Talk:Wage-price spiral/Archives/2013

Proposed illustration

Good day,

I recently answered someone (suspiciously socialist) concerning the issue of raising the minimum wage [[1]]. I created a simple (perhaps too simple) model for how it will affect inflation. The following is my answer. Sorry it's quite long and my economics is rusty. I was hoping it might be helpful to put it up but seriously beefed up with the effects of money supply, demand, and velocity to help explain pressure on prices; well as agressively editted. Maybe we can introduce capitol stocks and investments in here? Might be too long though.

We could raise the minimum wage, but are you willing to pay the price?

To elaborate, let me give the following oversimplification. We make the following premises:

1.) Money is worthless by itself without goods/services to trade with. The value of money lies in the willingness and ability of other people to trade goods/services for it.

2.) Income = Consumption i.e. The economy as a whole can only consume as much as it produces; and earn so long as others consume another's production. Or simply one's consumption is another's production and one's income is another's consumption. This is a derivation of the GDP equation: GDP = consumption + government spending + investments + net exports. We've taken out net exports and discounted investments effects on productivity to simplify matters. GDP, crudely, is the income part.

Now let us set up a hypothetical closed economy of 10 people. Each person produces 1 unit of bread and 1 unit of milk for a total of 10 for the economy. Each good is priced at P10 and the people are paid P20 each. To illustrate the equation is givenː

Income of 10 people = consumption of 10 people

10 x P20 = (1 bread + 1 milk) x 10 people

P200 = (P10 + P10) x 10 people

P200 = P200

income = consumption

Please note that there are only P200 worth of bills circulating in the economy therefore the entire GDP of the economy (10 bread and milk) is “priced” at P200. This is important because money is worthless by itself. It is only important if you can trade stuff for it. In this case, bread and milk.

Now let us raise the wage of P20 to P25… (This also raises money supply by P20 but let's not get into that).

Income of 10 people = Consumption of 10 people

10 x P25 = (1 bread + 1 milk) x 10 people

P250 = (P10 + P10) x 10 people

P250 = P20 x 10

P250 ≠ P200

How can this be? Sure workers get more pay but the economy still produces the same amount of goods (10 bread and milk). All that money can only still be exchanged for 10 bread and milk. And how can you increase total wages to P250 when your total sales are P200?

Two things happen hereː 1.) People start charging each other more for their goods to cover the increase cost of wages. 2.) People start bidding up the price of the goods in an attempt to buy more goods (after all they have more money now).

Either way this put upward pressure for the price of goods until the equation balances. So thatː

Income of 10 people = Consumption of 10 people

10 x P25 = (1 bread + 1 milk) x 10 people

P250 = (P12.5 + P12.5) x 10 people

P250 = P25 x 10

P250 = P250

Back to square one people still can only buy 1 bread and milk each. It's as if nothing happened EXCEPT FOR A LOT OF INFLATION (i.e. 10 bread and milk is now “priced” at P250). Unfortunately this isn't usually the case because of sticky prices and menu costs. Prices do not change in the short run. So firms may lay off workers or close up shop if they can't operate until prices adjust. Leading to unemployment. Let us assume 2 people are laid off.

Income of 8 people = Consumption of 8 people

8 x P25 = (1 bread + 1 milk) x 8 people

Noteː the economy now produces 8 bread and milk due to less workers

P200 = (P10 + P10) x 8 people

P200 = P20 x 8

P200 ≠= P160

How can the economy operate this way? Through dissaving. Firms/people can use up their savings until they can charge higher prices. Unfortuntely, this isn't sustainable and causes the capital stock of an economy to go down. I took capital stock out to simplify matters. This happens until prices adjustː

Income of 8 people = Consumption of 8 people

8 x P25 = (1 bread + 1 milk) x 8 people

P200 = (P12.5 + P12.5) x 8 people

P200 = P25 x 8

P200 = P200

Now we have less people employed (8people), less overall production (8 bread and milk), and inflation (8 bread & milk = P200). Will the employed and productivity go back to previous levels? Maybe, but it takes a lot of investments to put up a factory or business so it takes time. And what if minimum wages rise again w/o a corresponding increase in productivity? Firms will be even more reluctant to invest.

Caveatː I admit the real world economy is a lot more complicated than this. This is why effects illustrated here by an enormous rise in the minimum wage may or may not be immediately seen in the economy.

What if you doubled productivity in our model? :Income of 10 people = consumption of 10 people

20 x P20 = (2 bread + 2 milk) x 10 people <---- if double this shud increase

:P200 = (P20 + P20) x 10 people

P400 = P400Bold text'

People earn the same amount but now they can consume twice as much. Certainly more sustainable than raising the minimum wage. How? try the reforms I mentioned on top (in reality some inflation might be desirable when the growth happens but it's complicated). Responsiblebum 05:34, 3 November 2006 (UTC)