Inequality and the culprit economists overlook — their own wage theory

12 Oct, 2014 at 20:20 | Posted in Economics | 2 Comments

Though many economists today are sounding the alarm over rising income inequality, one culprit somehow has been overlooked: their own wage theory.

corporate-profitsv-wagesWage theory — one of the sacred truths of modern economics — suggests that competitive labor markets are self-regulating. Each worker is paid his or her productive worth. Unions, minimum wages, or any other interference — all just cause unemployment. Nearly all contemporary public policy is dictated by some version of this theory, but it simply no longer holds up.

Adam Smith, often called the father of classical economics, told a very different story. Smith believed that each society sets a living wage to cover “whatever the custom of the country renders it indecent for creditable people, even of the lowest order, to be without.” His successor David Ricardo similarly saw the “habits and customs of the people” as determining how to divide income between profits and wages. Marx’s class struggle was just a more confrontational version of the idea.

Around the turn of the 20th century, economists grew dissatisfied with this squishy sociologist’s answer, and some found it morally problematic. “The indictment that hangs over society is that of ‘exploiting labor,’” conceded John Bates Clark, a founder of the American Economic Association. He set out to disprove it.

Clark and other colleagues posited that firms shop for the best deal among “factors of production” — labor and capital — just as smart consumers shop for the best deal at the supermarket. Automakers, for example, could build cars by employing more workers and less machinery, or vice versa. By seeking the least expensive combination, the firms will pay only wages equal to a worker’s “marginal productivity” — the gain in output added when he or she was hired. …

With an entire organization cooperating to produce goods or services, and no individual contributing any ascertainable productivity, we are back to Smith, Ricardo, and Marx. The habits and customs of the people or class struggle, call it what you will, determine the wage structure. Of course, there are limits. The sum of the slices of the pie — the profits and wages paid to different workers — cannot be bigger than the pie. But how to slice the pie is a fundamentally social decision.

Jonathan Schlefer

A nice piece by the author of The Assumptions Economists Make.

Here is my own latest take on marginal productivity theory.


  1. From Jonathan Schlefer’s historical overview everybody gets the impression that neither orthodox nor heterodox economists have a clear idea of the fundamental economic concepts income and profit. As a matter of fact, what is known with certainty from the structural axiomatic analysis is that the conventional approaches are logically deficient (2014).

    An in-depth analysis shows that there is no such thing as “a share of profit in income” but there is “a share of distributed profit in income”. Most economists do not realize that profit and distributed profit are fundamentally different economic entities. Profit is not a factor income and it cannot be functionally attributed to capital. Because of this, the distribution of the period output has nothing to do with any marginal product of labor or capital (2012).

    From the refutation of marginalism, though, does not follow that the alternative approaches of Keynes or Kalecki or Kaldor or Keen, for example, are substantially better. For Kalecki see on this blog:

    The correct Profit Law reads for the investment economy:

    Qm =Yd+I-Sm: (2014, p. 8, eq. (18))

    Legend: Qm: monetary profit, Yd distributed profit, Sm: monetary saving, I investment expenditure.

    The Profit Law, which is testable with an accuracy of two decimal places, gets a bit longer as soon as foreign trade and government is included. The crucial thing is that profit for the economy as a whole does not at all depend on capital and productivity and this makes the Cambridge Capital Controversy pointless. The productivity-profit nexus holds for a single firm and cannot be generalized for the economy as a whole. This is the fallacy of composition — the trademark of conventional economic thinking (2013).

    Changes of the valuation price of assets are captured by nonmonetary profit Qn. This is a separate and lengthy issue to be dealt elsewhere (2011).

    The profit theory is false since Adam Smith. Without exception, the currently available distribution theories are hanging in the air.

    This is the actual state of economics: a perfect scientific vacuum.
    Egmont Kakarot-Handtke
    Kakarot-Handtke, E. (2011). Primary and Secondary Markets. SSRN Working Paper Series, 1917012: 1–26. URL
    Kakarot-Handtke, E. (2012). Income Distribution, Profit, and Real Shares. SSRN
    Working Paper Series, 2012793: 1–13. URL
    Kakarot-Handtke, E. (2013). Confused Confusers: How to Stop Thinking Like
    an Economist and Start Thinking Like a Scientist. SSRN Working Paper Series,
    2207598: 1–16. URL
    Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics:
    Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL

  2. As the Cambridge Capital Theory Controversies shown, the distribution between profits and wages is not determined endogenously by marginal productivities. It is instead an exogenous factor from the point of view of economic theory (it depends on institutional aspects such as custom, as noted in this post).

    Because those who receive wages have a higher marginal propensity to consume on average (as Kalecki and Keynes noted), and because consumption depends upon settled habit and custom, more equal distributions of income (where more income goes to wage-earners with higher propensity to consume) brings longer (more stable) periods of growth, as noted in a previous post in this blog.

    When distribution is unequal, and a large share goes to profit-receivers, who do not consume such a high percentage of their income as wage-earners, the only way for income to return to the economic circuit is through investment which is, as Keynes said, the most mercurial economic flow (Kalecki kept reformulating his explanation of investment due to its mercurial nature, or so I think). And currently that part of the income (that comes from profits) is being accumulated rather than reinvested, hence the prolonged nature of the crisis is connected to inequality.

    We must also understand that luxury consumption does not compensate inequality as it appears to be when looking at the data, because much of luxury consumption is derived from the stock of wealth (which is often being depleted) rather than from the flow of income, and hence it is not sustainable. When comparing consumption and income, we must take separate this wealth effect, so that we see only the relation between income and consumption, which is the dominant force in the long run (wealth is created and destroyed all the time throughout economic cycles, but the stock of wealth is always (re)created by flows of income).

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