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Labour market reform and the costs argument
Gerard Jackson
Now that John Legge has entered the public arena to attack labour market reform, I think it necessary to republish this article which was first published in The New Australian, No. 14, 18-24 November 1996, under the title Costs, markets and economic reform. It will serve the purpose of demonstrating that lefty haters of the market never seem to learn.
John Legge (lecturer at Swinburne University, Melbourne) complained that the past decade had been a trying experience for those who “believe the economics textbooks”. What is really trying is seeing Mr Legge’s anti-market, anti-economic nonsense being published as serious economics. His most recent effort (Australian Financial Review, 11 November 1996) clearly revealed how incredibly ignorant anti-marketeers are of modern economics. He claimed that one of the main assumptions about macro-economics is that costs pass through prices, thus inflation is caused by rising wages.
The textbooks I have read claim nothing of the kind. Samuelson, for example, (Economics, tenth edition 1976) makes it clear that for a wage push to translate into inflation macroeconomic policy would have to be expansionist if unemployment is to be avoided, meaning that the government would have to expand the money supply.
Lipsey (Positive Economics for Australian Students, second edition) pointed out that: “Monetary expansion is always a necessary part of inflation” second edition 1986. Edwin G. Dolan (Basic Economics, 1977) made it clear that in his opinion the cost-push theory of inflation is unsatisfactory. Of course, any genuine student of economics fully realises that cost push is underpinned by the implicit assumption that the monetary authorities will always underwrite any wage push.
Legge followed his nonsense on wage pushes with his even more nonsensical views on pricing. According to him, during the last 20 years Australian firms set prices on a cost-plus basis (mark up). If wages rose, prices followed. This process, Legge, averred, is rational if labour is a variable cost. However, the process ceases to be rational once labour becomes a fixed cost. Labour costs become variable when labour can be hired and fired at will or its hours of work varied.
He then argued that when costs become fixed the link between cost and prices becomes broken. Hence, holding down wages will not stop inflation. Keynesian policies, therefore, will only lead to higher prices without generating employment, and labour market reforms simply fatten profits and increase unemployment by cutting labour. (What else can one expect from a man whose ignorance of economic thinking is such that he can actually confuse the Austrian school with the Chicago school (sic) [Australian Rationalist, No 41]).
All of this is absolute drivel. It is clear that Legge has no understanding at all of the nature of cost and price determination. His views are clearly based on the fallacy of the cost-of-production theory of prices. In a free market prices always determine costs. It follows that it is only what entrepreneurs think consumers are prepared to pay for a product that determines what will be spent on its production.
Factors of production are paid according to the tenets of marginal productivity theory. The prices of factors, with the exception of labour, are the sum of their discounted future earnings (capitalisation). In other words, factor prices are imputed. Therefore the prices of factors change in the same direction as changes in the demand for their services.
If, for example, the demand for the services of a particular factor in its most valued use were to fall below the value of its alternative use(s), its price would fall to reflect the value of its services in it next most valuable use. (Specific factors, however, suffer disproportionate changes in value with changes in demand because they are ‘costless’). Regrettably, the real world of uncertainty and continuous change veils these relationships. But that only excuses laymen, not academics who are paid to know better.
The price of any good is always set by the existing stock and its demand schedule. Furthermore, demand for any product is price sensitive (what economists call elastic) above its market clearing level; this is the point of maximum net revenue. Raising the price above this point simply reduces the firm's net revenue. It should be clear from this — even to Mr Legge — that any attempt by the firm to pass on increased costs will only cause it to lose sales and cut production and jobs.
(The 1974-5 and 1981-82 wage pushes and the consequent unemployment are graphic refutations of Legge’s primitive economic thinking).
For Legge’s so-called cost-plus regime to work prices must always be less than the market clearing level, a ridiculous suggestion, or demand curves must be vertical, equally ridiculous. Nevertheless, cost-plus policies seem to have worked for a number of years. The solution is inflation. Only an accommodating money supply can create the illusion that cost-plus pricing actually works. From this it is only a short step to believing that inflation is a cost-push phenomenon.
As professor Thirlby pointed out, what also makes the cost-of-production fallacy totally irrelevant is the subtle fact that the products are ‘costless’. Once the bread is baked it has no alternative use (except, perhaps, as pigswill). The money spent on its production is gone and is now attached to something else. If the baker has overestimated his market, he must take what he can. The baker’s costs are totally immaterial to the consumer. The consumer simply does not care.
If the baker refuses to sell at the lower price, then that is now his cost. Costs are forgone alternatives and always involve choice. Once the alternative has been sacrificed it no longer has any ‘influence on price’. Money costs to the entrepreneur only equal opportunity costs when he plans the investment. Once his money costs are sunk they must be considered irretrievable spent. Bygones are always bygones. (The definition of cost as sacrificed alternatives [opportunity cost] explains behaviour that sometimes appears irrational).
Our definition of cost now brings us to his peculiar view that labour has become a fixed cost that breaks the link between costs and price. However, it has already been demonstrated that Legge has no understanding of value, the nature of cost or price determination, and his casual treatment of so-called fixed costs only serves to underline his ignorance.
