More on wages and employment

So my last post has led to a few comments on the relation between changes in real wages and employment. As my students are probably tired to hear real wages tend to be pro-cyclical, a well established empirical regularity. This poses a problem, not only for mainstream accounts of the labor market (and hence for the conventional views on the minimum wage), but also for Keynes' own views.

Keynes was forced to deal with those issues early on, as a result of the empirical research by Dunlop and Tarshis, and his answer in his famous 1939 paper (often published together with the General Theory, GT) "Relative Movements of Real Wages and Output." He said then:

"The only solution was offered by Dr Kalecki in the brilliant article which has been published in Econometrica. Dr Kalecki here employs a highly original technique of analysis into the distributional problem between the factors of production in conditions of imperfect competition, which may prove to be an important piece of pioneer work."

In other words, he suggests that some sort of constant returns, or increasing returns to scale, and, hence a mildly positively sloped labor demand curve could possibly explain the empirical regularity. Note also that Keynes had already in chapter 2 of the GT argued that the labor supply curve made no sense (two reasons one fundamental, and the other non-fundamental; see here). He says:

"the contention that the unemployment which characterises a depression is due to a refusal by labour to accept a reduction of money-wages is not clearly supported by the facts... A fall in real wages due to a rise in prices, with money-wages unaltered, does not, as a rule, cause the supply of available labour on offer at the current wage to fall below the amount actually employed prior to the rise of prices."

However, even if one gets rid of the labor supply curve, and determines employment in the market for goods, as a function of demand, as Keynes does, as it is clear from his reply to Dunlop and Tarshis the real problem with the conventional marginalist story (and Keynes' own) is on the acceptance of the marginal productivity of labor (MPL) as the source for labor demand.

One possible neoclassical response would be to suggest that real (supply side) shocks, which change the MPL upwards and downwards, is the main cause of fluctuations in output and employment. So Real Business Cycles (RBC) is the solution. In this case, pro-cylcial real wages can be explained by the mainstream. The main critique coming from other mainstream authors about this possibility, is that, since the real wages are only mildly pro-cyclical, a shock to the MPL would lead to small changes in the real wage only if labor supply is very elastic. In other words, workers labor supply would have to be very sensitive to changes in real wages, and, yet, the empirical evidence is that the number of hours worked does not change much with variations of the real wage.

Besides, there is the question of whether one can really assume that business cycles are explained by real shocks. Note that Lucas, who has for the most accepted the RBC interpretation of the working of the economy, still argues that the Great Depression is most likely explained by a demand shock (for him a monetary contraction a la Friedman).

That is why the capital debates, which undermine the rationale for the marginalist labor demand curve, is relevant for solving the pro-cyclicality of real wages conundrum. The capital controversies suggest that there is no reason to expect that firms buy more of a relatively cheap 'factor of production,' implying an inverse relation between remuneration and intensity of use. Once this notion is rejected, the problem of pro-cyclicality is easy to explain.

Classical (not neoclassical, but the old classical political economists and Marx) presumed that the real wage was determined by the relative bargaining power of workers and capitalists, and it is expected that in a boom, with low unemployment, workers would have the upper hand, and would be able to demand higher wages. So there is no need to resort to real shocks to explain this empirical regularity.