Bryan Caplan  

Posner's Primer on Wage Rigidity

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Very well-put:
Unfortunately, not all prices are flexible; wages especially are not. This is not primarily because of union or other employment contracts. Few private-sector employers in the United States are unionized and as a result few workers (other than federal judges!) have a guaranteed wage. The reasons that employers generally prefer to lay off workers than to reduce wages when demand drops are first that by picking the least productive workers to lay off an employer can increase the productivity of its work force; second that workers may respond to a reduction in their wages by working less hard, and, conversely, may work harder if they think that by doing so they are reducing the likelihood of their being laid off; and third that when all workers in a plant or office have their wages cut, all are unhappy, whereas with lay offs the unhappy workers are off the premises and so do not incite unhappiness among the ones who remain.
Perhaps strangely, this reminds me of Rothbard at his best:
Generally, wage rates can only be kept above full-employment rates through coercion by governments, unions, or both. Occasionally, however, the wage rates are maintained by voluntary choice (although the choice is usually ignorant of the consequences) or by coercion supplemented by voluntary choice. It may happen, for example, that either business firms or the workers themselves may become persuaded that maintaining wage rates artificially high is their bounden duty. Such persuasion has actually been at the root of much of the unemployment of our time, and this was particularly true in the 1929 depression.
I have a dream that one day workers will see employers who cut wages during downturns as people with "hard heads and soft hearts."  What will it take to bring my dream to life?

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COMMENTS (10 to date)
Alex J. writes:

There's inflation, for one.

David D. Friedman suggests that we may be stuck with irrational price (and thus wage) rigidity for some time:

Behavioral Consequences of the Belief in Just Prices

Instead of getting rid of people's hatred of wage reductions, we might focus it somewhere mostly harmless by scapegoating evil spirits or Andaman Islanders or "fear".

During the Asian financial crisis, I recall Koreans turning in their gold jewelry to help, so we could invoke a sense of duty and expiatory sacrifices. (I'm sure politicians prefer scapegoating.)

James Oaksun writes:

I think HP during a depression/recession went to 4 days work/4 days pay, rather than having a layoff. But I can't think of other examples.

Philo writes:

Posner writes that “by picking the least productive workers to lay off an employer can increase the productivity of its work force.” But those less productive workers should all along have been drawing lower wages, commensurate with their productivity. So getting rid of them offers no gain in productivity per unit of wages (as opposed to per employee or per hour worked). Also: “workers may respond to a reduction in their wages by working less hard, and, conversely, may work harder if they think that by doing so they are reducing the likelihood of their being laid off.” But don’t you always “reduce the likelihood of being laid off” by working harder; and don’t you also increase the likelihood of a promotion or raise in pay? In short, aren’t the incentives to work hard always present?

These are supposed to be explanations for employers’ preference for lay-offs or firings over broad reductions in wages. But these responses to a decline in demand are not mutually exclusive; probably both should be used.

Posner’s third explanation seems the best. People are unduly upset by the loss of an asset they possessed, compared with their pleasure in unexpectedly acquiring a new asset. So workers will react with irrational negativity to a reduction in their accustomed pay. But there must be considerable variation here. The wise manager will fire the worst sore-heads, and retain the more complaisant remainder at reduced pay.

bjk writes:

Japanese have low base salaries and then get paid bonuses. I don't think Americans would go for that because we'd figure that the low base salary was just a way to screw the worker out of a decent salary. And salespeople do regularly get fired and not paid their bonus.

Lord writes:

Some common routes are suspension of benefits, particularly 401k matches and pension contributions, bonuses, and suspension of work. The former tend to be too small, leading to the latter. As increasing volatility diminishes value, none of these will ever be truly popular and will be viewed as a reason to find other more steady employment especially by the best workers.

Snark writes:

Brookman et al (CEO Cash and Stock-Based Compensation Changes, Layoff Decisions, and Shareholder Value - SSRN 10/06):

"The CEOs of firms announcing layoffs receive 22.8% more total pay in the subsequent year than other CEOs. These pay increases result almost entirely from increases in stock-based compensation and are found to persist. In addition, layoff announcements are accompanied by shareholder value increases averaging $40 million to $95 million. One-time labor cost savings from layoffs average $65 million. We conclude CEOs receive pay increases following layoffs as rewards for past decisions and to motivate value-enhancing decisions in the future."

This, more than any other theory or explanation, is the tie that binds.

Tom Grey writes:

Getting to your dream?
How about:
when all wages above some low limit (min wage? 80% of the median?), include significant profit sharing.

So low profits AUTOMATICALLY mean lower wages, with no additional discretion.

Snark was right on -- CEO pay increases after layoffs support more layoffs, faster.

Layoffs are better for the firm, and in 'high employment' times, better for society. In a low employment period, lower wages would be better.

Sort of like not being able to short a stock going down.

robert arbon writes:

I've always wondered what are the effects of expectations, particularly those brought about by inflation, on the stickyness of wages.

For instance would if the central bank decided that it would follow a price deflation policy and that people year on year see the prices of goods fall, would wages be so sticky downwards?

Vasco writes:

I 'wonder' why Keynesians don't support automatic indexing of all wages to productivity, at least during recessions.

Well, I don't wonder, because I know they just use Keynesian economics as an ad-hoc justification for what they already support, but I'm surprised no intellectually honest Keynesian has ever supported this. I know there's no chance it'd pass in a democracy, but economists propose unpopular things all the time.

william simpson writes:

Bryan, this is already happening in Great Britain. Many companies in manufacturing have instituted pay cuts and 4 day weeks, and the verdict of the staff is that while they would rather have full pay or 5 days work, the employer is only responding to the dropoff in orders as humanely as possible.

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