Bryan Caplan  

Labor Market Rigidity: Psychology, Technology, and Peter Pan

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Real Wages During the 1981-82 ... David Friedman on Robert Frank...
Back in 2008, some of my favorite economists argued that unemployment wouldn't rise much, even if there were a big nominal shock.  Why not?  "Labor markets are more flexible than they used to be."  Why?  That was a little hazy, but the main reason seemed to be better management due to more advanced information technology.

I never bought this story, and unfortunately, as David Henderson points out, I was right.   Today's firms do have better management and more advanced information technology than they used to.  But the most important cause of labor market rigidity, at least in the U.S., is psychology.  People resent wage cuts, especially nominal wage cuts.  This resentment varies over place and time, but even economists feel it.  The awful unintended consequence of this resentment: Employers cut employment instead.  If you talk to employers off the record, they often explain that wage cuts hurt productivity by angering workers, but lay-offs raise productivity by scaring them.

Why was I so skeptical of the view that labor markets had changed?  Because cutting wages when labor demand falls isn't rocket science.  You don't need computers or just-in-time inventory systems to do it.  You don't even need a calculator.  Just cut wages by 2 or 3 percent, and see what happens.  The upshot: If workers didn't have a knee-jerk hatred for wage cuts, especially nominal wage cuts, employers would have solved the unemployment problem millenia ago.  And given this knee-jerk hatred, all the computing power in the world isn't enough to stabilize unemployment in the face of big nominal shocks.

Is labor market rigidity a market failure?  I'm afraid so.  But strangely enough, this market failure is largely caused by anti-market bias!  The main reason workers hate wage cuts is that they imagine that wage-cutting employers are satanically "unfair."  If workers saw wage cuts for what they are - a full-employment mechanism - they'd sing a different tune.  While they wouldn't be happy to see their wages cut, they'd grudgingly accept that a little wage variability is a fair price to pay for near-total employment security.  Once this economically enlightened perspective took hold, employers would eagerly cater to it - and the market failure would largely go away.

According to Peter Pan, "Everytime a child says 'I don't believe in fairies,' there's a little fairy somewhere that falls down dead."  As far as I know, he's wrong about fairies.  But if Peter had warned, "Everytime a person says, 'I don't believe in markets,' there's a worker somewhere that loses his job," he wouldn't have been far from the truth.  Scoff if you must!  People can and do cause market failure by believing in it.


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COMMENTS (29 to date)
Robin Hanson writes:
Everytime a person says, 'I don't believe in markets,' there's a worker somewhere that loses his job.
This should be worked somehow into the sequel to "Its a Wonderful Life". :)
Yancey Ward writes:

I lost my job last summer in a major retrenchment in headcount and costs, and the truth is this- they could have paid me 50% of what they were and I would have accepted it. I would have even offerred this solution except for one thing- the employer would never have agreed to it as a matter of policy. I can only speculate that cutting my salary would have set a precedent, should it become widely known, that would destroy the morale of the people who had not had their's reduced, or that is is generally believed that, if you pay someone half as much (or whatever percentage you wish to hypothecate about) as before, he will only produce half as much value, even if he volunteered to take the reduction in the first place. Instead, we fire people and have them take similar positions elsewhere at lower pay and perks, or different positions altogether. I can't imagine this increases efficiency in any way, but maybe I am missing something.

Bob Knaus writes:

In the "market" I grew up with, it was normal for wages to go up and down as supply and demand dictated. We're talking about "piecework" which is how pickers are normally paid to harvest fruits and vegetables. Would this work for teaching students economics? or serving up burgers at McDonalds? Hmmm....

As the son of the farmer, of course, I was on a different pay scale. I was a "sharecropper" who got paid once a year based on how the farm profited.

Honest. At 17 years old, I had to budget my yearly expenses based on an annual payout.

Builds character!

Sean A writes:

This is the problem with including precise speculations about psychology into economic analysis. What exactly constitutes a "market failure" here? Considering the history of labor unions' coercive manipulation of wages backed by government, along with countless other factors, its impossible to isolate this anti-market sentiment to the market processes. It seems more consistent with the notion that anti-market policy leads to more anti-market policy to "fix" the first failed intervention.

Strict Truth writes:

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david writes:

Or we could just, y'know, engage in across-the board inflation of (gasp) 4% or so. Nominal wages are only downwardly rigid.

qudrupole writes:

The problem with across the board wage cuts is that talent is unbelievably heterogenous. See how long your top talent hangs out even in a market apacolyse when you cut their salaries.

The rule of thumb is this... whenever you cut wages, only the overpaid will stay with you. And in talent driven businesses, when your top talent leaves you have a very big problem.

