Wages Aren’t Everything

[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.

Correction:

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.

  • http://ideasonliberty.wordpress.com Bardhyl Salihu

    I think this is a very important point to make. Where I come from (Prishtina, Kosovo), there are no minimum wages or any other wage-restrictive policies. Yet despite this, unemployment is absurdly high. I think the importance of capital (which we as a poor country are deprived of) is highlighted even more in the context of flexible labor markets which fail to reduce involuntary unemployment.

  • http://www.vforvoluntary.com/ Nielsio

    Hi Jon,

    I recommend you message an administrator of Reddit because it looks like your user is pegged as a spammer by the system. For example, you’ll see your user page doesn’t appear right now: http://www.reddit.com/user/joncatalan .

    • Jonathan Finegold Catalán

      That’s strange; I see it.

  • http://www.ideashaveconsequences.org Leonardo IHC

    There are more variables to consider than just wage, it is clear. First: bad communication between demand and supply of labour causes frictionary unemployment. Let me tell you it’s been a relevant problem in Italy ’till Adecco and the like stepped in.
    Then, it is always a matter of demand and supply i.e. how much am I willing to pay to get something and how much I desire to be paid to give something. You can infer that a € 400 wage will clear the market (zero unmeployment) from enterprises’ point of view, but it is hard to live with € 400 per month, I think there will be plenty of people who won’t even try get that job! There is a (subjective) lower bound for wages to be economically meaningful by the labourers’ side.
    This means that even without legal minimum wages, unemployment can persist because of subjective limits to lowering wages. This combines with the needs of firms to lower wages for they can increase production, but remember that production relies on a wide set of factors, so mere incresing of labour force does not assure sufficient returns to justify the production (moreover, the more the L/K ratio grows, the lower the marginal productivity of L goes ’till L become useless).

    At the core, I think there is a problem in interpreting the classical position on the labour market. Perfectly flexible wages to not assure full emplyment in the sense of zero unemployment, but assure the maximun employment possible according to the subjective scheme of labour/rest preferences and valorisations… A central planner couldn’t do any better anyway.

  • http://conscienceofanentrepreneur.blogspot.com/ Björn

    Isn’t there a logic error in the statement blow?

    “Why will firms not offer a lower wage? Because the costs of employment are greater than benefits of employing that extra unit of labor.”

    Do you assume that firms already have employees for which they cannot adjust wages downward? Then that is most obvious inflexibility I would say.

    I agree though with your general idea that wage flexibility doesn’t necessarily mean full employment at all times. I argue for the same conclusion (but from a completely different angle in this post): http://bit.ly/wPKval.

    • Jonathan Finegold Catalán

      I’m assuming perfect flexibility. If wages are inflexible, that’s another problem — but I am talking about underemployment. I’m saying that firms do not offer a lower wage, because the employment of an additional worker does not bring benefits which outweigh the costs of employment.

      • http://conscienceofanentrepreneur.blogspot.com/ Björn

        Aha, ok, I think my objection was perhaps mostly about language (“why will firms not offer a lower wage?”). I thought the profit motive would make employers lower wages whenever possible.

  • http://www.factsandotherstubbornthings.blogspot.com Daniel Kuehn

    This is dead-on (although I have other thoughts on the MP discussion). I’m writing a blog post on it right now.

  • http://unlearningeconomics.wordpress.com/ UnlearningEcon

    Not an argument I want to be making, but surely the point is that it’s a *price* reduction, not a drop in overall demand?

    • Jonathan Finegold Catalán

      I’m not sure I’m getting what you’re saying. In the scenario I’m discussing, it’s a price reduction that stems from a fall in aggregate demand (i.e. wages and employment during a depression).

  • patch

    John, a quick note. Supply curves are only forward sloping due to reservation demand. Reservation demand is due to speculation and direct use. For labor, this boils down to leisure and the nonspecificity of labor that allows it to seek employment across different industries. Excluding the first, because it is not a problem, and the second, because it we are assuming a general decline in AD(even without this, it is empheral and and workers would realize they have can’t earn higher wages elsewhere), the supply curve of labor is vertical, and a decline in demand will only lower the wage and not change employment.

