Literature I read in 2011

Democracy - Hans Hermann Hoppe

Quantitative Economic History - Joshua Rosenbloom

The Economic Causes of War - Lionel Robbins

Why Wages Rise - F.A. Harper

How I Became A Hindu - David Frawley

Religion Without God - Ray Billington

Human Capital - Joop Hartog & Henriette Brink

God - Victor Stenger

Crisis of Abundance - Arnold Kling

The Tragedy of the Euro - Philip Baggus

A Tiger by the Tail - Friedrich Hayek

A Short History of Financial Euphoria - John Galbraith

Epistemological Problems of Economics - Ludwig von Mises

Philosophy - Edward Craig

Ayodhya and After - Koenraad Elst

Collapsing Pakistan - N.S. Rajaram

Demographic Siege - Koenraad Elst

What Does it All Mean? - Thomas Nagel

Indian Muslims - K.S. Lal

The Secret - Rhonda Byrne

Family Matters - Rohinton Mistry

The God Delusion - Richard Dawkins

A Foreign Policy of Freedom - Ron Paul

Creating Your Path to A Policy Career - IHS

The Elements of Style - William Strunk

Striking The Root - Lawrence Reed

Left and Right - Murray Rothbard

The Politically Incorrect Guide to Islam - Robert Spencer

Economics - Robert Hall & Marc Lieberman

The Truth About Muhammad - Robert Spencer

On Hinduism - Ram Swarup

Negationism in India - Koenraad Elst

Monetary Policy Under the International Gold Standard - Arthur Bloomfield

The Making of Global Finance - Marc Flandreau & Frederic Zumer

Freedom of Expression - Sita Ram Goel

Why was the Industrial Revolution British?

(Draft of my essay submitted for EH401)

This essay summarizes the argument in R.C. Allen’s, “Why the Industrial Revolution was British” about how relative factor prices influenced the early onset of Industrial Revolution in Britain, and takes a critical look at the thesis.

The “Industrial revolution” refers to the historic increase in the productivity and income levels of a number of economies in the world--starting with Europe and North America initially—in the fields of industry, agriculture, transport services, technology etc., from the early decades of the 18^th century and extending well into the latter half of the 19^th century. The period of onset of the industrial revolution, however, varied in different countries: with Great Britain being the first to witness these revolutionary changes followed by other countries in western Europe and the European offshoots (North America), before the benefits of industrialization spread to the entire globe. Although the countries (that underwent the industrial revolution in the 18^th and the 19^th centuries) possessed strong institutions that fostered increased capital accumulation and technology (both of which were important contributors to increase in productivity and income), all of them did not witness simultaneous growth in income levels, or witness any kind of industrialized growth phase that directly followed as a result of the establishment of stable institutions. For instance, the Dutch economy failed to tread a path of technological and industrialized growth even under the persistence of stable institutions.

Why did countries that possessed a strong institutional setup, like in Britain, fail to replicate the successful performance of Britain? In other words, why was the Industrial revolution, at least initially, a British phenomenon? The spread of industry and technology was not a simultaneous process that spanned across Europe. While the British economy was witnessing growth of new industries and technological innovations (like the steam engine, for instance, that tremendously cut down the cost of transport), the whole of continental Europe was still predominantly an agricultural society. The underlying cause for the disparity in the structure and income of the British and continental European economies can be explained by taking into account the peculiar factor prices that existed in Britain, and that which was absent in continental Europe. Labour wages and energy prices in Britain influenced entrepreneurs to make certain decisions that spurred industrialization and technological development. The absence of such unique factor prices eventually made the difference between the success of Britain and failure of continental Europe.

Wages in Britain were considerably higher than what prevailed in other European countries, and the rest of the world. It was not just the nominal wages that were high in Britain, but also real wages (this can be seen in the welfare ratio figures). Apart from high wages, the other peculiar feature of the British economy was the low price of energy sources that could be used as capital in production. Also witness to this are figures on the price of wages relative to energy prices was highest in Britain (Allen, 2011). The presence of high wages and low energy prices provided the right mix of incentives for British entrepreneurs to find ways to cut down their outlay on labour and substitute labour with capital resources that were very cheap compared to labour. This naturally led entrepreneurs to invest in industrial technologies that could make use of cheap energy resources, instead of persisting with old technologies that required the use of expensive labour. The new demand for labour-saving technologies coupled with the patent system spurred the invention of new technologies – a particular feature that characterizes the industrial revolution in general.

