Archive for the 'involuntary unemployment' Category

On the Labor Supply Function

The bread and butter of economics is demand and supply. The basic idea of a demand function (or a demand curve) is to describe a relationship between the price at which a given product, commodity or service can be bought and the quantity that will bought by some individual. The standard assumption is that the quantity demanded increases as the price falls, so that the demand curve is downward-sloping, but not much more can be said about the shape of a demand curve unless special assumptions are made about the individual’s preferences.

Demand curves aren’t natural phenomena with concrete existence; they are hypothetical or notional constructs pertaining to individual preferences. To pass from individual demands to a market demand for a product, commodity or service requires another conceptual process summing the quantities demanded by each individual at any given price. The conceptual process is never actually performed, so the downward-sloping market demand curve is just presumed, not observed as a fact of nature.

The summation process required to pass from individual demands to a market demand implies that the quantity demanded at any price is the quantity demanded when each individual pays exactly the same price that every other demander pays. At a price of $10/widget, the widget demand curve tells us how many widgets would be purchased if every purchaser in the market can buy as much as desired at $10/widget. If some customers can buy at $10/widget while others have to pay $20/widget or some can’t buy any widgets at any price, then the quantity of widgets actually bought will not equal the quantity on the hypothetical widget demand curve corresponding to $10/widget.

Similar reasoning underlies the supply function or supply curve for any product, commodity or service. The market supply curve is built up from the preferences and costs of individuals and firms and represents the amount of a product, commodity or service that would be willing to offer for sale at different prices. The market supply curve is the result of a conceptual summation process that adds up the amounts that would be hypothetically be offered for sale by every agent at different prices.

The point of this pedantry is to emphasize the that the demand and supply curves we use are drawn on the assumption that a single uniform market price prevails in every market and that all demanders and suppliers can trade without limit at those prices and their trading plans are fully executed. This is the equilibrium paradigm underlying the supply-demand analysis of econ 101.

Economists quite unself-consciously deploy supply-demand concepts to analyze labor markets in a variety of settings. Sometimes, if the labor market under analysis is limited to a particular trade or a particular skill or a particular geographic area, the supply-demand framework is reasonable and appropriate. But when applied to the aggregate labor market of the whole economy, the supply-demand framework is inappropriate, because the ceteris-paribus proviso (all prices other than the price of the product, commodity or service in question are held constant) attached to every supply-demand model is obviously violated.

Thoughtlessly applying a simple supply-demand model to analyze the labor market of an entire economy leads to the conclusion that widespread unemployment, when some workers are unemployed, but would have accepted employment offers at wages that comparably skilled workers are actually receiving, implies that wages are above the market-clearing wage level consistent with full employment.

The attached diagram for simplest version of this analysis. The market wage (W1) is higher than the equilibrium wage (We) at which all workers willing to accept that wage could be employed. The difference between the number of workers seeking employment at the market wage (LS) and the number of workers that employers seek to hire (LD) measures the amount of unemployment. According to this analysis, unemployment would be eliminated if the market wage fell from W1 to We.

Applying supply-demand analysis to aggregate unemployment fails on two levels. First, workers clearly are unable to execute their plans to offer their labor services at the wage at which other workers are employed, so individual workers are off their supply curves. Second, it is impossible to assume, supply-demand analysis requires, that all other prices and incomes remain constant so that the demand and supply curves do not move as wages and employment change. When multiple variables are mutually interdependent and simultaneously determined, the analysis of just two variables (wages and employment) cannot be isolated from the rest of the system. Focusing on the wage as the variable that needs to change to restore full employment is an example of the tunnel vision.

Keynes rejected the idea that economy-wide unemployment could be eliminated by cutting wages. Although Keynes’s argument against wage cuts as a cure for unemployment was flawed, he did have at least an intuitive grasp of the basic weakness in the argument for wage cuts: that high aggregate unemployment is not usefully analyzed as a symptom of excessive wages. To explain why wage cuts aren’t the cure for high unemployment, Keynes introduced a distinction between voluntary and involuntary unemployment.

Forty years later, Robert Lucas began his effort — not the first such effort, but by far the most successful — to discredit the concept of involuntary unemployment. Here’s an early example:

Keynes [hypothesized] that measured unemployment can be decomposed into two distinct components: ‘voluntary’ (or frictional) and ‘involuntary’, with full employment then identified as the level prevailing when involuntary employment equals zero. It seems appropriate, then, to begin by reviewing Keynes’ reasons for introducing this distinction in the first place. . . .