    • Jonathan Finegold Catalán

      Yea, you’re right with regards to the supply curve for labor — I can’t believe I made that mistake in logic.

      I don’t think this totally does away with my point, though, if we stick just to the marginal productivity of labor. If before the fall in AD the firm has a maximum amount of workers at a certain wage, it doesn’t necessarily make sense for them to employ additional workers, even at a lower wage. If a worker is producing negative amounts of output, why employ him? It still seems that the important factor is capital.

      EDIT: I see how you would say “but there are no additional workers,” but there would be if we factor in the firms which are liquidating. The stock of employed capital does shrink.

      • http://www.ideashaveconsequences.org Leonardo IHC

        ” It still seems that the important factor is capital.”
        Like I said, labour is not the only factor; if you consider L and K, with K given (at the moment), the more labour you emply the lower k/L goes, this means that each worker has lower means to express his productivity.
        (simplisticly: Here are two hammers, here is a worker: he works; here are two workers: they work; here are three workers: one of them is useless… to make it more “smooth” you can simply consider the K/L ratio. All in all, there are really few jobs where a labourer can express productivity only via his mere presence and arm-work).

        It’s not capital per se the important factor of production: it is the relative scarcity of a factor compared to the other factors which affects its relative productivity (value).

        … and no one said all workers are good the same…

        • Jonathan Finegold Catalán

          That’s true, but the supply of labor is practically fixed. What I mean when I say that capital is important is that we should look at changing K to make possible the employment of more L.

          Of course, there are other complexities, including the fact you might not be able to increase K unless the price of L is low enough (since they are complimentary).

  • patch

    There are two empirical assumptions austrians about labor, besides the fact that leisure is a consumer good. First is the idea that labor is relatively nonspecific, which is really just an extension off the empirical axiom if a variety of resources. While there are different labor factors, and not everyone can he a singer, doctor, engineer, etc, the vast majority of people have the ability to perform multiple types of work. So while most labor can’t work into the extremely high paid sophisticated jobs, virtually everyone can move down the ladder, so to speak. The second deals with the fact that not all land will be put into production because the cost of labor is too high. This could change, and is based on the fact that we still have an abundance of natural resources. One does not have to look far into pessimistic movies (e.g wouldn’t green) to find that under extreme overpopulation this will not occur. So in the Austrian world, labor sup be only catallactally unemployed due to above market wages, some sub marginal poor quality land will not be used, and some capital goods because of prior malinvestments(and it costs too much to salvage). With MPP schedules, while there is some point where an additional unit of labor with all other factors held constant will lead to negative MP, the important fact to realize about labor is that it is nonspecific and can perform the tasks of capital goods. Look at some old factories or farm units way back when and you will find many workers performing tasks that machines would normally do. Why, because labor is so cheap that it can be employed that way. So capital can in fact not be used, and labor takes in place. This does not really require additional investment, but morsel a cutting down on money spent on capital goods for a particular production process.

    • Jonathan Finegold Catalán

      I’m sure that “[nonspecific labor] can preform the task of capital goods” is always true — the production process is a mixture of complimentary capital and labor. It is true that they are substitutable in some cases, but in general you always need some amount of capital to employ some amount of labor. For example, a human laborer can never replace a hammer.

    • Jonathan Finegold Catalán

      A thought on your agriculture example.

      Let’s say that Farm A has 100 workers and each worker is equipped with Y quantity of capital (Yk), which produces an output of 200. Farm A saves enough money to buy a machine that can produce three times the output (600) with a third of the workers — we’ll say 30, to keep it simple.

      Mathematically, Farm A would require 300 workers to produce the same output as that machine. But, let’s say that 100 workers is its maximum, because at 101 marginal productivity is below zero (the costs of employment are higher than the additional production). There’s no way that farm would be able to employ 300 workers, no matter how low their wages are.

      Let’s say that it is possible to employ 300 workers. Let’s say he can employ 200 workers for Wx. But, if 200(Wx) > price of the machine, it still doesn’t make sense to replace capital with labor.

  • patch

    There are some typos in the above post, I apologize since I’m typing on my phone. The movie km referencing is soylent green.