November 3, 2015

The key relationship between employment and wage rate

Comment on Lars Syll on ‘Wage cuts — the ultimate atomistic fallacy’


Orthodox economists know it, heterodox economists know it: the market economy does not work as standard economics says. This holds — with damaging consequences — in particular for the labor market.

The core of labor market theory, purified from the myriad of idiosyncratic variants, goes as follows “We economists have all learned, and many of us teach, that the remedy for excess supply in any market is a reduction in price. If this is prevented by combinations in restraint of trade or by government regulations, then those impediments to competition should be removed. Applied to economy-wide unemployment, this doctrine places the blame on trade unions and governments, not on any failure of competitive markets.” (Tobin, 1997, p. 11)

Until this day, the representative economist has not realized that the overall systemic interdependencies establish a positive feedback loop between ‘the’ product and ‘the’ labor market, that is, wage rate down → employment down → wage rate down → and so on. Vice versa with an increasing average wage rate. The market system is no equilibrium system. All equilibrium models are a priori false.

The most elementary version of the axiomatically correct Employment Law is given on Wikimedia AXEC62
From this equation follows inter alia:
(i) An increase in the expenditure ratio ρE leads to higher employment.
(ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite.
(iii) An increase in the factor cost ratio ρF≡W/PR leads to higher employment. This implies that a higher average wage rate W leads to higher employment. This is, of course, contrary to conventional economic wisdom. It is, though, easy to prove that conventional wisdom is a mere Fallacy of Composition (2015).
(iv) The complete Employment Law is a bit longer and contains in addition profit distribution, public deficit spending, and the trade balance with the rest of the world. As a matter of principle, the structural Employment Law contains only measurable variables and is testable. Hence, matters can be settled once and for all.

Point (i) and (ii) are well-known Keynesian stuff. Let us focus here alone on the factor cost ratio ρF as defined in (iii). This variable embodies the macroeconomic price mechanism which, however, does not work as the representative economist hallucinates. As a matter of fact, overall employment increases if the average wage rate W increases relative to average price P and productivity R.

The correct employment theory states that the average wage rate must rise in order to prevent unemployment and deflation. For the relationship between real wage, productivity, profit, and real shares see (2015, Sec. 10)

With the provably false standard employment theory economists bear the intellectual responsibility for the social devastation of unemployment. Since Keynes gave his diagnosis in ‘The Great Slump of 1930’ every economist could know that ‘what we economists have all learned, and many of us teach’ is dead wrong.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL
Tobin, J. (1997). An Overview of the General Theory. In G. C. Harcourt, and P. A. Riach (Eds.), The ’Second Edition’ of The General Theory, Vol. 2, 3–27. Oxon: Routledge.