Accepting the necessity of a distinction between explanations for normal and cyclical unemployment does not, however, compel one to identify the first as voluntary and the second as involuntary, as Keynes goes on to do. This terminology suggests that the key to the distinction lies in some difference in the way two different types of unemployment are perceived by workers. Now in the first place, the distinction we are after concerns sources of unemployment, not differentiated types. . . .[O]ne may classify motives for holding money without imagining that anyone can subdivide his own cash holdings into “transactions balances,” “precautionary balances”, and so forth. The recognition that one needs to distinguish among sources of unemployment does not in any way imply that one needs to distinguish among types.

Nor is there any evident reason why one would want to draw this distinction. Certainly the more one thinks about the decision problem facing individual workers and firms the less sense this distinction makes. The worker who loses a good job in prosperous time does not volunteer to be in this situation: he has suffered a capital loss. Similarly, the firm which loses an experienced employee in depressed times suffers an undesirable capital loss. Nevertheless, the unemployed worker at any time can always find some job at once, and a firm can always fill a vacancy instantaneously. That neither typically does so by choice is not difficult to understand given the quality of the jobs and the employees which are easiest to find. Thus there is an involuntary element in all unemployment, in the sense that no one chooses bad luck over good; there is also a voluntary element in all unemployment, in the sense that however miserable one’s current work options, one can always choose to accept them.

Lucas, Studies in Business Cycle Theory, pp. 241-43

Consider this revision of Lucas’s argument:

The expressway driver who is slowed down in a traffic jam does not volunteer to be in this situation; he has suffered a waste of his time. Nevertheless, the driver can get off the expressway at the next exit to find an alternate route. Thus, there is an involuntary element in every traffic jam, in the sense that no one chooses to waste time; there is also a voluntary element in all traffic jams, in the sense that however stuck one is in traffic, one can always take the next exit on the expressway.

What is lost on Lucas is that, for an individual worker, taking a wage cut to avoid being laid off by the employer accomplishes nothing, because the willingness of a single worker to accept a wage cut would not induce the employer to increase output and employment. Unless all workers agreed to take wage cuts, a wage cut to one employee would have not cause the employer to reconsider its plan to reduce in the face of declining demand for its product. Only the collective offer of all workers to accept a wage cut would induce an output response by the employer and a decision not to lay off part of its work force.

But even a collective offer by all workers to accept a wage cut would be unlikely to avoid an output reduction and layoffs. Consider a simple case in which the demand for the employer’s output declines by a third. Suppose the employer’s marginal cost of output is half the selling price (implying a demand elasticity of -2). Assume that demand is linear. With no change in its marginal cost, the firm would reduce output by a third, presumably laying off up to a third of its employees. Could workers avoid the layoffs by accepting lower wages to enable the firm to reduce its price? Or asked in another way, how much would marginal cost have to fall for the firm not to reduce output after the demand reduction?

Working out the algebra, one finds that for the firm to keep producing as much after a one-third reduction in demand, the firm’s marginal cost would have to fall by two-thirds, a decline that could only be achieved by a radical reduction in labor costs. This is surely an oversimplified view of the alternatives available to workers and employers, but the point is that workers facing a layoff after the demand for the product they produce have almost no ability to remain employed even by collectively accepting a wage cut.

That conclusion applies a fortiori when decisions whether to accept a wage cut are left to individual workers, because the willingness of workers individually to accept a wage cut is irrelevant to their chances of retaining their jobs. Being laid off because of decline in the demand for the product a worker is producing is a much different situation from being laid off, because a worker’s employer is shifting to a new technology for which the workers lack the requisite skills, and can remain employed only by accepting re-assignment to a lower-paying job.

Let’s follow Lucas a bit further:

Keynes, in chapter 2, deals with the situation facing an individual unemployed worker by evasion and wordplay only. Sentences like “more labor would, as a rule, be forthcoming at the existing money wage if it were demanded” are used again and again as though, from the point of view of a jobless worker, it is unambiguous what is meant by “the existing money wage.” Unless we define an individual’s wage rate as the price someone else is willing to pay him for his labor (in which case Keynes’s assertion is defined to be false to be false), what is it?

Lucas, Id.

