Do lower wages REALLY increase the natural level of output? Aren’t they missing something?
One thing that is seen sometimes is a strange teaching in economics and business. The teaching says that lower costs of production will increase the natural level of real GDP output.
Now the natural level of real GDP output is considered the limit at which the economy can produce. It is seen as the total productive capacity of the economy. The full-employment of the natural rate of unemployment is found there too. It is traditionally determined by looking at available factors of production at full-employment. Once real GDP reaches its natural level, output slows down and increased demand results in higher prices instead of more output.
However, some schools teach and therefore many businessmen have it in their heads that lower wages, which are a cost of production, will increase the total productive capacity of the economy.
Here are some links to examples…
- University of North Carolina’s Euro Challenge competition for high school students…
“The long-run supply curve can shift when the costs of production change. Examples of changes to the long-run aggregate supply curve:
- A restriction on immigration reduces the number of workers available, and thus increases the cost of production (wages will be higher).
- The reduction in the required minimum wage allows firms to hire more workers at less cost.
- Economics online from the UK…
“The effects of an increase in capital investment
“The initial impact of investment is on the AD (aggregate demand) curve, which shifts to the right as investment (I) is a component of AD,
“In the long run, the investment will increase the economy’s capacity to produce, which shifts the LRAS curve to the right. Finally, it is likely that production costs will fall as new technology increases efficiency and reduces average costs. This means that the SRAS curve shifts to the right. The combined effects are that the economy grows, both in terms of potential output and actual output, without inflationary pressure.
Here is a source that does a good job at explaining why lower wages would increase the potential output at the natural level… They show how higher wages and lower wages can increase the natural level of output. But this example still makes a critical error.
- Macroeconomics Principles, authors Libby Rittenberg and Tim Tregarthen.
“In Panel (a), an increase in the labor supply shifts the supply curve to S2. The increase in the supply of labor does not change the stock of capital or natural resources, nor does it change technology—it therefore does not shift the aggregate production function. Because there is no change in the production function, there is no shift in the demand for labor. The real wage falls from ω1 to ω2 in Panel (a), and the natural level of employment rises from L1 to L2. To see the impact on potential output, Panel (b) shows that employment of L2 can produce real GDP of Y2. The long-run aggregate supply curve in Panel (c) thus shifts to LRAS2. Notice, however, that this shift in the long-run aggregate supply curve to the right is associated with a reduction in the real wage to ω2.”
Behind these examples is a belief that the presence of a minimum wage will reduce the demand for labor, thus cutting people out of the labor force, thus reducing the numbers of people that will work, thus reducing long-run potential output.
If we look closely in the above examples, we will see an error in understanding. They view the supply and demand for factors of production affecting long-run output, but they do not view the supply and demand for money used for consumption affecting long-run output. The examples above do not include the fact that if real wages are lower, ultimate demand for production will be lower. Thus, they see more long-run production, but they don’t see the reduction in potential consumer demand.
All across the advanced countries we have been seeing a decline in labor’s share of national output. With this, we see a stagnation of real wages and an increase in corporate profits. Thus, the portion of output income that is given to labor to buy production is less. Do companies really think that lower real wages will keep long-run natural output from falling? Ultimately, at some point, weak consumer demand will be the limiting factor upon the long-run natural level of output.
The effective limit of demand upon the long-run natural level of output is called the effective demand limit.
It is a good idea to include an idea like the effective demand limit in the models for the long-run natural level of output.
I agree with you, but something more is going on here than just forgetting about “demand.”
The examples you cite would be remarkable for their stupidity if they were not more remarkable for their dishonesty. The worst is the North Carolina preparation for high school students. This is obvious political propaganda, and yet it is… i am supposing… welcomed into the schools as “educational material.”
And this is hardly the only material provided to schools that has a propaganda purpose. Apparently college sophomores aren’t stupid enough, they figure they have to get to the kids while they are still babies.
There may be two kinds of kids: the majority who will be so proud to have learned something that makes them smarter than everyone else… so they can spend the rest of their lives writing letters to the editor about “econ 101″… and the minority who eventually marginalize themselves by always disagreeing with the teacher.
Is it your thought that increased labor does not improve throughput provided the capital capacity exists?
Again very nice Ed.
An illustrative example from the Social Security debate arguing for private accounts. Sometime around 2005 Dean Baker put up the No Economist Left Behind Challenge which in one formulation is a challenge to economists and financial planners to come up with a scenario whereby returns on private accounts could outperform Social Security given the same economic projections. To my knowledge nobody was able to meet it though some claimed that they could by relying on much the same strategy that you outline: maximize return on investment by choking off labor costs, and following the by then couple decades old plan of off-shoring and automation.
As noted mostly the numbers just didn’t run and even less so when operating under the same Real GDP numbers in the Trustees projections, you can’t indefinitely get 6-8% real return on real growth under 3%. But even this wasn’t the key flaw.
The Bush plan assumed that everybody would be in the market and that everyone would fund their personal/private accounts out of personal earnings. But since by definition that new pool of investors would almost entirely overlap with the existing labor pool and investment scheme that relied on returns being supported by ever constricting controls on wages would have the effect of starving each constricted real wage worker’s paycheck and so the funding source of his personal account.
That is even if economists had been able to meet the bare outlines of Dean’s NELB it could only have worked for a minority of the population, because not everyone can benefit by starving the entire labor pool, only the starvers can.
If I can take the liberty the Bush Plan was itself limited by the effective demand reduction required to make the Plan work even in part for the few. If you automate the plant and layoff all the workers then the janitors who used to work there are even less able to fund their pension plans than before. Which ability may well have approached zero to start with.
Increased quantity of laborers would raise the natural output level. But to say that paying them lower wages will raise the output level is the error.
You will read in many web sites where the issue is correctly stated. They will say outright that the long-run natural rate of output is not changed by wages, but only short-run output. That is the correct way.
The supply-side economists are the ones saying that lower wages increase the long-run natural level of GDP. They say it in Europe too. This teaching is part of the problem why economics is making errors.
It’s this kind of reasoning that makes economists look silly.
For example, there was that argument for a while that raising the minimum wage would add 20 cents or 50 cents to the cost of a Big Mac, ignoring that this would be more than compensated for by the generally increased ability to afford Big Macs. Supply side economists, and most of them are supply side, are like people who think that tap water comes from some magic device inside the wall. Demand to them is some kind of magic, not the other side of the same equation.
This kind of thinking also ignores that rising labor costs encourage capital investment. High labor costs were a principal driver of the industrial revolution. The increased productivity usually more than compensates for the higher wages.