Pigou Effect on Wage Cut and Full Employment

A renowned neoclassical economist, A.C. Pigou, suggested a cut in wage rates in order to remove huge and widespread unemployment prevailing at the time of great depression during the period 1929-33. According to him, under free competition, the tendency of economic system is to automatically provide full employment in the labor market and if there is unemployment in the free economy, then there are two reasons of it- first, rigidity in wage structure and second, interference in working of free market economy.

For example: Government and trade unions of workers interfere free working of the capitalist economy and artificially keep the wage rates at high levels then:

High wages → high cost of production → price rise → decrease in demand of goods → supply is more than demand → decrease in demand of labour → unemployment.

He expressed the view that if the wage rates were cut down, demand for labor would increase so that all would get employment. It is called Pigou effect or real balance effect. The term,’ the Pigou effect’ was named by Don Patinkin in 1948.

Pigou pointed out that price level will fall due to cut in wages. The fall in price level will lead to the increase in real value of money assets such as stock of money, deposits in banks, bonds of government or private companies held by them. In other words, due to fall in price level, the purchasing power of their money assets will increase. As a result, demand for consumption goods and services will increase and sales will be pushed up. It will increase the demand for labor and ultimately full employment will be attained. It will be possible due to all-round cut in wages.

Later Parkinson supported Pigou’s view about favorable effect of reduction in wages on fall in price level and a favorable effect on demand for goods.

Pigou effect is based on the following assumptions:

 Wages, prices and rate of interest are perfectly flexible.

  • Labor is homogeneous.
  • There is a laissez-faire capitalist economy without government
  • interference.
  • There is perfect competition in labor and product markets.
  • It is a closed economy without foreign trade.
  • There is a direct and proportional relation between money wages and real wages. Nominal or money wages are the wages received by a worker in the form of money. while real wages can be defined as the amount of goods and services that a worker purchases from his nominal wages. Thus, real wages show the purchasing power of nominal wages. An increase in money wage rate implies an increase in real wage rate and decrease in money wage rate implies a decrease in real wage rate.

In the case of unemployment, a general cut in money wages would take the economy to the full employment level. According to classical economists, those workers who do not want to work at lower wages and remain unemployed are only voluntarily unemployed. This voluntary unemployment is not considered real unemployment. Involuntary unemployment is not possible in a free-market capitalist economy. All those workers who want to work at the going wage rate determined by market forces will get employment. Full employment of labor is possible due to quick adjustment of wages.

Labor Market Equilibrium-

According to Pigou, real wage is equal to the marginal product of labor and marginal Productivity diminishes as employment increases, so for the equilibrium position and full employment, it is must that real wage rate should be decreased with the increase in employment.

In the labor market, the demand for labor and the supply of labor both determine the level of output and employment. Producers demand for labor and they will employ labor until the marginal product of labor is equal to the given real wage rate.

Real wage rate is given by nominal wage rate divided by the general price level:

real wage rate = W/ P

where: W is the nominal or money wage rate and P is the price level. Thus, a producer will employ so much labor at which W/P = MPN

where MPN is the marginal product of labor.

The level of full employment is determined where labor supply equals labor demand. According to the classical economists specially Pigou, the demand for labor is a decreasing function of the real wage rate: DN = f (W/P)

where DN = demand for laborW = wage rate and P = price level.

Dividing wage rate (W) by price level (P), we get the real wage rate (W/P).

Supply of labor increases with the rise in wage rate, thus, supply of labor is an increasing function of the real wage rate: SN = f (W/P), where SN is the supply of labor.

In the above diagram, the DN and SN curves intersect at point E, the full employment level NF is determined at the equilibrium real wage rate W/P0. If the wage rate rises from W/P0 to W/P1, the supply of labor will be more than its demand by ds and there will be unemployment N1NF. Consequently, the wage rate will fall from W/P1 to W/P0   due to excess supply. It will again decrease the supply of labor and increase the demand for labor and the equilibrium point E will be restored along with the full employment level NF. On the contrary, if the wage rate falls from W/P0 to WP2 the demand for labor will be more than its supply. Excess demand will raise the wage rate from W/P2 to W/P0 and the equilibrium point E will be restored along with the full employment level NF. Since every worker is paid wages equal to its marginal productivity, therefore full employment level NF is reached when wage is reached from W/P1 to W/P0 [shown in Panel B]. Form the diagram it is clear, that the quick changes in the real wage rate upward or downward ensures that neither excess supply of labor, nor excess demand for labor will persist and thus equilibrium will be reached with full employment of labor in the economy.

Pigou gave an equation to understand the entire proposition:

N = qY/W


  • N =the number of workers employed
  • q = the fraction of income earned as wages
  • Y = the national income
  • W=the money wage rate
  • N can be increased by a reduction in W.

Thus, the key to full employment is a reduction in money wage.

It’s Criticism –

Pigou’s wage cut theory can be valid for an individual industry but in the case of the economy as a whole, this is not valid because a general cut in wages will reduce the incomes of the working class. Due to it, enough demand will not be there for the output produced by the whole economy. This deficiency in demand will reduce demand for workers as a result of which unemployment will spread among them. Keynes criticized this theory on the following bases-

Keynes proved Pigou’s view that cut in money wages will restore full employment as fallacious- Keynes put forward the view that wages are not only the cost of production, they are also incomes of the workers. When there is a general wage-cut, the income of the workers is reduced and aggregate demand will fall. As a result of decline in aggregate demand, level of production will have to be reduced and less labor will be employed than before. This will create more unemployment rather than reducing it.

From the practical view point, Keynes never favored a wage cut policy.

Wages and unemployment: There are the fundamental difference between Keynes and Pigou in respect of the relationship between wages and employment. Pigou thought that level of employment in an economy depends upon the level of money wages and therefore reduction in money wages will promote employment. On the other hand, Keynes thought that the level of employment depends upon the aggregate demand and aggregate demand declines as a result of an all-round cut in money wages.

State Intervention Essential- Keynes states that the capitalist system is incapable of using productive power fully. Therefore, state intervention is necessary. The state may directly invest to raise the level of economic activity or to supplement private investment. It may pass legislation recognizing trade unions, fixing minimum wages and providing relief to workers through social security measures. Keynes favored state action to utilize fully the resources of the economy for attaining full employment.

Long-Run Analysis Unrealistic- The classicists believed in the long-run full employment equilibrium through a self-adjusting process. Keynes had no patience to wait for the long period for he believed that “In the long-run we are all dead”.

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