BY HENRY HAZLITT
Economic in One Lesson, Chapter 20
Amateur writers on economics are always asking for “just” prices and “just” wages. These nebulous conceptions of economic justice come down to us from medieval times. The classical economists worked out, instead, a different concept—the concept of functional prices and functional wages. Functional prices are those that encourage the largest volume of production and the largest volume of sales. Functional wages are those that tend to bring about the highest volume of employment and the largest payrolls.
The concept of functional wages has been taken over, in a perverted form, by the Marxists and their unconscious disciples, the purchasing-power school. Both of these groups leave to cruder minds the question whether existing wages are “fair.” The real question, they insist, is whether or not they will work. And the only wages that will work, they tell us, the only wages that will prevent an imminent economic crash, are wages that will enable labor “to buy back the product it creates.” The Marxist and purchasing-power schools attribute every depression of the past to a preceding failure to pay such wages. And at no matter what moment they speak, they are sure that wages are still not high enough to buy back the product.
The doctrine has proved particularly effective in the hands of union leaders. Despairing of their ability to arouse the altruistic interest of the public or to persuade employers (wicked by definition) ever to be “fair,” they have seized upon an argument calculated to appeal to the public’s selfish motives, and frighten it into forcing employers to grant their demands.
How are we to know, however, precisely when labor does have “enough to buy back the product”? Or when it has more than enough? How are we to determine just what the right sum is? As the champions of the doctrine do not seem to have made any clear effort to answer such questions, we are obliged to try to find the answers for ourselves.
Some sponsors of the theory seem to imply that the workers in each industry should receive enough to buy back the particular product they make. But they surely cannot mean that the makers of cheap dresses should have enough to buy back cheap dresses and the makers of mink coats enough to buy back mink coats; or that the men in the Ford plant should receive enough to buy Fords and the men in the Cadillac plant enough to buy Cadillacs.
It is instructive to recall, however, that the unions in the automobile industry, at a time when most of their members were already in the upper third of the country’s income receivers, and when their weekly wage, according to government figures, was already 20 per cent higher than the average wage paid in factories and nearly twice as great as the average paid in retail trade, were demanding a 30 per cent increase so that they might, according to one of their spokesmen, “bolster our fast-shrinking ability to absorb the goods which we have the capacity to produce.”
What, then, of the average factory worker and the average retail worker? If, under such circumstances, the automobile workers needed a 30 per cent increase to keep the economy from collapsing, would a mere 30 per cent have been enough for the others? Or would they have required increases of 55 to 160 per cent to give them as much per capita purchasing power as the automobile workers? (We may be sure, if the history of wage bargaining even within individual unions is any guide, that the automobile workers, if this last proposal had been made, would have insisted on the maintenance of their existing differentials; for the passion for economic equality, among union members as among the rest of us, is, with the exception of a few rare philanthropists and saints, a passion for getting as much as those above us in the economic scale already get rather than a passion for giving those below us as much as we ourselves already get. But it is with the logic and soundness of a particular economic theory, rather than with these distressing weaknesses of human nature, that we are at present concerned.)
The argument that labor should receive enough to buy back the product is merely a special form of the general “purchasing power” argument. The workers’ wages, it is correctly enough contended, are the workers’ purchasing power. But it is just as true that everyone’s income—the grocer’s, the landlord’s, the employer’s—is his purchasing power for buying what others have to sell. And one of the most important things for which others have to find purchasers is their labor services.
All this, moreover, has its reverse side. In an exchange economy everybody’s income is somebody else’s cost. Every increase in hourly wages, unless or until compensated by an equal increase in hourly productivity, is an increase in costs of production. An increase in costs of production, where the government controls prices and forbids any price increase, takes the profit from marginal producers, forces them out of business, means a shrinkage in production and a growth in unemployment. Even where a price increase is possible, the higher price discourages buyers, shrinks the market, and also leads to unemployment. If a 30 per cent increase in hourly wages all around the circle forces a 30 per cent increase in prices, labor can buy no more of the product than it could at the beginning; and the merry-go-round must start all over again.
No doubt many will be inclined to dispute the contention that a 30 per cent increase in wages can force as great a percentage increase in prices. It is true that this result can follow only in the long run and only if monetary and credit policy permit it. If money and credit are so inelastic that they do not increase when wages are forced up (and if we assume that the higher wages are not justified by existing labor productivity in dollar terms), then the chief effect of forcing up wage rates will be to force unemployment.
And it is probable, in that case, that total payrolls, both in dollar amount and in real purchasing power, will be lower than before. For a drop in employment (brought about by union policy and not as a transitional result of technological advance) necessarily means that fewer goods are being produced for everyone. And it is unlikely that labor will compensate for the absolute drop in production by getting a larger relative share of the production that is left. For Paul H. Douglas in America and A. C. Pigou in England, the first from analyzing a great mass of statistics, the second by almost purely deductive methods, arrived independently at the conclusion that the elasticity of the demand for labor is somewhere between -3 and -4. This means, in less technical language, that “a 1 per cent reduction in the real rate of wage is likely to expand the aggregate demand for labor by not less than 3 per cent.” Or, to put the matter the other way, “If wages are pushed up above the point of marginal productivity, the decrease in employment would normally be from three to four times as great as the increase in hourly rates” so that the total income of the workers would be reduced correspondingly.
