By Frederic S. Lee
Whether it be inflexible prices, wage rates that are too high and sticky, or interest rates that cannot become negative, they all have the common property of disrupting the smooth workings of the price mechanism, thereby causing recessions, preventing economic recovery, and creating unemployment. But what if there is no price mechanism that allocated scarce resources among competing ends? Then the ‘price problem’ would disappear and the causes of recessions and persistent unemployment would be quite different. Ignoring the issue whether scarce resources as defined in mainstream economics exist or not, I am going to interrogate the supposed existence of the price mechanism that lies at the theoretical core of all mainstream explanations of recessions and unemployment.
Clearly there can be momentary glitches in the working of the price mechanism; but I am not concerned with these correctable imperfections. Instead the issue is: when does the waywardness of prices, wage rates, and interest rates cease to be glitches in price mechanism and actually eliminate it altogether. Starting with prices, since the 1930s, it has been known that price stability dominate the industrial, wholesale, and retail areas of the American economy. The 40-50 studies in the past fifteen years by Alan Binder and others which cover developed countries around the world further support the existence of price stability. One basis for its existence is the administered cost-plus pricing mechanism (used by virtually all business enterprises to set the prices) which neutralizes the impact of changing sales on costs hence prices. So price stability and its underlying pricing mechanism are systemic features of developed economies such as the American economy resulting in a disjuncture between price and quantity.
Turning to wage rate stability, evidence of its existence goes to the 19th century. Moreover, from the 1980s, wage rate stickiness has been a major concern of mainstream economists; and since the early 1990s, numerous empirical studies have shown its widespread existence, thus, as in the case of price stability, making it an irrefutable economic fact. Other studies show that wage rates are of minor importance when enterprises make hiring decisions. On the other hand, studies in how wage rates are actually determined are few; but what can be gleaned from the human resource literature is that the marginal product of labor has no role in the determination process whatsoever. Altogether, the implication is that there is no connection between the wage rate and the demand for labor.
Finally there is the question of the interest rate and its connection to investment decisions in plant and equipment and research and development. Again, the empirical evidence on the investment decision process shows that enterprises take a great many variables into account, including the interest rate. But in the end, the significance of the interest rate in the final decision is almost reduced to nothing. This is in part due to the fact that enterprises finance their investment from retained earnings (thus avoiding the financial markets) and that going enterprises do not view financial assets as substitutes for ‘real investment’.
A working price mechanism requires price, wage rate, and interest flexibility and most importantly a direct and inverse law-like connection to outputs/sales, employment, and real investment. However, with price and wage rate stability, they are not connected to sales and employment; and interest rates (whether nominal or not) have little bearing on investment decisions. Mainstream economists have over the past 70 years come up with ad hoc explanations/theories why any one of these outcome may occur; but they have never come up with an explanation why all three occur at the same time and have been persistently occurring for at least the past 80 years (if not for the past two centuries). So instead of continually blaming some kind of temporary imperfections in the working of the price mechanism as the cause of a malfunctioning economy, perhaps it is time to drop the myth of the price mechanism and dismiss the fictitious ‘price problem’ and seriously consider that problems of economic recessions and unemployment are only heterodox/Post Keynesian effective demand problems.
It has begun. request for next post: what if the maximum eigenvalue is less than one?
yes, actually I am wondering the answer of this question:) and also what if max. eigenvalue is more than one Dr. Lee?:))
I am looking forward to many future blog posts from Dr. Fred Lee.
A good text of Dr. Lee. He´s showing us a good path for understanding microeconomics.
Please keep posting Dr Lee.
Very good article indeed, it has crystalized some vague questions which I had floating at the back of my mind.
Keep it up!
Dr. Lee:
I am confused by your comment:
“…the marginal product of labor has no role in the determination process whatsoever. Altogether, the implication is that there is no connection between the wage rate and the demand for labor.”
