The reason that economy-wide wage cuts will not reduce unemployment relates to the observation that
Answer: Wages are both an income to workers and a cost to firms.
The answer is Option (a)
Prior to the 1930s, there was no separate field of study called macroeconomics.
The dominant neoclassical school of thought in economics at the time considered that to make statements about the economy as a whole (the domain of macroeconomics) one could just infer from reasoning conducted at the individual unit or atomistic level.
This reasoning was rejected in the 1930s, and macroeconomics became a separate discipline precisely because the dominant way of thinking at the time, blithely transposing microeconomic truisms to the macro scale, was riddled with errors of logic that led to spurious analytical reasoning and poor policy advice.
Microeconomics develops theories about individual behavioural units in the economy - at the level of the person, household, or firm. For example, it might seek to explain the employment decisions of a firm or the saving decisions of an individual income recipient. However, microeconomic theory ignores knock-on effects on others when examining these firm- or household-level decisions. That is clearly inappropriate if we look at the macroeconomy, where we must consider these wider impacts.
During the Great Depression, British economist John Maynard Keynes and others considered that by ignoring these interdependencies (knock-on effects), economists were creating a compositional fallacy.
Compositional fallacies are errors in logic that arise when we infer that something which is true at the individual level, is also true at the aggregate level.
The fallacy of composition arises here when actions that are logical, correct and/or rational at the individual level are found to have no logic (and may be wrong and/or irrational) at the aggregate level.
In the video that was relevant to this question, we discussed the paradox of thrift and another fallacy concerning the use of economy-wide wage cuts to improve employment prospects.
In the latter case, the superintendency that creates the logical flaw is that wages are not only a cost of production but also a major source of income, which determines consumption expenditure.
The dominant view was that the mass unemployment that had skyrocketed in the early 1930s could only be solved by wage cuts.
Their reasoning was based on their analysis of single firm decision-making. They believed we could generalise from firm-specific analysis.
Say we start with a single firm employing a few workers.
If the firm can persuade its workers to accept lower wages, then its labour costs will fall.
The loss of income of its workers as a result of the wage cuts, will, in the overall scheme of things, be inconsequential for the total sales of the firm.
Accordingly, with lower labour costs and no loss of sales, the firm will increase its profits, Neoclassical economists then asserted that the firm would then employ more workers.
Thus, the neoclassical solution to unemployment was to always engineer a wage cut.
This view was disputed by Keynes and others during the Great Depression, when the British Treasury engineered a wage cut for all workers and unemployment became worse.
Keynes asked the question: what would happen if we extended the individual logic to the economy as a whole?
What would happen if all the firms cut the wages for all workers in an effort to reduce unemployment?
Keynes opposed this solution during the Great Depression of the 1930s as neoclassical economists pressured governments to cut wages.
But this is no idle historical exercise.
The strategy remains a solution advocated by mainstream economists today.
The fallacy relates to the observation by Keynes that wages are both a cost item (supply-side), AND, a source of income (demand-side).
The neoclassical reasoning failed to account for the second characteristic.
Let's see what this means.
If all firms cut their wages, then labour costs throughout the economy will decline.
Neoclassical reasoning was that this would boost profits and businesses would start hiring the unemployed to produce more output and generate even greater profits.
But the dual nature of wages, meant that all workers now had less income, which meant that they could consume less. Consumption expenditure is the largest component of total spending in the economy (around 60 per cent of total).
As workers cut their spending, sales would fall, and, profits would start to decline.
Firms would note the unsold goods on their shelves and would cut back production and lay off workers. Firms only hire workers if they can sell the extra output produced.
So, the laid off workers would then lose their incomes and the problem would get worse.
Consequently, unemployment starts to rise, and, unless there is a spending stimulus from government, the economy will quickly enter recession.
The point is that the individual logic, even if true, cannot be applied at the aggregate level.
Mass unemployment is always the result of insufficient total spending and can be resolved by governments increasing spending if the non-government sector spending falls. Wages cuts are not a macroeconomic solution.