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In an exchange economy every-
body’s income is somebody else’s cost.
Every increase in hourly wages, unless
or until compensated by an equal increase in hourly productivity, is an
increase in costs of production. An increase in costs of production,
where the government controls prices and forbids any price increase,
takes the profit from marginal producers, forces them out of business,
means a shrinkage in production and a growth in unemployment.
Even where a price increase is possible, the higher price discourages
buyers, shrinks the market, and also leads to unemployment. If a 30
percent increase in hourly wages all around the circle forces a 30 per-
cent increase in prices, labor can buy no more of the product than it
could at the beginning; and the merry-go-round must start all over
again.
No doubt many will be inclined to dispute the contention that a
30 percent increase in wages can force as great a percentage increase in
prices. It is true that this result can follow only in the long run and only
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Economics in One Lesson
if monetary and credit policy permit it. If money and credit are so
inelastic that they do not increase when wages are forced up (and if
we assume that the higher wages are not justified by existing labor
productivity in dollar terms), then the chief effect of forcing up wage
rates will be to force unemployment.
And it is probable, in that case, that total payrolls, both in dollar
amount and in real purchasing power, will be lower than before. For a
drop in employment (brought about by union policy and not as a tran-
sitional result of technological advance) necessarily means that fewer
goods are being produced for everyone. And it is unlikely that labor
will compensate for the absolute drop in production by getting a
larger relative share of the production that is left. For Paul H. Dou-
glas in America and A.C. Pigou in England, the first from analyzing a
great mass of statistics, the second by almost purely deductive meth-
ods, arrived independently at the conclusion that the elasticity of the
demand for labor is somewhere between –3 and –4. This means, in
less technical language, that “a 1 percent reduction in the real rate of
wage is likely to expand the aggregate demand for labor by not less
than 3 percent.”
1
Or, to put the matter the other way, “If wages are
pushed up above the point of marginal productivity, the decrease in
employment would normally be from three to four times as great as
the increase in hourly rates”
2
so that the total income of the workers
would be reduced correspondingly.
Even if these figures are taken to represent only the elasticity of
the demand for labor revealed in a given period of the past, and not
necessarily to forecast that of the future, they deserve the most seri-
ous consideration.
3
But now let us suppose that the increase in wage rates is accompa-
nied or followed by a sufficient increase in money and credit to allow
it to take place without creating serious unemployment. If we assume
1
A.C. Pigou,
The Theory of Unemployment
(London: Macmillan, 1933), p. 96.
2
Paul H. Douglas,
The Theory of Wages
(New York: Macmillan, 1934), p. 501.
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“Enough to Buy Back the Product”
137
that the previous relationship between wages and prices was itself a
“normal” long-run relationship, then it is altogether probable that a
forced increase of, say, 30 percent in wage rates will ultimately lead to
an increase in prices of approximately the same percentage.
The belief that the price increase would be substantially less than
that rests on two main fallacies. The first is that of looking only at the
direct labor costs of a particular firm or industry and assuming these
to represent all the labor costs involved. But this is the elementary
error of mistaking a part for the whole. Each “industry” represents
not only just one section of the productive process considered “hor-
izontally,” but just one section of that process considered “vertically.”
Thus the
direct
labor cost of making automobiles in the automobile
factories themselves may be less than a third, say, of the total costs;
and this may lead the incautious to conclude that a 30 percent increase
in wages would lead to only a 10 percent increase, or less, in automo-
bile prices. But this would be to overlook the indirect wage costs in
the raw materials and purchased parts, in transportation charges, in
new factories or new machine tools, or in the dealers’ markup.
Government estimates show that in the fifteen-year period from
1929 to 1943, inclusive, wages and salaries in the United States averaged
69 percent of the national income. These wages and salaries, of course,
had to be paid out of the national product. While there would have to
be both deductions from this figure and additions to it to provide a fair
estimate of “labor’s” income, we can assume on this basis that labor
costs cannot be less than about two-thirds of total production costs and
may run above three-quarters (depending upon our definition of
“labor”). If we take the lower of these two estimates, and assume also
that dollar profit margins would be unchanged, it is clear that an
increase of 30 percent in wage costs all around the circle would mean
an increase of nearly 20 percent in prices.
But such a change would mean that the dollar profit margin, rep-
resenting the income of investors, managers, and the self-employed,
would then have, say, only 84 percent as much purchasing power as it
had before. The long-run effect of this would be to cause a diminu-
tion of investment and new enterprise compared with what it would
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