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Sticky Wages

Why does a reduction in demand reduce output rather than prices and wages? Although in the early 1980s some workers accepted reductions in wages and benefits in the hope of protecting jobs, this adjustment is uncommon. There are several reasons why it is more common to sacrifice workers and protect wages.

One reason involves cases in which a union vote is necessary to change contracts. If the choice is between no reduction in compensation with a 40% reduction in work force, or a mere 5% reduction in compensation with no reduction in work force, the former option may win if the 60% of the workers who will keep their jobs are easily identified. Since layoffs are usually determined by seniority, those who will keep their jobs are usually identifiable. Hence, it is not in the interests of workers with a great deal of seniority to vote for any reduction in compensation unless the very survival of the organization is at stake.

However, the majority of wage agreements are made without union involvement and in these agreements reductions in compensation are also uncommon. When the threat of a strike does not exist, workers have other options. They can leave the company if they are unhappy with compensation, and the ablest workers can most easily move. High turnover raises training costs. In addition, morale is a factor in determining productivity, and any agreement forced on workers can have effects on morale that might eliminate any advantage that the organization receives from lower wages.

Suppose that management of a company comes to its workers and announces that because of difficult economic conditions, it believes that a 10% reduction in wages is in order. How will workers react? They will have considerable reason to doubt management because a reduction in compensation will always increase profitability. Therefore, management always has the incentive to ask for lower wages whether or not a reduction is justified by poor economic conditions. The workers do not know whether or not management has seriously tried other methods to reduce costs, or even if there is any condition of economic difficulty. Hence, workers often disbelieve statements that pay cuts are needed and fight attempts to cut wages.

On the other hand, when management announces that due to economic difficulties it must lay off 10% of the work force, there is usually no reason to doubt their sincerity. Cutting work force will cut output, and in normal periods this cut will reduce profits. Since the potential for abuse does not exist in allowing companies to adjust work schedules, but a potential for abuse does exist if companies are allowed to adjust pay schedules at will, workers permit companies the former right but resist the second with whatever means at their disposal.

A final reason that workers may be unwilling to accept a cut in pay is that they believe that their current wage is an accurate measure of what they are worth. They believe that they could leave their present job and find another that will pay them as much. If their wage is cut, they could stay in their present jobs, but that would mean that they would be receiving less than they were worth; the firm would be "exploiting" them. However, leaving and searching for a new job is costly, involving time, risk, and adjustment to a new workplace. Since neither alternative, staying with lower pay or a job search, is attractive, workers resist pay cuts.

One might argue that the above discussion does not explain why an employer cannot simply discharge all workers and hire new ones if there are plenty of available applicants willing to accept lower wages. This is an option when unskilled labor is the dominant type of labor, and has been a major obstacle in the organization of migrant workers. It is not a good option when on-the-job learning makes new workers less productive than old workers, or when the firm finds it difficult to separate (or screen) those applicants who are qualified from those who are not. Also, the law gives certain privileges (or rights) to workers so that discharging them can be expensive. The employer may have to pay either sums to the discharged workers or higher unemployment-insurance payments. Finally, discharging workers raises a risk of violence and destruction of the employer's facilities.

A surprising result when quality of labor depends on wage is that an equilibrium wage might coexist with some level of unemployment. Economists have constructed theories in which a reduction in demand for labor does not lead to a reduction in wages.

The purpose of the above discussion is to point out reasons why wages do not fall readily. It is not meant to convince you that wage rates can never fall. They have. From 1929 to 1933, the average wage of production workers in manufacturing fell by about 20%. It is probable that with comparable levels of unemployment, wages would fall even today. If workers are convinced that their choice is to accept lower wages or have the firm collapse, they will often accept lower wages. The point of the above discussion is to suggest that until a firm is facing the prospect of bankruptcy, it finds cutting wages very difficult.

The problem in the labor market is not symmetrical; workers are willing to take higher wages readily to adjust to an increase in demand. Employers may not want to increase wages, but either they must or they will lose both existing workers and high-quality applicants. When spending increases rapidly, there are fewer rigidities in the labor market and prices and wages will respond more readily than they would to a fall in demand.

Next we take a look at types of unemployment.

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Copyright Robert Schenk