Chapter 10: The means of income policy




01st About the concept of income policy

02nd Wage reduction as a means of employment

03rd Wage expansion as a means of employment

04th The productivity-oriented wage policy

05th Overall economic orientation versus sectoral economic orientation

06th The effects of labour time reductions

07th About the problem of the constancy of the consumption rate

08th Consequences of the cost-theoretical approach

09th Consequences of the quantity-theoretical approach

10th The alliance of the labour



01st About the concept of income policy


Within the scope of income policy, there is an influence exerted on incomes with the aim of guaranteeing stability and full employment. Favourable worded, it is about macroeconomic aims; in the negative sense, it should be noted that no distribution policy is intended with these measures.


However, not all incomes can be influenced. Income policy is predominantly applied to wage income only; the income of the self-employed cannot be influenced directly in a free market economy anyway. The profit is represented as the residual amount which remains when all costs for raw materials and semi-finished products as well as for income from labour, land, and capital are deducted from the sales proceeds.


There are different types of income policy: either maximum or minimum wages are set, as is the case mainly abroad, but recently also in Germany, or wage guidelines are agreed - as was previously the case in Germany together with the collective bargaining parties - which, however, are generally not binding.



02nd Wage reduction as a means of employment


The aim of a politically decreed wage reduction is to increase employment (e.g. Brüning's deflationary policy in Germany during the global economic crisis). Thereby is assumed that employment depends on the level of the real wage.


But how does a nominal wage reduction change the real wage? Politically, only the nominal wage can be changed in a direct way. The real wage results always as a reaction to certain political interventions. 


Under assumptions based on quantity theory, a reduction in the nominal wage a decline in prices is to be expected. A reduction in wages leads initially to an increased production; with a constant money supply, the prices of goods must decline. Nevertheless, a decline in the real wage is to be expected. How strongly the real wage is influenced depends on the elasticity of supply and demand.


The starting point is a four-quadrant diagram. In the first quadrant (NO), the amount of labour (A) is plotted on the abscissa and the real wage rate (l/P) is plotted on the ordinate. In the second quadrant (SO), the production quantity (X) is read on the ordinate. The third quadrant (SW) assigns a price level (P) to the production quantity. Finally, the angle from the coordinate origin of the fourth quadrant (NW) indicates the change in the real wage.




Let us now assume a given labour market imbalance (A*- A0), i.e. a supply overhang. This imbalance would lead in free markets to a reduction in wages (l/P*) while full employment prevails. In a first step, the price level would still remain constant. Due to the associated increase in employment, there will also be an increase in production. 


Since, with a constant quantity of money and a constant velocity of circulation of money, the price level must decrease by the same percentage as the quantity of goods increased according to the quantity equation, the price level will necessarily decrease. Consequently, the initial decline of the real wage will not remain and thus neither the initial increase in employment will remain.


Initially, it remains unclear whether the real wage decreased effectively and thus employment increased. The graph shows, however, that there exists in any case (if the money supply and the velocity of circulation money remain constant) a real wage at which equilibrium is achieved on the labour market; and to this increase in employment corresponds an increase in the quantity of goods and an equal reduction in the price level.


However, this merely proves that equilibrium exists on the labour market (question of the existence of equilibrium). It remains initially unclear, however, whether the market leads from any starting point to this equilibrium by itself due to its equilibrium forces (question of the tendency towards equilibrium). If there exists such an equilibrium tendency depends crucially on the one hand on the elasticity of labour demand to wage changes and on the other hand on whether the central bank continues to keep the money supply constant despite deflation.


Let us assume the case that the elasticity of labour demand is precisely one. This means that a decline in the real wage of 1% leads to an increase in labour demand of 1% as well. Now, if production were also to increase by just this one percentage point, the price level would necessarily have to fall by one percent (at a constant money supply and a constant velocity of circulation of money).


This would mean that the nominal wage rate and price level would have fallen equally strong in the ultimate result and thus it was not achieved to lower the real wage in the long term. However, this would also remove the initial increase in employment. The equilibrium on the labour market could not be achieved by itself.


