The AS/AD model that we teach our students is misnamed, as it has nothing to do with the supply and demand model used in microeconomics. To take one simple example, the vast majority of industry supply curves are almost perfectly elastic (horizontal) in the long run. The long run aggregate supply curve is almost perfectly inelastic (i.e. vertical.) These are just completely unrelated concepts.
This can help us to evaluate some issues raised by Tyler Cowen:
If you think “stimulus” is effective right now, presumably you think supply curves are pretty elastic and thus fairly horizontal. That is, some increase in price/offer will induce a lot more output.
If you think we should hike the minimum wage right now, presumably you think supply curves are pretty inelastic and thus fairly vertical. That is, some increase in price for the inputs will lead not to much of a drop in output and employment, maybe none at all. The supply curve is fairly vertical.
What matters for stimulus is the short run aggregate supply curve. What matters for the minimum wage is the long run industry supply curve. These two curves are especially unrelated.
[There also the question of whether industry supply curves even exist. Minimum wage proponents usually deny it–claiming that industries are monopolistically competitive. The evidence suggests that industry supply curves do exist.]
I oppose both fiscal stimulus and minimum wage laws, but for reasons mostly unrelated to supply elasticities.
If you favor a minimum wage hike because you think the demand for labor is inelastic, does that mean you don’t see “downward sticky wages” as a big problem? After all, the demand for labor is inelastic, right?
Minimum wage laws should be evaluated on the basis of their long run effects. Proponents probably believe that a good chunk of the higher minimum wage will come out of the pockets of other workers (via higher prices.) I’ll have to pay more for fast food. And the empirical evidence supports that claim. So minimum wage proponents would claim no inconsistency in their views on minimum wages and sticky wages. But this is one problem with the argument for higher minimum wages. If they raise prices then they probably also cost jobs. (My own view is that the bigger problem with minimum wage laws is that they reduce non-wage compensation.)
This is a good point:
If you favor a minimum wage hike, do you criticize wage subsidies because inelastic demand for labor means most of the value of the wage subsidy will be captured by the employer? Or do you somehow want both policies at the same time, because they both involve “government helping people”?
I support wage subsidies to low wage workers because I believe that minimum wage industries tend to be highly competitive, with zero long run economic profits. And for exactly the same reason I oppose minimum wage laws.
READER COMMENTS
John Hall
Jan 19 2021 at 1:46pm
Older article that is related:
https://www.econlib.org/archives/2015/09/who_benefits_fr.html
I recall a discussion of elasticities and minimum wage a few years back from Tyler and others.
Market Fiscalist
Jan 19 2021 at 2:34pm
It seems entirely consistent to believe that employment is very sensitive to changes in AD but not very sensitive to changes in the minimum wage. In times of depressed AD stimulus will lead to a short-term increase in output with little effect on the price level. A moderate rise in the minimum wage will likely lead in the long term to a small increase in the price level with little effect on output.
I am missing the contradiction that Tyler seems to be calling attention to.
Jeff G.
Jan 20 2021 at 12:33am
Tyler’s point was that if you think an increase in input prices (i.e. wages) will result in a small reduction in output, then you are describing a vertical industry supply curve. And when you aggregate across industries you get a vertical AS curve. And if you have a vertical AS curve an increase in AD will not change output by much. Then, of course, Scott’s point was that the supply curve for all industries need not be resprensenative of the AS curve.
BJH
Jan 19 2021 at 6:33pm
(Great post!)
Cody Boyer
Jan 19 2021 at 10:58pm
If long run industry supply curves are perfectly elastic, how do you get a long run aggregate supply curve that’s perfectly inelastic? I’m not saying you’re wrong – I’m curious how both statements can be true? You say the concepts are unrelated, so what is aggregate supply aggregating?
Scott Sumner
Jan 20 2021 at 1:38pm
Cody, An ordinary supply curve shows the response to relative (real) price changes. The AS curve shows the response to (nominal) price level changes, i.e. changes in the value of money. It’s misleading to call them both supply curves, they are radically different concepts.
Thomas Hutcheson
Jan 20 2021 at 6:03am
I wish more people who think higher minimum wages cause unemployment favored wage subsidies (an improved EITC) as an alternative.
Matthias
Jan 20 2021 at 10:35pm
The Singapore government seems to think so. We don’t have a minimum wage, but we do have wage subsidies.
There’s also a policy lever to give everyone effectivelya wage cut in times of recession: the mandatory employer contribution to the pension fund varies with the state of the economy.
However, I don’t think if you are against minimum wage you need to propose another government intervention as an alternative. You could just favour abolishing or lowering it without alternative. In the long run, productivity is what’s driving living standards after all.
Rajat
Jan 20 2021 at 6:14am
Don’t they believe it comes from the pockets of firms? The monopsony model suggests that higher wages increase both employment and total welfare, while transferring wealth from firms to employees. Personally, I find it hard to take the monopsony model seriously in most urban settings. In Australia, the minimum wage is about $US15/hr for permanent adult workers (who get holiday & sick leave), $US20/hr for ‘casual’ workers and higher again for workers with above-minimum skills. Yet somehow people are willing to work for UberEats, etc, for $US10/hr. I presume that couldn’t be true if our minimum wages were set at or below the competitive market wage?
Scott Sumner
Jan 20 2021 at 1:40pm
Some may believe that, but it seems like a rather implausible assumption. Most industries are either competitive or monopolistically competitive, with zero economic profits in the long run. This is especially true of minimum wage industries.
Matthias
Jan 20 2021 at 11:19pm
Most companies make a profit. But I guess you mean that most industries don’t make a profit after taking some standard cost of capital into account?
But how do you define that standard cost of capital? If you take some kind of average, doesn’t your statement about no economic profits become a meaningless tautology? (So what other definition do you use?)
Barriers to entry are a problem in eg the US. And they are exactly what would keep industry profits from being competed away. (Though as you point out, barriers to entry seem to be worse in industries with wages higher than minimum wage.)
Scott Sumner
Jan 21 2021 at 1:23am
Yes, it could lower the aggregate return on capital, but I’d expect that to reduce the US capital stock, which would hurt employment.
Market Fiscalist
Jan 20 2021 at 10:16am
When a firm faces falling demand for its product it is likely that it will reduce output rather than prices in response. If this is an economy-wide situation then stimulus will likely cause demand (and output) to pick up again. This would imply a short-term horizontal supply curve just as Tyler suggests (both at the firm and the AS level)
When a firm faces rising input costs it will likely increase prices and then adjust output to match the new demand. This size of the adjustment will depend upon the elasticity of demand for its products. If demand is inelastic output won’t change much. In this case the supply curve is also horizontal but moves up as a result to the input cost increase. The relevant issue is the slope of the demand curve but at the AD level it probably quite vertical.
So I think one can assume a horizontal supply curve and think both that 1) stimulus works and 2) that a minimum wage will not have much affect on demand for labor.
As Scott says long term AS is vertical. Stimulus probably won’t move it much, but most likely a higher minimum wage will move it to the left a bit as a result of the less free markets but it wouldn’t take too many additional assumption to make it move to the right.
Jeff G.
Jan 20 2021 at 4:55pm
If you think the current AS curve is horizontal and the AD curve is vertical, then how do you explain the current drop in output from a supply-side shock? If you think we’re in a demand-side recession, then how would you explain the -31% drop in GDP in Q2 and immediate reversal in Q3?
Market Fiscalist
Jan 20 2021 at 8:12pm
Great question.
I suppose what i really meant is that the supply curve is horizontal(ish) below full employment at which point it becomes increasing vertical(ish).
A supply side-shock is this curve shifting to the left.
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