During the 90’s there was a high demand for network and internet technical expertise. That labor was in demand and wages were bid up accordingly.
Also during the 90’s, my wife was in the furniture business. When the import boom from China started there was great demand for warehouse personnel. Those wages were bid up 2x to 3x from original level. (When things settled down, and demand dropped, wages returned to original levels).
I acknowledge that the destruction of the unions helped decouple wage growth from productivity growth. Outsourcing has also done a lot to limit demand for US labor which has resulted in stagnated wages.
However, even in this depression, there still some areas where labor demand is high (example: Derivatives Traders) and you will still see wages and compensation being bid up in those areas.
First, you have to provide empirical support for your claims of wages ‘bidding up’. Second, the marginal revenue product says that changes in the firms product market price determines the quantity of workers demanded by the firm in conjunction with the workers labor/leisure reservation wage which isn’t the case. The level of employment is determined by the level of sales in the business (as an example see Richard Lester 1946). Stated another way, if the sales aren’t there, there won’t be any hiring regardless of the wage.
And, to make matters worse the demand for labor is in whole laborers while the supply f laborers is in units of time make the two incomparable (yikes). If you put demand in units of time, however, you lose diminishing returns because both labor and capital will be variable making the model null and void.
Further, the marginal revenue product relies on the production of a single output and is indeterminate if there is multi product production (which is overwhelmingly the case). If the marginal revenue product (I.E. Firm demand curve for labor) is indeterminate, there is no direct causal relationship between price and quantity as is required by the theory.
Just because a wage changes doesn’t mean it’s related to the quantity of laborers. That’s the logical fallacy of assuming the consequent. Wages change for a multitude of reasons. Sara Rynes has a nice book on the subject (2003).
Wage determination is very under theorized – but from the available information it’s fairly clear that firms don’t use marginal products to determine wages or any variant of it ( notwithstanding multi product production). The topic is huge and it’s hard to give you a better response in the blog comments, but I can send you some stuff via email if you wish.
Good read; It appears that mainstream micro-economic theory sets forth assumptions/conclusions from the start; then much of the empirical analysis is using their assumptions to explain why their assumptions never actually hold in the real world. It is highly self-referential/circular. It is amazing that the mainstream economic project continues to survive under the ever-mounting pressure of the evidence.
Part of the appeal of ‘ideal’ market society is that all of the incentives are there- people operate to produce and distribute in the best way intuitively based on price signals- there is no need for an authority to decide on production/distribution decisions- it all takes care of itself. This is an ironic juxtaposition with the moralizing done by traditional economists about people/governments interfering with these ‘natural market forces’. They fail to recognize that there appears to be just as ‘natural’ an impulse to regulate markets and avoid competition. Rather than posturing as scientists and opting to study the persistent and ubiquitous anti-competitive forces, they just decry the immoral tamperings of government intervention or come up with ad-hoc theories of temporary market pollution. The science of economics is dominated by capitalist Utopian idealists, not scholars who want to understand how we carry out society’s provisioning process.
Upon closer examination- markets (their values/activities) are more likely akin to societal structures like gender roles- they actually take a SIGNIFICANT amount of effort to reinforce and maintain, but those who assume they are natural have a strong confirmation bias- they only see the evidence that gender roles are an absolute biological reality and are able to ignore the wealth of counterfactuals and gender-variance.
What would post- conventional price mechanism economics look like? I wonder what all functions are served by economic theory existing in its current condition- and what would a new theory need to be able to accomplish to be more useful? Is it a matter of making better policy recommendations and outcome predictions? More comprehensively and accurately describing economic activity? Or is economic theory more a reflection of the existing social relationship of production? Have heterodox schools succeeded in providing an alternative approach, or are they merely in the process doing so? Do they need a new ‘meta-theory’ to replace the conventional price-mechanism, or will the process and application of economic theory and research be radically different if a revolution against the neo-classical price regime is successful?