Although the Allen’s thesis that outlines the factors that led to industrial revolution in Britain-- through the replacement of expensive labour with cheap capital-intensive technologies--those factors that are mentioned to be unique to the British case are not necessarily so unique in satisfying the requirements of capital-intensive development (that industrial revolution calls for) as such. In other words, the existence of a particular pattern of relative prices in the form of high wages and low energy costs (that is unique to the British case) is not a necessary precondition for productivity-enhancing technology to be invented and subsequently adopted. In the 20^th century, the experience of improvement in agricultural productivity in countries like the United States and Japan show the role played by relative factor prices in determining the quality of the technological inventions that result. Japan, which had relatively little amount of land (and hence higher land prices) compared to its endowment of labour invested in resource-saving ‘biological innovations’ that increased the yield of land; while United States, which had relatively little amount of labour (and hence higher wages) compared to its land endowments invested in labour-saving ‘mechanical innovations’ that increased the productivity of labour.

While relative factor prices can influence the incentives of entrepreneurs in adopting either labour-saving or resource-saving technologies, it does not influence the motives of entrepreneurs to invest in technology itself. The motive to invest in technology (of either type) is independent of relative factor prices; although the kind of investment (labour-saving or resource-saving) depends on the relative factor prices. If so be the case, there is no reason to believe that relative factor prices were decisive in Britain’s technological development. Entrepreneurs who want to cut down on the cost of production of goods, as such, do not care whether their cost-cutting measures economize on labour or resource outlays. While there lies a tendency for entrepreneurs to concentrate primarily on economizing factors of production that contribute most to the cost of production, this does not however mean that disparity in factor prices necessarily hastens the process of invention of new technology itself. That being said, there is definitely an incentive for entrepreneurs to economize on production costs of goods that involve high cost of production, irrespective of the respective factor prices. If so be the case, there is no reason not to believe that high energy costs in continental Europe shouldn’t have spurred entrepreneurs to invest in developing resource-saving technology.

The high energy costs in continental Europe should have spurred the same kind of technological innovation-spree, but of a different quality (resource-saving in the case of continental Europe, rather than labour-saving), that characterized industrialization in Britain. The case of 20^th century Japanese agriculture stands testimony to the fact that an economy could be steered along the path of resource-saving technology when factor prices favour such a path. The conditions in 18^th century continental Europe also suggest that investing in resource-saving technologies would have been highly profitable for entrepreneurs. For instance, cost of energy in France was six times high as much in Britain (Allen,2009). The fact that continental Europe did not move on the path towards resource-saving technology probably suggests that there must have been other qualitative differences in the economic environment of Britain and continental Europe, which needs to be explored further.