I must admit that, reading this passage again perhaps 30 or more years after my first reading, I’m astonished that I could have once read it without astonishment. Lucas gives the game away by accusing Keynes of engaging in evasion and wordplay before embarking himself on sustained evasion and wordplay. The meaning of the “existing money wage” is hardly ambiguous, it is the money wage the unemployed worker was receiving before losing his job and the wage that his fellow workers, who remain employed, continue to receive.

Is Lucas suggesting that the reason that the worker lost his job while his fellow workers who did not lose theirs is that the value of his marginal product fell but the value of his co-workers’ marginal product did not? Perhaps, but that would only add to my astonishment. At the current wage, employers had to reduce the number of workers until their marginal product was high enough for the employer to continue employing them. That was not necessarily, and certainly not primarily, because some workers were more capable than those that were laid off.

The fact is, I think, that Keynes wanted to get labor markets out of the way in chapter 2 so that he could get on to the demand theory which really interested him.

More wordplay. Is it fact or opinion? Well, he says that thinks it’s a fact. In other words, it’s really an opinion.

This is surely understandable, but what is the excuse for letting his carelessly drawn distinction between voluntary and involuntary unemployment dominate aggregative thinking on labor markets for the forty years following?

Mr. Keynes, really, what is your excuse for being such an awful human being?

[I]nvoluntary unemployment is not a fact or a phenomenon which it is the task of theorists to explain. It is, on the contrary, a theoretical construct which Keynes introduced in the hope it would be helpful in discovering a correct explanation for a genuine phenomenon: large-scale fluctuations in measured, total unemployment. Is it the task of modern theoretical economics to ‘explain’ the theoretical constructs of our predecessor, whether or not they have proved fruitful? I hope not, for a surer route to sterility could scarcely be imagined.

Lucas, Id.

Let’s rewrite this paragraph with a few strategic word substitutions:

Heliocentrism is not a fact or phenomenon which it is the task of theorists to explain. It is, on the contrary, a theoretical construct which Copernicus introduced in the hope it would be helpful in discovering a correct explanation for a genuine phenomenon the observed movement of the planets in the heavens. Is it the task of modern theoretical physics to “explain” the theoretical constructs of our predecessors, whether or not they have proved fruitful? I hope not, for a surer route to sterility could scarcely be imagined.

Copernicus died in 1542 shortly before his work on heliocentrism was published. Galileo’s works on heliocentrism were not published until 1610 almost 70 years after Copernicus published his work. So, under Lucas’s forty-year time limit, Galileo had no business trying to explain Copernican heliocentrism which had still not yet proven fruitful. Moreover, even after Galileo had published his works, geocentric models were providing predictions of planetary motion as good as, if not better than, the heliocentric models, so decisive empirical evidence in favor of heliocentrism was still lacking. Not until Newton published his great work 70 years after Galileo, and 140 years after Copernicus, was heliocentrism finally accepted as fact.

In summary, it does not appear possible, even in principle, to classify individual unemployed people as either voluntarily or involuntarily unemployed depending on the characteristics of the decision problem they face. One cannot, even conceptually, arrive at a usable definition of full employment

Lucas, Id.

Belying his claim to be introducing scientific rigor into macroeocnomics, Lucas restorts to an extended scholastic inquiry into whether an unemployed worker can really ever be unemployed involuntarily. Based on his scholastic inquiry into the nature of volunatriness, Lucas declares that Keynes was mistaken because would not accept the discipline of optimization and equilibrium. But Lucas’s insistence on the discipline of optimization and equilibrium is misplaced unless he can provide an actual mechanism whereby the notional optimization of a single agent can be reconciled with notional optimization of other individuals.

It was his inability to provide any explanation of the mechanism whereby the notional optimization of individual agents can be reconciled with the notional optimizations of other individual agents that led Lucas to resort to rational expectations to circumvent the need for such a mechanism. He successfully persuaded the economics profession that evading the need to explain such a reconciliation mechanism, the profession would not be shirking their explanatory duty, but would merely be fulfilling their methodological obligation to uphold the neoclassical axioms of rationality and optimization neatly subsumed under the heading of microfoundations.

Rational expectations and microfoundations provided the pretext that could justify or at least excuse the absence of any explanation of how an equilibrium is reached and maintained by assuming that the rational expectations assumption is an adequate substitute for the Walrasian auctioneer, so that each and every agent, using the common knowledge (and only the common knowledge) available to all agents, would reliably anticipate the equilibrium price vector prevailing throughout their infinite lives, thereby guaranteeing continuous equilibrium and consistency of all optimal plans. That feat having been securely accomplished, it was but a small and convenient step to collapse the multitude of individual agents into a single representative agent, so that the virtue of submitting to the discipline of optimization could find its just and fitting reward.

