Bryan Caplan  

Correcting a Favorite Textbook Author

The Dining Room Table Responds... Who Said It?...
Maybe I'm just misinterpreting this passage, but I feel the need to correct one of my favorite textbook authors.  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).
Yes, assuming their hours are fixed, wage cuts decrease the income of people who already have jobs.  But it is premature to claim there is a negative macro income effect, because there are two countervailing factors.  Cutting wages can easily increase overall income and spending because...

1. Lower wages do not imply lower overall labor income.  If labor demand is elastic, total labor income actually rises.

2. No matter how little or how much employment increases as a result of lower wages, a $1/hour fall in labor income still necessarily implies a $1/hour rise in employer income.  Unless employers have a higher marginal propensity to stuff their income under mattresses than workers, overall income and spending stay the same or go up.

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COMMENTS (6 to date)
Alex Tabarrok writes:

Bleh. My point is that even if you accept Krugman's argument in its strongest form it does not apply at all to the most realistic policy reform on the table, payroll tax cuts. A payroll tax cut increases AD even accepting Krugman's argument.

Steve Roth writes:

> Unless employers have a higher marginal propensity to stuff their income under mattresses than workers

This is often taken as a given. Owners generally have higher income/wealth, hence lower marginal propensity to spend newfound income. They "save" it instead.

I might have missed the posts where you question that, or the papers that do so.


woupiestek writes:

While you can cut nominal wages, you cannot cut real wages in the long run, or can you? You get a double effect of on one hand lowering production costs and on the other giving a large number of people less money to spend.

Come to think of it, the short term effect might be small because of rational expectations/ efficient markets. So what is left is an excessive amount of money, which raises inflation expectations. That boosts aggregate demand. Do I get that straight?

Lord writes:

No. If labor income is elastic, lower wage workers are substituted for higher wage workers. Lower wage workers being less productive mean more employment but not more labor income. There is no reason to expect an increase in labor income other than a greater propensity of low wage workers to spend than high wage workers. If labor income is inelastic, income is redistributed from labor to employers and to the assets they own and invest in. Labor income is reduced while profits and asset prices are increased. Unless there is a greater propensity to spend, no increase occurs.

Norman writes:

Lord said "If labor income is elastic, lower wage workers are substituted for higher wage workers."

Perhaps I'm missing something, but it seems to me the only way most of the effect of a reduction in minimum wage is substitution of one type of labor for another is if there is very little idle capacity in the economy. Since we are talking about a situation where there is high unemployment of both low wage and high wage workers, I just don't see how this makes sense. Are you really suggesting that firms will fire an engineer or accountant and hire four high school students?

For that matter, the labor substitution problem goes away in all cases if the intervention is a payroll tax cut as Alex is discussing rather than a minimum wage cut.

It seems to me the strongest argument against it is that we shouldn't waste political energy on something that is likely to have a small effect (like a minimum wage cut). Now, whether the effect of a particular payroll tax cut will be small is debatable, but I feel like the objections to Bryan's point are more of a Yakov Smirnoff approach to policy debate:

"In Microeconomics, you cut wages.
"In Macroeconomics, wages cut you!"

Lord writes:

The trade off would be between minimum wage workers and sub minimum wage workers and even with high unemployment there is still a lot of employment churn. The problem is there is little if any increase in the propensity to spend due to this so no increase in labor income. At best there is no increase in labor income and most likely less. Falling wages would intensify deflationary expectations leading to even worse results.

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