[See correction on the bottom.]
This is a random thought of mine. Since this has most likely been covered somewhere, by someone (Keynes?), what I am really looking forward to is someone showing me what I am missing.
The common claim is that if wages are flexible, they will fall to a wage rate that will clear the labor market (no unemployment). Within the context of a recession/depression, it seems to me that the concept of “unemployment” has lost any valuable meaning, if what we mean by it is a cleared labor market. If, however, we define (unnatural) unemployment by those who are willing and able to work, but not demanded, then it seems to be that even falling wages cannot recuperate full employment.
Let me try to illustrate my argument with a simple supply and demand graph first,
We see a leftward shift in aggregate demand, which is supposed to represent a fall in nominal demand for labor (i.e. a fall in the number of dollars being bid towards labor). With perfect price flexibility, we see a fall in wages to a new equilibrium point — labor markets clear. At this new equilibrium point, though, we see a reduction in the quantity of labor employed.
Usually, supply and demand graphs are interpreted to display how much a(n) firm/industry/economy will supply at a given price, and/or how much a(n) individual/firm/industry/economy will demand at a given price. So, for instance, if the equilibrium price is PE, a firm will not supply more of that product than is demanded.
If you use a supply and demand graph to show the labor market, then this interpretation is a bad one. You have a supply of labor that exists before the fall in aggregate demand. This supply of labor does not shrink when aggregate demand falls — the number of people willing and able to provide their labor remains the same (or, may even grow, if new laborers are willing and able to enter the market). If we assume full employment at the original level of demand, then the bracket (on the above graph) showing the change in the quantity of labor employed represents the number of unemployed in a depressed market.
Now, here is a graph showing the relationship between the marginal product of labor and the marginal costs of labor employment,
The red dotted line represents the wage rate in a competitive market, where the marginal product of labor is equal to the marginal costs of employment. Why will firms not offer a lower wage? Because the costs of employment are greater than benefits of employing that extra unit of labor.
During a depression, you have a certain number of workers who are now unemployed (see that supply and demand graph). These workers are able and willing to work, but firms are not looking to buy extra units of labor. Why? Because the costs of employing that labor are higher than the benefits.
Does this not fly in the face of the Austrian claim that in a free market everyone will find employment? Yes and no. Like I said, I think that this disproves the notion that perfect wage flexibility will end all involuntary unemployment. The derivation of the marginal product of labor is based on “everything else being equal.” Austrians are not counting on everything else being equal. Since wants are essentially limitless (as long as people are acting), then there is always opportunity for employment. But, capital and labor are complimentary, and thus for there to be a greater quantity of people employed there must be an increase in the quantity of employed capital — i.e. an increase in marginal productivity.
What this tells me is, that in the study of depressions the most important factor is not necessarily labor, but capital.
As Patch comments below, the supply and demand graph does not adequately show what I’m trying to say, mostly because my supply and demand graph is wrong. This is what it should really look like,
The supply of labor is constant. I added the graph to the right to show my mistake. The new wage would be the point where aggregate demand intersects with the existing supply of labor (you don’t see an intersection? that’s why that graph was a bad one).
So I have to change the way I present underemployment. Like I write in response to patch, the surplus of labor would be a product of a shrinking base of employed capital (i.e. liquidating firms). This is, more or less, in line with the Austrian business cycle theory, since malinvestment would do this to you. I will have to work on this over the weekend.