Involuntary Unemployment, the Mind-Body Problem, and Rubbernecking

The term involuntary unemployment was introduced by Keynes in the General Theory as the name he attached to the phenomenon of high cyclical unemployment during the downward phase of business cycle. He didn’t necessarily restrict the term to unemployment at the trough of the business cycle, because he at least entertained the possibility of underemployment equilibrium, presumably to indicate that involuntary unemployment could be a long-lasting, even permanent, phenomenon, unless countered by deliberate policy measures.

Keynes provided an explicit definition of involuntary unemployment in the General Theory, a definition that is far from straightforward, but boils down to the following: if unemployment would not fall as a result of a cut in nominal wages, but would fall as a result of a cut real wages brought about by an increase in the price level, then there is involuntary unemployment. Thus, Keynes explicitly excluded from his definition of involuntary unemployment, unemployment caused by minimum wages or labor-union monopoly power.

Keynes’s definition has always been controversial, because it implies that wage stickiness or rigidity is not the cause of unemployment. There have been at least two approaches to Keynes’s definition of involuntary that now characterize the views of mainstream macroeconomists to involuntary unemployment.

The first is rationalization. Examples of such rationalization are search and matching theories of unemployment, implicit-contract theories, and efficiency-wage theories. The problem with such rationalizations is that they are rationalizations of why nominal wages are sticky or rigid. But Keynes’s definition of involuntary unemployment was based on the premise that reducing nominal wages does not reduce involuntary unemployment, so the rationalizations of why nominal wages aren’t cut to reduce unemployment seem sort of irrelevant to the concept of involuntary unemployment, or, at least to Keynes’s understanding of the concept.

The second is denial. Perhaps the best example of such denial is provided by Robert Lucas. Here’s his take on involuntary unemployment.

The worker who loses a good job in prosperous times does not volunteer to be in this situation: he has suffered a capital loss. Similarly, the firm which loses an experienced employee in depressed times suffers an undesired capital loss. Nevertheless the unemployed worker at any time can always find some job at once, and a firm can always fill a vacancy instantaneously. That neither typically does so by choice is not difficult to understand given the quality of the jobs and the employees which are easiest to find. Thus there is an involuntary element in all unemployment, in the sense that no one chooses bad luck over good; there is also a voluntary element in all unemployment, in the sense that however miserable one’s current work options, one can always choose to accept them.

R. E. Lucas, Studies in Business-Cycle Theory, p. 242

Because Lucas believes that it is impossible to determine the extent to which any observed unemployment reflects a voluntary choice by the unemployed worker, or is involuntarily imposed on the worker by a social process beyond the worker’s control, he rejects the distinction as artificial and lacking empirical content, the product of Keynes’s overactive imagination. As such, the concept requires no explanation by economists.

Involuntary unemployment is not a fact or a phenomenon which it is the task of theorists to explain. It is, on the contrary, a theoretical construct which Keynes introduced in the hope that it would be helpful in discovering a correct explanation for a genuine phenomenon: large-scale fluctuations in measured, total unemployment. Is it the task of modern theoretical economics to “explain” the theoretical constructs of our predecessors, whether or not they have proved fruitful? I hope not, for a surer route to sterility could scarcely be imagined?

Id., p. 243

Lucas’s point seems to be that the distinction between voluntary and involuntary unemployment is purely semantic and doesn’t correspond to any observable phenomena that are of scientific interest. He may be right, and if he chooses to explain observed fluctuations in unemployment without reference to the distinction between voluntary and involuntary unemployment, he is under no obligation to accommodate the preferences of those economists that believe that involuntary unemployment is a real phenomenon that does require an explanation.

There is a real conflict of paradigms here. Surely Lucas is entitled to reject the Keynesian involuntary unemployment paradigm, and he may be right that trying to explain involuntary unemployment is unlikely to result in a progressive scientific research program. But it is not obvious that he is right.

One might argue that Lucas’s argument against involuntary unemployment resembles the argument of physicalists who deny the reality of mind and of consciousness. According to physicalists, only the brain and brain states exist. The mind and consciousness are just metaphysical concepts lacking any empirical basis. I happen to think that denying the reality of mind and consciousness borders on the absurd, but I am even less of an expert on the mind-body problem than I am on the existence of involuntary unemployment, so I won’t push this particular analogy any further.

