Do Lower Wages REALLY Increase the Natural Level of Output? Aren’t They Missing Something?

One thing that is seen sometimes is a strange teaching in economics and business. The teaching says that lower costs of production will increase the natural level of real GDP output.

Now the natural level of real GDP output is considered the limit at which the economy can produce. It is seen as the total productive capacity of the economy. The full-employment of the natural rate of unemployment is found there too. It is traditionally determined by looking at available factors of production at full-employment. Once real GDP reaches its natural level, output slows down and increased demand results in higher prices instead of more output.

However, some schools teach and therefore many businessmen have it in their heads that lower wages, which are a cost of production, will increase the total productive capacity of the economy.

Here are some links to examples…

• University of North Carolina’s Euro Challenge competition for high school students…

“The long-run supply curve can shift when the costs of production change. Examples of changes to the long-run aggregate supply curve:

• A restriction on immigration reduces the number of workers available, and thus increases the cost of production (wages will be higher).
• The reduction in the required minimum wage allows firms to hire more workers at less cost.

• Economics online from the UK…

“The effects of an increase in capital investment

“The initial impact of investment is on the AD (aggregate demand) curve, which shifts to the right as investment (I) is a component of AD,

“In the long run, the investment will increase the economy’s capacity to produce, which shifts the LRAS curve to the right. Finally, it is likely that production costs will fall as new technology increases efficiency and reduces average costs. This means that the SRAS curve shifts to the right. The combined effects are that the economy grows, both in terms of potential output and actual output, without inflationary pressure.

Here is a source that does a good job at explaining why lower wages would increase the potential output at the natural level… They show how higher wages and lower wages can increase the natural level of output. But this example still makes a critical error.

• Macroeconomics Principles, authors Libby Rittenberg and Tim Tregarthen.

“In Panel (a), an increase in the labor supply shifts the supply curve to S₂. The increase in the supply of labor does not change the stock of capital or natural resources, nor does it change technology—it therefore does not shift the aggregate production function. Because there is no change in the production function, there is no shift in the demand for labor. The real wage falls from ω₁ to ω₂ in Panel (a), and the natural level of employment rises from L₁ to L₂. To see the impact on potential output, Panel (b) shows that employment of L₂ can produce real GDP of Y₂. The long-run aggregate supply curve in Panel (c) thus shifts to LRAS₂. Notice, however, that this shift in the long-run aggregate supply curve to the right is associated with a reduction in the real wage to ω₂.”

Behind these examples is a belief that the presence of a minimum wage will reduce the demand for labor, thus cutting people out of the labor force, thus reducing the numbers of people that will work, thus reducing long-run potential output.

If we look closely in the above examples, we will see an error in understanding. They view the supply and demand for factors of production affecting long-run output, but they do not view the supply and demand for money used for consumption affecting long-run output. The examples above do not include the fact that if real wages are lower, ultimate demand for production will be lower. Thus, they see more long-run production, but they don’t see the reduction in potential consumer demand.

All across the advanced countries we have been seeing a decline in labor’s share of national output. With this, we see a stagnation of real wages and an increase in corporate profits. Thus, the portion of output income that is given to labor to buy production is less. Do companies really think that lower real wages will keep long-run natural output from falling? Ultimately, at some point, weak consumer demand will be the limiting factor upon the long-run natural level of output.

The effective limit of demand upon the long-run natural level of output is called the effective demand limit.

It is a good idea to include an idea like the effective demand limit in the models for the long-run natural level of output.