In the sequel to "It's a Wonderful Life," an angel will meet the supposedly-evil banker Mr. Potter (Mr. was apparently his first name) and show his wonderful life. If he had never existed, the banker with a heart would have frittered away the capital of the townspeople. Mr. Potter made it possible for a town with a healthy economy to rescue Bailey's bank.

Daniel writes:

Worse, the problem is self reinforcing. People prefer layoffs because of anti-market bias, and become more biased against markets when the effects of unemployment kick in.

Doc Merlin writes:

I disagree Bryan!
Look at the chart and you see the wages drop for all the other recessions EXCEPT for this one. That suggests it isn't a psychological problem, but a structural one. And it isn't just a structural problem but it is a NEW structural problem.

The real question should be, what has changed since the last recession?

Patrick writes:

@Doc Merlin

DEFLATION. That's what changed.

JPIrving writes:

I think Bryan is siding with Sumner here.(?) People suffer money illusion, and have debts denominated in nominal dollars, should have kept NGDP growing goddamnit! But can a central bank control the price level so precisely as to produce the near instant 4% inflation David suggested above? Or do we get 8% inflation a year later? Long and variable lags?

Too bad we dont have more of the labor force in self employed or contracting work. Plumbers, carpenters, web designers can more easily adjust their wages to keep busy during recessions.

Doc Merlin writes:

@Patrick:
We see a 4% change in what appears to be a single month, but the deflation was spread out over a longer period. So, I suspect its something other than that (although that may have contributed). One thing is the higher minimum wage kicked in then, and the bailout money got spent shortly before that.

Bryan Pick writes:

qudrupole: "The rule of thumb is this... whenever you cut wages, only the overpaid will stay with you. And in talent driven businesses, when your top talent leaves you have a very big problem."

That's highly plausible. So if employers agree that "wage cuts hurt productivity by angering workers, but lay-offs raise productivity by scaring them," then a compromise solution is to cut wages selectively.

Then again, one benefit of laying people off instead of cutting wages is that the resentful people are no longer hanging around, dragging everyone else down. And when you are confident that you can profitably hire new people again, they're grateful for the opportunity, not just thinking that they've finally regained the wages they used to earn there.

William Barghest writes:

So what, the list of major problems that could be solved if only people believed certain simple things is enormous. Good institutions must be build around how people are not how they should be.

Tom West writes:

I think Bryan should look at this economically.

Are people better off *as a whole* with rejecting nominal wage cuts that they would be accepting them?

I'd argue yes. Like lots of human behaviour, I think this is another quick and dirty rule that actually manages 90% of what strict adherence to a sophisticated economic model would provide without the knowledge or effort.

I suggest that many (most?) people only really closely look at wages for their job when they're getting a new job. That's about it for their understanding of what the market rate is for their job.

After accepting a job, it takes an enormous differential before many people will jump jobs. Especially if there's no guarantee of finding another job immediately, having to move, etc. (i.e. there are *some* job markets that are very competitive, most aren't.)

If employers are aware of this behaviour, it makes sense to offer $x on startup and then drop salaries by a small number of percent each year afterwards.

But, by getting angry with a nominal wage drop, the workers basically protect themselves from this tactic. Sure, lots of other things can go wrong, but they're a lot better off than if they didn't have this rule at all.

Is the rule perfect? Of course not. But as a whole, it makes workers better off. (Unless we live in an a fantasy reality where workers always know their fair market value, and can shift jobs with ease).

I'd also say this particular "irrationality" has been an especially good thing for university professors, who, as a whole, are enormously job sticky :-).

Brian Moore writes:

In the recent downturn, the segment of my company that I work for decided to use small wage decreases instead of firing anyone. They basically stated that if they felt they could do without someone enough to be fired, they already would have done so.

While certainly I'm upset about a 3% lower wage, and though I don't think I would have been fired if they had terminated people (who does?), I value my co-workers enough (and fear the difficulty of having to train new ones when the market turns around) that I prefer this.

Whenever I had the "wage cut vs. firing" explained in the past, employers told me they had usually preferred to fire people, because while firing and wage cuts both made employees extremely upset, fired employees weren't around to complain any more. So I think perhaps that the bias for firing exists also in the employer, though obviously partially driven by what they perceive to be the employee's reaction.

Lo Statuz writes:

Why haven't employers solved this problem? For example, why not pay employees partly in fixed wages and partly in profit sharing? If profit drops, the labor cost falls automatically. Paying salespeople on commission has the same automatic effect.

