Are Low Wages Good?

In their Salon piece, Robert Atkinson and Michael Lind argue that one major fallacy propagated by “Econ 101” is that “low wages are good for the economy.” I agree that this latter statement is untrue, but I’m not sure if it’s really something that’s taught in Econ 101. Rather, I think there is something of a misunderstanding of what economists are really saying when, within a certain context, they argue that wages ought to fall. When economists advocate lowering wages they always have a reference point in mind, and when it concerns the well-being of the worker it’s this reference point that matters: the marginal [value] productivity of labor.

In equilibrium, wages are determined by the marginal productivity of labor. What marginal productivity measures is the change in output in response to a change in the unit of input. The market wage, then, is the marginal productivity of the last worker employed (if we conceptualize it in terms of supply and demand, the wage is determined at that point where the next willing and able worker charges too much for the return the profit maximizing firm expects — where supply and demand intersect). (Note that “wage” can refer to something other than the monetary compensation for labor, including fringe benefits [and, I’d argue, things like higher labor standards].) This market rate is what I refer to as “reference point,” above. If wages are above the equilibrium rate, profit maximizing firms will find that they have to cut workers to avoid a loss, even if there are people willing and able to work for a lower wage. If wages are below the equilibrium rate, firms will find that the pool of willing and able applicants shrinks. The former leads to, and is the leading explanation for, involuntary unemployment — workers are earning a return higher than that of the marginal laborer.

Where I can agree with Atkinson and Lind, although I doubt they had this in mind, is that in Economics 101 movement in the wage level is the main method of labor market adjustment. To be fair, I think this is because they want to teach certain, simplified concepts to introduce the student to economics, keeping in mind that time is limited. The conclusions of these models shouldn’t be interpreted as policy recommendations, even if academic economists ultimately do advocate wage level adjustments to deal with involuntary unemployment. Case in point, there is an alternative — that many economists also recommend — policy that can be pursued, which is to increase the price level. The desirability of this policy depends on the context, but assume that the context we’re interested in is that of the business cycle. Suppose that an increase in demand for money forces the price level to fall. If wages are sticky, this will cause involuntary unemployment. An alternative solution is to maintain the price level by increasing the supply of money, or what economists refer to maintaining monetary equilibrium. Other economists advocate a monetary response that goes beyond maintaining monetary equilibrium, recommending inflation, but even in this case the outcome is that inflation will chip away at the real value of the wage; in all cases, the point is to return the wage level to its “reference point.”

But, outside the context of wage adjustments towards the “reference point,” economic theory — whether we’re Keynesians, Freshwaters, or whatever — suggests that the higher the “reference point” the better off that economy is. Why? Because a higher equilibrium wage level implies higher productivity. So, in the long-run, economists are actually more interested in higher [real] wages, not lower wages. How do real wages increase? Capital accumulation and investment. The more capital intensive an economy is, the more it produces, the higher the real wage will be. Assume a stable price level and, therefore, a stable nominal wage, but growing productivity. While the nominal wage rate is the same, the relative value of the dollar rises (which is the same as saying that the relative values of non-monetary goods fall); the same nominal wage is worth more.

If this is the case, why do we outsource production? If our workers are more productive, and therefore ought to earn a higher return, shouldn’t the U.S. be a preferable location? We have to analyze outsourcing in the context of the international division of labor, including differences in factor endowment. The U.S. is the least competitive in areas where production techniques are relatively labor intensive. But, it’s more competitive in capital intensive production processes. As the U.S. economy becomes more capital intensive, it will reallocate labor towards production processes that are also relatively capital intensive. For example, at some point, an economy will grow to the point where one person with a tractor can produce more than ten people with plows. The nine people who are no longer necessary can be reallocated towards the production of other things. There are technical limits to productivity. We can reach a point where we can’t change the technique to make the process more productive, and this is where relative differences in the capital intensity of the process come up. We call these processes relatively labor intensive.

Why are poorer nations more competitive in the labor intensive industries? The key is opportunity cost. In a capital intensive economy, a firm earns a higher return providing a product with a greater value. Workers will be interested in earning the highest wage they can. Firms which specialize in labor intensive products will be at a disadvantage, forced to pay a higher wage than what the technique calls for. It makes sense to outsource these production processes to areas where the real wage is lower. The U.S. is better off because of it. By importing goods where we don’t have a competitive advantage, we can reallocate labor to firms that produce higher valued products — the economy gains efficiency.

Economic theory predicts steadily increasing real wages, and if it suggests lower wages it’s only within the special context of nominal disequilibrium in the labor market. We want higher wages, but we want higher wages without inducing involuntary unemployment and capital consumption — this leads to an efficiency loss and makes us worse off. To increase real wages we have to increase our stock of capital, which requires production and saving.

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