Thus, we conclude that an equilibrium tendency can only be expected if a one-percent wage reduction leads to an increase in production of less than one percent. In this case, the induced price reduction is lower than the nominal wage reduction, with the result that the real wage has been reduced also in the long term, thus creating the preconditions for employment to rise in the long term and that a free labour market also shows an equilibrium tendency.


In general, we assume that the law of diminishing marginal revenue of labour is valid and this means that production and therewith also the price level always increases to a lesser extent than employment. Thus, there are certain chances that a free labour market could lead to an increase in employment via wage cuts.


There is also another reason why in reality certain equilibrium tendencies emanate from nominal wage cuts at unemployment. We had assumed previously that, despite wage and price cuts, the amount of money in circulation would remain unchanged. But just this assumption is unlikely. In general, the central banks are striving to prevent general price cuts, since deflation processes would have to lead to an economic downturn.


At this point, we would like to leave the question unanswered of how far this thesis is empirically proven by the contractive effects of deflation. At this point, we simply assume that the central banks try to counteract by expanding the money supply in anticipation of deflation. An increase in the money supply, however, induces itself partial price increases, with the consequence that in the final result the price level will fall - if at all – much less than the wage rate. In this case, nominal wage cuts will de facto lead to reductions in real wages, which in turn will induce a reduction in unemployment, actually.



03rd Wage expansion as a means of employment


In contrast to this deflation policy, particularly trade unions attempted in the past to increase employment by means of an expansive wage policy, i.e. by raising wages. These models are based on the Keynesian theory. The term expansive wage policy refers to a wage increase that goes beyond the increase in labour productivity. 


The starting point of this consideration is the "naive" purchasing power theory as represented by Agartz:



If the wage rates (l) are increased, then, at initially constant employment (B), increases the wage total (L = l * B) and along with it the consumption total (C), the domestic product (Y) and finally employment (B).


But this reasoning can be criticised. Instead of a proof, the result is presupposed. Hence there is a petitio principii. This argument is based tacitly on the assumption that as a first step the wage increase does not lead to a reduction in employment. This, however, is precisely the point at issue that shall be resolved by this thesis.


The classicists of economic theory assume that in the normal case wage rate increases lead to a reduced demand for labour. This reaction results directly from the fact that the demand for labour is determined by the course of the curve of the marginal revenue of labour. 


Now, by assuming that this assumption is wrong, that on the contrary, despite an increase in the wage rate there is no reason to fear a decline in employment, the representatives of an expansive wage policy are anticipating the result, which shall be proven with the help of this argumentation.


Furthermore, only induced consumer demand continues to rise, but an increase in employment would only be expected at an increase of autonomous demand. We speak of induced demand when consumer demand rises because income has risen previously. Whereas an increase in autonomous demand occurs only if consumer demand rises at the same income.

If the Keynesian theory is taken as a basis, the equilibrium of goods is decisively determined by the course of the consumption function. Only if it would be possible to change the course of the consumption function, then the goods market equilibrium would be at a changed production quantity and thus also at a changed employment quantity. Accordingly, employment depends on the effective (autonomous) demand.


In fact, the demand and supply value of the goods increase by the same amount in the case of wage increases. Therefore, there also will be no change in the equilibrium point. If employment remains constant, wage income increases by exactly the same percentage as wage rate increases. But at the same time the cost value of the supply increases by the same amount. But a reduction in the excess supply would only occur if demand increased more than the value of supply.


The equilibrium remains still with the previous too low level of employment. Although supply may initially increase as a result of increased demand, due to a deflationary gap, supply will fall back again to the original quantity of goods. Entrepreneurs notice that they cannot sell all the additional goods they produced, which means they will reduce production again and consequently employment.




However, A. P. Lerner has developed a model from which, based on Keynesian assumptions, it can be derived that wage increases can lead to an increase in employment under certain conditions.


Lerner assumes that a wage rate increase leads to an increase in the wage ratio. If it is assumed simultaneously that the employees show a higher consumption rate than the entrepreneurs, then a wage ratio increase leads automatically to an increase in the overall economic consumption rate. This shifts the C+I curve upwards and the new equilibrium point is at a higher domestic product and thus also at higher employment. 





