An individual who earns more money per week is obviously in a position to spend more in buying consumers’ goods than is an individual who earns less money per week. For example, a man who makes $1,000 per week has the ability to spend $1,000 per week, while a man who makes only $900 per week has the ability to spend only $900 per week. (For the sake of simplicity, we’re ignoring such possibilities as going into debt or using up savings, and assuming that the individuals both want to live within their incomes.)
When there is unemployment and free-market economists urge the freedom of wage rates to fall as the means of eliminating the unemployment, many people think of examples like the above and conclude that the free-market solution would only serve to make matters worse. They reason, in effect, that now workers who had been earning $1,000 per week would only earn $900 per week and thus be reduced to spending only $900 per week instead of $1,000 per week. Generalizing from this example to wage reductions of any size, and to their effect across the whole economic system, people conclude that wage-rate reductions cause reductions in overall consumer spending and therefore must serve to make the problem of unemployment worse, rather than better. In fact, often going under the name of Keynesianism, this is far and away the prevailing doctrine on the subject and is why reductions in wage rates are rarely if ever advocated as the means of reducing unemployment in the present-day world.
However, let us approach matters now not from the perspective of an individual wage earner, but from that of the economic system as a whole, essentially just like Henry Hazlitt did in his brilliant Economics In One Lesson.
In the economic system as a whole, in any given year, there’s a certain overall total amount of payroll expenditures by business firms, i.e., a certain overall total amount of wage payments. There’s also a certain overall total amount of consumer spending that takes place in the year. Since it’s always essential to think in terms of numbers when dealing with such matters, let’s assume that in the economic system as a whole in a given year total payroll expenditures amount to 400 units of money. (This is certainly a very small number of units, but each unit can be understood as representing as many billions or tens of billions of dollars as may be necessary for the 400 units to represent the actual total payrolls of the present-day United States. Thinking in terms of a small number of units allows us to avoid wasting valuable brain space in holding strings of unnecessary zeros in our minds)
Let’s also assume that total annual spending to buy consumers goods in this economic system is 500 units of money, with each unit of money representing as many billions or tens of billions of dollars as does each of the 400 units of money paid as wages.
So here we are: 400 units of money is total wage payments and 500 units of money is total consumer spending in our hypothetical economic system.
We can assume that 400 of the 500 of consumer spending represents consumption expenditure by wage earners, out of their 400 of wage incomes. The remaining 100 of consumer spending can be taken as representing consumption by businessmen and capitalists, out of profits, interest, and dividends, and/or out of previously accumulated capital.
Now imagine that in this hypothetical economic system, there is 10 percent unemployment. That means that there is also 90 percent, positive employment. Going from 10 percent unemployment to full employment means increasing positive employment in the ratio of 10 to 9.
Isn’t it clear that if total payroll spending were maintained, a 10 percent reduction in wage rates would secure full employment? That it would mean 10/9 the workers employed at 9/10 the average wage. Wouldn’t consumer spending also hold up in these circumstances, with 10/9 the workers spending 9/10 the average wage per worker?
And if the output per worker remained the same, wouldn’t the same total consumer spending of 500 units of money be sufficient to buy 10/9 the output at 9/10 the prices? And wouldn’t total profit in the economic system, and, by implication, the average rate of profit, be the same, despite the fall in prices? (Wouldn’t total profit essentially continue to be 500 units of money in the form of consumption expenditure minus 400 units of money in the form of wage payments?)
What of real wages? If prices and wage rates both fall to the same extent, wouldn’t real wage rates be the same? In fact, wouldn’t real take-home wage rates actually increase because of the elimination of the burden of supporting the unemployed, who would now be employed and supporting themselves?
And notice the implication for how real wage rates can continually be further increased, namely, simply by virtue of labor becoming more and more productive and thus progressively increasing the supply of consumers’ goods relative to the supply of labor, thereby more and more reducing prices relative to wage rates.
This example, of 400 of wage payments and 500 of consumer spending, is a depiction of the economic world in terms of essentials. Mises would call it an imaginary construction. It is very highly simplified. Yet it is also extremely pregnant with implications: for employment/unemployment, for real wages, for profit/interest, and for much else besides.
