Mises’ “Unhampered Market” Fantasy World

A statement by Mises in his explanation of labour markets and what causes demand for labour, and in the context of the Great Depression:

“Wage rates are market phenomena, just as interest rates and commodity prices are. Wage rates are determined by the productivity of labor. At the wage rates toward which the market is tending, all those seeking work find employment and all entrepreneurs find the workers they are seeking. However, the interrelated phenomena of the market from which the ‘static’ or ‘natural’ wage rates evolve are always undergoing changes that generate shifts in wage rates among the various occupational groups. There is also always a definite time lag before those seeking work and those offering work have found one another. As a result, there are always sure to be a certain number of unemployed.

Just as there are always houses standing empty and persons looking for housing on the unhampered market, just as there are always unsold wares in markets and persons eager to purchase wares they have not yet found, so there are always persons who are looking for work. However, on the unhampered market, this unemployment cannot attain vast proportions. Those capable of work will not be looking for work over a considerable period—many months or even years—without finding it.” (Mises 2006 [1931]: 164–165).

This view is hardly unique to Austrian economics of course; many streams of neoclassical theory think labour demand is wholly or mainly a function of the wage rate (and this is why they are obsessed with labour market deregulation and wage flexibility).

The trouble is: it is not true. That is to say, the main cause of demand for labour is aggregate demand for output, and wages rates are very much a secondary phenomenon. Of course, nobody denies that if wage rates get too high, it will probably reduce demand for labour, or that in some markets wage rates might be the determining factor. But in most markets wages are relatively inflexible downwards, and a high degree of wage stickiness is a persistent and omnipresent characteristic of modern advanced economies.

The empirical evidence that has accumulated over the years shows that people in general object to having their nominal wages cut, and workers are not generally, nor do they tend to be, paid their marginal labour product. In fact, very often workers simply do not know what their marginal product even is, and managers/employers find it difficult to calculate it (Bewley 1999: 82, 407). In many cases, such as when output is produced by a large number of workers with different roles, it is probably not even possible to calculate the marginal labour product of an individual worker.

But it is worse than this, because there is a great deal of evidence that even managers and capitalists often dislike pay cuts. Recent studies suggest that employers avoid pay cuts because they diminish workers’ morale, and then falling morale reduces productivity, amongst many other reasons (Bewley 1999; see a nice summary of Bewley’s work on wages here). There is even evidence that by the late 19th century downwards nominal wage rigidity was already a serious fact of life in the American manufacturing sector (Hanes 1993). This type of significant wage stickiness has clearly been around for a long time, and certainly it existed in the golden age of capitalism (1946–1973), yet in that period unemployment was historically low and it was not due to wage rates adjusting rapidly to allegedly clear labour markets.

Even when demand shocks are severe enough to cause wage and price deflation (as in the early 1930s), in an environment of high private debt, this would cause a severe debt deflationary crisis in a capitalist economy.

Mises’ “unhampered market” is a fantasy world of little relevance to an empirical economics, and the central element in it – that wage rates would be the primary determinant of demand for labour and would be flexible enough to ensure that involuntary unemployment never reaches significant levels – is hardly credible as a condition that we would see in the real world.

Further Reading
“Post Keynesian Labour Market Theory: A Summary,” August 21, 2014.

“Two Summaries of Bewley’s Why Don’t Wages Fall During a Recession?,” June 17, 2014.

“James Galbraith on the Essence of Keynes’ View of Labour Demand,” May 2, 2014.

“Keynes on Nominal Wage Flexibility,” June 7, 2014.

“The Essence of Post Keynesian Theory of Unemployment,” May 16, 2013.

“Steve Keen, Debunking Economics, Chapter 6: Wages,” February 12, 2014.

“Were Nominal Wages Flexible in 1890s and Early 1900s America?,” January 31, 2014.

BIBLIOGRAPHY
Bewley, T. F. 1999. Why Wages Don’t Fall During a Recession. Harvard University Press, Cambridge, MA.

Hanes, Christopher. 1993. “The Development of Nominal Wage Rigidity in the Late 19th Century,” The American Economic Review 83.4: 732–756.

Mises, Ludwig von. 2006 [1931]. “The Causes of the Economic Crisis,” in Percy L. Greaves (ed.). The Causes of the Economic Crisis, and Other Essays Before and After the Great Depression. Ludwig von Mises Institute, Auburn, Ala.

Steve Keen, Debunking Economics, Chapter 6: Wages

I review Chapter 6 of Steve Keen’s Debunking Economics below, which is a discussion of wages and labour markets.

