Common to all theories of unemployment discussed above is the implicit assumption that unemployment persists and is often caused by excessive wages. Moreover, unemployment is caused either by shifts in demand for labour or supply of labour, not both. The discussion in section 2 underscores the fact that factors that affect both supply and demand for labour have been responsible for the unemployment rise. Hence, none of the theories above can claim to be an exhaustive theory of unemployment. Moreover, New Keynesian theories fail to explain why labour demand, in proportion to the population of working age, has not increased strongest in the countries with the smallest increase in the wage gap. New Classical theories fail to explain why the labour participation rate has not increased most in countries with the strongest increase in the after tax real wage. It appears therefore that the search for an adequate theory of the OECD unemployment needs to continue.
4 Wages and Unemployment: The Disequilibrium Wage
Hypothesis
The link between real wages and unemployment plays a pivotal role in unemployment theories. The theoretical and empirical links are discussed below and the real wage gap theory associated with Bruno and Sachs (1985) is evaluated.
4.1.1 The Theory of Real Wages and Employment
The negative relationship between real wages and employment
is derived from the neoclassical system of perfect
competition, where employment is set at the point where the real wage is equal to the marginal productivity of labour. A decrease in the real wage increases employment via the assumption of a diminishing marginal product of labour.
The assumption of imperfect competition does not change the principal hypothesis of a negative relationship between
real product wages and employment. Assuming that the
capital stock, the marginal user costs, and the marginal wage rate, are fixed, labour demand can be derived as follows. Given profit maximization as the firms objective
max P ° Y - W N - R K
where R is cost of capital, P° output prices, Y GDP, W wages and N employment the first order condition for profio
maximization is P° = 8 (W N + R K) /5y under perfecn
competition. Under imperfect competition on the gooes
market and constant factor prices we get
where (I = 1 + 1/rj and rj is the price elasticity of demand.
Assuming that 8k/8y is zero and a homogeneous Cobb-Douglas
production function, Y = (AN)aK 1-a, then
P° = |i W/ (AaaNa-1K 1_a) .
Isolating N on the left hand side, with lowercase letters in logs, gives
n = - 1 / (a - l)log a + 1 / (a - l)log}i + a/(a - l)log A
+ k + 1 / (a - 1) (w - p°) . (1)
Since a < 1 a negative relationship exists between real product wages and employment.
Since firms are never demand constrained in the
neoclassical world, secondary demand effects of changes in
wages are unimportant. If firms are demand constrained as a possibility allowed for in the Barro and Grossman (1971) model, in the sense that firms wish to produce more than they are able to sell at prevailing prices, an increase in
wages in excess of value-added prices and productivity may
affect employment via following channels: 1) A higher
propensity to consume out of wages than profit, at least in
the short-run, increases demand. 2) A capital loss on
financial assets, when wages increase is announced and
realized, curbs consumption via the wealth effect in the
product wages have an impact on employment via investments in the long-run. Lower profitability affects investments through the profitability constraint and the financing constraint. In the former, due to Tobin (1969), investment is undertaken if the stock capitalization is in excess cf the replacement value of capital. The latter is due to Catinat et al. (1988) where internal financing cf investments may be constrained by low profitability. This in turn, affects the external financing since a lack cf internal funds is likely to hamper the access to external credit.
4.1.2 Empirical Evidence on the Relationship Between Real Wages and Employment
The real wage-employment relationship has been studied extensively. Most studies find a statistically negative relationship between employment and real wages (Hammermesh (1986)) but the evidence is mixed. Some studies, notably the study by Geary and Kennan (1982), however, fail to find a negative relationship between employment and real wages. Nickell and Symons (1990) show that this outcome is likely to be due to the use of an inaccurate price-deflator. Summers (1987) has pointed out that empirical studies with lagged real wages in the labour demand function may find a spurious negative relationship for the following reason: If firms increase prices, due to a surge in demand in the first period, but then increase the supply of goods and
demand for labour in the next period, a negative relationship is established since real wages have been falling in the first period. Anyadike-Danes and Godley (1989) demonstrating a similar point by finding a significant negative relationship between employment and real wages with generated data from a model without any causal link from real wages to employment. In order to avoid the possibility of a spurious employment-real wage relationship due to the possibility of a price rise ahead of a wage rise, chapter 3 of the thesis estimates the employment-real wage relationship using five and seven years differences in the variables to measure changes in employment and real wages for 22 OECD countries. Employment is found significantly to be negative correlated with real w a g e s .
The secondary demand effects of an increase in the disequilibrium wage that I discussed in the previous section are hard to quantify and much influenced by the often intangible reactions of credit and financial markets. If firm profitability is "high" the impact of a wage rise on employment via credit and financial markets is likely tc be low. Concerning investments, the impact of profitability has not been studied much empirically. Catinat et al. (1988) find profitability to be a statistically significant determinant of investment, but its quantitative impact or. investments is low.