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The Unscientific Foundation of All Wage, Price, and Contract-term Controls

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Here’s a slightly amended and extended version of a comment [2] that I left on this EconLog post by David Henderson [3].

David: Excellent post, as usual.

The prevailing belief among many non-economists (and, sadly, increasingly among economists) is the deeply unscientific one that certain wages and prices – or, more generally, certain contract terms – are arbitrary. This belief is reflected, for example, in the fact that many people assert (or imply) that if government forces wages up from their prevailing market levels that the only consequences are distributional: sellers (workers) get more of the gains from trade while buyers (employers) get fewer. But (it is assumed) nothing happens to resource use. Minimum wages cause no reduction in the quantities of labor hours purchased (or a worsening of job conditions); ditto for mandated overtime pay; ditto for mandated leave, be it paid or unpaid.

A similar unscientific belief that prices are arbitrary lies at the foundation of the argument of those who insist that prohibitions on so-called “price gouging” merely prevent sellers from making unjust profits and protect buyers from paying unjustly high prices.  (I recall how in the 1970s defenders of the then-existing price ceilings on oil and gas in the U.S. argued for their position mostly by asserting that these ceilings prevent oil companies from making excess profits.)

An interesting and important question is: where does this unscientific belief in the arbitrariness of wages and prices come from? Such a belief is understandable and forgivable in non-economists; they’re not trained in price theory. But the economics profession today has in it a number of men and women (several of whom, such as Paul Krugman, are prominent) who write and speak about wages and (some) prices as if these are arbitrary – as if these wages and prices reflect no particular underlying reality. It’s a wholly untheoretical belief. Or, more accurately, it’s an unscientific theory of wages and prices in that it regards many wages and price to be set more or less randomly.

Note that it won’t work to defend the economists whom I refer to above by saying that these economists theorize that wages and prices are determined mostly by the greater bargaining power that employers and firms are (usually without much thought or evidence) simply assumed to have over workers and consumers. Even unusual bargaining power (for example, that which comes with a monopsony position in the labor market) will be fully exploited in the market by those who possess it. This full exploitation of bargaining power means that prevailing wages and prices are not arbitrary – forcibly raise such a wage and employers with monopsony power will adjust employment contracts on other margins in ways that will make most workers worse off. Forcibly lower the prices charged by a genuine monopolist and other of the terms of sale (e.g., product quality) will worsen.  The fact that the economists who advocate minimum wages or other price controls (or other arbitrary restrictions on terms of exchange) write or speak as if the only effects of such controls or restrictions are distributional reveals that these economists’ theory of wages and prices is nothing more than “wages and prices are determined randomly.”

Yesterday you had a lovely short post [4] on a Harry Markowitz [5] comment about Armen Alchian [6]. One lesson that cannot be missed by anyone who reads Alchian’s works [7] with any care is that competitive forces are robust. These forces are so robust, and the number of real-world margins on which they play out are so numerous and (often) subtle, that there is no excuse for any economist ever to treat wages and prices prevailing on markets as arbitrary. Such a treatment of wages, prices, and other contract terms is as unscientific as would be, say, an astronomer’s insistence that there’s nothing special about the particular orbit of the earth around the sun. Everyone would correctly reject as daffy the counsel of an astronomer who proposed to use a giant rocket to force the earth into an orbit at twice the distance from the sun as its current orbit. A similar rejection should greet the counsel of any economist who proposes to force wages, prices, and other contract terms from their current positions.

Putting this point differently (and in a way that is obviously inspired by Thomas Sowell [8]), to assume that minimum wages improve the lot of all low-skilled workers while harming none – to assume that prohibitions on so-called “price gouging” improve the welfare of all consumers while harming none – to assume that mandated family leave improves the well-being of workers while harming none – is to assume that reality is optional.  This assumption is about as unscientific as an assumption can be.  And, among the economists who use this assumption, it reflects a rejection of price theory.  Such economists, again, have no theory of price, at least not one worthy of the designation “theory.”

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