Market Clearing in the Aggregate Labor Market - Essay Example

Market clearing describes a situation where the aggregate economy is capable of generating enough purchasing power to satisfy the aggregate output of the economy. This then implies that the aggregate output value of the economy equals its aggregate purchasing value (Keynes, 1936). Put differently, the aggregate demand of the economy will be equal to its aggregate supply. As to whether it is appropriate to regard the aggregate labor market as market clearing one, I would want to disagree because there are many factors which come into play in the long run and the labor market may not always clear (Rima, 2001). This paper will present and discuss and evaluate the labor market equilibrium under different scenarios including restricted and unrestricted markets. First is a background review of the market clearing concept. In the late 18th century, there were concerns in France about possibility that markets may fail to clear; causing a “glut of output”. These concerns had emerged because central authority in France directed output toward luxury goods primarily for export to earn gold. As a result, there was growing fear that French purchasing power would be weakened. This fear was later suppressed by the advent of Say’s “law of the markets” in 1803 which was simply summarized to mean “supply creates its own demand”. Jean-Baptiste Say argued that the production process spawns corresponding flow of factor payments hence eliminates possibility for purchasing power shortage. In the 19th century, John Stuart Mill introduced Say’s reasoning into England and was used till 1930s when John Maynard Keynes’ theory shifted focus to incorporate the relationship between economic activity and shifts in monetary aggregates (Davidson, 1972). According to Keynes, Say’s law was deficient since it argued on the basis of a barter economy in which money would have no significant role other than as a means of exchange, which according to Keynes, would not be a true reflection of the aggregate demand and supply functions in the market (Keynes, 1936). Keynes maintained that the “aggregate demand curve in a monetary economy does not coincide with the aggregate supply curve”(P. 109). Keynes therefore argued that at any specified level of technical knowhow, involuntary unemployment in an economy reflects the economy’s resource capability deficiency to support aggregate effective demand (Keynes 1936; Weintraub 1966). Those who agreed with Keynes based their arguments on the fiscal policy. They believed that lower tax revenues and higher government bond sales financed expenditure would through the multiplier effect increase aggregate expenditure. This would cause market clearance at a higher income level in both the product and labor markets. Subsequently therefore, the normal equilibrium (market clearing) state of the economy would occur when there is full employment (i.e. when aggregate demand equals aggregate supply). Keynes theory was reinterpreted by John R. Hicks who introduced the abstinence theory which looked at savings as a function of both the income and the interest rate. This would be clear if Hicks’ abstinence theory would be joined with Keynes’ liquidity preference theory by an intersection of the IS and the LM curves. At that point of intersection, “the savings function, the investment function, the system’s monetary stock, and the liquidity preference function” produces the interest rate determinant (Rima, 2001). Therefore Hicks and Alvin Harvey Hansen redefined and integrated Walra’s general equilibrium by mathematically demonstrating that, “ all markets are inter-reliant and are capable of clearing product and factor markets concurrently with an auctioneer’s direction through whom the players re-contracted, until jointly fulfilling trade is established” (Hansen, 1953). The neo-Walrasian approach, which was primarily a counter revolution against Keynes, asserted that flexible wages and prices characterize the economy’s market clearing ability. According to Patinkin, Keynes failed to acknowledge the impact of fluctuations of prices on the real value financial balances and assets in equilibrium restoration in the product, bond and labor markets (Patinkin, 1956). Later developments and researches were directed towards addressing the inadequacy in the Keynesian Framework. More specifically, efforts were tailored establishing why rigidities have continued to persist in both price and wages causing failure for markets to clear and to evaluate results attained through coordination efforts (Weintraub, 1979). The need for workers by business firms drives them into the market to source for labor. In the market, labor is not for free. Therefore, the amount of labor demanded by a given firm will be influenced by the firm’s own needs and the market wage. Usually, a firm will purchase labor up to a point where the marginal revenue product (MRP) of labor equals the market wage. MRP in this case, refers to the additional revenue a firm derives purchasing an additional unit of labor (Rima, 2001). Firms will continue to employ more labor as long as MRP of labor is more or equal to the