Question

Briefly discuss why sometimes wage and price reductions may not result to higher sales and employment. Moreover using a well labelled diagram, demonstrate how the government can intervene to restore the Nash Equilibrium

Answer 1

When all-round cut in wages is made in all industries, it will reduce the aggregate demand for the products because workers would have no less income and therefore would spend less on goods and services. With reduced demand for the products of industries smaller output will be produced.

Therefore, smaller amount of labour will be demanded and employed. To quote Stonner and Hague, “When there is general unemployment, a general cut in wages in all industries cannot be assumed to leave demand unchanged, for part of that demand results from spending out of wages. It is thus quite clear that a general cut in wages will merely cause a reduction and will not in itself remove unemployment.

Thus, we see that classical econo­mists neglected the adverse effect of all-around cut in wages on the level of aggregate demand.

But, according to Keynes, all-round cut in wages will reduce incomes of the workers and therefore expenditure made by workers which will cause a leftward shift in the aggregate demand curve AD, say to the new position AD₁ .If the decrease in aggregate demand is proportional to the increase in aggregate supply, then equilibrium might be reached at the original aggregate output Y_o. Consequently, level of employment will remain below the full-employment level. It may however be noted that the impact of a wage cut on aggregate demand is more complicated than described above.

As a matter of fact, as a result of all-round cut in wages the extent to which aggregate demand will decline depends on several factors such as its effect on propensity to consume, rate of interest, marginal efficiency of capital etc.

But the classical analysis that there is a direct link between wage cut and rising employment through reduction in cost of production is also not valid because it neglects the role of aggregate effective demand when all-round cut in money wages is made. Professors Stonier and Hague rightly write, “A general equilibrium analysis of wage cuts is futile unless it pays attention to the problem of whether aggregate demand will rise or fall as wages are reduced.”

Whether employment will rise or fall when wages are cut depends on whether aggregate demand in terms of money will remain constant, will it fall less than in proposition to the cut in money wages or will it fall more than in proportion to cut in money wages. In Keynesian macroeconomic analysis, the impact of cut in money wages is explained through its effect on the three main determinants of aggregate demand, namely.

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A stylized fact of the labour market in developing countries is that it is highly segmented in informality. One of the main factors that induce workers and firms into informality is an excessive regulatory system that makes formal economy little attractive. This study aims to analyze the dynamics of workers and firms’ entrance and withdrawal of the formal and informal economy, assessing the impact of taxes by using an evolutionary game theory approach in which economic agents decide for one these markets according to the expected pay-off. Moreover, the optimal relation between regulatory and enforcement action by the government is evaluated.