Instead, let me try another analogy. Within the legal speed limits, drivers choose different speeds at which they drive while on a turnpike. Does it make sense to distinguish between situations in which they drive less than the speed limit voluntarily and situations in which they drive less than the speed limit involuntarily? Sometimes, there are physical bottlenecks (e.g., lane closures or other obstructions of traffic flows) that prevent cars on the turnpike from going as fast as drivers would have chosen to but for those physical constraints.

Would Lucas deny that the distinction between driving at less than the speed limit voluntarily and driving at less than the speed limit involuntarily is meaningful and empirically relevant?

There are also situations in which drivers involuntarily drive at less than the speed limit, not because of any physical bottleneck on traffic flows, but because of the voluntary choices of some drivers to slow down to rubberneck at something at the side of the turnpike but doesn’t physically obstruct the flow of traffic. Does the interaction between the voluntary choices of different drivers on the turnpike result in some drivers making involuntary choices?

I think the distinction between voluntary and involuntary choices may be relevant and meaningful in this context, but I know almost nothing about traffic-flow theory or queuing theory. I would welcome hearing what readers think about the relevance of the voluntary-involuntary distinction in the context of traffic-flow theory and whether they see any implications for such a distinction in unemployment theory.

Never Reason from a Disequilibrium

One of Scott Sumner’s many contributions as a blogger has been to show over and over and over again how easy it is to lapse into fallacious economic reasoning by positing a price change and then trying to draw inferences about the results of the price change. The problem is that a price change doesn’t just happen; it is the result of some other change. There being two basic categories of changes (demand and supply) that can affect price, there are always at least two possible causes for a given price change. So, until you have specified the antecedent change responsible for the price change under consideration, you can’t work out the consequences of the price change.

In this post, I want to extend Scott’s insight in a slightly different direction, and explain how every economic analysis has to begin with a statement about the initial conditions from which the analysis starts. In particular, you need to be clear about the equilibrium position corresponding to the initial conditions from which you are starting. If you posit some change in the system, but your starting point isn’t an equilibrium, you have no way of separating out the adjustment to the change that you are imposing on the system from the change the system would be undergoing simply to reach the equilibrium toward which it is already moving, or, even worse, from the change the system would be undergoing if its movement is not toward equilibrium.

Every theoretical analysis in economics properly imposes a ceteris paribus condition. Unfortunately, the ubiquitous ceteris paribus condition comes dangerously close to rendering economic theory irrefutable, except perhaps in a statistical sense, because empirical refutations of the theory can always be attributed to changes, abstracted from only in the theory, but not in the real world of our experience. An empirical model with a sufficient number of data points may be able to control for the changes in conditions that the theory holds constant, but the underlying theory is a comparison of equilibrium states (comparative statics), and it is quite a stretch to assume that the effects of perpetual disequilibrium can be treated as nothing but white noise. Austrians are right to be skeptical of econometric analysis; so was Keynes, for that matter. But skepticism need not imply nihilism.

Let me try to illustrate this principle by applying it to the Keynesian analysis of involuntary unemployment. In the General Theory Keynes argued that if adequate demand is deficient, the likely result is an equilibrium with involuntary unemployment. The “classical” argument that Keynes disputed was that, in principle at least, involuntary unemployment could not persist, because unemployed workers, if only they would accept reduced money wages, would eventually find employment. Keynes denied that involuntary unemployment could not persist, arguing that if workers did accept reduced money wages, the wage reductions would not get translated into reduced real wages. Instead, falling nominal wages would induce employers to cut prices by roughly the same percentage as the reduction in nominal wages, leaving real wages more or less unchanged, thereby nullifying the effectiveness of nominal-wage cuts, and, instead, fueling a vicious downward spiral of prices and wages.

In making this argument, Keynes didn’t dispute the neoclassical proposition that, with a given capital stock, the marginal product of labor declines as employment increases, implying that real wages have to fall for employment to be increased. His argument was about the nature of the labor-supply curve, labor supply, in Keynes’s view, being a function of both the real and the nominal wage, not, as in the neoclassical theory, only the real wage. Under Keynes’s “neoclassical” analysis, the problem with nominal-wage cuts is that they don’t do the job, because they lead to corresponding price cuts. The only way to reduce unemployment, Keynes insisted, is to raise the price level. With nominal wages constant, an increased price level would achieve the real-wage cut necessary for employment to be increased. And this is precisely how Keynes defined involuntary unemployment: the willingness of workers to increase the amount of labor actually supplied in response to a price level increase that reduces their real wage.