additional hours of work. A firm will be said to operate at optimal capacity when MRP of labor is equal to the market wage. Where MRP of labor is less than the market wage, the firm will be utilizing excess labor hence need for readjustment. These scenarios can be summarized as below: MRP > w: firm will buy more labor MRP = w: firm is operating at optimal capacity MRP < w: firm is purchasing excess labor The law of diminishing returns explains why labor demand reaches optimal point when MRP=w. As a firm employs more workers, an extra hour of labor paid for produces larger additional income. But as more time is input by the workers, less marginal revenue will be realized from each extra hour worked. The reason could be that additional labor input would result into surplus output surpassing demand, or simply because additional labor at one point may become fruitless (Patinkin, 2008). Fig.1: Diminishing Returns in the MRP of Labor. Source: http://www.sparknotes.com/economics/micro/labormarkets/labordemand/. Since the firm aims at making profit, it will show willingness to hire more labor or to pay for an additional work hour as long as MRP>W. The firms MRP curve can thus represent the firm’s labor demand curve. As MRP of labor falls, so does the firms demand for labor and vice versa (Keynes, 1936). Fig: 2: Labor Demand Curve. Source: http://www.sparknotes.com/economics/micro/labormarkets/labordemand/. Fig. 3: Firm’s profits. Source: http://www.sparknotes.com/economics/micro/labormarkets/labordemand/. The aggregate demand curve for labor can be attained by summing up all individual labor demand curves. The intersection between the aggregate labor supply curve and the aggregate labor demand curve will give the labor market equilibrium. But this market clearing scenario will not be the case where there is artificial restrictions in the market e.g. a minimum wage. In the next section, we consider various possibilities: There may be an unrestricted labor market with shifts in either the supply or demand curves. Considering two complimentary goods m and c, if the price of m increases, demand for c will drop. When demand for c drops, the price for c falls. The drop in price for c reduces the MRP of workers in the c industry. This is because for example, if Fred is able to produce 2000 packets of c per day, his MRP would be $2000 a day if the price was $2 a packet. If price falls to $1 a packet, Fred can still produce only 2000 packets a day, and his MRP has gone down to $1000. MRP is the product of marginal product of each worker and the price (MRP= (P) x (MP) (sparknotes, 2011). Fig.4: Drop in MRP of Labor. Source: http://www.sparknotes.com/economics/micro/labormarkets/labordemand/. Since the MRP reflects the firms labor demand curve, a drop in MRP above will imply a drop in the firm’s demand for labor (in our example, Fred will put in fewer work hours); Fig.5: Drop in MRP of Labor. Source: http://www.sparknotes.com/economics/micro/labormarkets/labordemand/. On the other hand, a drop in MRP of labor will impact on all the firms in the c industry hence affect the aggregate labor demand curve. Therefore the aggregate demand curve will also shift inwards. If no change occurs in the supply of labor, the overall effect will be to reduce the wage paid to c workers. Fig.6: Drop in Wage. Source: http://www.sparknotes.com/economics/micro/labormarkets/labordemand/. It may not however be true to assume that a drop in the price of m in reality would drastically affect the c industry. The likely impact is smaller compared to the foregoing scenario. This may be due to fact that c industry workers might as well find better salaried jobs elsewhere, causing the labor supply curve to shift inwards, hence reducing the quantity of labor utilized in the c industry, which would result into higher wages to c workers (sparknotes, 2011). Fig.7: Shift in Labor Supply. Source: http://www.sparknotes.com/economics/micro/labormarkets/labordemand/. If the demand curve was to shift first followed by a shift in the supply curve, an intermediate equilibrium would observed as above. However, if the two shifts occur simultaneously, the equilibrium would be seen to shift directly from D1S1 Q1W1 to D2 S2 Q2W2. Next we consider a situation where the market is restricted. Just like in the commodity and services market where the government may impose some artificial controls in the market, the government may regulate the labor market through income tax and minimum wage controls. These would significantly influence the operation of the labor market. An example would be where a government imposes a progressive tax regime. This is where a worker pays more tax as his income increases. As a result, the worker’s incentive to work declines with increase in pay because either, he is contented with what he already has or because he feels he is working s hard to earn less (Patinkin, 2008). Considering a scenario where there is a minimum wage set by government for firms to comply with, it has the same effect as that of a price floor. Where the equilibrium wage is above the minimum wage, there will be no discernible impact on market arising from the minimum wage. On the other