Literature I read in 2010

Economic Sophisms - Frederic Bastiat
The Market That Failed - C.P. Chandrasekhar & Jayati Ghosh
America's Great Depression - Murray Rothbard
The Production Of Security - Gustave de Molinari
The Vampire Economy - Guenter Reimann
The Case Against The Fed - Murray Rothbard
The Politically Incorrect Guide To The Great Depression And The New Deal - Robert Murphy
The Failure Of The New Economics - Henry Hazlitt
Time And Money - Roger Garrison
Common Sense Economics - Albert Hahn
Economic Science And The Austrian Method - Hans Hermann Hoppe
Our Enemy, The State - Albert Jay Nock
What You Should Know About Inflation - Henry Hazlitt
From Bretton Woods To World Inflation - Henry Hazlitt
The Fortune At The Bottom Of The Pyramid - C.K. Prahalad
The Making of Modern Economics - Mark Skousen
Will Dollars Save the World? - Henry Hazlitt
Freakonomics - Steven Levitt & Stephen Dubner
For A New Liberty - Murray Rothbard
Interventionism: An Economic Analysis - Ludwig von Mises
The Inflation Crisis and How To Resolve It - Henry Hazlitt
Denationalization of Money - Friedrich von Hayek
Early Speculative Bubbles and Increases in the Supply of Money - Doug French
Defending the Undefendable - Walter Block
Crash Proof - Peter Schiff
The Austrian School - Jesus Huerta de soto
The Mystery of Banking - Murray Rothbard
Crisis and Leviathan - Robert Higgs
The State - Franz Oppenheimer
Notes on Democracy - H.L. Mencken
Lessons for the Young Economist - Robert Murphy
Two Essays - Ludwig von Mises
Depression, War and Cold War - Robert Higgs
India's Economic Transition - Rahul Mukherji
Greenback Populism as Conservative Economics - Gary North
The Confusion of Language in Political Thought - Friedrich von Hayek
Politically Impossible? - W.H.Hutt
Applied Economics - Thomas Sowell
The Man versus The State - Herbert Spencer
American Capitalism - John Kenneth Galbraith
Walk Away - Douglas French
The Return of Depression Economics - Paul Krugman
Thinking As A Science - Henry Hazlitt

Defending the capitalist

Not many characters of importance have earned as much scorn as the monopolist, who through his superior business abilities, and through the constant ability to innovate, has managed to stamp his superiority over others. While I do not wish to defend the business owner (or interest groups), who through crony links with agents of the State, manages to amass a fortune for himself, defending the business man who gains a superior stature in the market purely through the satisfaction of the demands of the consumers earns a place high on my agenda.

Natural tendency of the market

A free market when left unto itself, with the aid of the price system (formed through the knowledge decisions of billions), possesses the tendency to allocate the economy's labor resources towards the most important ends. However, it is not 'the market' as an independent entity that performs the task. Rather it is individuals who act in their own self-interest who aid the market in the process. Individual actions make the market.

While all individual choices (for their own self-interest) are guided towards the achievement of the market's objective of efficient allocation of economically scarce resources, the role played by entrepreneurs in achieving allocational efficiency of limited resources is indispensable in any market economy. A planner in a socialist economy would find it immensely difficult to gather all the knowledge that is required to allocate the economically scarce resources in his economy towards uses that are most highly valued by his citizens. In a capitalist economy, however, the total amount of information knowledge that is required to bring about the best allocation of the economy's resources is broken down into smaller pieces, essentially solving the problem of 'economic calculation'.

The capitalist-entrepreneur

While billions offer their labor services to others, in a market economy, in exchange for the products of others' labor, there always remains a huge array of new ends towards which labor (and other resources) could be directed in order to bring about rational allocation of the economy's resources (by maximizing utility). For instance, raw material like iron ore could be directed towards the production of several consumer goods. The essential role of the entrepreneur in a market economy is to sense the demands of the consumer, and thus to direct resources towards ends of the consumers that are most urgent. In this particular case, entrepreneurs would allocate iron ore towards the production of consumer goods that are most demanded by the consumers. In essence, the preferences of the consumers direct the entrepreneur's actions.

Entrepreneurs who best forecast or anticipate the future demands of the consumers make profits (here is a special post on profits), giving them possession of more money and hence the greater power to direct the allocation of resources towards various ends. The better the entrepreneur serves the demands of the consumers, the richer he becomes, and hence, the more his power to direct the allocation of resources.

Is wealth concentration harmful?

Well, a straight answer would be no. As I've explained here, the market certainly directs more of the purchasing power in the economy towards capitalists who serve the demands of their consumers. But does that mean bad news? Are capitalists capitalizing on their ability to initially serve the consumers to exploit them eventually? Well, no again. As I already mentioned, the market economy has the strong tendency to employ or direct the economy's labor into the most important ends of society. For instance, the market prefers to employ Justin Bieber into making music rather than being a doctor or an engineer (in which he'd probably serve less important ends of society). The same applies to the case of capitalists too.

