On the blog he shares with Tyler Cowan, Alex Tabarrok writes:
A fall in wages increases the incentive to hire (call this the substitution effect) but it decreases the income of people who already have jobs and this in turn decreases their spending and other people’s income (call this the macro income effect). In essence, Krugman and others are arguing that the macro income effect can dominate under certain situations.
Yes, but one needs to go a bit further than this. If the macro income effect dominates, then there will be layoffs in other sectors, most immediately in those producing outputs that low wage workers purchase. And these layoffs will not be confined to low wage workers. This means that even if the employment of low wage workers rises, there will be a decline in employment across other segments of the skill distribution. Concede this point and we're done.
Tabarrok doubts the empirical relevance of the macro effect, based as far as I can tell on the perusal of a before-and-after table by Scott Sumner. I will leave the empirical question to the empiricists, except to say that the magnitudes of the various effects will obviously depend on the initial level of the minimum wage and on prevailing economic conditions.
Finally, let me repeat that I agree with Winterspeak, Tyler Cowan, and The Economist that the effects on aggregate demand of changes in the mimimum wage, regardless of their sign, are likely to be small. But it's important to get the reasoning right, because the same methods apply to discussions of flexible wages and prices more generally.
Update (12/18). As I said in my earlier post on the topic, the aggregate demand consequences of a fall in wages also depend on financial market effects. If the the unspent portion of the rise in employer incomes makes it into the bond market, lower long-term rates could stimulate investment. If it goes into stocks, the resulting asset price appreciation could also conceivably raise investment. Neither of these effects seems likely under current conditions. This is why I have argued that Greg Mankiw's proposal of an investment tax credit is deserving of serious attention.
Update (12/19). It's worth thinking a bit more closely about what Alex calls the substitution effect. This is presumably what Tyler had in mind when he urged me to shift marginal cost curves down and watch what happens. He was arguing that the firm will lower price and use the additional hires to step up production to meet the increased demand. Now obviously this will not increase market share if one's competitors are doing the same thing, but it could increase the overall consumption of goods and services produced with low wage labor. Even disregarding the macro income effect, this implies a decline in demand for goods and services produced with skilled, high wage labor. In other words, there will be a "substitution effect" in unemployment patterns, more unskilled jobs and less skilled jobs. Add the macro income effect to the analysis and matters become worse. The only way that lower wages can increase aggregate demand is by stimulating private investment through changes in asset prices and interest rates. This is just not going to happen under current conditions (hence my support for this proposal). In any case, a partial equilibrium analysis is totally inadequate for thinking through these questions.
Update (12/19). Nick Rowe (via Mark Thoma) addresses the "microeconomic miscreants" from a macroeconomic perspective. I personally feel a bit uneasy using models with such high levels of aggregation because they leave out too many things (for instance, the effects of changes in the minimum wage on the skill distribution among the unemployed). But he makes some useful points.
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Update (12/18). As I said in my earlier post on the topic, the aggregate demand consequences of a fall in wages also depend on financial market effects. If the the unspent portion of the rise in employer incomes makes it into the bond market, lower long-term rates could stimulate investment. If it goes into stocks, the resulting asset price appreciation could also conceivably raise investment. Neither of these effects seems likely under current conditions. This is why I have argued that Greg Mankiw's proposal of an investment tax credit is deserving of serious attention.
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Update (12/19). It's worth thinking a bit more closely about what Alex calls the substitution effect. This is presumably what Tyler had in mind when he urged me to shift marginal cost curves down and watch what happens. He was arguing that the firm will lower price and use the additional hires to step up production to meet the increased demand. Now obviously this will not increase market share if one's competitors are doing the same thing, but it could increase the overall consumption of goods and services produced with low wage labor. Even disregarding the macro income effect, this implies a decline in demand for goods and services produced with skilled, high wage labor. In other words, there will be a "substitution effect" in unemployment patterns, more unskilled jobs and less skilled jobs. Add the macro income effect to the analysis and matters become worse. The only way that lower wages can increase aggregate demand is by stimulating private investment through changes in asset prices and interest rates. This is just not going to happen under current conditions (hence my support for this proposal). In any case, a partial equilibrium analysis is totally inadequate for thinking through these questions.
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Update (12/19). Nick Rowe (via Mark Thoma) addresses the "microeconomic miscreants" from a macroeconomic perspective. I personally feel a bit uneasy using models with such high levels of aggregation because they leave out too many things (for instance, the effects of changes in the minimum wage on the skill distribution among the unemployed). But he makes some useful points.
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