Pigou Effect on Wage Cut and Full Employment
Pigou Effect on Wage Cut
and Full Employment
A renowned neoclassical economist, A.C. Pigou, suggested a cut in wage rates in order to remove huge and widespread unemployment prevailing at the time of great depression during the period 1929-33. According to him, under free competition, the tendency of economic system is to automatically provide full employment in the labor market and if there is unemployment in the free economy, then there are two reasons of it- first, rigidity in wage structure and second, interference in working of free market economy.
For example: Government and
trade unions of workers interfere free working of the capitalist economy and
artificially keep the wage rates at high levels then:
High wages → high cost of production → price rise → decrease in demand of goods → supply is more than demand → decrease in demand of labour → unemployment.
He expressed the view that if the wage rates were
cut down, demand for labor would increase so that all would get employment. It
is called Pigou effect or real balance effect. The term,’ the Pigou
effect’ was named by Don Patinkin in 1948.
Pigou pointed out that price level will fall due to
cut in wages. The fall in price level will lead to the increase in real value
of money assets such as stock of money, deposits in banks, bonds of government
or private companies held by them. In other words, due to fall in price level,
the purchasing power of their money assets will increase. As a result, demand
for consumption goods and services will increase and sales will be pushed up. It
will increase the demand for labor and ultimately full employment will be
attained. It will be possible due to all-round cut in wages.
Later Parkinson supported Pigou’s view about favorable effect of reduction in wages on fall in price level and a favorable effect on demand for goods.
Pigou effect is based on the following
assumptions:
· Wages,
prices and rate of interest are perfectly flexible.
· Labor is
homogeneous.
· There is a
laissez-faire capitalist economy without government
· interference.
· There is
perfect competition in labor and product markets.
· It is a
closed economy without foreign trade.
· There is a direct and proportional
relation between money wages and real wages. Nominal or money wages are the
wages received by a worker in the form of money. while real wages can be
defined as the amount of goods and services that a worker purchases from his
nominal wages. Thus, real wages show the purchasing power of nominal wages. An
increase in money wage rate implies an increase in real wage rate and decrease
in money wage rate implies a decrease in real wage rate.
In the case of unemployment, a general
cut in money wages would take the economy to the full employment level. According
to classical economists, those workers who do not want to work at lower wages
and remain unemployed are only voluntarily unemployed. This voluntary
unemployment is not considered real unemployment. Involuntary unemployment is
not possible in a free-market capitalist economy. All those workers who want to
work at the going wage rate determined by market forces will get employment. Full
employment of labor is possible due to quick adjustment of wages.
Labor Market Equilibrium- According to Pigou, real wage is equal to the
marginal product of labor and marginal Productivity diminishes as employment
increases, so for the equilibrium position and full employment, it is must that
real wage rate should be decreased with the increase in employment.
In the labor market, the demand for labor and the
supply of labor both determine the level of output and employment. Producers demand
for labor and they will employ labor until the marginal product of labor is
equal to the given real wage rate.
Real wage rate is given by nominal wage rate
divided by the general price level:
real wage
rate = W/ P
where: W is the nominal or money wage rate and P is the price level. Thus, a producer will employ so much labor at which W/P = MPN
where MPN is the marginal product of labor.
The level of full employment is determined where
labor supply equals labor demand. According to the classical economists
specially Pigou, the demand for labor is a decreasing function of the real
wage rate: DN = f (W/P)
where DN = demand for labor, W = wage
rate and P = price level.
Dividing wage rate (W) by price level (P), we get the real wage rate (W/P).
Supply of labor increases with the rise in wage rate, thus, supply of labor is an increasing function of the real wage rate: SN = f (W/P), where SN is the supply of labor.
In the above diagram, the DN and SN curves
intersect at point E, the full employment level NF is determined at the
equilibrium real wage rate W/P0. If the wage rate rises from W/P0 to W/P1, the
supply of labor will be more than its demand by ds and there will be
unemployment N1NF. Consequently, the wage rate will fall from W/P1 to W/P0 due to
excess supply. It will again decrease the supply of labor and increase the
demand for labor and the equilibrium point E will be restored along with the
full employment level NF. On the contrary, if the wage rate falls from W/P0 to
WP2 the demand for labor will be more than its supply. Excess demand will
raise the wage rate from W/P2 to W/P0 and the equilibrium point E will be
restored along with the full employment level NF. Since every worker is paid
wages equal to its marginal productivity, therefore full employment level NF is
reached when wage is reached from W/P1 to W/P0 [shown in Panel B]. Form the
diagram it is clear, that the quick changes in the real wage rate upward or
downward ensures that neither excess supply of labor, nor excess demand for labor
will persist and thus equilibrium will be reached with full employment of
labor in the economy.
Pigou gave an equation to understand the entire
proposition:
N = qY/W
Where:
·
N =the number
of workers employed
·
q = the
fraction of income earned as wages
·
Y = the
national income
·
W=the money
wage rate
·
N can be
increased by a reduction in W.
Thus, the key to full employment is a reduction in
money wage.
It’s Criticism –
Pigou’s wage cut theory can be valid for an
individual industry but in the case of the economy as a whole, this is not
valid because a general cut in wages will reduce the incomes of the working
class. Due to it, enough demand will not be there for the output produced by
the whole economy. This deficiency in demand will reduce demand for workers as
a result of which unemployment will spread among them. Keynes criticized this
theory on the following bases-
Keynes proved Pigou’s view that cut in money wages
will restore full employment as fallacious- Keynes put forward the view that wages are not
only the cost of production, they are also incomes of the workers. When there
is a general wage-cut, the income of the workers is reduced and aggregate
demand will fall. As a result of decline in aggregate demand, level of
production will have to be reduced and less labor will be employed than
before. This will create more unemployment rather than reducing it.
From the practical view point, Keynes never
favored a wage cut policy.
Wages and unemployment: There are the fundamental difference between
Keynes and Pigou in respect of the relationship between wages and employment.
Pigou thought that level of employment in an economy depends upon the level of
money wages and therefore reduction in money wages will promote employment. On
the other hand, Keynes thought that the level of employment depends upon the
aggregate demand and aggregate demand declines as a result of an all-round cut
in money wages.
State Intervention Essential- Keynes states that the capitalist system is
incapable of using productive power fully. Therefore, state intervention is
necessary. The state may directly invest to raise the level of economic
activity or to supplement private investment. It may pass legislation
recognizing trade unions, fixing minimum wages and providing relief to workers
through social security measures. Keynes favored state action to utilize fully
the resources of the economy for attaining full employment.
Long-Run Analysis Unrealistic- The classicists believed in the long-run full
employment equilibrium through a self-adjusting process. Keynes had no patience
to wait for the long period for he believed that "In the long-run we are
all dead".
Dr. Swati Gupta
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