Costs are not fixed by some mysterious force but are determined by the total entrepreneurial demand for factors of production which in turn is driven by consumer preferences. To reason, as Legge evidently does, from the individual firm is to suffer the illusion of treating costs as given; moreover, not only is he treating costs as given but also as fixed. However, he is not alone in falling prey to this particular fallacy of composition.
Legge also uses the neoclassical short run approach in his treatment of cost. This approach divides costs into fixed (which do not vary with output) and variable costs. This is a serious misrepresentation of reality and ignores the fact that the alleged fixity of costs is really a function of the amount of time involved.
So what we have are different degrees of variability for different factors with some factors giving their best results over certain ranges of output. This is simply another way of saying that, as professor Coase put it: “Some categories of cost which vary for some changes in output do not vary for all changes in output”.
Coase also pointed out that “there is no need to distinguish between ‘fixed’ and ‘variable’ costs. By concentrating on what cost variations will occur, one avoids the necessity of dividing costs up into the categories of ‘fixed’ and ‘variable’ costs”. He added that cost variations also depend on how much notice is given of any variation in output. In short, the time element is very important.
Professor Robbins stressed the same point when he wrote: “What are prime [fixed] and what supplementary [variable] expenses depend essentially upon the length of time over which a change of output is expected to be operative”. Robbins also stressed the expectations of producers in influencing cost. It should be clear that the introduction of time makes all costs variable.
Furthermore, the definition of cost as displaced values renders the concept of fixed costs as economically meaningless. It follows that cost is linked to decisions because cost only occurs when decisions are made which means, in the words of professor Thirlby, that “cost is ephemeral”. All of this really makes it impossible to establish cost categories.
Legge claimed that Keynesian policies only cause rising prices without increasing employment and that firms “don't want their labour to be flexible in the economic sense”. (Is there some other sense?) This is so bad it is difficult to know where to start. The first assertion only demonstrates that he knows nothing about how Keynesian policies affect employment, prices, the structure of production etc.
The second assertion is self-evident nonsense. What makes labour ‘flexible’ is that it is the most variable factor. Nothing can change this fact. What Legge has not grasped is that it is not so much ‘flexibility’ in the firm that matters but ‘flexibility’ in the market place.
In a free market there is a tendency for labour, as for every other factor, to receive the full value of its marginal product — this is because the market moves to allocate resources to the margin, i.e., their most valued use. Hampering the market in this process only keeps productivity lower than it would otherwise be.
His other statement that microeconomic reform is a bad joke because cost savings are absorbed into profits and displaced workers are left unemployed. Of course cost cuts are made to increase profits. Minimising costs is essentially the same thing as maximising profits. A firm does society no favours by acting to the contrary. (Perhaps he prefers bankruptcy?)
If displaced workers cannot find employment it is because they have been priced out of work. For this you can blame the ACTU. Not that Legge would ever do that. And this brings me to Legge's claim that labour market reform is “about cutting wages and conditions outright...” This is a malicious statement. The reforms are about allowing labour costs to reflect the value of labour's marginal product.
His view that theories based on perfect competition without fixed costs or theories based on mark up are no longer useful serves to ram home his ignorance:
1. The theory of perfect competition was demolished by the Austrians decades ago; as Hayek said: “Perfect competition is no competition”. Legge has absolutely nothing new to offer in his criticism of perfect competition.
2. Fixed costs are a fiction; costs are subjective, ephemeral and consist of displaced alternatives. Legge’s views make it painfully clear that he has made no serious study of the nature of cost.
3. The notion that ‘mark up’ was ever a serious economic theory is so silly that it does not even warrant a comment.
Entrepreneurship drives an economy and savings fuel it. Technological advance is applied through capital and capital comes from savings. Therefore, no matter how energetic a country’s entrepreneurs are, no matter how inventive and skilled its innovators and inventors, if savings are not available inventions cannot be applied. The usual result is a brain drain and the loss of new developments to foreign investors.
Finally, one can only hope that Legge has the decency to keep his economic garbage out of the classroom.
A further note on ‘fixed’ costs
Legge’s fixed cost idea is just a version of the Schmalenbach thesis, only Schmalenbach applied it to capital — he was too smart to make Legge's error and apply it to labour According to this thesis the growth of fixed costs makes it futile to try and offset a fall in demand through production cuts; it is much better to maintain production with average costs because this reduces the size of the loss. The thesis also states that the transformation of ‘variable’ costs into ‘fixed’ costs robs firms of their flexibility in adjusting output to changes in demand.
What happens, of course, is that any firm faced with this situation would only continue production if it expected demand to pick up. If its expectations are disappointed its alleged ‘fixed’ costs quickly become ‘variable’ as labour is fired, contracts terminated, rent and electricity bills cease, etc. In short, the firm closes down.
Labour market reform comes under attack and the Liberal Government flounders
Free labour markets and a leftwing academic’s propaganda
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 3 October 2005