“Some Further Comments on Nominal Wage Flexibiliy”

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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

that we should cut minimum wage, and links to Bryan Caplan for an
explanation. And Caplan

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
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

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.

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