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The Too-Easy Partiality of General-Equilibrium Assertions

Posted By Don Boudreaux On February 26, 2013 @ 8:10 am In Economics,Work | Comments Disabled

Commenting on this post [1], Brandon Forester writes:

I think the problem here is that you think that ceteris paribus is a real thing that can exist in the real world. It’s not. Price of X goes up thus demand for X goes down isn’t the end of the model when discussing something as complex as labor markets and how wages affect consumption, productivity and demand. It’s quite possible that a raise in the wage of workers who turn their increased wages directly into increased consumption (of retail, services and other industries that employ minimum wage workers) could have an impact on demand for those goods and services that results in a net increase in the demand for low wage labor. An increase of poverty wages can also have an effect on productivity of these workers. Increased productivity would have a similar effect to lowering the price of labor. Saying simply that raising the price floor for labor would have a net decrease and denying the possibility that it could have little, no or even a positive effect on the demand for labor in the long term is resigning yourself to the kind of shallow evaluation that precisely a week of econ 101 would prepare you for.

Mr. Forester is correct that ceteris paribus seldom, if ever, holds true in reality – especially in social and economic reality.  And this fact is precisely why ceteris paribus theorizing is so crucial.  Our theories are meant to give us mental pictures of parts of reality.  To take mental snap shots of any part of reality that we wish to better understand, we cannot rely upon reality itself to isolate for us those parts of itself – those parts of reality – that we’re most interested in understanding.  So we theorize, and in theorizing we economists (as do all scientists) use ceteris paribus restrictions.  To use such restrictions is no sign that the scientist really believes that ceteris is paribus - or that ceteris should be paribus.  To use such restrictions is simply an unavoidable part of thinking seriously about an ever-changing and complex reality.

Mr. Forester is also correct that (and here I use economists’, not his, terms) partial-equilibrium analysis differs from general-equilibrium analysis.  Understanding a part of the economy, working in isolation, is not necessarily to understand that part of the economy as it is connected to the larger economy.  What is true for that part of the economy were it isolated from the rest of the economy might well not be true for that part of the economy when the effects of changes in extend outward to other parts and then, in turn, the reactions from the other parts of the economy work their way back to affect M.

But in order to legitimately dismiss the lessons of partial-equilibrium analysis because of alleged contrary feedback from the larger, general economy, one needs more than just-so stories or hypotheticals.

Mr. Forester, alas, has only these.  It’s possible, of course, that a higher minimum wage will cause low-skilled workers to spend more in the aggregate and this greater spending will so increase aggregate demand that the demand for low-skilled workers will rise rather than fall.  Possible.  But this much-told story – even politicians such as Pres. Obama repeat it – is inadequate to compel us to abandon the lessons of the partial-equilibrium analysis that says that a mandated higher cost of employing low-skilled workers will reduce the employment options open to such workers.  The reason it is inadequate is that, for this ‘higher-demand-feedback’ story to be sufficiently compelling, someone must explain – not merely imply or assert – that (1) higher hourly wages will in fact result in more money overall in low-skilled workers’ pockets, and (2) that the additional money so forced into the pockets of low-skilled workers would not have been spent otherwise.

A mandated minimum wage might so reduce the quantity demanded of low-skilled workers that, although some of these workers – those who remain employed – have higher disposable incomes, the reduction to $0.00 per hour of the wage earned by workers thrown into unemployment by the minimum-wage requirement renders the amount of disposable income earned per period of time by low-skilled workers lower than it would be without the minimum wage.  If this scenario holds – and it is not at all unreasonable to say that it might indeed hold – then the very general-equilibrium effect that Mr. Forester, Mr. Obama, and so many others point to with confidence as a justification for raising the minimum wage undermines, rather than supports, their case.

Similarly, even if a higher minimum wage results in greater aggregate disposable income for low-skilled workers, what reason is there to believe that the higher total wages paid to such workers would not have been spent otherwise by those employers not obliged to pay more in total wages?  If the assumption is – as I believe it must be – that these employers were, before the hike in the minimum wage, sitting idly on hoards of cash, then it seems likely that these employers were so frightened of the investment and business climate that they chose indeed to sit on such hoards rather than to put it to productive use.

It’s not at all clear that regulatory policy that forces greater expenditures on L will so relieve businesses and investors of their concerns about the state of the economy that they do not attempt to cut back on their expenditures on K or on some other margins of their operations.

It’s not remotely enough clear that a higher minimum wage will cause aggregate demand to rise in such as way as to swamp the very clear predictions of the partial-equilibrium theory that predicts that a higher cost of employing low-skilled workers will prompt employers to employ such workers for fewer hours.

Likewise for the assertion that employers generally are too dumb to figure out, in the absence of a mandated higher minimum wage, that paying a higher wage to low-skilled workers might actually increase employers’ profits.

…..

To show how easy it is to disorient oneself from rigorous thinking about economic reality by pretending that one’s imaginations about general-equilibirum effects swamp those of the partial-equilbirium model, consider the following scenario.

Pres. Jones, in the 2023 State of the Union Show, calls on Congress to impose maximum wages.  ”By making it unlawful to pay workers more than $10 per hour, our economy will boom,” thunders the president, to the applause of his party.  The president explains: “Some say that a maximum wage will create a shortage of workers, which would admittedly be bad for business.  But because under my proposal firms will spend less on labor, firms will have more money to invest and to innovate.  R&D and business expansion will accelerate mightily.  And the resulting fall in the prices of goods and services will mean that each worker’s ten-dollars per hour pay will buy so much more for him and his family.  With $10 able to buy so much more, many more people would be willing to work for $10 per hour.  The new equilibrium wage, as my economist advisors call it, would become $10.”

Pres. Jones story is absurd, of course.  But it’s possible that the scenario he spells out will come to pass.  Yet surely no one would leap from this possibility to the conclusion that the results of the partial-equilibrium model ought to be cast aside and replaced with this more general-equilibrium story.

I believe that the results of the partial-equilibrium model as it explains the consequences of a minimum wage are not to be abandoned simply because some people can tell general-equilibrium stories that, if these stories were true, would render the model’s prediction false.

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