12.2 – A Review of the Orthodox Wage and Price Adjustment Story
Learning Objectives
By the end of this section, you will be able to:
- Explain the primary components of orthodox macroeconomics
- The significance of price and wage adjustments within the orthodox paradigm
- The inherent laissez-faire aspects of the orthodox argument
Generally, for most contemporary orthodox economists (neoclassical school, New Keynesian, et al.) the macroeconomic purpose of price adjustments can be likened to releasing a marble down the side of a large bowl, eventually after making several passes, moving up and down along the sides, the marble will come to rest at the bottom of the bowl. In this analogy the bowl represents the economy, the marble represents prices, and the marble coming to rest represents equilibrium. In practice this means that if demand were to decline, then at existing prices there will be a surplus of (unsold) products in the economy. In the case of a surplus, price deflation becomes the market adjustment needed to correct for the disequilibrium, restoring equilibrium as well as economic stability.
Orthodox economics argues that wage and price flexibility represents the normal condition of markets and the macroeconomy in general, allowing the economy to consistently operate at its greatest potential. In Chapter X, the “Introduction to the Orthodox Perspective,” the neoclassical economic foundations of the orthodox viewpoint regarding the importance of flexible wages and prices is neatly summarized.
“The classical view, the predominant economic philosophy until the Great Depression, was that short-term fluctuations in economic activity would rather quickly, with flexible prices, adjust back to full employment.”
In other words, “optimal” economic conditions are assured by wage and price flexibility.
For clarification purposes, it’s worthwhile to take a closer look at the mechanics of the orthodox position. Orthodox economics emphasizes that in a market system characterized by wage and price flexibility, any market experiencing disequilibrium will quickly return to equilibrium as wages and prices adjust (upward or downward), as necessary, to eliminate market surpluses and/or shortages. The result is an economy in which all markets, product (goods and services) and resource (labor, etc.), gravitate toward equilibrium. By continuation, if all markets gravitate toward equilibrium, then it is the tendency of the economy to have a fully employed labor market because equilibrium means that labor supply equals labor demand. General equilibrium will also mean that the economy will also produce and sell the full employment level of products.
If wage and price flexibility tends to generate ideal economic conditions, then it also stands to reason that the opposite, wage and price stickiness, will be responsible for “sub-optimal” economic outcomes. Assuming that the economy is destabilized by any unforeseen factor(s), while wage and price flexibility will return the economy to general equilibrium, wage and price stickiness would be responsible for extending periods of disequilibrium and, therefore, prolonging instability. In the absence of flexibility, disequilibrated markets would not experience the necessary wage and price adjustments to rectify the disequilibrium caused by an economic disturbance. Should there be, albeit unlikely in the orthodox perspective, an abrupt reduction in aggregate demand, then firms will experience rising inventories which will result in firms reducing production and employment. The result would be an economy operating at less than full employment and less than full resource utilization as surpluses of resources and products go unsold.
Should there be a reduction in aggregate demand, given flexible wages and prices, orthodox economics argues that laborers will also, collectively, not fall victim to the “money illusion” and will universally accept wage reductions because unemployed workers would rather work for lower wages than not work at all. Ultimately, the wage reductions do not negatively impact the purchasing power of laborers because the wage reductions are offset by the price reductions.
The Money Illusion
The money illusion is the idea that economic agents, in this case laborers, do not understand the difference between money wages (wage paid per hour) and real wages (the wage adjusted for inflation). As a result, when confronted with the demand to reduce their money wages, laborers will resist money wage reductions, presumably not understanding that their wage reductions will reduce employer costs and, subsequently, allow employers to reduce prices. Falling prey to the money illusion means that laborers simply do not understand that their wage reductions will be completely offset by price reductions.
Orthodox economic theory, assuming both perfect information and “rational” economic agents, argues that economic agents will always understand that money wage reductions will reduce costs to their employers and thus allow firms to reduce their prices which then allows laborers to maintain constant real purchasing power in spite of their initial money wage reductions. As a result, from an orthodox economic perspective it would be illogical for laborers not to accept wage reductions because they are erroneously concerned that lower wages necessarily mean a reduced standard of living.
For orthodox economic theory, because the belief is that perfectly informed rational economic agents will not experience the money illusion, it is assumed that both laborers and firms will negotiate wages on the basis of real wages (wages adjusted for inflation) as opposed to money wages.
To the contrary, in the General Theory Keynes makes the argument that it is not necessarily illogical for laborers to resist a money wage reduction and states, more importantly, that “whether logical or illogical, experience shows us that this is how labour in fact behaves (p. 9),” Keynes’ point being that what may be logical or rational to the orthodox economist may not actually reflect the behavior of economic actors.
Instead, Keynes provides a logical reason why laborers might resist a money wage reduction. While it is certainly reasonable that firms are influenced by real wages in their wage bargaining decisions, because firms both set their prices and negotiate money wages, laborers will not have the same considerations as their employers because laborers can only directly negotiate their money wage. As a result, it is actually not logical for laborers to attempt to negotiate their real wage as they cannot be guaranteed that they will arrive at a given real wage from a money wage adjustment. In other words, laborers through bargaining can only influence one half of the real wage value, their money wage and are not going to openly appreciate or embrace money wage reductions.
As a general rule, however, because orthodox economics assumes that wage and price flexibility is normal, prolonged economic contractions and unemployment are not really a concern. If, however, stickiness should emerge, many orthodox economists tend to provide two reasons for why it is still best to simply let market forces work themselves out without government involvement. First, any wage and price stickiness is apt to only last for a short amount of time, so long run equilibrium will tend to emerge sooner, rather than, later. Second, among more laissez-faire oriented orthodox economists, government action is generally perceived to make matters worse as opposed to better because the government, due to informational lags, inefficiencies, and a propensity to generate negative unintended consequences, will inadvertently cause misallocations of resources.
For some orthodox economists, however, wage and price stickiness is more common than is recognized by the more laissez-faire oriented orthodox economist. In this other orthodox view, if there is wage and price stickiness and aggregate demand, for example, decreases, then an economic recovery would not be immediately forthcoming. Chapter X summarizes this point with the following statement regarding the Great Depression,
“…although AD fluctuated, prices and wages did not immediately respond as economists often expected. Instead, prices and wages are “sticky,” making it difficult to restore the economy to full employment and potential GDP.”
To establish wage and price stickiness some orthodox economists provide a series of ad hoc examples of factors that generate wage and price stickiness. The Orthodox Macroeconomic Perspective chapter provides several examples of stickiness,
- implicit contracts
- efficiency wage theory
- adverse selection of wage cuts argument
- insider-outsider model
- coordination argument
- relative wage coordination argument
- menu costs
The significance of the wage and price stickiness argument is that the economy could get stuck in a less than full employment situation. As a result, for some orthodox economists, government stabilization often becomes a useful remedy for kick starting a weak market or markets and waiting for the long run is unnecessary as short run government policies can be used to accelerate the return to full employment.
In summary the orthodox perspective approaches price stickiness or flexibility with a take-it-or-leave-it quality, lacking in urgency. If something does come along and destabilizes the demand-side of the economy, and prices are flexible, then the economy will quickly adjust back to full employment. Alternatively, if prices are sticky, then the return to full employment will just take a little longer unless the government gets involved. In orthodox economics the issue of price stickiness or flexibility is now fundamentally semantic. Have some patience or ask the government to speed things along, either way macroeconomic instability is temporary.
