A.C. Pigou, an American economist, was of the view that wages are flexible. He said that if we cut overall wages during a recession unemployment rate decreases because by reducing the overall wage-rate cost of production falls which leads to falling in price level and due to this income increases which will further lead to an increase in aggregate demand and by this national income and employment would also increase.
Keynes’s viewpoint was that reducing the overall wage rate would cause a reduction in the overall income of consumers, which leads to a decrease in aggregate demand, which further leads to a fall in national income and an increase in unemployment.
Suppose the maximum capacity of the land to produce output is 500 kg wheat, but we are producing only 200 kg by employing 10 labourers and giving them a wage rate equal to 1000 rupees per labour. If we reduce the wage rate considering it flexible, still output and employment would increase for a very short period, and the consumption of time producing that output would be less to a certain point after the economy will go further into the recessionary period. Let’s understand this.
We were producing 200 kg by employing 10 labourers and the wage rate was 1000 rupees and time consumption was high. By reducing the wage rate we are now in a position to employ some more labour, say reducing the wage rate from Rs 1000 to Rs 500. By this, we can now employ 20 labourers and they can produce 400 kg of wheat out of maximum capacity which is 500 kg. Now this time consumption would be less than before, and if we further decrease the wage rate, the employment and output will also increase to a certain point.
The main thing is that once we got our maximum output which is 500 kg. After that decreasing the wage rate will not cause employment and output to rise but inversely it will cause the type of unemployment which is commonly known as “disguised unemployment” this means if we can attain the total output by employing say 10 labourers but still, we are employing more than 10 labourers say 15 extra 5 labourers we are employing are disguisedly unemployed. This disguised unemployment would cause the marginal productivity of labour to decrease according to the “law of diminishing returns” which says that if we go on increasing the variable factor over the fixed factor its marginal product will firstly increase and for some time it will remain constant after that it will start to decrease. So the number of labourers which we are employing by cutting the overall wage rate beyond the point of maximum output is just causing unemployment and output to fall which in recession could lead us to further recession. So here we can see that there is a positive relationship between wage cuts and unemployment to a certain point, decreasing the wage rate will also decrease unemployment but only to a certain point. And also we can understand from this that there is a negative relationship between the number of labourers and the time for production to a certain point. If we increase the number of labourers, the time for production will decrease and if we decrease the number of labourers the time for production will increase but this negative relationship is only valid up to a certain period of time.
This was the relationship between wage cuts and unemployment if wages according to Pigou are flexible. But even though in the real world they are rigid. There are various theories of wage rigidity – Staggered wage contracts theory, Implicit contract theory, Sticky nominal wages, etc.
Cutting the wage rate will initially increase output and employment for a very short period. Once we attain the point where output is maximum beyond that cutting wage rate would only and only cause diminishing marginal product of labour and also disguised unemployment that would lead us to further recession.
The author is pursuing Masters in Economics from Aligarh Muslim University. He can be reached at [email protected]