Combating Employment

23 May

In my last post, I explained how inflation can be caused by people getting payrises without producing anything extra. If people can do this, it leads to a “prisoner’s dilemma” situation – if both players demand a payrise, both are worse off. If neither do, both are better off. If only one does, the guy who gets a payrise is better off, and the guy who showed restraint is worse off.

If there were only two workers in the economy, they could negotiate and come to some agreement. Unfortunately, in the real economy, there are more than two workers, and the payrise-inflation game becomes a multi-player prisoner’s dilemma.

In this game, there are millions of workers. At any one time, many of them could approach their bosses and demand a payrise – getting more pay for the same amount of work. Those who obtain a payrise are better off, but add a little to inflation, making others worse off – and the total amount of harm to all the other members of society is more than the what the worker with the payrise gains. The more wages outstrip productivity, the more the cost of goods and services goes up.

So, to solve this problem, we have to either

  • get a million people to cooperate voluntarily, so that they all remain contented with their pay (or earn more through increased productivity), even though many of them could gain a payrise
  • change the game, so that it’s no longer a prisoner’s dilemma.

In modern developed economies, the government usually chooses the second option.

Imagine an economy with 100 workers, as shown below.

An Economy With Full Employment

An Economy With Full Employment

Each of these workers can approach their bosses and say “I’d like more money”. Their bosses don’t have much choice – good staff are hard to find, and nobody responds to their job ads – at least, nobody desperate for work. Now imagine there is 6% unemployment.

An Economy With 6% Unemployment

An Economy With 6% Unemployment

Now there are 6 people desperately looking for work. They would be happy to accept work at any price (at least, any price significantly above their unemployment benefits). It’s harder for the existing workers to demand a payrise, too – sure, they can try, but the boss might easily say “no”. He doesn’t need a greedy staff member who’s demanding more money without producing more, when he can hire an unemployed person instead.

In essence, the game has changed. It’s no longer

Your colleague
No Payrise Payrise
You No Payrise No inflation A little inflation
No payrise for you
Payrise A little inflation
more money for you

45454 when you retire



Your colleague
No Payrise Payrise
You No Payrise No inflation Your colleague needs
a new job
Payrise You need a new job You both need a new job

In this game, there’s no incentive to demand a payrise, hence there’s no inflation. The game has changed, it’s no longer a prisoner’s dilemma, and the best outcome for society arises even when everyone looks out for their own interests. Everyone wins! Except, of course, for the 6 poor blighters who no longer have a job.

So full employment leads to inflation, because people don’t cooperate to keep wages aligned with productivity. High unemployment changes the game so that cooperation is no longer needed.

This is what the reserve bank is trying to do when they raise interest rates. They are deliberately trying to reduce the demand for employees, so that the game changes.

When interest rates are high, mortgage holders want to pay off their mortgages faster, rather than spending money at the shops. Companies don’t want to borrow money for new projects. Business slows down, unemployment increases, and wages stay lower than at other times, and inflation is under control. If business slows down too much, or employment goes too high, the reserve bank lowers interest rates, hoping to encourage people and companies to spend money, boosting the economy. They play a difficult dance between inflation and unemployment – they are forced to do so, because a million people playing the prisoner’s dilemma amongst themselves will not cooperate.

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