Debunking Economics Part 3: Work and Wages

A common argument from neo-classical economists is that minimum wage legislation causes unemployment. The same economists regard this to be incontrovertible, as inevitable as the proposition that the angles of a triangle sum to 180 degrees, given Euclid’s axioms. But assumptions matter! (see Part 2) For example, the angles of a triangle don’t add up to 180 degrees if Euclid’s axioms are invalid, which they are on curved surfaces:

So,  to prove that minimum wages cause unemployment, have economists done the equivalent of assuming that the earth is flat? I’ll argue that yes, they have!

Economists have their own version of geometry – one often sees a “gemoetric proof” that minimum wages cause unemployment, looking something like this:

The above picture is taken from this article, which also makes some criticisms of the assumptions going into the “proof” that a minimum wage (Wmin above) greater than an “equilibrium wage” (w* above) causes unemployment.

But the article I linked seems not to question some more fundamental “axioms” going into the “proof”. These are:

1 – The labour supply curve (S) is a line, sloping up

2 – The labour demand curve (D) is a line, sloping down

3 – The two curves are independent of each other.

Are the above assumptions correct? Let’s examine each in turn. First, what does the labour supply curve tell us? It tells us how much workers want to work for a given wage. An upward sloping line implies that increasing wages in a given profession increase the supply of workers wishing to work in that profession. Of course this is true in some cases – Michael Albert gives one illustration in response to a reader comment that “Extrinsic rewards actually demotivate people”:

“You think so? That would mean if we were to raise the wages of cab drivers to 10,000 a month, for six hour works days, there would not be a massive line outside every cab company in the country, for jobs. But there would be, of course.”

The flipside, supposedly, is that an artificially high wage results in unemployment – taxi firms would go out of business if the government forced them to pay taxi drivers the wages Albert suggested above and  people would resort to using buses or cars instead.

But this argument doesn’t apply across the board (as Michael Albert is perfectly aware). It assumes we are talking about a situation where it is easy to change professions. That we have a labour market like the ideal Adam Smith describes in Wealth of Nations:

“The whole of the advantages and disadvantages of the different employments of labour and stock must, in the same neighbourhood, be either perfectly equal or continually tending to equality. If in the same neighbourhood, there was any employment evidently either more or less advantageous than the rest, so many people would crowd into it in the one case, and so many would desert it in the other, that its advantages would soon return to the level of other employments. This at least would be the case in a society where things were left to follow their natural course, where there was perfect liberty, and where every man was perfectly free both to chose what occupation he thought proper, and to change it as often as he thought proper.

Noam Chomsky has referred to the above passage to justify this statement of his :

“He [Adam Smith] did give an argument for markets, but the argument was that under conditions of perfect liberty, markets will lead to perfect equality. That’s the argument for them, because he thought that equality of condition (not just opportunity) is what you should be aiming at.”

In other words markets are good (perfect equality) if everybody is free and able to change between any and all professions as often as they like (perfect liberty).

Are Adam Smith’s pre-requisites for a market system met in practice? Let’s take medical school as an example – only a certain number of places are made available and the training takes a long time. Say a hospital lowers wages for its doctors – will taxi drivers step in to replace them? No, they cannot, they lack the required training. This condition gives doctors a higher degree of bargaining power than taxi drivers – as a result, their wages are higher. Classical economist John Stuart Mill was very clear on this point in his book Principles of Political Economy:

“All the higher grades of mental or educated labour are at a monopoly price; exceeding the wages of common workers in a degree very far beyond that which is due to the expense, trouble and loss of time required in qualifying for the employment.”

Economists act as if anyone can change between professions as easily as changing their socks and this assumption colors their theory of labour supply. In reality, labour supply curves might take almost any given shape, depending on the factors pertaining to the type of employment – they need not always slope up. In fact, if a person lacks bargaining power the curve may even slope down! As Prof Keen points out:

“if wages are just above starvation levels you will have to work a lot of hours just to stay alive”

I’m sure we can all think of  parts of the world where the above applies. And if employers in such places lower wages, they will find that they get people offering even more hours of work “just to stay alive”, not less. Yet with axiom #1, economists declare this outcome to be impossible. Conversely,  enforcing a minimum wage in cases where employee bargaining power is negligible might very well decrease unemployment, by allowing for more workers working shorter hours each, rather than fewer workers working longer hours each.

“The generality of labourers in this and most other countries have as little choice of occupation and freedom of locomotion, are practically as dependent on the will of others, as they would be in any other system short of actual slavery.” — John Stuart Mill

What about axiom #2: a downward sloping labour demand curve? This is an even more questionable assumption on the way to “proving” that minimum wages cause unemployment. The assumption is that labour costs are the main factor setting limits to what a firm can produce. As Prof. Keen explains, this notion of how a firm operates was challenged by the Italian economist Piero Sraffa in a paper written in 1926.

Sraffa was challenging the “law” of economics upon which the neo-classical theory of the firm was based: the law of diminishing marginal returns. Diminishing marginal returns says that the value to the firm of what each worker produces, minus the costs of hiring them, falls with each additional worker. This is the supply side version of our old friend from my Debunking Economics: Part 1 post on consumer demand, the law of diminishing marginal utility.