Men who are enterprising than others in serving the demands of the consumers eventually end up with the possession of resources, which they have utilized efficiently to serve the consumers. The position of the capitalist, however, is not permanent. Present or past success offers no guarantee for future endowment with the economy's resources. The capitalist has to keep satisfying his consumers till he wishes to be endowed with the economy's limited resources. Competing capitalists always have the opportunity to take over his position.

But wait, wouldn't too much concentration of purchasing power in the hands of the capitalists lead to the economy's resources being used to serve the ends of the rich capitalists alone? No again. Something very vital to understand at this point is that capitalists need to invest a large part of their resources in capital assets in order to maintain their position at the top, which in turn is essential to fund their big-spending ways. Whenever a big capitalist (or his heirs probably) starts spending his wealth on funding his personal consumption activities, he gives away control over the economy's productive resources (capital assets). He becomes a consumer, making way for other capitalists to serve his own needs as a consumer. Even in the most extreme case of a capitalist who has served his consumers so well that he gains possession of all wealth in the world (except people's labor of course), he (the capitalist) would still have to serve his consumers by investing in productive assets rather than on consumption.

Conclusion

The economic function of the capitalist in a market economy is basically to serve the demands of the consumers. He obviously doesn't carry out his services out of a sense of altruism, but motivated by self-interest. The position of the capitalist depends on his ability to invest his resources in producing goods (that are of use to consumers), and cutting down on consumption. The consumption spending of successful capitalists is probably enough to motivation to spur men towards entrepreneurial adventures, isn't it?

Understanding wealth distribution

Orthodox public opinion regards wealth distribution to be a zero-sum game, where one man's gain is considered to be others' loss. The booming wealth of Capitalists is supposed to be at the cost of others. If only these Capitalists were controlled, or completely eliminated, by the State, we'd live in a much better 'just society', they say. While the concept of economic scarcity may very well seem to support the zero-sum notion, for what belongs to one person cannot belong to anybody else, it would not hold sway over the public's mind when the actual character of the economics of wealth distribution is understood.

In a planned economy, where every kind of property is 'centralized', the question of wealth distribution assumes a character that is very different from that in a market economy. The State, in a planned Socialist economy, orders it's citizens to produce what it deems fit (according to the planning board's plans) and distributes the produce according to it's plans. In such an 'economy', all wealth is necessarily under the control of the State. In other words, the State owns a monopoly of all wealth. In a market economy on the other hand, which allows peaceful voluntary trade between individuals, the distribution of the economy's wealth is purely based on individuals' ability to produce goods that are 'in demand' in the market. Individuals who produce goods that others are more ready to pay for see their share of the total wealth enhanced, while those whose output is not attractive to consumers are pushed down the economic ladder.

Does this race to the top mean that the rich get richer at the cost of others? If wealth distribution were a zero-sum game, that would indeed be the case. The human race would be in a pathetic situation with the masses fighting it out to plunder most of the limited wealth. But, however, when one understands that wealth is not a given constant, and that it is real human beings who create wealth--which they in turn exchange in return for other goods--he ends up with recognizing the positive side of the natural wealth distribution that results from voluntary trade between individuals. Then comes the realization, the rich get richer not at the cost of others' fortunes at obtaining wealth, but in fact by aiding the masses in enhancing their own standard of living.

How do we measure wealth distribution (or concentration) among different sections of the population? Since the exchange value (in terms of money-price) is the best available 'objective' valuation of any commodity, we shall employ the same to gauge the distribution of wealth. The monetary value or the price of individuals' assets as compared with the total monetary value of all assets in the economy should provide us with an idea of the distribution of wealth in any economy. We shall also, quite safely, assume that in the long-run resources come under the direct ownership control of individuals who are more enterprising than others, or at least under their more active control (in the case of legal owners renting their property to enterprising individuals). In simpler words, it can be concluded that individuals who make money necessarily possess control over the economy's limited resources.

