The General Theory Chapter 2 (the sixth of six parts)

Again our Guest Blogger BF

Let’s go off on a bit of a tangent here – just how fundamental was that second postulate, that the observed wage-labour combination lies on the labour supply curve – to the classics?  Well, Adam Smith bought into it.  In Wealth of Nations, Smith developed what is sometimes described as a labour theory of value but what is better described as a disutility of labour measure of value.  Smith took the view that human beings were all pretty much of a muchness.  He argued that a certain type of basic labour effort (low skill agricultural labour perhaps?) yielded the same disutility at all times and in all places.  He also took the view that the wage for that labour – whatever the currency units or whatever payment medium might be involved – would just compensate for the disutility of a quantity that basic labour.  There’s the second classical postulate.  That meant that if you wanted to compare costs and standards of living across times and places, you should start by finding out what the pay was for that basic type of labour.  On a purchasing-of-disutility power parity basis, those amounts could be taken as being equivalent, and you could do your comparisons of costs, incomes and relative standards of living starting from there.

Turning back to Keynes, notice that what he’s rejecting is the second classical postulate, not the first one – not the one which says that the observed wage-labour point lies on the labour demand curve, so labour is paid the value of its marginal product.  You might ask (at least, my students do ask) why, if a firm found itself lying below the labour VMP curve, so that it was paying a wage less than the value of the marginal product of the labour it was employing, it didn’t just sit there, and pocket the difference.  Because it doesn’t – it increases the quantity of labour it employs until it’s moved, horizontally, onto the VMPL curve, increasing its output as it goes.  So to get back onto the VMPL curve it doesn’t raise the wage it’s paying, rather it increases the amount of labour it employs, and it does this because each of those additional units of labour adds more to revenue (by producing output, which the firm sells) than it does to cost.

But can’t a firm be demand constrained, so it can’t increase sales?  No – that’s covered in the definition of the VMPL curve.  It’s the additional revenue a firm can get from hiring one more worker.  If it couldn’t sell the output, no additional revenue.  If it has to cut the price to sell the output, we’re talking about the Marginal Revenue Product of Labour curve, but basically the same idea.  So JMK accepted the view that, based on the definition of the VMPL curve, a profit maximizing competitive firm’s wage-labour combination will always lie on the curve showing value of the marginal product of labour: the labour demand curve.

Now, the labour supply curve still reflects the amount labour has to be paid to overcome the disutility of work – that definition hasn’t changed.  What has changed is the assumption that the wage is equal to the value of the marginal product of labour and also to the amount which compensates for the disutility of labour, both at the same time – i.e. Keynes is rejecting the idea that the observed wage lies on both the labour demand curve and the labour supply curve, simultaneously.  But the only way for the wage to be on both curves at the same time is for the curves to intersect and the observed wage to be at that intersection, so if the wage isn’t on both curves at the same time, the labour market isn’t in equilibrium.

So, according to JMK, the fact that in a time of unemployment the observed wage, which lies on the labour demand curve, lies above the labour supply curve, doesn’t mean that the unemployment is caused by the wage being too high.