An essential ingredient for good policy analysis is a sound theoretical framework. Successful policy is not built on wishful thinking; rather, it is the product of clear-sighted analysis. For this reason, economic theory should always precede economic policy.
Given this, it is necessary to begin with a brief characterization of the economy as it really works. Such a characterization involves four axiomatic principles.
DIAGNOSING THE PROBLEM
1. The levels of employment and output (GDP) depend on the level of demand for goods and services. Slack demand tends to lower output and employment; brisk demand tends to produce inflationary pressures.
2. The level of demand depends importantly on the distribution of income between wages and profits. High wages tend to stimulate demand owing to their effect on consumption. However, to the extent that higher wages reduce the profit rate, they can adversely affect investment spending, which reduces demand.
3. The distribution of income between wages and profits depends on bargaining between workers and firms. Conflict is an essential part of this bargain, because profits come at the expense of wages in bargaining between individual firms and workers. Moreover, the relative bargaining strengths of workers and firms depend importantly on the state of the economy, with increases in the rate of unemployment serving to weaken worker power. Worker power is also affected by the case with which firms can replace existing workers and by labor legislation providing benefits for workers and protection against layoffs and other employer sanctions.
4. Firms are driven by the search for profits and will therefore shift their production to new sites if they can earn higher profits by doing so. This principle applies to both manufacturing and financial firms. Manufacturing firms shift the location of production in response to cost differences: financial firms manipulate the composition of their portfolios if they can earn higher yields (with unchanged risk) by doing so.
............ At the center of the analysis lies the issue of bargaining power, which determines the distribution of income across wages and profits. Income distribution then affects the level of demand for goods and services, which in turn determines the level of economic activity. This affects employment conditions and the rate of unemployment, which feeds back on the distribution of bargaining power between firms and workers.
Not only is bargaining power determined by current conditions within the economy, it is also affected by structural factors that are independent of current economic conditions. These outside factors include the extent of capital mobility, which refers to the ease with which firms can shift the geographical site of their activities. They include the nature of technology, which affects how easy it is to replace workers. Ease of replacement is also affected by labor laws governing replacement. Bargaining power is affected by the extent of unionization, because collective action by workers