On Partial Equilibrium Models of Demand and Supply, by Rajiv Sethi: My last post on the aggregate demand effects of changes in nominal wages has attracted some attention, so I'd like to clarify a couple of things.
It was not the point of the post to claim that declines in nominal wages would lower or increase aggregate demand. The point was to argue that the simple partial equilibrium models of demand and supply that were being used by some to address the question were simply not up to the task of answering it. It was a reaction against the view -- expressed by Bryan Caplan and endorsed by Tyler Cowen -- that such effects could easily be deduced from textbook microeconomic theory. And it was a plea to move beyond partial equilibrium analysis in addressing such questions.
Tyler Cowan responded to this with yet another partial equilibrium model of supply and demand:
Graph a monopolist and shift the marginal cost curve down. Watch what happens. The first main paragraph of Sethi simply doesn't consider this mechanism but rather it assumes that changes at the margin don't matter.
That was in the comments section of Mark Thoma's blog. A similar claim now appears on his own page:
There is a simple story here. Lower the minimum wage and firms with market power will in general hire more labor. (Sethi's critique refuses to consider that mechanism but simply shift the MC curve and watch it happen.)
By all means, shift the MC curve and watch what happens. But please keep in mind not a single firm but a population of firms, some of which do not pay minimum wage at all. And be sure to shift the demand functions for all firms producing goods and services that minimum wage workers currently purchase. And now tell me whether it is self-evident that aggregate demand will rise in response to a decline in nominal wages.
It is not self-evident. In order to address the question it is necessary at a minimum to work with a model with multiple firms, in which the expenditure patterns from wage and capital income are properly specified, and some alternatives to immediate consumption (such as financial assets) exist. Simulate this model on a computer if you like, and watch what happens. I would be interested to know. But please don't make definitive claims about aggregate demand effects of changes in nominal wages based on an introductory textbook model that is simply incapable of carrying the weight.
Andrew Gelman is puzzled by all of this:
But, politically, of course nobody's going to cut the minimum wage. Can you imagine the unpopularity of a minimum wage cut during a recession? I can't imagine that all the editorial boards of all the newspapers in the country could convince a majority of Congress to vote for this one, whatever its economic merits.
Which makes me wonder why the idea is being discussed at all. Is it an attempt to shoot down a minimum wage increase that might be in the works? Krugman mentions that Serious People are proposing a minimum wage cut, but he doesn't mention who those Serious People are. I can't imagine that they're serious about thinking this might happen.
P.P.S. I posted this at the sister blog to see if anyone could tell me how anyone could be considering minimum wage cuts as a serious political option. Nobody bit, but Tom Beecroft wrote that "it's a theoretical economics argument, rather than a political reality argument." That makes sense, but it still seems to me that something more is going on here than a dispute over pure theory. As a political scientist, it just seems funny for me to see people debating a policy that has no chance of being implemented. There must be something else going on here.
In the background is a more general and long-standing argument about whether falling wages is a good thing or a bad thing when an economy is in a deep recession. For example, this is Krugman back in May of this year:
Falling Wage Syndrome, by Paul Krugman, Commentary, NY Times: Wages are falling all across America. Some of the wage cuts, like the givebacks by Chrysler workers, are the price of federal aid. Others, like the tentative agreement on a salary cut here at The Times, are the result of discussions between employers and their union employees. Still others reflect the brute fact of a weak labor market: workers don’t dare protest when their wages are cut, because they don’t think they can find other jobs.
Whatever the specifics, however, falling wages are a symptom of a sick economy. And they’re a symptom that can make the economy even sicker. ...
Not everyone believes that falling wages make an economy sicker, some people generally believe that falling wages are a necessary part of the adjustment process, and that falling wages would speed the adjustment to shocks. This group also believes that any attempt to support wages makes things worse (which is the heart of the debate where the minimum wage is concerned). Here's more from Krugman from November 2008:
Not much point in going through Amity Shlaes’s latest: after having inadvertently revealed that she has no idea what Keynesian economics is, she’s back on the warpath against FDR, and me. The main line of empirical argument seems to be that FDR didn’t succeed in ending the Great Depression. Since that’s also what my side of the debate says — fiscal expansion was too cautious, and disastrously abandoned in 1937 — I don’t see what this is supposed to prove.
But I think it’s worth pointing out why Ms. Shlaes thinks the New Deal was destructive of employment: namely, that it raised wages. Funny she should mention that — because the effect of wage changes on employment was the subject of a whole chapter in Keynes’s General Theory.
And what Keynes had to say then is as valid as ever: under depression-type conditions, with short-term interest rates near zero, there’s no reason to think that lower wages for all workers — as opposed to lower wages for a particular group of workers — would lead to higher employment. ...
Update: More from Paul Krugman: Dining room tables and minimum wages.
[In the above, I should have also added that the continuing debate over the effect that the minimum wage has on employment -- which is always spirited -- is also part of the reason this topic is receiving so much attention.]