The reasoning goes as follows: there is a “factor of production” (a set of machines, or something) that is fixed in the short-term and “too many cooks spoil the broth” – a point is reached where additional workers (“cooks”) contribute less additional value (“broth”) than the cost of their wage. If more output is desired, wages must be lowered to offset this. Hence labour supply curves slope down. QED.

Except that this isn’t a realistic picture of how most modern firms operate. Prof. Keen explains that instead of being limited by rising marginal costs:

“The output of a firm is constrained by all those factors familiar to ordinary businessmen but abstracted away by economic theory. These are, in particular, rising marketing and financing costs, both of which are ultimately a product of the difficulty of encouraging consumers to buy your output rather than a rivals”

If you’ve ever watched programs like Dragons’ Den, the above concern is practically a cliche amongst the “dragons”. Yet economists behave as if it was an irrelevance in determining a firm’s profits. In fact, it is marginal returns themselves which are pretty much irrelevant as a limiting factor. This is proven by the fact that rather than stopping just shy of excess labour capacity, most firms instead operate with significant excess production capacity. Prof. Keen explains why:

“A firm with no spare capacity has no flexibility to take advantage of sudden, unexpected changes in the market, and it also has to consider building a new factory as soon as its output grows. The economist Janos Kornai has explored this issue in detail and concluded that excess [production] capacity is essential for survival in a market economy.”

Based on the law of diminishing marginal returns, economic theory declares the above strategy to be irrational – too much broth and not enough cooks. But it is not irrational – rather the assumed “law” is inapplicable to real markets. Prof. Keen explains:

“The crux of Sraffa’s critique was that ‘the law of diminishing marginal returns’ will not apply in general in an industrial economy. Instead, Sraffa argues that the common position would be constant marginal returns, and therefor horizontal (rather than rising) marginal costs. Sraffa’s argument constitutes a fundamental critique of economic theory, since diminishing marginal returns determine everything in the economic theory of production.”

Do any industries follow the law of diminishing marginal returns? This brings us on to the third and final “axiom”. Sraffa argued that some would, but that for these industries supply would not be independent of demand! It would be meaningless to draw a single curve for each and predict that the market settles to the state where the two lines intersect. Prof. Keen gives an example of such an industry, agriculture, whose fixed “factor of production” is land:

“Since additional land can only be obtained by converting land from other uses (such as manufacturing or tourism) it is clearly difficult to increase that factor in the short run. The ‘argiculture industry will therefor suffer form diminishing marginal returns, as predicted”

In fact it was the example of agriculture that classical economists first based the law of diminishing marginal returns upon – the famous metaphor of “the low hanging fruit” which will be picked first was intended quite literally! John Stuart Mill, for example, expressed that diminishing marginal returns apply to land, but not industry, in his book Principles of Political Economy:

“The cost of production of the fruits of the Earth increases, ceteris paribus, with every increase of the demand. No tendency of a like kind exists with respect to manufactured articles. The tendency is in the contrary direction. The larger the scale on which manufacturing operations are carried on, the more cheaply they can in general be performed.”

Sraffa argued that neo-classical economists subsequently over-generalised this “law”, applying it wholesale to all industry, far beyond its intended domain of validity. But even in the cases where it is valid, the assumed “geometry” of supply and demand will not apply! Prof Keen explains why:

“However, such a broadly definedind industry [as agriculture] is so big that it changes in its output must affect other industries. In particular, an attempt to increase agricultural output will affect the price of the chief input – labour – as it takes workers away from other industries …

if increasing the supply of agriculture changes the relative prices of land and labour, then it will also change the distribution of income. As we saw in Chapter 2 [see Part 1], changing the distribution of income changes the demand curve. There are different demand curves for every different supply curve for agriculture. This makes it impossible to draw independent demand and supply curves that intersect in just one place.”

Only “broadly defined” industries like agriculture will satisfy the law of diminishing marginal returns, but then in these cases we lose axiom #3. Thus Sraffa argues that the predictability of the theory of supply and demand, our very ability to construct geometric “proofs” of what markets will do, break down precisely in the cases where the law of diminishing marginal returns is a good approximation!

In such cases, instead of independent supply and demand curves, there is a feedback between supply and demand. We’re back to the idea from Part 2 that economics must abandon the idea of “equilibrium” and learn to include non-linear dynamics in its models.

A Lorentz attractor – “equilibrium” would be at the centre of the two “eyes”. But the system trajectory (gold) is never in equilibrium!

Hence the axioms 1-3 are never simultaneously valid. It is impossible to say whether a minimum wage increases or decreases unemployment. The argument that it increases it is a specious one, based upon a theory of supply that doesn’t apply to real firms. It is not sensible to base public policy on the conclusions of an economic theory deriving from false axioms. In other words, the economy is not flat, so the angles of a triangle do not sum to 180 degrees!

Click here to read the final part!


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~ by freedomthistime on December 27, 2011.

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