Interestingly, in trying to explain why nominal-wage cuts would fail to increase employment, Keynes suggested that the redistribution of income from workers to entrepreneurs associated with reduced nominal wages would tend to reduce consumption, thereby reducing, not increasing, employment. But if that is so, how is it that a reduced real wage, achieved via inflation, would increase employment? Why would the distributional effect of a reduced nominal, but unchanged real, wage be more adverse to employment han a reduced real wage, achieved, with a fixed nominal wage, by way of a price-level increase?

Keynes’s explanation for all this is confused. In chapter 19, where he makes the argument that money-wage cuts can’t eliminate involuntary unemployment, he presents a variety of reasons why nominal-wage cuts are ineffective, and it is usually not clear at what level of theoretical abstraction he is operating, and whether he is arguing that nominal-wage cuts would not work even in principle, or that, although nominal-wage cuts might succeed in theory, they would inevitably fail in practice. Even more puzzling, It is not clear whether he thinks that real wages have to fall to achieve full employment or that full employment could be restored by an increase in aggregate demand with no reduction in real wages. In particular, because Keynes doesn’t start his analysis from a full-employment equilibrium, and doesn’t specify the shock that moves the economy off its equilibrium position, we can only guess whether Keynes is talking about a shock that had reduced labor productivity or (more likely) a shock to entrepreneurial expectations (animal spirits) that has no direct effect on labor productivity.

There was a rhetorical payoff for Keynes in maintaining that ambiguity, because he wanted to present a “general theory” in which full employment is a special case. Keynes therefore emphasized that the labor market is not self-equilibrating by way of nominal-wage adjustments. That was a perfectly fine and useful insight: when the entire system is out of kilter; there is no guarantee that just letting the free market set prices will bring everything back into place. The theory of price adjustment is fundamentally a partial-equilibrium theory that isolates the disequiibrium of a single market, with all other markets in (approximate) equilibrium. There is no necessary connection between the adjustment process in a partial-equilibrium setting and the adjustment process in a full-equilibrium setting. The stability of a single market in disequilibrium does not imply the stability of the entire system of markets in disequilibrium. Keynes might have presented his “general theory” as a theory of disequilibrium, but he preferred (perhaps because he had no other tools to work with) to spell out his theory in terms of familiar equilibrium concepts: savings equaling investment and income equaling expenditure, leaving it ambiguous whether the failure to reach a full-employment equilibrium is caused by a real wage that is too high or an interest rate that is too high. Axel Leijonhufvud highlights the distinction between a disequilibrium in the real wage and a disequilibrium in the interest rate in an important essay “The Wicksell Connection” included in his book Information and Coordination.

Because Keynes did not commit himself on whether a reduction in the real wage is necessary for equilibrium to be restored, it is hard to assess his argument about whether, by accepting reduced money wages, workers could in fact reduce their real wages sufficiently to bring about full employment. Keynes’s argument that money-wage cuts accepted by workers would be undone by corresponding price cuts reflecting reduced production costs is hardly compelling. If the current level of money wages is too high for firms to produce profitably, it is not obvious why the reduced money wages paid by entrepreneurs would be entirely dissipated by price reductions, with none of the cost decline being reflected in increased profit margins. If wage cuts do increase profit margins, that would encourage entrepreneurs to increase output, potentially triggering an expansionary multiplier process. In other words, if the source of disequilibrium is that the real wage is too high, the real wage depending on both the nominal wage and price level, what is the basis for concluding that a reduction in the nominal wage would cause a change in the price level sufficient to keep the real wage at a disequilibrium level? Is it not more likely that the price level would fall no more than required to bring the real wage back to the equilibrium level consistent with full employment? The question is not meant as an expression of policy preference; it is a question about the logic of Keynes’s analysis.

Interestingly, present-day opponents of monetary stimulus (for whom “Keynesian” is a term of extreme derision) like to make a sort of Keynesian argument. Monetary stimulus, by raising the price level, reduces the real wage. That means that monetary stimulus is bad, as it is harmful to workers, whose interests, we all know, is the highest priority – except perhaps the interests of rentiers living off the interest generated by their bond portfolios — of many opponents of monetary stimulus. Once again, the logic is less than compelling. Keynes believed that an increase in the price level could reduce the real wage, a reduction that, at least potentially, might be necessary for the restoration of full employment.

