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Wednesday, December 16, 2009

"Some Further Comments on Nominal Wage Flexibility"

Rajiv Sethi follows up on the post about the folly of reducing the minimum wage to generate jobs:

Some Further Comments on Nominal Wage Flexibiliy, by Rajiv Sethi: Tyler Cowan thinks that we should cut minimum wage, and links to Bryan Caplan for an explanation. And Caplan thinks that it's all quite elementary:
Cutting wages increases the quantity of labor demanded. If labor demand is elastic, total labor income rises as a result of wage cuts. 
Even if labor demand is inelastic, moreover, wage cuts reduce labor income by raising employers' income.  So unless employers are unusually likely to put cash under their matresses, wage cuts still boost aggregate demand.
Let's take this step by step. First, consider the claim that cutting wages increases the quantity of labor demanded. Through what mechanism does this occur? Consider a firm (McDonald's, say) that can now pay its workers less. It will certainly do so. But will it increase the size of its workforce? Not unless it can sell more burgers and fries. Otherwise its newly expanded workforce will produce a surplus of happy meals that will (unhappily) remain unsold. And this will not only waste the expense of hiring and training new workers, it will also waste significant quantities of meat, potatoes and cooking oil. So the firm will make do with its existing workforce until it sees an uptick in demand. And no cut in the minimum wage will automatically provide such an increase in demand. As a result, the immediate effect of a cut in the minimum wage will be a decline in total labor income.
Employer income, of course, will rise. Some of this will be spent on consumption, but less than would have been spent if the same income had been received by low wage earners. The net effect here is lower aggregate demand. But wait, what will happen to the remainder of the increase in employer income? It will not be placed under mattresses, on this point I agree with Caplan. It will be used to accumulate assets. If these are bonds, then long rates will decline, and this might induce increases in private investment. Then again, it might not, unless firms believe that additions to productive capacity will be utilized. And right now they do not: private investment is not being held down by high rates of interest on long-term debt.
Finally, what if employers use the unspent portion of their augmented income to buy shares? We would have a run up in stock prices not unlike that we have seen in recent months. Note that this would not be a speculative bubble: the higher prices would be warranted given that firms have lower labor costs. But would this asset price appreciation stimulate private investment in capital goods? Again, not unless the additional capacity is expected to be utilized.
Mark Thoma has more on this, as does Paul Krugman. I discussed the opposing views of Becker and Tobin in an earlier post. What I cannot understand is why people of considerable intelligence persist in conducting a partial equilibrium Walrasian analysis of the labor market, as we were dealing with the market for oranges. Please stop it.

    Posted by on Wednesday, December 16, 2009 at 02:27 PM in Economics, Unemployment | Permalink  TrackBack (0)  Comments (110)

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