Neoclassical economics analyses labour as a commodity, like any other, governed by the law of supply and demand (Keen 2011: 129).

Two crucial requirements of standard neoclassical analysis of labour markets are that (1) labour demand curves are necessarily downward-sloping and supply curves upwards-sloping, and (2) each worker tends to be paid the marginal product of labour (Keen 2011: 130–131).

Yet labour is fundamentally different from other commodities: whereas demand for some commodity like bread is determined by consumers and supply decisions by producers, the supply of labour is offered by consumers, and demand decisions are made by producers (Keen 2011: 129).

Steve Keen sees a number of problems with the neoclassical analysis:

(1) the labour supply curve can “slope backwards”: e.g., a fall in the wage rate can induce an increase in the supply of labour;

(2) the market power of some employers can result in unfair wages even in neoclassical theory, so that worker trade unions or collective bargaining can make wages fairer;

(3) standard supply and demand analysis can be inappropriate when applied to labour markets in light of Piero Sraffa’s aggregation problem;

(4) the fundamental explanation of labour supply as workers choosing between leisure and work is flawed;

(5) that market demand curves, including labour demand curves, necessarily obey the law of demand is unrealistic.

In regard to (1), Keen notes how a higher wage rate can result in the same income level for a worker if he or she works fewer hours: therefore less labour might be supplied as the wage rises (Keen 2011: 133–134).

Attempts to overcome this problem with the substitution effect are not convincing:

“… it makes no sense to separate the impact of an increase in the wage rate into its substitution effect and income effect: the fact that the substitution effect will always result in an increase in hours worked is irrelevant, since everyone will always have twenty-four hours to allocate between work and leisure.

Since an increase in wages will make workers better off, individual workers are just as likely to work fewer hours as more when the wage rate increases. Individual labor supply curves are just as likely then to slope backwards – showing falling supply as wages rise – as they are to slope forwards.

At the aggregate level, a labor supply curve derived by summing many such individual supply curves could have any shape at all. There could be multiple intersections of the supply curve with the demand curve (accepting, for the moment, that a downward-sloping demand curve is valid). There may be more than one equilibrium wage rate, and who is to say which one is valid? There is therefore no basis on which the aggregate amount of labor that workers wish to supply can be unambiguously related to the wage offered. Economic theory thus fails to prove that employment is determined by supply and demand, and reinforces the real-world observation that involuntary unemployment can exist: that the employment offered by firms can be less than the labor offered by workers, and that reducing the wage won’t necessarily reduce the gap.

This imperfection in the theory – the possibility of backward-bending labor supply curves – is sometimes pointed out to students of economics, but then glossed over with the assumption that, in general, labor supply curves will be upward sloping. But there is no theoretical – or empirical – justification for this assumption” (Keen 2011: 134).

The problem Keen identifies here is that labour supply curves need not be well behaved.

This is just as easy to see in reductions in wages. A strong general characteristic of most households is that they wish to maintain their standard of living, as they face fixed contractual obligations like debt, and hence the need to maintain income levels (Lavoie 1992: 222).

Therefore labour supply often depends on a perceived target wage rate and past standards of living (Lavoie 1992: 222–223), not necessarily on actual movements of the wage rate. If wages fall, this may well increase labour supply as a breadwinner or other members of the household decide to look for more work to maintain household income.

To turn to point (2) above, the real world is far from the perfect or near competition models of neoclassical theory.

Even if one wants to assume that workers should be paid their marginal product, firms with market power will pay wages below this value, so that a trade union acting as a single seller of labour will drive wages higher, so that wages will be fairer (the so-called monopsony argument).

In regard to point (4), neoclassical theory holds work and leisure to be two “goods,” between which workers freely choose as the wage rate changes. In a truly laissez faire society with no welfare or social security, this idea is of course nothing more than a sick joke: either you work for whatever wages so can obtain or starve.

Even in modern welfare states, the idea is still dubious: for most forms of leisure require money and income, and in most full-time work hours worked are strictly set by employers and not often negotiable.

Keen also notes how in recessions or depressions where there is a very high level of (normally) fixed private nominal debt, cutting wages and prices (and hence profits, which are the income of businesses) to increase demand for labour will induce debt deflationary pressures, a self-defeating exercise (Keen 2011: 138).

BIBLIOGRAPHY
Keen, Steve. 2011. Debunking Economics: The Naked Emperor Dethroned? (rev. and expanded edn.). Zed Books, London and New York.

Lavoie, Marc. 1992. Foundations of Post-Keynesian Economic Analysis. Edward Elgar Publishing, Aldershot, UK.