In the U.S., the Fair Labor Standards Act makes use of profit sharing harder, and of course the minimum wage sets a floor, but it should still work for a lot of employees.

mattmc writes:

The main reason workers hate wage cuts is that they imagine that wage-cutting employers are satanically "unfair."

I think it's more like workers have taken on a set of fixed expenses equal to their current income. Off course, you can't lay off your kids, but you can cut their benefits.

Lord writes:

Employers are simply practicing the same policy that they employ when not in recession, accepting wages as market determined and adjusting demand in response. Cuts would always be painful and they can avoid it by cutting demand. Libertarians that oppose income redistribution through taxation support it through wage cuts. While the unemployed would favor it, the employed have no reason to as they benefit from it. Only the unemployed care about unemployment.

Mikko Sandt writes:

Isn't it possible that the extension of unemployment benefits keeps the real wage rate higher than it'd be otherwise? This is because a person who's been laid off recently, instead of accepting a job with a lower nominal wage rate simply chooses to remain unemployed and therefore doesn't show up in wage statistics.

Ryan Vann writes:

Money illusion probably does come into play; however, I do concur with some of Doc Merlin's assertions about a change in structure. Some of the same advances in management and informatics that Prof Caplan mentions would probably effect the slope of labor demand. Because much of these processes require specialized knowledge, once a person is unemployed, they find difficulty finding positions in other fields. Those that are hiring, are particular about the knowledge they want employees to have, and are less inclined to hire just anyone.

quadrupole writes:

Ah... Bonuses... Those are are an effective way to tune wages ... Folks with a 10% bonus target won't be pissed at the company if bonuses are reduced or eliminated in a rough year, because that part of compensation is explicitly linked to performance.

Brian C writes:

In my company we had layoff then later a 5% pay cut (plus removal of 2% 401k matching) plus some slow departments went to 32 hours a week (no pay cut for them and employees on contracts that revenue was based on their salaries were not cut either) I can say a lot of the best people have left, and if others could find a job they would leave also. Add into the fact the a drop in housing prices limits quite a few from moving and the impact has not been to bad in a lighter rescission. My issue with pay cuts are flat across the board. Pay decreases (other than for management) should be based on performance just as increase should be.

When it comes to profit sharing, I am very skeptical. I know accounting well enough to know how one can manipulate the numbers so I would not trust it. For example, my dad works for a Public Utility company. Everyone in the company gets a bonus based on yearly profitability. However, that is pretty much 100% dictated by weather. One year the power consumption was so high everyone should of received a huge bonus. However, because it was so large the company deferred the revenue so they would not have to pay out a huge bonus, nor would they in the future. For example, when one has revenue recognition based on Percent Complete method (PCM) one can adjust revenue based on adjusting Estimate at Completion. The longer your contracts the easer it is to massage the numbers with PCM by changing expected cost. There are many other ways to adjust net income. Net operating cash flow is about the only accounting metric I would substitute a large amount of my salary for a performance bonus because one can pretty much not adjust that number in a period.

Mark Washenberger writes:

Lately I've been wondering if the psychology of downward nominal wage rigidity would fade away if we went through a long term period of deflation. It seems like if wage-earners experienced the gradual trend of becoming richer in real terms while becoming poorer in nominal terms, it might be easier to temporarily become poorer in both.

Matthew C. writes:

Because if you cut people's salaries, they can't pay their fixed expenses such as mortgages, car payments, credit cards, etc. So obviously this will crush morale. . .

Mark Washenberger writes:

Not that anyone is still following this thread, but Matthew C's post intrigues me more. Isn't the establishment of a large number of fixed expenses funded by credit a result of the inflationary fiat currency regime? Is it conceivable that if NGDP per capita remained relatively fixed through time that people would eschew debt in general? If so, they wouldn't have as many fixed expenses so their morale would possibly be more resilient.

Lorenzo from Oz writes:

It is better to terminate an existing employment relationship than to poison continuing ones, as I discuss here. For an employer to cut wages while expecting the same level of work deeply undermines the notion of a contract. (By contrast, failing to raise wages in a situation of inflation does not breach any contract that does not have indexation built into it.)

@Lorenzo from Oz

But most employees are not under any fixed contract--we are employed at will. That means that either side can terminate the relationship at any time for any reason or no reason at all (except for a handful of forbidden reasons). If your employer can fire you without breaking any "contract," your employer can also cut your wages (or, equivalently, fire you and offer you back your job at reduced wages).

What you, in your blog post, call an "ongoing, even evolving, contract ... more defined by [employer/employee] interactions than by any written agreement" is not what any legal system understands by the word "contract" (which, by the way, does not need to be in writing to be binding in most cases). If you want to talk about reasonable expectations, use that word and we'd have a different argument.

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