the use of the term “classical” is somewhat inappropriate, since the “classical” economists are generally considered to have written in the period from 1776 to about 1850 or 1860. A postclassical school, developing “neoclassical economics,” began around 1870, dominated economic thinking to about 1930, and remains important today; and the unemployment theory that Keynes attacked was essentially a neoclassical theory. Roughly simultaneously with the neoclassical developments, a second school of economists, the Austrians, was developing on the European continent. While the Austrian position on business cycles differed from neoclassical thinking, the Austrians reached many similar conclusions with respect to unemployment determination. Thus we can talk of a “neoclassical-Austrian” perspective on unemployment.
Wage-Based Perspectives on Unemployment
At the outset, it should be stated emphatically that in his General Theory Keynes created a straw man, a caricature of true thinking by the orthodox neoclassical and Austrian writers of his time. Keynes implied that these economists had a well-developed and articulated theory of unemployment that was virtually universally accepted as part of orthodox economic doctrine. That assertion is somewhat dubious. To be sure, the accepted price theory carried with it an implicit explanation of unemployment. As mentioned in the previous chapter, however, there was very little explicit scholarly writing about unemployment before 1930, and textbooks of the era generally gave scant attention to the subject. Moreover, when the Great Depression began and businesses, under government prodding, began to follow policies antithetical to those that the theory of orthodox economists suggested, there was little outcry from that group. This was in marked contrast to their behavior with respect to the increased tariffs passed as part of the Smoot-Hawley Act.2 While there was an orthodox economic explanation of unemployment, a majority of economists did not believe it with the great conviction they felt about other parts of conventional economic doctrine.
With this caveat in mind, what was the predominant view of the causes of unemployment during the first three decades of the century? In short, the important determinant of unemployment is the wage rate. Unemployment is created when existing wage rates exceed the level necessary to “clear” the labor market. Just as a surplus of wheat exists if the prevailing price is above the equilibrium level that equates the quantity supplied and the quantity demanded, so there is a surplus of labor—unemployment—when the prevailing price, or wage, of labor exceeds the equilibrium level that eliminates unemployment.
Figure 2.1 can help further elucidate the theory. The quantity demanded of labor varies inversely with its price. At lower wages, the quantity demanded is greater, because the additional revenue a worker brings to a firm, or marginal revenue product, is lower the greater the quantity of labor.3 Put differently, lowering the wage makes it profitable to hire some workers whom it would be unprofitable to hire at a higher wage.
It is generally acknowledged, as figure 2.1 depicts, that the quantity of labor supplied varies directly with its price.4 As employers raise wages, some persons are willing to work who would forego the opportunity at a lower wage.
Suppose that initially the wage rate is OW, and the demand for labor is denoted by curve D. Note that at wage OW the quantity of labor supplied exceeds the quantity of labor demanded; there is unemployment in the amount AB. The basic price theory suggests that there are four ways in which the unemployment might be eliminated:
FIGURE 2.1 WAGES AND THE DETERMINATION OF UNEMPLOYMENT
1) a reduction in the existing money wage from level OW to OY;
2) an increase in labor demand (e.g., to curve D*) from higher prices on goods that workers produce; this raises the money value of the marginal revenue product of labor;
3) an increase in the demand for labor arising from an increase in labor productivity, reflecting technological advances, increased capital availability, etc;
4) a decrease in the supply of labor, denoted by an upward movement in the supply curve (not shown in figure 2.1).
A decrease in money wages would reduce unemployment both by decreasing the quantity of labor supplied and by increasing the quantity of labor demanded. Increases in the prices of goods or services produced by labor raise dollar revenues attributable to any given amount of labor, thus increasing the amount employers would be willing to pay to obtain any given number of workers. Also, higher prices mean that a given money wage has less purchasing power, so an increase in prices means a reduction in real wages. Higher productivity means higher physical product per worker which, in turn, means higher revenues per worker, similarly increasing demand. Finally, a shift to the left in the labor supply curve reduces the gap between the quantity of labor demanded and supplied.
If labor supply is highly inelastic (relatively nonresponsive to wage changes) and if it moves over time slowly and predictably with demographic and other trends, then the theorizing above would suggest that short-term variations in unemployment are determined by changes in money wages, prices, or the productivity of labor.5 As indicated, the money wage divided by the price level is the real wage. The real wage per unit of physical output is simply the real wage divided by the productivity of workers, or what we might call the “adjusted real wage” or “real unit-labor costs.” The bulk of the remainder of this volume will be devoted to testing the validity of the proposition that unemployment in the United States has been systematically positively related to the adjusted real wage: higher adjusted real wages mean higher unemployment.
There is another way of expressing the basic hypothesis that unemployment is positively related to the adjusted real wage. Real wages are equal to money wages (W) divided by some price index (P), or W/P. Similarly labor productivity equals money output per hour (O) divided by a price index (P), or O/P. Assuming the same price index in both calculations, dividing real wages, W/P, by labor productivity, O/P, gives W/O. The latter expression is simply labor compensation as a proportion of total output (GNP, or using distributive-shares data, national or personal income). Thus the adjusted real wage can be measured by looking at labor’s share of personal income. If that share rises, the adjusted real wage is rising and, the theory predicts, unemployment should rise as well.6
While the theory as expressed above was not often or well articulated by the bulk of economists living in the first third of the twentieth century, few would disagree with it. At least one, A. C. Pigou, laid the theory out very explicitly and at great length.7 One obvious problem with the theory is that, at any given moment of time, there always was some unemployment, and the wage mechanism was never fully successful in completely clearing the labor market—unemployment never fell to zero.
Pigou recognized this, and considered “frictional unemployment” explicitly. At any given time, a certain number of workers would be temporarily between jobs; when one loses one’s job, it is unusual for the unemployed worker instantly to obtain new employment. Learning about job opportunities takes time and effort, and the fact that labor-market information is not costless and instantly available means that some unemployment is inevitable, as unemployment is traditionally defined.
Later economists, particularly in the 1960s, introduced the concept of structural unemployment, arguing that often there is a mismatch between the skills of those out of work and the skills needed for available jobs. Unskilled, unemployed construction workers cannot fill vacant positions for computer programmers.
The labor force can be defined to exclude those temporarily