But here is my question: why would an increase in the price level reduce the real wage rather than raise money wages along with the price level. To answer that question, you need to have some idea of whether the current level of real wages is above or below the equilibrium level. If unemployment is high, there is at least some reason to think that the equilibrium real wage is less than the current level, which is why an increase in the price level would be expected to cause the real wage to fall, i.e., to move the actual real wage in the direction of equilibrium. But if the current real wage is about equal to, or even below, the equilibrium level, then why would one think that an increase in the price level would not also cause money wages to rise correspondingly? It seems more plausible that, in the absence of a good reason to think otherwise, that inflation would cause real wages to fall only if real wages are above their equilibrium level.

Why Are Wages Sticky?

The stickiness of wages seems to be one of the key stylized facts of economics. For some reason, the idea that sticky wages may be the key to explaining business-cycle downturns in which output and employment– not just prices and nominal incomes — fall is now widely supposed to have been a, if not the, major theoretical contribution of Keynes in the General Theory. The association between sticky wages and Keynes is a rather startling, and altogether unfounded, inversion of what Keynes actually wrote in the General Theory, heaping scorn on what he called the “classical” doctrine that cyclical (or in Keynesian terminology “involuntary”) unemployment could be attributed to the failure of nominal wages to fall in response to a reduction in aggregate demand. Keynes never stopped insisting that the key defining characteristic of “involuntary” unemployment is that a nominal-wage reduction would not reduce “involuntary” unemployment. The very definition of involuntary unemployment is that it can only be eliminated by an increase in the price level, but not by a reduction in nominal wages.

Keynes devoted three entire chapters (19-21) in the General Theory to making, and mathematically proving, that argument. Insofar as I understand it, his argument doesn’t seem to me to be entirely convincing, because, among other reasons, his reasoning seems to involve implicit comparative-statics exercises that start from a disequlibrium situation, but that is definitely a topic for another post. My point is simply that the sticky-wages explanation for unemployment was exactly the “classical” explanation that Keynes was railing against in the General Theory.

So it’s really quite astonishing — and amusing — to observe that, in the current upside-down world of modern macroeconomics, what differentiates New Classical from New Keynesian macroeconomists is that macroecoomists of the New Classical variety, dismissing wage stickiness as non-existent or empirically unimportant, assume that cyclical fluctuations in employment result from high rates of intertemporal substitution by labor in response to fluctuations in labor productivity, while macroeconomists of the New Keynesian variety argue that it is nominal-wage stickiness that prevents the steep cuts in nominal wages required to maintain employment in the face of exogenous shocks in aggregate demand or supply. New Classical and New Keynesian indeed! David Laidler and Axel Leijonhufvud have both remarked on this role reversal.

Many possible causes of nominal-wage stickiness (especially in the downward direction) have been advanced. For most of the twentieth century, wage stickiness was blamed on various forms of government intervention, e.g., pro-union legislation conferring monopoly privileges on unions, as well as other forms of wage-fixing like minimum-wage laws and even unemployment insurance. Whatever the merits of these criticisms, it is hard to credit claims that wage stickiness is mainly attributable to labor-market intervention on the side of labor unions. First, the phenomenon of wage stickiness was noted and remarked upon by economists as long ago as the early nineteenth century (e.g., Henry Thornton in his classic The Nature and Effects of the Paper Credit of Great Britain) long before the enactment of pro-union legislation. Second, the repeal or weakening of pro-union legislation since the 1980s does not seem to have been associated with any significant reduction in nominal-wage stickiness.

Since the 1970s, a number of more sophisticated explanations of wage stickiness have been advanced, for example search theories coupled with incorrect price-level expectations, long-term labor contracts, implicit contracts, and efficiency wages. Search theories locate the cause of wage nominal stickiness in workers’ decisions about what wage offers to accept. Thus, the apparent downward stickiness of wages in a recession seems to imply that workers are turning down offers of employment or quitting their jobs in the mistaken expectation that search will uncover better offers, but that doesn’t seem to be what happens in recessions, when quits decline and layoffs increase. Long-term contracts can and frequently are renegotiated when conditions change. Implicit contracts also can be adjusted when conditions change. So insofar as these theories posit that workers are somehow making decisions that lead to their unemployment, the story seems to be incomplete. If workers could be made better off by accepting reduced wages instead of being unemployed, why isn’t it happening?