hand, if the equilibrium age is lower than the minimum wage, there will be a labor surplus. At that high minimum wage point, the aggregate supply is higher than the aggregate demand hence there will be unemployment situation (excess labor). Some of the workers willing to work for the fixed wage will not find anyone to employ them. Fig.8: Labor Market with a Minimum Wage. Source: http://www.sparknotes.com/economics/micro/labormarkets/labordemand/. The immediate concern is whether setting a minimum wage is desirable. Some scholars have argued that absence of the minimum wage will result to lower unemployment although employees would not earn sufficient wages to sustain their personal and family needs. On the other hand, imposing a minimum wage would yield more income to the employed although many more employees will fail to get employment hence remain unproductive and dependent on the employed (Sparknotes, 2011). The minimum wage continues to be a controversial debate because it may not be very clear who it may hurt most. Ironically, proponents of the minimum wage believe that the minimum wage would help the bottom-line employees. In reality however, firms usually endeavor to retain skilled employees at all costs. Therefore when a minimum wage is imposed necessitating cost cutting measures, the so called bottom-line worker will be the first casualty, yet the minimum wage was initially meant to help him. This is because the MRP of the “unskilled” bottom-line worker may be lower than the new minimum wage (Sparknotes, 2011). To conclude this discussion, it is important to revisit Walra’s Law which was briefly mentioned in the previous sections. Walra’s law posits that totals of excess demands in all markets must equal zero, regardless of whether there exists equilibrium in the economy or not. The interpretation of this law is that any positive excess demands existing in one market will be cancelled by equivalent negative excess demand in one other market hence all markets must clear at any given time (Patinkin, 2008). In a general equilibrium formulation, if the model has m agents, and n products, market clearing may be imposed for n-1 commodities, and introduce the n-th market clearing condition. For instance, budget constraints for m agents may be included, plus any extra equations depicting the agent’s best possible actions. The significance of the agents’ budget constraints renders redundant the n-th market clearing condition hence serves to ensure Walra’s law holds. According to Walra’s law, if the only commodities in the market are laptops and desktops, in the absence of any other market, if excess demand for laptops is zero, then it follows that by Walra’s law, excess demand for desktops is also zero. Excess demand for desktops would mean (a surplus, or negative excess demand) for desktops; and the market value for the excess demand for desktops will equal the market value of the excess supply of desktops (Weintraub, 1966). For Walra’s Law to hold, every agent’s budget constraint must hold with equality. The agent’s budget constraint is simply the equation which indicates that the sum of market value of the panned spending of the agent must equal the sum of the market value for the agent’s expected revenue. If this happens, the agent will neither be willing to acquire goods for free nor give away any goods for free. The implication for Walra’s law in the labor market is that when all product markets are in equilibrium, it follows that the labor market will also be in equilibrium. This is a position that has been criticized by many as not realistic especially for a macroeconomic modeler to say "let us assume that all markets are in equilibrium except the labor market" (Weintraub, 1966). In summary therefore, it may not be appropriate to regard the labor market as market clearing because it will entail assuming a number of critical variables constant which ordinarily will not reflect the normal market operations. For instance, we have seen the cases where there are market restrictions in the labor market. Although followers of Walra’s law will hold a different view, I do not think there is sufficient reason to maintain that the labor market is market clearing. References: Davidson, P. 1972. Money and the Real World. 2nd ed. London: Macmillan. Hansen, A. H. 1953. A Guide to Keynes. New York: McGraw-Hill. Hicks, J. R. 1937. Mr. Keynes and the Classics: A Suggested Reinterpretation. Econometrica 6: 147–159. Keynes, J. M. 1936. The General Theory of Employment, Interest, and Money. New York: Harcourt, Brace. Patinkin, D. 1965. Money, Interest, and Prices. 2nd ed. New York: Harper and Row. Patinkin, D. 2008. "Walras's Law," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract. Rima, I.H. 2001. Development of Economic Analysis. 6th ed. London and New York: Routledge. SparkNotes Editors. (n.d.). SparkNote on Labor Demand. Retrieved March 26, 2011, from http://www.sparknotes.com/economics/micro/labormarkets/labordemand/ Weintraub, E. R. 1979. Microfoundations. Cambridge, U.K.: Cambridge University Press. Weintraub, S. 1966. A Keynesian Theory of Employment Growth and Income Distribution. Philadelphia: Chilton. Read More