Read this article to learn about the Expansion and Ricardo effect of wage flexibility.
Expansion Effect:
Professor Oscar Lange considers wage flexibility merely a special case of the general theory of price flexibility and examines the circumstances under which wage flexibility could restore full employment equilibrium.
According to Professor Lange a general cut in money wages would restore full employment of labour only if the “positive monetary effect” is present.
To illustrate it, let us assume that there is unemployment of a factor of production (labour), if its price is flexible, it will fall as a result of this. This fall in its price will produce two effects—firstly, a fall in the factor price will lead to its substitution for other factors (presuming the prices of all other factors to be constant) called the “substitution effect” and, secondly, the marginal cost of products into the production of which this product enters would fall (prices of products remaining constant), this will cause an expansion in output and therefore lead to an increase in the demand for unemployed factor (labour). This is called by Professor Oscar Lange “expansion effect.”
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It is to be noted that the prices of other factors and products are also subject to variation. When none of unemployed factors is substituted for other factors, the demand for others also falls and therefore their prices. The substitution effect will take place only when other factor prices fall less in proportion as compared to the fall in the price of unemployed factor.
Similarly, expansion effect will take place only when the prices of the products produced with the unemployed factor fall less in proportion to the fall in the marginal cost. According to Professor Oscar Lange this will happen only when “positive monetary effect” is present in the economy. He defines monetary effect as “the reaction of the community to a proportional change in all prices—i.e., whether community reacts by a substitution of goods for money or by substitution of money for goods. The monetary effect is said to be positive when a proportional fall of all prices causes substitution of goods for money and vice versa.”
Ricardo Effect:
Ricardo Effect lays down that as real wages fall (on account of high prices of consumer goods or cut in money wages) there will be greater use of labour for capital. The process of production will become less and less round about making smaller use of capital and greater use of labour. This will create more employment. But employment is a function of investment which in turn depends on capital using methods. The fall in real wages results in its elimination and less use of capital. It is, therefore, doubtful whether Ricardo Effect could result in greater employment opportunities.