Even if these figures are taken to represent only the elasticity of the demand for labor revealed in a given period of the past, and not necessarily to forecast that of the future, they deserve the most serious consideration.
But now let us suppose that the increase in wage rates is accompanied or followed by a sufficient increase in money and credit to allow it to take place without creating serious unemployment. If we assume that the previous relationship between wages and prices was itself a “normal” long-run relationship, then it is altogether probable that a forced increase of, say, 30 per cent in wage rates will ultimately lead to an increase in prices of approximately the same percentage.
The belief that the price increase would be substantially less than that rests on two main fallacies. The first is that of looking only at the direct labor costs of a particular firm or industry and assuming these to represent all the labor costs involved. But this is the elementary error of mistaking a part for the whole. Each “industry” represents not only just one section of the productive process considered “horizontally,” but just one section of that process considered “vertically.” Thus the direct labor cost of making automobiles in the automobile factories themselves may be less than a third, say, of the total costs; and this may lead the incautious to conclude that a 30 per cent increase in wages would lead to only a 10 per cent increase, or less, in automobile prices. But this would be to overlook the indirect wage costs in the raw materials and purchased parts, in transportation charges, in new factories or new machine tools, or in the dealers’ mark-up.
Government estimates show that in the fifteen-year period from 1929 to 1943, inclusive, wages and salaries in the United States averaged 69 per cent of the national income. These wages and salaries, of course, had to be paid out of the national product. While there would have to be both deductions from this figure and additions to it to provide a fair estimate of “labor’s” income, we can assume on this basis that labor costs cannot be less than about two-thirds of total production costs and may run above three-quarters (depending upon our definition of “labor”). If we take the lower of these two estimates, and assume also that dollar profit margins would be unchanged, it is clear that an increase of 30 per cent in wage costs all around the circle would mean an increase of nearly 20 per cent in prices.
But such a change would mean that the dollar profit margin, representing the income of investors, managers and the self-employed, would then have, say, only 84 per cent as much purchasing power as it had before. The long-run effect of this would be to cause a diminution of investment and new enterprise compared with what it would otherwise have been, and consequent transfers of men from the lower ranks of the self-employed to the higher ranks of wage-earners, until the previous relationships had been approximately restored. But this is only another way of saying that a 30 per cent increase in wages under the conditions assumed would eventually mean also a 30 per cent increase in prices.
It does not necessarily follow that wage-earners would make no relative gains. They would make a relative gain, and other elements in the population would suffer a relative loss, during the period of transition. But it is improbable that this relative gain would mean an absolute gain. For the kind of change in the relationship of costs to prices contemplated here could hardly take place without bringing about unemployment and unbalanced, interrupted or reduced production. So that while labor might get a broader slice of a smaller pie, during this period of transition and adjustment to a new equilibrium, it may be doubted whether this would be greater in absolute size (and it might easily be less) than the previous narrower slice of a larger pie.
This brings us to the general meaning and effect of economic equilibrium. Equilibrium wages and prices are the wages and prices that equalize supply and demand. If, either through government or private coercion, an attempt is made to lift prices above their equilibrium level, demand is reduced and therefore production is reduced. If an attempt is made to push prices below their equilibrium level, the consequent reduction or wiping out of profits will mean a falling off of supply or new production. Therefore an attempt to force prices either above or below their equilibrium levels (which are the levels toward which a free market constantly tends to bring them) will act to reduce the volume of employment and production below what it would otherwise have been.
To return, then, to the doctrine that labor must get “enough to buy back the product,” The national product, it should be obvious, is neither created nor bought by manufacturing labor alone. It is bought by everyone—by white collar workers, professional men, farmers, employers, big and little, by investors, grocers, butchers, owners of small drug stores and gasoline stations—by everybody, in short, who contributes toward making the product.
As to the prices, wages and profits that should determine the distribution of that product, the best prices are not the highest prices, but the prices that encourage the largest volume of production and the largest volume of sales. The best wage rates for labor are not the highest wage rates, but the wage rates that permit full production, full employment and the largest sustained payrolls. The best profits, from the standpoint not only of industry but of labor, are not the lowest profits, but the profits that encourage most people to become employers or to provide more employment than before.
If we try to run the economy for the benefit of a single group or class, we shall injure or destroy all groups, including the members of the very class for whose benefit we have been trying to run it. We must run the economy for everybody.
 A. C. Pigou, The Theory of Unemployment (1933), p. 96.
 Paul H. Douglas, The Theory of Wages (1934), p. 501.
Henry Hazlitt (1894-1993) was the great economic journalist of the 20th century. He is the author of Economics in One Lesson among 20 other books. He was chief editorial writer for the New York Times, and wrote weekly for Newsweek. He served in an editorial capacity at The Freeman and was a board member of the Foundation for Economic Education.
Used with the permission of the Foundation for Economic Education.