But if we consider the results of likewise Keynesian-oriented distribution theory of Nicholas Kaldor, the wage ratio (l/Y) will by no means rise already when expansive wage increases are implemented. Rather, a wage ratio increase will only occur if the employees spend a higher percentage of their income on savings (s).


A mere nominal wage increase would be passed on by the enterprises to the prices of goods, with the result that neither real wages nor the wage ratio would rise. In this case, however, the employment effect of nominal wage increases shown by Lerner is also removed.




When considering which employment effects emanate from a wage increase, it should also be considered that wage variations have several side effects that can ultimately have quite different impacts on the level of employment.




Let us begin with the liquidity effect. As wage income rises, more money is kept in cash on average. This means that the demand for money (LP for liquidity preference) increases. As a result, the interest rate on the money market will rise, and this will lead to a decline in the investment volume and this in turn will cause a decline in employment.


Furthermore, what does the Pigou effect mean? The entrepreneurs will pass on wage rate increases in the selling price, thus increasing the price level. Since this will reduce the real value of cash in hand, households will try to compensate for this loss in value by increasing their savings. The resultant reduction in consumer demand leads to a reduction in income and employment.


The substitution effect means that an increase in the wage rate at a constant interest rate also improves the wage-interest ratio. It is therefore worthwhile for enterprises to switch to more capital-intensive productions. Employment therefore decreases while the product quantity remains the same.


The differences between substitution effects and rationalisation effects can be illustrated by the following graphic: 




Even if we assume that there will be no change in our knowledge of technology, certain yield increases can be achieved by substituting capital for labour, given that we assume a classical production function. According to this, there is a very specific optimal input ratio of labour to capital. As long as this optimum has not yet been reached, i.e. as long as too little labour accounts for the capital unit, the average return can be increased by expanding employment. As soon as this optimum is reached an expansion of employment would lead to a reduction in the average return, however.


But if the technical knowledge changes, the yield function can be shifted upwards with the result that higher average revenues (X/A) can be achieved even with the same input ratio of labour and capital.



04th The productivity-oriented wage policy


The determination of wage rates in the FRG is the task of the tariff partners. Accordingly, the state does not have the right to determine the wage rates by political means. The tariff partners primarily pursue distribution policy aims. However, since the determination of wage rates in turn has its own influence on the price level of goods and the task of guaranteeing monetary stability is the responsibility of the state (including the central bank), there is a legitimate interest on the part of politics in ensuring that the side effects of wage increases on price levels are considered when wage rates are determined.


For this reason, there occurred the demand on the part of politicians to allow only such wage increases that do not jeopardise the aim of monetary stability. It is generally assumed that wage increases are not likely to breach the stability aim only if they are limited to the growths in labour productivity.


The reasoning that monetary stability is maintained, especially when wage increases are limited to the growth in labour productivity, occurs somewhat different, depending on whether we base our reasoning on a demand-oriented, i.e. Keynesian, theory or whether we argue based on supply theory and thus classical.


If we take a demand theory approach, it is valid:


d p/p = 0, if dN / N = d X / X


· dN/N: annual growth rate of consumption demand


· dX/X: annual growth rate of production of consumer goods


According to this, price stability can only be expected if demand growth and supply growth are just equivalent.





In a first step, we assume a constantly predefined consumption rate (c). At the same time, we want to assume that the employment rate will likewise remain constant. At first, we ask for the demand for goods. To simplify matters, the demand of independent households will be disregarded. In this case, total demand for consumer goods (N) corresponds to the product of consumption rate (c) and wage income (L), which itself is equal to the product of wage rate (l) * employment (A).


The increase in demand (dN/N) is accordingly calculated from the quotient (dl * c * A) referred to the demand (c * l * a). Here the consumption rate (c), which is regarded as constant, as well as the constant amount of labour in the numerator and denominator can be cancelled so that the increase in the demand (dN/N) equals the increase in the wage rate (dl/l).


dN/N = (dl * c * A) / (l * c * A) = dl/l



Now, let us turn to the supply side.




