Labor Demand

I am a huge fan of Bryan Caplan.  I hope that if I were ever at GMU, or had the opportunity otherwise, that I would be a protégé of his.  However, in responding to what Paul Krugman wrote the other day, he writes two points that I have issues with myself.

• Cutting wages increases the quantity of labor demanded. If labor demand is elastic, total labor income rises as a result of wage cuts.

I found an intuitive problem with this critique.  I believe Caplan has his causation reversed.  You see, the reason why one would a take a wage cut in the first place is because labor demand is decreasing.  One takes the wage cut just to stop the demand of labor from decreasing.

As a producer, I would want to lay off workers because I’m closing down production, or having no service to provide.  It would not be wise for me to give my employees wage cuts, and then get more labor, which would take away all the savings I made from the wage cuts in the first place.

You might say that I would have increased productivity and therefore, cheaper goods.  You’d be right, but what businessman is thinking of increasing, or maintaining, costs when no one is buying the product in the first place?  While it makes sense as economists that we get more labor when it’s cheaper, and make the product cheaper to sell more of it, most businessmen don’t think that way.

Luckily for us, Bryan allows for another possibility.

• Even if labor demand is inelastic, moreover, wage cuts reduce labor income by raising employers' income. So unless employers are unusually likely to put cash under their mattresses, wage cuts still boost aggregate demand.

I’m just not sure about that.  If that were the case, then there would be firms showing more profit, or expanding their production.  And that simply is not happening.

The point of all of this goes to the question of: if Caplan is right, then why is demand for anything still down?