The London Business School with Gower Publishing
Authors: Robinson Bill , Wade Keith 
Published: January 2008

The theory of employment is reasonably well understood. Producers are confronted with a given level of aggregate demand. They decide how much they can profitably produce, and decide on the mix of capital and labour in response to a given set of relative prices. Over most of the post‐war period variations in employment were accounted for mainly by variations in aggregate demand, but that situation changed dramatically during the 1970s. As unemployment has mounted, so has the interest in so‐called supply‐side explanations of the problem, since it has become obvious that an increase in employment on the scale required can hardly come from a demand stimulus alone.

In our account of the 1980 recession, we tended to focus on profitability as a key element in the decision to supply. If the price of goods is too low relative to the price of the factors of production needed to produce them, then the supply of output will fall. In the 1980 recession the price of all the factors of production rose dramatically: real wages shot up following the Clegg awards; real interest rates were at record levels; and the price of energy had recently soared following the OPEC II oil shock. At the same time goods prices were being constrained by the government's counter‐inflationary strategy, and most notably by a strong exchange rate.

Under these circumstances a substantial proportion of firms, especially in the traded goods sector, found it unprofitable to continue producing. When unprofitable production lines were abandoned, the associated capital equipment was scrapped. These decisions, once taken, were for the most part irreversible even if, as must have happened in some cases, subsequent movements in factor prices would have made production profitable once again. We discussed this phenomenon in the April Forecast Release and showed that, on the assumption that capital‐labour ratios had remained at their trend levels, some £25bn of capital equipment (at I980 prices) had been scrapped. The fact that manufacturing output and employment have remained far below their 1979 levels, even though total output at home and abroad is at or well above that level is, we believe, mainly due to this capital scrapping. The jobs in manufacturing will not be re‐created ‐ even though UK competitiveness has been restored to pre‐1980 levels ‐ until the capital stock is re‐built.

The scrapping phenomenon is important because it creates a link between employment and too‐high real wages (or other factor costs) that is often ignored. In standard production theory a rise in real wages leads to the substitution of capital for labour and employment may fall (if the rive in real wages does not create a more than offsetting increase in aggregate demand). However, production theory is complicated by the fact that capital and labour are complements as well as substitutes. Since a large part of the nation's productive‐capacity, once built, uses capital and labour in fixed proportions, a rise in real wages may render part of the existing capital stock uneconomic. High real wages thus destroy capital as well as jobs.

In our April Forecast Release, in order to estimate the scale of the scrapping problem, we made the simplifying assumption that capital‐labour ratios remained on trend. In practice they vary in line with movements in relative factor prices. In the present Forecast Release we look more closely at the role of factor prices. We find some evidence that changes in relative factor prices affect the capital‐labour mix. However, the substitution elasticities are small. The conclusion of this analysis is that the job losses which resulted from too‐high factor prices (mainly wages) during the recession cannot be quickly reversed.