The cooperation of men, under the system of division of labor, to enhance the production of wealth, however, does not relieve mankind of the essential problem of economic scarcity. If economic cooperation in a free market economy cannot relieve mankind of it's scarcity, what is it that necessarily differentiates wealth distribution from a fixed pool of economic wealth, as against wealth distribution from an increasing (but nevertheless scarce) pool of economic wealth? The essential difference lies in the fact that while men try to get the better of others in the former case, they cooperate in the latter case.

A few cases

Lets take the case of a very simple economy where apples (like money) denote wealth. The economy has just three members (X, Y and Z), with each possessing two apples each. So there are totally 6 apples in the economy and each member owns one third of the total wealth of the economy (since apples, as money, can be used to bid for the economy's resources).

First, suppose we are placed with socialist minds, and made to believe X is the Capitalist who is bent upon exploiting his fellow citizens. In such a case, we would have to view X as an exploiter who robs Y and Z. X doesn't produce anything to exchange with either Y or Z, but simply just strips Y and Z of their rightful wealth. Since nothing is produced, and the only thing that happens is exploitation of the weak by the strong, X would end up owning everything (all 6 apples with which he can bid all resources) in the economy, and the rest would be left to starve.

In a second case, lets suppose we are fixed with a good economist's brain. In this case, X is the most enterprising member of the economy. He discovers some new recipes of exotic cakes, uses the labor of Y and Z (for the wage of an apple each) and sells them (say he produced two cakes) to both Y and Z at the price of 2 apples for a piece of cake. Now we see that the total wealth distribution in the economy has altered quite drastically. X now owns two-thirds (four-sixths) of the total wealth while the rest own just one-third. However, in the second case, the total wealth of society has increased from just 6 apples previously to: 6 apples plus two cakes. Both Y and Z are better off (and that's exactly why they gave up 2 apples for a cake, otherwise they wouldn't have) with a cake each, while X too is better off with four apples (as against 2 previously). On the whole, we find that X actually produced goods (cakes) of use to Y and Z, and in the process increasing his share of the total wealth in the economy.

The essential difference between the two cases is the character of the economic relationship between the individuals. The first case explains an exploitative relationship while the latter shows a cooperative (yet competitive) relationship between the individuals.

Now lets move on to a much more extreme case. In the course of time, could an enterprising X end up owning all resources in the economy? Should he own all resources, wouldn't it happen that X completely prohibits others from using his resources? The chances of such a 'catastrophe' are quite minute nevertheless. Lets take the case of an interesting stat I heard recently, about 83% of American stocks lying in the hands of just 1% of the population. Sounds like a disaster? Well, it shouldn't. Ownership of resources by itself does not benefit capitalists. Even when a single or a few capitalists own most or all of an economy's resources, they would still have to cooperate with the overwhelming number of masses in order to produce anything at all. The same basic rules of human association (reading on absolute and comparative advantage should help) still apply. Capitalists would still have to produce, with sufficient cooperation from the masses, for the masses (since they now, by offering their services to the monopoly capitalist, have the purchasing power to guide economic activity according to their needs). Even the capitalist who possesses a monopoly over all resources would have the incentive to make maximum use of the labor of the masses, both to satisfy his own personal ends and that of the masses in a mutually beneficial climate. Proof: Bill Gates still requires the services of General Motors mechanics to make his car which he wouldn't be able to manufacture otherwise (absolute advantage), and the services of his lawn mower to apply his time on managing Microsoft (comparative advantage).

Conclusion

Wealth distribution as such has nothing to do with economic welfare, until trade is peaceful and voluntary. A society with an increasing wealth gap could still be growing richer overall, with businessmen finding it profitable business to serve the masses at cheap prices.

