Wages and Employment

The Classical View:According to Pigou, the

tendency of the economic system was to
automatically provide full employment in
the labour market.
 Assumption
• Unemployment resulted from the rigidity in the
wage structure and interference in the working
of free market system in the form of trade union
legislation/minimum wage legislation, etc. Full
employment exists “when everybody who at the
running rate of wages wishes to be employed.”
However, this classical view on full employment
is consistent with some amount of frictional,
voluntary, seasonal or structural unemployment.
 Keynesian Analysis
• In the first place he agreed on the inverse relationship between
and employment
• Keynes did not agree that a cut in money wages for the economy
as a whole will cut the real wages
• Keynes believed that while keeping the money wages constant,
aggregate demand must be raised to increase employment.
• Wage earners do not mind rise in prices but resist wage cut it
may increase their debt.
• He believes that MEC, interest rate and consumption function
are determinants of income and employment rather than wage
cut
 General Equilibrium Analysis on the Wage
Cut and Employment
• Keynes examined the effect of reduction in
wages on employment by considering its
effect on the following determinants of
aggregate demand:
• 1. Propensity to consume
• 2. The marginal efficiency of capital
• 3. The rate of interest
• 4. Real Balance Effect or Pigou Effect
 Propensity to Consume:

• The effect of reduction in money wages is likely to reduce consumption

demand by adversely affecting propensity to consume. All-round cut in
money wages will reduce prices of products since wages are an important
element of costThe reduction in money wages and fall in prices of
products are likely to lead to the redistribution of real income from wage
earners lo those sections of the society whose money incomes have not
been reduced. Another type of redistributive effect of falling prices is that
redistribution of income from debtors to creditors occurs which also
reduces consumption expenditure. The debit repayments are usually fixed
in money terms so that fall in prices due to all-round reduction in wages
which was not expected when debts were incurred causes an increase in
the real value of mortgage and installment payments by debtors to
creditors which usually happen to be individual savers and banks.
 Debtor and Creditor
•  decline in the price level creates increased real burdens for 
debtors. When the price level goes down, the purchasing power of the
currency increases. We would say, “A dollar becomes more valuable.” Since
most debts take the form of a specific sum of money owed, and the real
purchasing power of this sum increases as the price level decreases, the
real purchasing power that the debtor has to hand over also increase.
Looked at another way, across-the-board deflation means that the debtor
cannot charge as much for whatever she sells, but the amount of money
she has to pay to the creditor does not change. Therefore, she now has to
sell more units (of whatever it is she sells) to pay back the debt. Debt
service will swallow up an increasing proportion of her gross income. “If
the fall of wages and prices goes far � those entrepreneurs who are
heavily indebted,” Keynes argues, “may soon reach the point of
insolvency.” That is, deflation can result in an epidemic of bankruptcies.
 Marginal Efficiency of Capital:

• the expectation effect of fall in wages and prices is

likely to have more adversely affect marginal
efficiency of capital. If fall in wages and prices lead
people to expect that they will fall even further in
the future, it will reduce consumption demand.
This will make entrepreneurs to become
pessimistic about future economic prospects. As a
result, marginal efficiency of capital will fall which
will cause a reduction in investment demand.
 Rate of Interest: Keynes’ Effect:

• cut in money wages and consequent fall in prices is likely to reduce the rate
of interest which will favourably affect investment demand. This is
generally referred to as Keynes’s effect as compared to Pigou effect which
traces out the favourable effect of money wage cuts on consumption
demand. According to Keynes, when cut in money wages is made and
consequently prices fall, speculative demand for money will decline which
will cause increase in the money supply . This increase in money supply
will cause a reduction in the rate of interest. However, Keynes asserted that
rate of interest can be easily lowered through expansion in money supply.
Therefore, according to Keynes, theoretically “We can produce the same
effect on the rate of interest by increasing the quantity of money while
keeping the level of wages unchanged” World of difference between them
in practice only a foolish person would prefer a flexible wage policy to a
flexible monetary policy”
 Real Balance Effect or Pigou Effect:

• All-round cut in wages and consequent fall in prices produces a

favourable effect on aggregate demand and employment in
another may which was first pointed out by Pigou and is,
therefore, known after his name as Pigou effect. According to
Pigou effect, when wage cut causes fall in prices, real value of
money balances increases as a result of which people become
richer which induces them to increase their consumption
expenditure which raises aggregate demand and employment.
Pigou effect or real balance effect is theoretically possible but
whether it is strong enough to raise aggregate demand
sufficiently to ensure full employment is highly doubtful.
 money illusion
• By money illusion it is meant that workers fail to realize that value of
money, that is, its purchasing power in terms of commodities,
changes when prices rise. They regard money such as a rupee as
something which has a stable value or purchasing power, that a
rupee is a rupee and a dollar is a dollar with fixed real purchasing
power.
• Therefore, while they would strongly oppose and resist any cut in
money wages, they would not resist much if their real wages are
reduced through rise in prices of commodities with money wages
remaining constant. Thus Keynes wrote, “Whilst workers will usually
resist a reduction of money wages, it is not their practice to
withdraw their labour whenever there is a rise in the price of wage
goods”.
 money illusion
• First reason for the existence of money illusion is that workers of a firm or
industry think that though rise in prices reduce their real wages, but that this
rise in prices equally affects workers in other industries so that their relative
wages as compared to those employed in other industries remain the same.
• Therefore, workers who are more concerned with their relative position with
other workers will strongly resist the cut in their money wages, while they will
not oppose so strongly their cut in real wages through rise in the general price
level.
• (ii) The second reason for strong resistance to cut in money wages is that the
workers blame their own employers for this, whereas they think that a cut in real
wages through rise in prices in general is the outcome of the working of general
economic forces over which strikes in an industry would have little effect.
However, it does not necessarily mean that trade unions remain silent spectators
if they feel that changes in Government policy adversely affect their economic
interests.
Modern Theory of Wages and Employment

• It is pointed out in fixing prices of their

products, the producers usually follow full-cost
pricing rather than on marginal cost
• In short run there is no change in technology
and equipment causing MC to rise.In actual
technology is constantly being updated.
• MC increase with output.According to Modern
view MC may decrease with an increase in
output due to technology.
 Application to Wage policy
• Analysis of wage employment relationship helps
government to formulate policies
• Due to wage cut, there will be reduction in
income of people which will adversely affect the
employment and output.
• Monetary and fiscal measures are more
important
• Wage should be raised keeping in view the
productivity and efficiency