Whoever starts to think about this example will have many questions, the answers to which obviously cannot be fitted into a brief article such as this. The questions can concern such things as the effects of adding the buying and selling of capital goods into the example, the effects of allowing for changes in the amount of spending in the economic system and for changes in the relationship between different kinds of spending, and more. For answers to all such questions, I invite those interested to read my book Capitalism: A Treatise on Economics. There I think they will find not only just about all of the answers they are looking for, but also many questions they have not thought of asking, along with the answers to those questions as well.
This article is copyright © 2006, by George Reisman. Permission is hereby granted to reproduce and distribute it electronically and in print, other than as part of a book and provided that mention of the author’s web site www.capitalism.net is included. (Email notification is requested.) All other rights reserved. George Reisman is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics.
{ 12 comments }
“..simply by virtue of labor becoming more and more productive and thus progressively increasing the supply of consumers’ goods relative to the supply of labor”
Another effect here, which I deem quite important, is that the quality and variety of goods increases too, affording consumers more utility. This effect of course is in addition to the increased purchasing power per se. In particular, lowering unemployment should have this effect, since more types of goods will be produced. Also, people would supply more labor (more hours, more participation) given the greater increased marginal utility of the real wage. This happened at the outset of the Industrial Revolution. I think this might be one reason the Europeans work so much less than Americans; their product market regulations are stifling, forbidding an increased variety of products, so diminishing marginal utility sets in quicker in Europe.
No, it is not clear that the wage fund theory is coherent.
In another book, Hazlitt shows himself incompetent when it comes to setting out neoclassical theories of employment and labor.
Some people will have trouble absorbing this because they can’t think in the aggregate; they only think about individuals. Of course, if an individual, or small group of individuals, get less pay, their standard of living will decrease because they earn less and prices have continued to climb. This only works on a national level.
One of the benefits of inflation is that it fools the workers into thinking they’re getting more money when they get a raise, and as a result keeps real wages lower than they might be without inflation.
Robert Vienneau wrote:
“No, it is not clear that the wage fund theory is coherent”
So what is your main point of criticism about this theory ? Is it about workings of deflationary process or distribution of incomes in economic system ?
Mr Reismans example seems to show that relative shares of national income going to “capitalists” and “workers” are not changed by the fall in wages. There is now just larger number of people working.
Asko Kauppinen, student of economics, Finland
All you good Libertarians volunteering to take a pay cut for the good of the Nation? No? Neither am I.
It is interesting that some air line employees voted to take a pay cut to save their collective jobs. It is much easier for a company to lay off an entire shop than to cut wages.
It is much easier for a company to lay off an entire shop than to cut wages.
Only if it is a unionized shop. In a business not forced by the law to deal with the collectivist extortion, reducing individual salaries is easy – and whomever is not happy, can leave. The business is also has much more flexibility – it can keep salaries of valued staff high, and reduce salaries of employees whose skills are in oversupply, thus inducing some of them to leave.
In another book, Hazlitt shows himself incompetent when it comes to setting out neoclassical theories of employment and labor.
Sorry, but it is Keynes who is incompetent and ignorant — his basic thesis “The wage is equal to the marginal product of labour” is so obviously false to any practicing entrepreneur who often hires and retains employers for reasons having nothing to do with value of their labour (and how does one measure that value, anyway? engineer makes device, salesman sells it – without either of them there are no revenues, so how much of the value each contributes?) that it makes one wonder about Keynes’s sanity.
“Isn’t it clear that if total payroll spending were maintained, a 10 percent reduction in wage rates would secure full employment?”
I don’t think so. Would employers all of a sudden renounce their right to select the “best” employees?
All conclusions based on above “evident fact” seem null and void to me.
Willy:”Would employers all of a sudden renounce their right to select the “best” employees?”
Most companies want to grow. Growth is often limited by the number of employees they can afford to hire. This is especially true as we become more of a service economy which is very labor intensive. If wages across the country were suddenly 10% lower, companies would hire more people and expand. Maybe not 10%, because we don’t know the elasticity of demand for employees. They might hire 5% more workers, or 25%.