Literature I read in 2009

An Introduction To Austrian Economics - Thomas C. Taylor
Bureaucracy - Ludwig von Mises
Economic Calculation In The Socialist Commonwealth - Ludwig von Mises
Profit And Loss - Ludwig von Mises
The Anti-Capitalistic Mentality - Ludwig von Mises
Planned Chaos - Ludwig von Mises
The Prince - Nicolo Machiavelli
Government - James Mill
Economics For Real People - Gene Callahan
Economics In One Lesson - Henry Hazlitt
The Conquest Of Poverty - Henry Hazlitt
Media Control - Noam Chomsky

An Introduction To Economic Reasoning - David Gordon
The Politics Of Obedience - Etienne de La Boetie
Deflation And Liberty - Jorg Guido Hulsmann
The Law - Fredric Bastiat
The Government Against The Economy - George Reisman
The Road To Serfdom - Friedrich von Hayek
How An Economy Grows And Why It Doesn't - Irwin Schiff
Chaos Theory - Robert P. Murphy
Not A Zero-Sum Game - Manuel F. Ayau
Inclined To Liberty - Louis E. Carabini
The Concise Guide To Economics - Jim Cox
Principles Of Economics - Carl Menger
Economic Principles - Frank Fetter
The Market For Liberty - Morris & Linda Tannehill
Mises And Austrian Economics - Ron Paul
Gold, Peace And Prosperity - Ron Paul
Capital And Interest - Eugen von Bohm Bawerk
Essentials Of Economics - Faustino Ballve
The Fallacy Of The Mixed Economy - S.C. Littlechild
Economic Calculation In The Socialist Society - Trygve J.B. Hoff
Socialism - Ludwig von Mises
Understanding The Dollar Crisis - Percy L. Greaves
Collectivist Economic Planning - Friedrich von Hayek
Anatomy Of The State - Murray Rothbard
Foundations Of The Market-Price System - Milton M. Shapiro
Economic Depressions: Their Cause And Cure - Murray Rothbard
Capital And Production - Richard von Strigl
What Has Government Done To Our Money? - Murray Rothbard
Planning For Freedom - Ludwig von Mises
Money, Bank Credit, And Economic Cycles - Jesus Huerta de Soto
Human Action - Ludwig von Mises
Protection Or Free Trade - Henry George
The Austrian Theory Of The Trade Cycle And Other Essays - Richard Ebeling
Capitalism - George Reisman
Man, Economy, And State - Murray Rothbard
The Pure Theory Of Capital - Friedrich von Hayek
Market Theory And The Price System - Israel Kirzner
Principles Of Economics - Gregory Mankiw
Principles Of Macroeconomics - Joseph G. Nellis & David Parker
On The Origins Of Money - Carl Menger
Macroeconomics - Gregory Mankiw
Keynes And Hayek - G.R. Steele

What's a false boom?

(This is a rough write-up I posed on the Mises forum. Documenting certain replies saves me from re-typing answers in future situations, so that's the reason--if you ever wonder why)

It's a boom that is not backed by voluntary savings.

People allocate their money funds towards two things: present consumption (like buying food, clothes, etc.) and future consumption (that is, savings that get invested into building industries that can increase the production of consumption goods).

Suppose the economy's total money supply is $100. People save $50 and spend the remaining $50 on present consumption. If you notice here: 50% of the economy's purchasing power went into savings and the other 50% went into present consumption. Now the Fed increases the money supply to $200 by printing $100 worth of extra money and lends $150 ($100 of new money + $50 of voluntary savings from people) it to investments, while $50 are still spent on present consumption by people. Note here: 75% of the total purchasing power in the economy goes into savings while only 25% goes into present consumption.

People when left to themselves have a consumption-savings proportion of 50-50 with 50 percent purchasing power going into savings (investment) and 50 percent going into present consumption, but when the Fed increases money supply it alters the original consumption-savings ratio of people by increasing money supply and thereby allocating 75% of the economy's purchasing power towards savings while only 25% goes into present consumption. In short, the Fed imposes forced saving on people.

So the industrial sector (fed by lots of phony savings) sees a boom. But it is temporary. Why? Because when the $200 completely percolates into the economy, people would again reassert their consumption-savings proportion, by saving $100 and spending the rest (one hundred dollars) on present consumption. See the difference? People have reasserted that they want only 50% of their purchasing power to go into savings and not 75% as the Fed wants things to be.

