Some Further Comments on Nominal Wage Flexibility
Tyler Cowan thinks that we should cut the 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 if we were dealing with the market for oranges. Please stop it.
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Update (12/16). Thanks to Mark for reposting this, and to Paul Krugman for following up. Tyler responds as follows on Mark's page:
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.
To which I have replied as follows:
Tyler, a fall in wages won't just shift the marginal cost curve down, it will also shift down the demand curve and hence marginal revenue. This will happen for all firms who produce stuff that minimum wage workers consume, regardless of whether or not they themselves pay minimum wage. Now we may disagree about what the eventual outcome will be (I think there will be debt deflation, as described in Fisher 1933, and so admirably summarized recently on your blog). You may disagree. But we can't settle this with partial equilibrium models of monopolists and their cost curves.
I'm sure that this debate will continue. My only hope is the we get beyond partial equilibrium models from introductory microeconomics in discussing these terribly important questions.
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Update (12/17). The Economist points out (quite sensibly) that even demand constrained firms may increase hiring with lower wages in order to improve product quality: "If a firm can produce a particular number of burgers with either 5 workers earning $7 an hour or 6 workers earning $6 an hour it won't necessarily prefer the 5 worker set-up." True enough, but this is not the appropriate comparison: if the wage drops, employment will rise only if 6 workers earning $6 an hour are preferred to 5 workers earning $6 (not $7) an hour. In other words, the choice is between improving quality or pocketing the difference in wages.
I do not doubt, by the way, that a lower minimum wage could raise employment in some firms. But unless the aggregate wage bill rises, some other firms will experience declining demand, and may respond by laying off workers across a much broader range of skills. My point is simply that in order to capture these effects, it is essential that one move beyond the partial equilibrium framework. More here.
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Update (12/18). Winterspeak adds:
Any discussion of the minimum wage turns into a Rorschach test for the ideology of the commenter.
This is unfortunately true, and ideology does seem to be clouding judgment and analytical clarity on the issue. My focus has remained on the methods one uses to reason about the effects of changes in the minimum wage, rather than on the magnitude or sign of these changes. I agree with Winterspeak, Tyler Cowan, and The Economist that the effects of such changes on aggregate demand, regardless of their sign, will likely be small. But it's important to get the reasoning right, because the same methods apply to discussions of flexible wages and prices more generally. To answer Andrew Gelman, this is why I think the debate is important. Hence the title of this post, and the content of the earlier post to which it refers.
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Update (12/19). Perhaps some signs of progress in this debate. Alex Tabarrok writes:
A fall in wages increases the incentive to hire (call this the substitution effect) but it decreases the income of people who already have jobs and this in turn decreases their spending and other people’s income (call this the macro income effect). In essence, Krugman and others are arguing that the macro income effect can dominate under certain situations.
My response:
Yes, but one needs to go a bit further than this. If the macro income effect dominates, then there will be layoffs in other sectors, most immediately in those producing outputs that low wage workers purchase. And these layoffs will not be confined to low wage workers. This means that even if the employment of low wage workers rises, there will be a decline in employment across other segments of the skill distribution. Concede this point and we're done.
It's worth thinking a bit more closely about what Alex calls the substitution effect. This is presumably what Tyler had in mind when he urged me to shift marginal cost curves down and watch what happens. He was arguing that the firm will lower price and use the additional hires to step up production to meet the increased demand. Now obviously this will not increase market share if one's competitors are doing the same thing, but it could increase the overall consumption of goods and services produced with low wage labor. Even disregarding the macro income effect, this implies a decline in demand for goods and services produced with skilled, high wage labor. In other words, there will be a "substitution effect" in unemployment patterns, more unskilled jobs and less skilled jobs. Add the macro income effect to the analysis and matters become worse. The only way that lower wages can increase aggregate demand is by stimulating private investment through changes in asset prices and interest rates. This is just not going to happen under current conditions (hence my support for this proposal). In any case, a partial equilibrium analysis is totally inadequate for thinking through these questions.