Efficiency wages posit a different cause for wage stickiness: that employers have cleverly discovered that by overpaying workers, workers will work their backsides off to continue to be considered worthy of receiving the rents that their employers are conferring upon them. Thus, when a recession hits, employers use the opportunity to weed out their least deserving employees. This theory at least has the virtue of not assigning responsibility for sub-optimal decisions to the workers.

All of these theories were powerfully challenged about eleven or twelve years ago by Truman Bewley in a book Why Wages Don’t Fall During a Recession. (See also Peter Howitt’s excellent review of Bewely’s book in the Journal of Economic Literature.) Bewley, though an accomplished theorist, simply went out and interviewed lots of business people, asking them to explain why they didn’t cut wages to their employees in recessions rather than lay off workers. Overwhelmingly, the responses Bewley received did not correspond to any of the standard theories of wage-stickiness. Instead, business people explained wage stickiness as necessary to avoid a collapse of morale among their employees. Layoffs also hurt morale, but the workers that are retained get over it, and those let go are no longer around to hurt the morale of those that stay.

While I have always preferred the search explanation for apparent wage stickiness, which was largely developed at UCLA in the 1960s (see Armen Alchian’s classic “Information costs, Pricing, and Resource Unemployment”), I recognize that it doesn’t seem to account for the basic facts of the cyclical pattern of layoffs and quits. So I think that it is clear that wage stickiness remains a problematic phenomenon. I don’t claim to have a good explanation to offer, but it does seem to me that an important element of an explanation may have been left out so far — at least I can’t recall having seen it mentioned.

Let’s think about it in the following way. Consider the incentive to cut price of a firm that can’t sell as much as it wants at the current price. The firm is off its supply curve. The firm is a price taker in the sense that, if it charges a higher price than its competitors, it won’t sell anything, losing all its sales to competitors. Would the firm have any incentive to cut its price? Presumably, yes. But let’s think about that incentive. Suppose the firm has a maximum output capacity of one unit, and can produce either zero or one units in any time period. Suppose that demand has gone down, so that the firm is not sure if it will be able to sell the unit of output that it produces (assume also that the firm only produces if it has an order in hand). Would such a firm have an incentive to cut price? Only if it felt that, by doing so, it would increase the probability of getting an order sufficiently to compensate for the reduced profit margin at the lower price. Of course, the firm does not want to set a price higher than its competitors, so it will set a price no higher than the price that it expects its competitors to set.

Now consider a different sort of firm, a firm that can easily expand its output. Faced with the prospect of losing its current sales, this type of firm, unlike the first type, could offer to sell an increased amount at a reduced price. How could it sell an increased amount when demand is falling? By undercutting its competitors. A firm willing to cut its price could, by taking share away from its competitors, actually expand its output despite overall falling demand. That is the essence of competitive rivalry. Obviously, not every firm could succeed in such a strategy, but some firms, presumably those with a cost advantage, or a willingness to accept a reduced profit margin, could expand, thereby forcing marginal firms out of the market.

Workers seem to me to have the characteristics of type-one firms, while most actual businesses seem to resemble type-two firms. So what I am suggesting is that the inability of workers to take over the jobs of co-workers (the analog of output expansion by a firm) when faced with the prospect of a layoff means that a powerful incentive operating in non-labor markets for price cutting in response to reduced demand is not present in labor markets. A firm faced with the prospect of being terminated by a customer whose demand for the firm’s product has fallen may offer significant concessions to retain the customer’s business, especially if it can, in the process, gain an increased share of the customer’s business. A worker facing the prospect of a layoff cannot offer his employer a similar deal. And requiring a workforce of many workers, the employer cannot generally avoid the morale-damaging effects of a wage cut on his workforce by replacing current workers with another set of workers at a lower wage than the old workers were getting. So the point that I am suggesting seems to dovetail with morale-preserving explanation for wage-stickiness offered by Bewley.

If I am correct, then the incentive for price cutting is greater in markets for most goods and services than in markets for labor employment. This was Henry Thornton’s observation over two centuries ago when he wrote that it was a well-known fact that wages are more resistant than other prices to downward pressure in periods of weak demand. And if that is true, then it suggests that real wages tend to fluctuate countercyclically, which seems to be a stylized fact of business cycles, though whether that is indeed a fact remains controversial.


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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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