Economic Reasoning, Lecture 3

Wages

Wages Are Prices

●In the first two lectures, I’ve contrasted Austrian economics with neoclassical, or mainstream, economics. But on wages, there isn’t much difference between the schools.

●Hazlitt makes a fundamental point about wages. Wages are a price, i.e., the price of labor. There isn’t a separate theory of how wages are determined.

Supply and Demand

●The basics of prices are simple. Suppose I want to sell 5 apples. I offer them for sale at a price—say, $5.00 an apple. I probably won’t sell any.

●I will then lower my price until I succeed in selling all the apples.

Supply and Demand Continued

●What happens if I set the price at 1 cent per apple? Then, I will probably find that people will want more than 5 apples. Because I have only 5 apples available, some people will offer me more money.

●The price will stabilize when all the apples are sold, and there are no buyers willing to offer a higher price. At the stable, or equilibrium price, the quantity of apples supplied (for sale) equals the quantity demanded (bought).

Many Sellers

●Suppose that there are many people selling apples. This doesn’t change things. Bidding between buyers and sellers will lead to a price at which what is offered for sale is bought. At this price, no one who wants to buy is turned away.

●Why is this true? If there are goods supplied that people won’t buy (a surplus), sellers will lower the price. If people want more of a product than is available (a shortage), they will bid up the price.

An Objection

●Very often, when you go into a store, you can’t bargain about the price. When you eat at McDonalds, you’re probably not going to say, “How about $1.00 off on the Big Mac”? If so, is it still true that supply and demand determine price?

●Yes, it is. You don’t need actual bargaining. If people don’t buy all the Big Macs at the price that is set, the McDonald’s management will lower the price. If they don’t have enough Big Macs to supply their customers, they will raise prices.

Wages

●Wage rates are set in exactly the same way. Workers are selling their labor services. Employers are the buyers. The wage rate for a particular kind of labor will be set so that the quantity supplied equals the quantity demanded at that price.

●Again, it doesn’t matter if there is actual bargaining. If employers don’t offer high enough wages to lead as many workers as they want to accept work, they will offer more money.

The Bargaining Power Objection

●Some people object that an individual worker for a large company may have no bargaining power. Suppose that someone has no other job available than working for Wal-Mart. (Assume no welfare benefits).

● If he loses the job, he faces starvation. Wal-Mart could easily hire someone else in his place. Doesn’t he have to accept whatever wages Wal-Mart offers him?

Objection Answered

●It’s true that the Wal-Mart could easily get along without this particular worker. But Wal-Mart is in competition with other firms, both large and small, that hire unskilled labor. If it offers wages that are below standard, other firms will bid their workers away.

●We can understand this better by thinking of a buyer who offers an exceptionally low price for an apple. He won’t get the apple if other buyers offer more. In the same way, a large company won’t get workers if others offer more money.

A Mistake to Avoid

●Remember the Austrian view of competition. An industry is competitive so long as entry and exit is free, and all products compete for money from consumers.

●The normal rules of price formation that we have just explained apply so long as there is competition in this sense. The rules don’t change if some firms are very large.

What Determines Wage Rates?

●We know that the wage for a particular kind of labor will be set so that quantity supplied and quantity demanded are equal. But can we go further? What determines how much labor is demanded?

●An employer will want to hire a worker so long as the worker contributes more to the value of the product than his wages.

Marginal Product

●As more workers are hired, their value tends to decrease. Why?

●This is an instance of a general economic law, the law of diminishing marginal returns. Suppose that you need labor + machines to produce a car. If you hold one of these factors of production constant, you can’t keep getting more and more cars just by adding to the other one. If , e.g., it takes a certain number of workers to operate a car assembly line, adding more than this number will after a while lead to workers who have nothing to do.

Diminishing Marginal Returns

●How does this law apply to a company like Wal-Mart, which sells goods rather than produces them?

●If Wal-Mart kept hiring sales clerks without expanding the store, the clerks would eventually get in each other’s way. Unlike the law of diminishing marginal utility, where new units of a good always have lower utility, you can sometimes have increasing returns. But they will eventually diminish.

Wages and Marginal Revenue Product

●We know then, that as more workers are hired, their marginal revenue product will go down. The marginal revenue product determines the wage rate.

●An employer won’t offer more than this, because he would then be paying more than the worker contributes to the product. It’s to his advantage to hire workers as long as the wage is slightly below their marginal product. Note that all workers get the marginal wage.

