Neoclassical economics analyses labour as a commodity, like any other, governed by the law of supply and demand (Keen 2011: 129).
Two crucial requirements of standard neoclassical analysis of labour markets are that (1) labour demand curves are necessarily downward-sloping and supply curves upwards-sloping, and (2) each worker tends to be paid the marginal product of labour (Keen 2011: 130–131).
Yet labour is fundamentally different from other commodities: whereas demand for some commodity like bread is determined by consumers and supply decisions by producers, the supply of labour is offered by consumers, and demand decisions are made by producers (Keen 2011: 129).
Steve Keen sees a number of problems with the neoclassical analysis:
(1) the labour supply curve can “slope backwards”: e.g., a fall in the wage rate can induce an increase in the supply of labour;In regard to (1), Keen notes how a higher wage rate can result in the same income level for a worker if he or she works fewer hours: therefore less labour might be supplied as the wage rises (Keen 2011: 133–134).
(2) the market power of some employers can result in unfair wages even in neoclassical theory, so that worker trade unions or collective bargaining can make wages fairer;
(3) standard supply and demand analysis can be inappropriate when applied to labour markets in light of Piero Sraffa’s aggregation problem;
(4) the fundamental explanation of labour supply as workers choosing between leisure and work is flawed;
(5) that market demand curves, including labour demand curves, necessarily obey the law of demand is unrealistic.
Attempts to overcome this problem with the substitution effect are not convincing:
“… it makes no sense to separate the impact of an increase in the wage rate into its substitution effect and income effect: the fact that the substitution effect will always result in an increase in hours worked is irrelevant, since everyone will always have twenty-four hours to allocate between work and leisure.The problem Keen identifies here is that labour supply curves need not be well behaved.
Since an increase in wages will make workers better off, individual workers are just as likely to work fewer hours as more when the wage rate increases. Individual labor supply curves are just as likely then to slope backwards – showing falling supply as wages rise – as they are to slope forwards.
At the aggregate level, a labor supply curve derived by summing many such individual supply curves could have any shape at all. There could be multiple intersections of the supply curve with the demand curve (accepting, for the moment, that a downward-sloping demand curve is valid). There may be more than one equilibrium wage rate, and who is to say which one is valid? There is therefore no basis on which the aggregate amount of labor that workers wish to supply can be unambiguously related to the wage offered. Economic theory thus fails to prove that employment is determined by supply and demand, and reinforces the real-world observation that involuntary unemployment can exist: that the employment offered by firms can be less than the labor offered by workers, and that reducing the wage won’t necessarily reduce the gap.
This imperfection in the theory – the possibility of backward-bending labor supply curves – is sometimes pointed out to students of economics, but then glossed over with the assumption that, in general, labor supply curves will be upward sloping. But there is no theoretical – or empirical – justification for this assumption” (Keen 2011: 134).
This is just as easy to see in reductions in wages. A strong general characteristic of most households is that they wish to maintain their standard of living, as they face fixed contractual obligations like debt, and hence the need to maintain income levels (Lavoie 1992: 222).
Therefore labour supply often depends on a perceived target wage rate and past standards of living (Lavoie 1992: 222–223), not necessarily on actual movements of the wage rate. If wages fall, this may well increase labour supply as a breadwinner or other members of the household decide to look for more work to maintain household income.
To turn to point (2) above, the real world is far from the perfect or near competition models of neoclassical theory.
Even if one wants to assume that workers should be paid their marginal product, firms with market power will pay wages below this value, so that a trade union acting as a single seller of labour will drive wages higher, so that wages will be fairer (the so-called monopsony argument).
In regard to point (4), neoclassical theory holds work and leisure to be two “goods,” between which workers freely choose as the wage rate changes. In a truly laissez faire society with no welfare or social security, this idea is of course nothing more than a sick joke: either you work for whatever wages so can obtain or starve.
Even in modern welfare states, the idea is still dubious: for most forms of leisure require money and income, and in most full-time work hours worked are strictly set by employers and not often negotiable.
Keen also notes how in recessions or depressions where there is a very high level of (normally) fixed private nominal debt, cutting wages and prices (and hence profits, which are the income of businesses) to increase demand for labour will induce debt deflationary pressures, a self-defeating exercise (Keen 2011: 138).
Keen, Steve. 2011. Debunking Economics: The Naked Emperor Dethroned? (rev. and expanded edn.). Zed Books, London and New York.
Lavoie, Marc. 1992. Foundations of Post-Keynesian Economic Analysis. Edward Elgar Publishing, Aldershot, UK.