Don’t assume that all of the “best” employees are working, either. Employers often have to choose between several equally good employees. Lower wages would allow more of the “best” employees to find work. If wages were low enough, companies would find it economical to hire less than the “best”, too. Finally, even though all wages dropped by 10%, companies would still maintain wage differentials between the “best” and not so “best” employees. For example, McDonalds would never pay 16-year old people getting their first job the same as a 20-year veteran.
All you good Libertarians volunteering to take a pay cut for the good of the Nation? No? Neither am I.
Neither would I, for the good of the nation, whatever the heck that means. If due to competition I have to take into consideration a lower wage, and weight it against no wage at all, I would take it.
It is interesting that some air line employees voted to take a pay cut to save their collective jobs. It is much easier for a company to lay off an entire shop than to cut wages.
Actually, laying off people IS cutting wages, because companies can now hire people at a lower wage, or keep the most productive, lowering expenditures. Of course, if unions interfere, then this simple market process is hindered, the employees become more expensive and the company less profitable (and more vulnerable).
Many statist and collectivists still hang on to the idea that companies “owe” jobs, and by consequence, owe the employees the current wage level or more. In fact, jobs are nothing more than a part of the production process. Companies do not owe jobs – they owe the best possible product, at the most agreeable price possible, to consumers. Jobs are a consequence of consumer choice, and not the raison d’etre of companies. The work an employee does is the same as any other service; it is priced in and by a market, and a company can keep or change the supplier any time it wants. Only collectivists and statist think that companies must be kidnapped by the employees via violent, coercive action, with the help of the State.
How amusing “averros” is. He demonstrates a complete inability to read this demonstration of Hazlitt’s incompetence.
First, Keynes, in the passage quoted, is making no empirical claim about how actually existing capitalist economies work. He is making claims about the content of pre-Keynesian economics. To investigate these claims, one looks at the history of economic thought, not at any capitalist economies.
Second, “averros” provides no reason why entrepreneurs, when deciding on the hiring of a particular additional worker will not compare the additional revenues they think they can obtain with that worker’s effort, versus the cost of that worker. Be that as it may, it is not clear that the pre-Keynesian theory, as put forth after Keynes, requires entrepreneurs to consciously make these calculations. According to the theory, an opportunity exists for the entrepreneur to make pure economic profits when the wage falls below the marginal value product of labor. Economists, including some Austrians, have put forth evolutionary arguments about competition. These don’t require the sort of consciousness that “averros” decries. So not only does “averros” fail to establish his point about how entrepreneurs operate, it is not even clear that the validity of his point is relevant to the truth of the equality between the wage and the marginal product.
Third, it is not clear that Keynes’ theory needs this equality anyways. One can look at Kalecki’s formulation of a Keynes-like theory in the context of a markup pricing theory or some of Keynes post-GT views.
Fourth, Hazlitt states that wage equals the marginal product of labour. So if believing in that equality marks one as incompetent, “averros” should conclude, on his own grounds, that Hazlitt is incompetent and ignorant. (I would not conclude that one who held, in 1959, this equality to be valid was incompetent. Nor would I hold that one who doubted it around then was incompetent, either.)
Robert Vienneau seems to have a valid point concerning theory of Keynes and Hazlitts response to that. At least Labour Economics courses which I have attended here in Finland teach the same formal structure ( Supply and demand schedules based on entrepeneurs profit maximization and labourers/households work/leisure trade-off ). This theory is of course based on conventional economics since heterodox economics is not taught here.
Same marginalist principles should logically also hold in Austrian economics since opportunity to increase profit by increasing employment by marginal unit would be noticed by entrepeneurs throught discovery. Still we probably would not need some trappings of neoclassical theory ( like differentiability of production function and homogeneous capital goods ).
I would like ask same question again from Robert Vienneau:
So what is your main point of criticism about this theory ? Is it about workings of deflationary process which brings equilibrium or distribution of incomes in economic system ?
Mr Reismans example seems to show that relative shares of national income going to “capitalists” and “workers” are not changed by the fall in wages. There is now just larger number of people working. Total consumption of goods is same since both “classes” consume some portion of the net product.
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