An Objection

●Sometimes people object to the marginal productivity theory of wages. The say it isn’t possible to tell how much each factor of production contributes to the value of the product. E.g., how much do the sales clerks contribute to Wal-Mart’s revenue?

●Very often you can tell, though, by seeing what the factor of production earns in other uses. How much do sales clerks earn in other jobs? That gives a rough idea of their contribution to this job.

Workers’ Productivity

●The workers’ marginal revenue product does not mean what the worker contributes to the product, solely by his own effort.

● If the employer puts in new machines, and this enables a worker to produce more, then the worker’s marginal revenue product has gone up. His own skill may not have risen---the new method may even require less skill than before—but the worker benefits from the capital investment of the employer.

Another Objection

●David Schweickart, a Marxist philosopher and economist, objected to using the point about workers’ productivity as an argument for the free market.

●Against those who say that the worker benefits from the machinery and tools that he hasn’t created, Schweickart says, “Why aren’t the tools and machinery owned by the workers also? Why are they owned by the employers?”

Response

●This objection ignores the fact that workers in a free market can set up their own businesses, if they want to do this. In some cases they do, but in many cases, they prefer to let others take the risks of investment.

● In any case, the objection doesn’t affect the point that workers’ wages benefit from increases in machinery and tools. This increases their marginal revenue product.

Discounted Marginal Revenue Product

●One point that we’ll just touch on is that workers actually get, not the marginal revenue product, but this product discounted by the rate of interest.

●We don’t have to go into all the details here, but the basic reason is that the employer has to pay the workers before he sells the product and makes money.

Minimum Wage Laws

●What happens if the government enacts a minimum wage law? If the rate is above the market wage for certain kinds of labor, anyone worth less than that to the employer won’t be employed.

●Minimum wages create an artificial surplus of labor.

Are Minimum Wage Laws Bad?

●If minimum wage laws cause unemployment, does it follow that they are bad and that we should get rid of them?

●This is an ethical judgment and doesn’t follow from economic analysis. Economics just says what will happen, not what ought to happen.

●However, as Mises points out, we can say that from the point of view of the advocates of minimum wage laws, these laws won’t achieve their purpose. People who favor such laws don’t want unemployment.

Are Minimum Wage Laws Important?

●You might think minimum wage laws aren’t important. The current federal minimum wage is $7.25 an hour, and most people earn substantially more than that.

●But a worker’s salary include all his benefits, and sometimes laws impose requirements about these. These include health insurance, retirement benefits, vacation, sick leave etc. These laws about benefits can cause unemployment.

Interns

●We can see one effect of minimum wage laws in the rise of unpaid interns in many professions. Employers can’t offer below minimum wages to young people entering the job market.

● If they could, and interns were doing valuable work, then employers would offer money to lure away interns from their competitors. Payment would rise until interns were earning their discounted marginal revenue product.

Labor Unions

●If a labor union gets a wage increase for its members that is above the market wage, then the employer will either cut staff or not hire as many new workers as he otherwise would have.

●The workers who would have been employed at the market rate have to seek jobs elsewhere and they drive down wages in these jobs.

Zones of Indeterminacy

●Sometimes labor union bargaining over wages is defended in this way.Even though the market tends toward an equilibrium price, market conditions don’t strictly fix this price. We can see this, e.g., in gasoline prices. The price of gasoline in stations within a few miles of each other will vary by a few cents. Union advocates say there is a zone of indeterminacy within which bargaining will help.

Zones Continued

●There isn’t much evidence that these zones exist or that, to the extent they do, workers without unions end up in the worst part of the zone for them.

Utility and Monopoly Prices

●One point from last time. I didn’t explain clearly one of the objections to neoclassical monopoly theory.

●The standard theory features a diagram by which you can prove that a monopoly price results in a deadweight loss. The gain to the monopolist is less than the loss to those who buy the product.

An Austrian Objection

●How is this diagram to be interpreted? What do the boxes in it show? If you take them to be dollar amounts, this makes sense, but not if you take them to be showing a utility loss. You can do this only if you take utility as some sort of quantity. It doesn’t follow that you have to think you can measure utility, but the notion of increases or decreases in total utility has to make sense. It’s difficult to see how it could make sense, if utility only refers to a ranking of goods.