Questions About Falling Wages

On Monday, economist/pundit Paul Krugman wrote a column about the problems of falling wages. The general free market theory is that if wages are falling, then prices must be falling as well as companies using the saved capital to reduce costs. However by his estimation:

“Suppose that workers at the XYZ Corporation accept a pay cut. That lets XYZ management cut prices, making its products more competitive. Sales rise, and more workers can keep their jobs. So you might think that wage cuts raise employment — which they do at the level of the individual employer.

But if everyone takes a pay cut, nobody gains a competitive advantage. So there’s no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy’s problems on other fronts. In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt…”

Ok, so here is my first question: why do we assume that, in real life, an entire industry in tandem will be able to cut costs equally, leading to a complete neutralization of costs and no competitive advantage? I realize that many free market economic models often assume constants that seem somewhat unrealistic (and am willing to entertain those critiques), but here I think the push back is fair.

However, lets take Krugman’s assumption on its face. We’ll grant for the sake of argument that if all the wages of XYZ industry are reduced by 5% in tandem, it won’t make products in that industry more competitive (and thus won’t increase employment potential). But even though products aren’t more competitive, the firms still do have more money on hand, an increase relative to their wages cut. And assuming that firms pay differently (though competitively), this means firms will have varying amounts of extra capital. Those firms will then put that capital to use, likely towards innovating their product. This could lead to reduced production costs, more efficient technology, industry breakthrough, or nothing at all. In any case, for an industry with multiple firms, there will be varied outcomes.

Those varied outcomes will lead to changes in the marketplace. Those changes don’t mean all will grow, but they don’t mean all will decline in profits. In fact it is highly unlikely that a 5% increase in expense spending will hurt a firm. It is also highly unlikely that every firm will receive the exact same increase in quality and some might become more productive/competitive than others.

Therefore, while falling wages don’t necessarily translate into jobs (in the Krugman assumption scenario), it doesn’t mean they can’t. And his assumption scenario certainly doesn’t mean they absolutely won’t. Wage cuts aren’t inherently a bad thing, particularly if the wages were unsustainable in the first place (think financial industry or the Beanie Baby bubble executive pay scandals).


Mario Rizzo also had a critical response to Krugman here.