The art of economics consists in looking not merely at the immediate, but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group, but for all groups.
This is an ongoing series of posts on Henry Hazlitt’s Economics in One Lesson. You can access the Table of Contents here. Although written in 1946, it still touches on many of the issues we face in 2017, particularly the fallacies government economic programs are built upon.
Again, this is an extremely timely chapter written 50 years ago.
Amateur writers on economics are always asking for “just” prices and “just” wages. These nebulous conceptions of economic justice come down to us from medieval times. The classical economists worked out, instead, a different concept—the concept of functional prices and functional wages. Functional prices are those that encourage the largest volume of production and the largest volume of sales.
Functional wages are those that tend to bring about the highest volume
of employment and the largest payrolls. Oddly, the Marxists took over the concept of functational wages, which has then been promoted by their unconscious disciples, creating the “purchasing power” myth.
Marxist (socialists/central planners) insist that the only wages that will work to prevent an imminent economic crash are wages that enable labor to buy back the product it creates. They attribute every economic depression and recession to a preceding failure to pay wages that allowed this. And no matter the era they live in, they will insist that wages are still not high enough to buy back the product.
Unions use this argument all the time and quite effectively. They can’t persuade “wicked” employers to be “fair” and sometimes even the public doesn’t like their antics, but they know they can appeal to the public’s selfish motives and frighten it into forcing employers to grant their demands.
How are we to know, however, precisely when labor does have “enough to buy back the product”? Or when it has more than enough? How are we to determine just what the right sum is? As the champions of the doctrine do not seem to have made any clear effort
to answer such questions, we are obliged to try to find the answers for ourselves.
In theory the buy-back-the-product myth implies that workers in a given industry should receive enough income to buy back the particular product they make. So fast-fashion garment workers should be able to buy back the cheap clothes they make?
In Hazlitt’s time, the automobile industry’s union workers were already in the top third of the country’s wage earners. Their weekly wage, according to government figures, was 20 percent higher than the average wage paid in factories and nearly twice as great as the average paid in retail trade. Yet when Hazlitt wrote this book, they were demanding a 30 percent increase so that they might, according to one of their spokesmen, “bolster our fast-shrinking ability to absorb the goods which we have the capacity to produce.”
Dad would have said “bully for the car union workers”, but Mom would have pointed out that the average factory and retail worker couldn’t afford to buy the cars the auto union workers produced. Hazlitt estimated workers in those industries would require wage increases of 55 to 160 percent to give them as much per capita purchasing power as the automobile workers?
The argument that labor should receive enough to buy back the product is merely a special form of the general “purchasing power” argument. The workers’ wages, it is correctly enough contended, are the workers’ purchasing power. This neglects the fact that the grocer, landlord and even the employer must also have purchasing power to buy what others sell.
And one of the most important things for which others have to find purchasers is their labor services.
In an exchange economy everybody’s income is somebody else’s cost. An increase in wages must be compensated by an increase in productivity, otherwise, it becomes an increase in the cost of production, which increases prices. If government controls prices and forbids any price increase, then increases in the cost of production forces marginal producers out of the market, causing a shrinkage in production and a growth in unemployment.
Even where a price increase is possible, the higher price discourages buyers, shrinks the market, and also leads to unemployment. If a 30 percent increase in hourly wages all around the circle forces a 30 percent increase in prices, labor can buy no more of the product than it could at the beginning; and the merry-go-round must start all over again.
The problem is that we don’t think long-term. A 30 percent increase in wages can force a 30 percentage or greater increase in prices only over the long run. .If money and credit are so inelastic that they do not increase when wages are forced up, then the chief effect of forcing up wage rates will be to force unemployment. Total payrolls, both in dollar
amount and in real purchasing power, will be lower than before. For a drop in employment necessarily means that fewer goods are being produced for everyone.
And it is unlikely that labor will compensate for the absolute drop in production by getting a larger relative share of the production that is left.
The belief that the price increase would be substantially less than the increase in wages rests on two main fallacies.
The first looks only at the direct labor costs of a particular firm or industry and assumes these to represent all the labor costs involved. But this is the elementary error of mistaking a part for the whole. Each “industry” represents not only just one section of the productive process considered “horizontally,” but just one section of that process considered “vertically.” Thus the direct labor cost of making automobiles in the automobile factories themselves may be less than a third, say, of the total costs; and this may lead the incautious to conclude that a 30 percent increase in wages would lead to only a 10 percent increase, or less, in automobile prices.
This overlooks the indirect wage costs in the raw materials and purchased parts, in transportation charges, in new factories or new machine tools, or in the dealers’ markup.
Government estimates show that in the fifteen-year period from 1929 to 1943, inclusive, wages and salaries in the United States averaged 69 percent of the national income. These wages and salaries had to be paid out of the national product. While there would have to
be both deductions from this figure and additions to it to provide a fair estimate of “labor’s” income, we can assume on this basis that labor costs cannot be less than about two-thirds of total production costs and may run above three-quarters. If we take the lower of these two estimates, and assume also that dollar profit margins would be unchanged, it is clear that an increase of 30 percent in wage costs all around the circle would mean an increase of nearly 20 percent in prices.
But such a change would mean that the dollar profit margin, representing the income of investors, managers, and the self-employed, would then have, say, only 84 percent as much purchasing power as it had before. The long-run effect of this would be to cause a diminution of investment and new enterprise compared with what it would otherwise have been, and consequent transfers of men from the lower ranks of the self-employed to the higher ranks of wage earners, until the previous relationships had been approximately restored.
[T]his is only another way of saying that a 30 percent increase in wages under the conditions assumed would eventually mean also a 30 percent increase in prices.
Equilibrium wages and prices are the wages and prices that equalize supply and demand. If, either through government or private coercion, an attempt is made to lift prices above their equilibrium level, demand is reduced, followed by a reduction of production. If an
attempt is made to push prices below their equilibrium level, the consequent reduction of profits will mean a falling off of supply or new production. Therefore an attempt to force prices either above or below their equilibrium levels (which are the levels toward
which a free market constantly tends to bring them) will act to reduce the volume of employment and production below what it would otherwise have been.
The national product is not created or bought by manufacturing labor alone. It is bought by
everyone—by white collar workers, professional men, farmers, employers, big and little, by investors, grocers, butchers, owners of small drug stores, and gasoline stations—by everybody, in short, who contributes toward making the product.
As to the prices, wages, and profits that should determine the distribution of that product, the best prices are not the highest prices, but the prices that encourage the largest volume of production and the largest volume of sales. The best wage rates for labor are not the
highest wage rates, but the wage rates that permit full production, full employment, and the largest sustained payrolls. The best profits, from the standpoint not only of industry but of labor, are not the lowest profits, but the profits that encourage most people to become employers or to provide more employment than before.
By trying to run the economy for the benefit of restricted groups or classes, the central planners injure all groups, including the members of the very class for whose benefit they are trying to run it.
We must run the economy for everybody and that’s a highly complex calculation that has proven impossible time after time.