and from a falling money wage.

Here is where the plot thickens, because Alchian adds the following comment.

And this is perfectly consistent with Keynes’s definition of [involuntary] unemployment, and it is also consistent with his entire theory of market adjustment processes . . . , since he believed 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,” Amer. Econ. Rev. 50 [March 1960]:43-66). Without this 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.

So, according to Alchian, Keynes’s assumption that the information extracted by workers from a price-level increase is not the same as the information extracted from a nominal wage cut depends on the existence of a lag in the adjustment of wages to an inflationary disturbance. Keynes believed that during periods of inflation, output prices rise before, and rise faster than, wages rise, at least in the early stages of inflation. But if prices and wages rise simultaneously and at the same rate during inflation, then there would be no basis for workers to draw different inferences about their employment opportunities from observing price increases as opposed to observing a nominal wage cut. Alchian believes that the assumption that there is a wage-lag during inflation is both theoretically problematic, and empirically suspect, relying on several important papers that he co-authored with Reuben Kessel that found little support for the existence of such a lag in the historical data on wages and prices.

I have two problems with Alchian’s caveat about the existence of a wage-price lag.

First, Alchian’s premise (with which I agree totally) in the article from which I am quoting is that lack of information about the characteristics of goods being sold and about the characteristics of sellers or buyers (when the transaction involves a continuing relationship between the transactors) and about the prices and characteristics of alternatives induces costly search activities, the holding of inventories, and even rationing or queuing, as alternatives to immediate price adjustments as a response to fluctuations in demand or supply. The speed of price adjustment is thus an economically determined phenomenon, the speed depending on, among other things, the particular characteristics of the good or service being sold and the ease of collecting information about the good and service. For example, highly standardized commodities about which information is readily available tend to have more rapidly adjusting prices than those of idiosyncratic goods and services requiring intensive information gathering by transactors before they can come to terms on a transaction. If employment transactions typically involve a more intensive information gathering process about the characteristics of workers and employers than most other goods and services, then Alchian’s own argument suggests that there should be a lag in wage adjustment relative to the prices of most other goods. An inflation, on Alchian’s reasoning, ought to induce an initial response in the prices of the more standardized commodities with price adjustments in less standardized, more informationally complex, markets, like labor markets, coming later. So I don’t understand Alchian’s theoretical basis for questioning the existence of a wage lag.

Second, my memory is a bit hazy, and I will need to check his article on the wage lag, but I do believe that Alchian pointed out that there is a problem of interpretation in evaluating evidence on the wage lag, because inflation may occur concurrently, but independently, with another change that reduces the demand for labor and causes the real wage to fall. So if one starts, as did Keynes in his discussion of involuntary unemployment, from the premise that a recession is associated with a fall in the real demand for labor that requires a reduction in the real wage to restore full employment, then it is not clear to me why it would be rational for a worker to increase his reservation wage immediately upon observing that output prices are increasing. Workers will typically have some expectation about how rapidly the wage at which they can find employment will rise; this expectation is clearly related to their expectation of how fast prices will rise. If workers observe that prices are rising faster than they expected prices to rise, while their wage is not rising any faster than expected, there is uncertainty about whether their wage opportunities in general have fallen or whether the wage from their current employer has fallen relative to other opportunities. Saturos, in a comment on Tuesday’s post, argued that the two scenarios are indeed symmetrical and that to suggest otherwise is indeed an instance of money illusion. The argument is well taken, but I think that at least in transitional situations (when it seems to me theory supports the existence of a wage lag) and in which workers have some evidence of deteriorating macroeconomic conditions, there is a basis, independent of money illusion, for the Keynesian distinction about the informational content of a real wage cut resulting from a price level increase versus a real wage cut resulting from a cut in money wages.  But I am not sure that this is the last word on the subject.

Alchian on Why Wages Adjust Slowly and Why It Matters

In my previous post, I reproduced a footnote from Armen Alchian’s classic article “Information Costs, Pricing and Resource Unemployment,” a footnote explaining the theoretical basis for Keynes’s somewhat tortured definition of involuntary unemployment. In this post, I offer another excerpt from Alchian’s article, elaborating on the microeconomic rationale for “slow” adjustments in wages. In an upcoming post, I will try to tie some threads together and discuss the issue of whether there might be, contrary to Alchian’s belief, a theoretical basis for wages to lag behind other prices, ata least during the initial stages of inflation. Herewith are the first four paragraphs of section II (Labor Markets) of Alchian’s paper.

Though most analyses of unemployment rely on wage conventions, restriction, and controls to retard wage adjustments above market-clearing levels, [J. R.] Hicks and [W. H.] Hutt penetrated deeper. Hicks suggested a solution consistent with conventional exchange theory. He stated that “knowledge of opportunities is imperfect” and that the time required to obtain that knowledge leads to unemployment and a delayed effect on wages. [fn. J. R. Hicks, The Theory of Wages, 2d ed. (London, 1963), 45, 58. And headed another type – “the unemployment of the man who gives up his job to look for a better.”] It is precisely this enhanced significance that this paper seeks to develop, and which Hicks ignored when he immediately turned to different factors – unions and wage regulations, placing major blame on both for England’s heavy unemployment in the 1920s and 30s.