The product quantity (X) depends on how high the average revenue of a labour unit (X/A) is and how many labour units (A) are employed. The average revenue of a labour unit is called labour productivity (pi):


Thus, applies for the increase in quantities of goods (dX/X):



Also here, the expression (A) can be cancelled in numerator and denominator, such that the increase in the amount of goods corresponds to the change in labour productivity. The formula is valid:



As a consequence, we conclude that the precondition for the price level to remain constant and not being influenced by wage increases is that the increase in the wage rate equals precisely the increase in labour productivity.



05th Overall economic orientation versus sectoral economic orientation


The demand for a productivity-oriented wage policy is discussed in two variants. At the one variant the demand is made that collectively agreed wages in the individual sectors of the economy should be aligned with overall economic productivity. The second variant of this demand, by contrast, requires that wages are aligned with the productivity of the sector for which collective bargaining is currently taking place.


If these two rules would be applied in all sectors of the economy, the demand for a productivity-oriented wage policy would be fully met. Both, if the tariff partners would always align their wage demands with the macroeconomic labour productivity or always with the productivity of the respective sector, it would be ensured that the macroeconomic average of wage increases would also reach the same level as the macroeconomic labour productivity growth.


The following point, however, speaks in favour of a macroeconomic orientation: de facto, employees in sectors with below-average productivity will not be satisfied with below-average wage increases. There are particularly areas (associations, state authorities) in which there is no increase in productivity, as the services are not offered on a market and thus there is no market revenue. In the absence of a value for the output, in these sectors the value of the output is measured by the value of the input. In this case, however, labour productivity equals always one and no productivity increases can be observed. And this lack is not based on the laziness of public servants, but simply on the fact that no market value can be established for the services provided by the authorities.


But now it cannot be expected that employees in these sectors will forever refrain from experiencing an adjustment of wages to the general wage development. They as well will fight for wage increases and consequently, with sectoral adjustment, the entire wages would rise more than productivity. For these reasons, a productivity-oriented wage policy can only be achieved by adjusting wages in all sectors of the economy to the increase in macroeconomic productivity growth.



06th The effects of labour time reductions


An increase in productivity can serve to increase the welfare of citizens in two ways. An increase in productivity can be used both for more leisure time as well as for more income. If more leisure time is spent, it will be at the expense of income growth.


The formula is valid:


Sum of leisure time growth and income growth = increase in productivity.






We assume the equation of the macroeconomic consumption demand. Since we have disregarded the incomes of the self-employed, total demand corresponds to the product of consumption rate (c), wage rate (l) and number of labour hours (A).


Now, if we differentiate this equation according to l and A, we get a term for the change in demand due to a change in the wage rate, as well as a term for the change in the number of labour hours. In the first term the value for c and A can be cancelled out, in the second term the value for c and l can be cancelled out. We thus get to the result that the percentage change in demand is composed of the sum of the rates of change of the wage rate and of the labour time.




Similarly, we can understand supply (X) as the product of labour quantity (A) and labour productivity (pi). Again, we can differentiate this equation for the supply with respect to l as well as to A, and again the change in the supply can be understood as the sum of two terms which show how a change in labour productivity and labour quantity influences the supply of goods.


If we finally plug in these expressions for the change in supply and demand in our equilibrium condition (dX/X = dN/N), we obtain the result that wage policy does not influence the monetary value just when the wage rate increase corresponds precisely to the productivity increase.





At first glance, this conclusion seems to contradict the thesis that the wage rate can rise less than productivity if leisure time increases, given that inflationary tendencies are to be avoided. This contradiction is resolved if we distinguish between the wage rate (l) and the wage income (L = l * A).


In the case of an increase in leisure time, wage income (l * A) may increase only less than labour productivity, nevertheless the wage rate (l) may be increased to the same extent as labour productivity. In fact, at a constant wage rate, wage income decreases when the number of labour hours is reduce


L↓, if l const. and A ↓