This decrease in the savings available for funding investment projects leads to higher interest rates (just like how a decrease in the supply of apples in the market, under constant demand conditions, leads to higher prices), and the marginal borrowers of loans will be unable to fund their projects any longer, or if they have already completed building their project they would be unable to pay the higher interest rates that prevail now after people have reasserted their consumption-savings proportion. For example, James sees that he can get a 4% return on a business project and when he sees that the interest rate (artificially lowered by the Fed) is just one percent, he gets all excited and plunges into the project. But when interest rate eventually hikes, lets say to 5%, he sees that his project is no longer profitable and starts defaulting on his loans.

Lastly, when interest rates hike after savers reassert their consumption-savings ratio, the Fed doesn't usually let the bust happen. Instead it again inflates money supply to impose forced saving on people again, and keeps the interest rates artificially low. But this policy can't continue forever, since the money will eventually get debased because of inflation.

Whoever said Ads were a waste of resources.

Courtesy: www.youtube.com

Can efficiency wages cause unemployment?

If one wants to see the market process as a mechanistic repetition with no heed cause-effect approach to analysis, mainstream economics should be the ideal pick. And Mankiw's Principles suggests just the same, for one more time. The issue is with unemployment, and efficiency wages are suggested as one of the causes of unemployment.

Mankiw's case

So writes Mankiw in his best-seller 'Principles Of Economics':

"A fourth reason why economies always experience some unemployment--in addition to job search, minimum-wage laws, and unions--is suggested by the theory of efficiency wages. According to this theory, firms operate more efficiently if wages are above the equilibrium level. Therefore, it may be profitable for firms to keep wages high even in the presence of a surplus of labor."

In essence, Mankiw implicates efficiency wages (which are voluntarily paid by capitalists) to be the cause of the market price staying above the market's 'clearing price'.

Correcting Mankiw

As I've pointed out already, although in a succinct manner, 'efficiency wages' are offered by capitalists in a purely voluntary basis. So it would do good to contrast 'efficiency wages' from minimum wage laws that fix wage levels above the labor market's 'clearing price', a coercive action.

Lets see this difference with the help of an example. Before plunging in, it must be understood that the price at which any market 'clears'(all of the supply is sold) is, essentially, the price at which the the marginal seller and the marginal buyer successfully exchange the marginal product. If sellers flood the market with 500 shirts, and assuming the sellers want to have their whole stock sold-off, they would have to find the exact price at which the buyers are ready to buy the whole stock of 500 shirts. That would be the shirt market's 'clearing price'.

Any price that is above the market's 'clearing price' would lead to an excess stock of unsold shirts. And any price below the 'clearing price' would lead to shortages--buyers ready to pay the price(in this case being the sub-clearing price) of the shirt but finding shirts already out of stock. So it is the 'clearing price' alone that essentially matches the 500 shirts with exactly 500 buyers(who most urgently need, or are ready to pay for it).

If I could rephrase what I've been trying to say through the example as something like this: the market 'clearing price' is that price at which the marginal seller exchanges the shirt for the buyer's money(price).

So now, the next question to be asked would be: does an efficiency wage really mean a price(wage rate, in the case of labor) that is above the 'market clearing' price? Mankiw obviously seems to think so. And the problem could be attributed to his adherence to the mainstream notion of some particular 'clearing price' somewhat automatically generated in the market machine; such that any price above that particular 'clearing price' should lead to the market being left with excesses(unemployed laborers, in the case of the labor market).

But does the real economy suffer from such mechanistic order of things? Is there are any magically processed price at which the labor market clears? No there isn't. The 'market clearing' price, if any, is determined by purposeful human action. All that it requires for the labor market to 'clear' is for the marginal buyer to agree to the marginal wage offer of the capitalist.

Conclusion

So, all that it requires for the market to clear is to let the employers and workers to act voluntarily in the market. And that definitely is the case with 'efficiency wages'. There is no coercive intervention involved when a capitalist wants to provide better wages to his workers. If the capitalist is ready to pay above-average wage rates to the marginal worker, the market will still clear.

The growing size of Government in the US economy.

Courtesy: www.lewrockwell.com