We digress to note that Keynes, in using a quantity-, instead of a price-, adjustment theory of exchange, merely postulated a “slow” reacting price without showing that slow price responses were consistent with utility or wealth-maximizing behavior in open, unconstrained markets. Keynes’s analysis was altered in the subsequent income-expenditure models where reliance was placed on “conventional” or “noncompetitive” wage rates. Modern “income-expenditure” theorists assumed “institutionally” or “irrationally” inflexible wages resulting from unions, money illusions, regulations, or factors allegedly idiosyncratic to labor. Keynes did not assume inflexibility for only wages. His theory rested on a more general scope of price inflexibility. [fn. For a thorough exposition and justification of these remarks on Keynes, see A. Leijonhufvud, On Keynesian Economics and the Economics of Keynes (Oxford, 1968).] The present paper may in part be viewed as an attempt to “justify” Keynes’s presumption about price response to disturbances in demand.

In 1939 W. H. Hutt exposed many of the fallacious interpretations of idleness and unemployment. Hutt applied the analysis suggested by Hicks but later ignored it when discussing Keynes’s analysis of involuntary unemployment and policies to alleviate it. [fn. W. H. Hutt, The Theory of Idle Resources (London, 1939), 165-69.] This is unfortunate, because Hutt’s analysis seems to be capable of explaining and accounting for a substantial portion of that unemployment.

If we follow the lead of Hicks and Hutt and develop the implications of “frictional” unemployment for both human and nonhuman goods, we can perceive conditions that will imply massive “frictional” unemployment and depressions in open, unrestricted, competitive markets with rational, utility maximizing, individual behavior.

So Alchian is telling us that it is at least possible to conceive of conditions in which massive unemployment and depressions are consistent with “open, unrestricted, competitive markets with rational, utility maximizing, individual behavior.” And presumably would be more going on in such periods of massive unemployment than the efficient substitution of leisure for work in periods of relatively low marginal labor productivity.

Alchian on the Meaning of Keynesian “Involuntary” Unemployment

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.

The Midnight Economist Reminisces About His Colleague and Co-author Armen Alchian and the Brief but Wonderful Golden Age of the UCLA Econ Department

Bill Allen was a stalwart member of the UCLA economics department in the years of its glory from the late 1950s to the early 1970s. A distinguished economist in his own right, specializing in the international economics and the history of economic thought, Allen is probably best known for having been selected by Armen Alchian to be his co-author in writing the greatest economics textbook ever written and for later becoming the Midnight Economist, delivering daily economic commentaries over the radio from the late 1970s to the early 1980s. The broadcasts are now available on the web or as podcasts, and were also collected in book form.

I have written several earlier posts (e.g., this and this) in which I wrote about what a great place UCLA was to learn economics and what a loss it has been for the economics profession that the special brand of economics taught and practiced at UCLA has been overshadowed by the more formalistic and axiomatic approaches that now dominate the profession, and, alas, even the UCLA economics department itself.

Just yesterday I stumbled upon Bill Allen’s memoir about his own life in Econ Journal Watch and especially about his years at UCLA, and his relationships with his colleagues, and especially, of course, with Alchian. Herewith are a few excerpts:

What defined and distinguished the Core [the central group within the department who were the intellectual leaders of the department and gave the department its unique character, most notably during my day Alchian, Jack Hirshleifer, Allen, George Hilton, Harold Demsetz, Axel Leijonhufvud, and Earl Thompson; Karl Brunner left before I arrived–DG] is a question of considerable subtlety and nuance. The leader of the impressive band clearly was Alchian. His position of prominence evolved and developed, not by his intention or machinationn or the extroverted personality of a self-conscious and self-serving field marshall. (Much later, when as chairman I was recruiting the eminent Jim Buchanan, I apologized to Alchian for being obliged to offer Jim a salary greater than Alchian’s. Armen firmly put me at ease—after all, he had some understanding of how markets work.) Almost always soft-spoken, unaggressive, and seemingly bemused, he was genuinely curious about certain workings of the world, and he was imaginatively and innovatively bold in seeking explanations—and he was remarkably generous in helping other curious analysts. He was confident that much of previously unaccountable behavior and phenomena could be explicated by fundamental and often quite simple (when adroitly utilized) analytic propositions and techniques. The tools of Econ l and 2 can be powerful in masterly hands. Larry Miller observed, with some appreciation, that Alchian “found economics behind every rock.”

The department in its brief Golden Age was aware of being out of step with most of the profession both in the purpose and nature of the work of the Core and in how the work was conducted. For members of the Core, Economics was to be dedicated to genuine, bone fide, real-worldly, enlightening and useful empirical problem-solving. Who is to gain what from the efforts of economists? What is the relevance and worth of their meditations and exercises? How great and widespread would be the net calamity if all the economists suddenly departed for their esoteric Nirvana?

In a 1985 memorandum to me, Leijonhufvud wrote: [Alchian’s] unique brand of price theory is what gave UCLA Economics its own intellectual profile and achieved for us international recognition as an independent school of some importance—as a group of scholars who did not always take their leads from MIT, Chicago or wherever. When I came here (in 1964) the Department had Armen’s intellectual stamp on it (and he remained the obvious leader until just a couple of years ago ….). Even people outside Armen’s fields, like myself, learned to do Armen’s brand of economic analysis and a strong esprit de corps among both faculty and graduate students sprang from the consciousness that this ‘New Institutional Economics’ was one of the waves of the future and that we, at UCLA, were surfing it way ahead of the rest. But Armen’s true importance to the UCLA school did not stem just from the new ideas he taught or the outwardly recognized ‘brandname’ that he created for us. For many of his young colleagues he embodied qualities of mind and character that seemed the more important to seek to emulate the more closely you got to know him.

The entire essay is eminently worth reading, though, like all golden-age stories, it is also, sadly, one of decline and fall. Sic transit gloria mundi.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.


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