Alchian on the Meaning of Keynesian “Involuntary” Unemployment

In his classic paper “Information Costs, Pricing, and Resource Unemployment,” Armen Alchian explains how the absence of full information about the characteristics of goods and services, and about the prices at which they are available leads to a variety of phenomena that are inconsistent with implications of idealized “perfect markets” at which all transactors can buy or sell as much as they want to at known, market-clearing, prices. The main implications of less than full information are the necessity of search, less than instantaneous price adjustment to changes in demand or cost conditions, the holding of (seemingly) idle or unemployed inventories, queuing, and even rationing. The paper was originally published in 1969 in the Western Economic Journal (subsequently Economic Inquiry) and was republished in a 1970 volume edited by Edmund Phelps, Microeconomic Foundations of Employment and Inflation Theory. It is included in The Collected Works of Armen Alchian (volume 1) published by the Liberty Fund.

Alchian’s explanation of Keynes’s definition of involuntary unemployment appears in footnote 27 in the version published in the Phelps volume (23 in the version published in volume 1 of The Collected Works). Here is the entire footnote:

An intriguing intellectual historical curioso may be explainable by this theory, as has been brought to my attention by Axel Leijonhufvud. Keynes’ powerful, but elliptical, definition of involuntary unemployment has been left in limbo. He wrote:

Men are involuntary unemployed if, in the event of a small rise in the price of wage-goods relative to the money-wage, both the aggregate supply of labour willing to work for the current money wage and the aggregate demand for it at that wage would be greater than the existing volume of employment.

[J. M. Keynes, The General Theory of Employment, Interest, and Money (The Macmillan Company, London, 1936).] To see the power and meaning of this definition (not cause) of unemployment, consider the following question: Why would a cut in money wages provoke a different response than if the price level rose relative to wages – when both would amount to the same change in relative prices, but differ only in the money price level? Almost everyone thought Keynes presumed a money wage illusion. However, an answer more respectful of Keynes is available. The price level rise conveys different information: Money wages everywhere have fallen relative to prices. On the other hand, a cut in one’s own wage money wage does not imply options elsewhere have fallen. A cut only in one’s present job is revealed. The money versus real wage distinction is not the relevant comparison; the wage in the present job versus the wage in all other jobs is the relevant comparison. This rationalizes Keynes’ definition of involuntary unemployment in terms of price-level changes. If wages were cut everywhere else, and if employees knew it, they would not choose unemployment – but they would if they believed wages were cut just in their current job. When one employer cuts wages, this does not signify cuts elsewhere. His employees rightly think wages are not reduced elsewhere. On the other hand, with a rise in the price level, employees have less reason to think their current real wages are lower than they are elsewhere. So they do not immediately refuse a lower real wage induced by a higher price level, whereas they would refuse an equal money wage cut in their present job. It is the revelation of information about prospects elsewhere that makes the difference. And this is perfectly consistent with Keynes’ definition of [involuntary] unemployment, and it is also consistent with his entire theory of market-adjustment processes (Keynes, The General Theory of Employment, Interest, and Money) since he believed that money wages lagged behind nonwage prices – an unproved and probably false belief (R. A. Kessel and A. A. Alchian, “The Meaning and Validity of the Inflation-Induced Lag of Wages Behind Prices,” American Economic Review 50 (March 1960): 43-66). Without that belief a general price-level rise is indeed general; it includes wages, and as such there is no reason to believe a price level rise is equivalent in real terms to a money wage cut in a particular job.

PS There is a lot of unpacking that needs to be done in the last two sentences, but that is best left for another post.