Relative Prices and the Demand for Labour in British Manufacturing

Abstract

The existence of an aggregate demand for labour schedule, derived from profit maximization of the individual firm and giving a negative relationship between the labour-capital ratio and the real wage, is central to most traditional theoretical macroeconomics, even though such a relationship is typically not embodied in macroeconomic models. But beginning with the work of Dunlop (1938) and Tarshis (1939), the negative relationship could not be found in the data: a more modern reference is Bodkin (1969). This evidence led naturally to disequilibrium analysis, notably that of Barro and Grossman (1971). More recently Sargent (1978) has attempted, with some success, to rehabilitate the demand for labour schedule by showing that costly adjustment of the workforce obscures the current relationship between the wage and labour demand, while leaving it essentially intact. That paper (and the related one by Neftci, 1978) was criticized by Geary and Kennan (1979) because it had used retail prices to represent output prices, and they showed that for a number of countries employment could not be explained satisfactorily by the real product wage. However, Geary and Kennan failed to allow for the simultaneous effect of the real prices of raw materials and capital services. In this paper we shall see that, allowing for the effects of other relative prices, notably the price of inputs relative to output and the real interest rate, the real wage has a powerful but slow-acting negative effect on the demand for labour: the long-run elasticity is about 2 and the mean lag is over 18 months. We also find that the price of inputs has a long-run elasticity of about -2, and that high values of the real interest rate have a powerful depressant effect on the level of employment in manufacturing. The most striking implication for policy of our analysis is that measures of demand (output, money, government spending) do not have a significant influence on manufacturing employment, controlling for the effects of relative prices. Thus, government macroeconomic policy can affect the level of employment in manufacturing if and only if it can affect relative prices.