Bryan Caplan  

How Wage Rigidity is Special

PRINT
Metaphors for the Economy... Compared to What?...
Both nominal wages and nominal housing prices are what economists call "downwardly inflexible."  In most markets, falling demand swiftly leads to falling prices, and surpluses don't last long.  But in labor and housing markets, market adjustment to negative demand shocks is far more reluctant.

There are plenty of regulations that exacerbate the problem, of course.  But the main cause in both cases seems to be psychological.  Workers resent nominal wages cuts, and resentful workers are unproductive workers.  Home owners resent selling their home for less than they think it's "really worth," especially if they're already underwater.

And yet there's one important asymmetry between labor and housing markets.  In housing markets, sellers really do have a foolproof way to sell an unwanted house: Cut their asking price.  Just going 10% below the price the typical stubborn seller insists upon usually does the trick.

In labor markets, in contrast, this seemingly foolproof method is strangely ineffective.  Unless I'm sadly misinformed, saying "I'll happily work for 10% less than you're offering" simply isn't a good interviewing strategy.  It might work.  But it also makes you sound weird.  Net effect on your probability of landing a job: Unclear.  Net effect on your expected income:  negative.

Two questions:

1. Do housing and labor markets really work as I describe?

2. If so, why the asymmetry?  Why is human psychology so easy to unilaterally circumvent in housing markets, but so hard to escape in labor markets?



COMMENTS (17 to date)
Various writes:

Yes, I think the markets work as you believe they do....sort of. When I was mid-way through grad school, I lobbied Wall Street firms to hire me at zero cost for a summer internship. I received no takers. Once on Wall Street, I could see the problem. There is an adverse selection issue, part imaginary, and part reality. I say part imaginary because I believe many bosses put too much weight in pedigree and other similar types of signaling. I think salary requirements are an important form of signaling. But there is a dose of reality as well. In my experience, the cost of one "lemon" employee outweighs the benefits of several good ones. Thus the information conveyed by salary requirements is significant.

By the way, I think the risk of adverse selection in hiring declines the lower the skill level. The problem is, the cost of benefits and other non-wage expenses increases at lower wage levels, thus roughly offsetting the decreasing lemon factor.

David Friedman writes:

A possible explanation is that the seller is better informed, relative to the buyer, about the value of what he is selling in the case of labor than in the case of the house, hence his willingness to lower the price is more likely to be taken as a signal of lower quality.

Jim Rose writes:

Alchian and Ben Klein both wrote about wage and price rigidity, layoffs and dependent assets. The renegotiation of wages is suppressed to prevent opportunism.

Alchian (1969) listed three ways to adjust to unanticipated demand fluctuations:
• output adjustments;
• wage and price adjustments; and
• Inventories and queues (including reservations).

Alchian (1969) suggests that there is no reason for wage and price changes to be used regardless of the relative cost of these other options:
• The cost of output adjustment stems from the fact that marginal costs rise with output;

• The cost of price adjustment arises because uncertain prices and wages induce costly search by buyers and sellers seeking the best offer; and

• The third method of adjustment has holding and queuing costs.

There is a tendency for unpredicted price and wage changes to induce costly additional search.

Long-term contracts including implicit contracts arise to share risks and curb opportunism over sunken investments in relationship-specific capital. These factors lead to queues, unemployment, spare capacity, layoffs, shortages, inventories and non-price rationing in conjunction with wage stability.

Alchian and Woodward’s 1987 'Reflections on a theory of the firm' says:

“… the notion of a quickly equilibrating market price is baffling save in a very few markets.

Imagine an employer and an employee. Will they renegotiate price every hour, or with every perceived change in circumstances?

If the employee is a waiter in a restaurant, would the waiter’s wage be renegotiated with every new customer? Would it be renegotiated to zero when no customers are present, and then back to a high level that would extract the entire customer value when a queue appears? …

But what is the right interval for renegotiation or change in price? The usual answer ‘as soon as demand or supply changes’ is uninformative.”

Alchian and Woodward then go on to discuss the role of protecting composite quasi-rents from dependent resources as the decider of the timing of wage and price revisions.

Alchian and Woodward explain unemployment to the side effect of the purpose of wage and price rigidity, which is the prevention of hold-ups over dependent assets.

Alchian and Woodward note that unemployment cannot be understood until am adequate theory of the firm explains the type of contracts the members of a firm contract with one another.

Benjamin Klein’s theory of rigid wages in American Economic Review in 1984 is one of the few that explored rigid wages as an industrial organisation issue.

Klein treated rigid wages as a response to opportunism and hold-up problems over specialised assets and is a form of exclusive dealership or take-or-pay contracts.

liberty writes:

"If the employee is a waiter in a restaurant, would the waiter’s wage be renegotiated with every new customer? Would it be renegotiated to zero when no customers are present, and then back to a high level that would extract the entire customer value when a queue appears? …"

This is actually a terrible example for making the point, because the answer in America, at least in major cities like NY, is a resounding YES. Waiters in NY make a trivial nominal wage but their true wage is in tips. Every hour depending upon their performance and the amount of customers present their wage is renegotiated. It is only that this is negotiated directly between the customer and the employee, without going through the employer as an intermediate. Normally the employer will set prices based on costs and expected demand at each price, and then pay wages out of the profit. In this situation the employer does that for the product food, but for the service, that which this kind of employee provides, he allows the customer to decide the price and his wages come (almost) entirely out of that revenue - and the employee can (usually) keep all of it. The customer and the employee negotiate the wage on a continuing basis.

E. Barandiaran writes:

The two transactions differ in an important dimension. You sell/buy the house and you don't see again the other party --perhaps, you never see him/her again. You bargain and once you agree with the other party about a price and other terms, good bye. In the housing market there is a lot of bargaining because each house (even apartments in the same building) are different in at least one dimension. Housing markets differ from apple markets because houses are much more expensive and therefore buyers and sellers have an incentive to bargain much longer.

In labor markets there are several situations, but a common one is that of employers hiring people for a non-defined period of time. In this particular situation, an employer hires a person to work every day for a long time and he/she doesn't want to re-negotiate the salary too often (it's more like renting a house than buying a house). How often salaries must be adjusted becomes a relevant issue when designing the contract. In addition, most likely the employer is hiring more than one person, and given that two workers are not alike the employer has to deal with the consequences of renegotiating salaries on the other workers. Indeed, unions and labor laws add constraints to what I have just said.

In sum, don't put houses, apples and labor in the same basket. The beauty of micro theory is that it forces you to identify similarities and differences across goods that are relevant to their production, trade and consumption.

Jeremy, Alabama writes:

Selling a house is a one-time transaction.

Employment is an ongoing transaction. The employer often has a considerable investment in the employee. The employee will interact with the product, customers and other employees, and can do considerable harm.

Lowest-price often DOES work for one-time employment, by contract.

William Bruntrager writes:

In the Alchian and Allen textbook, the authors point out that firms rely on a wide variety of inputs to produce their output. Thus when there is a fall in nominal spending that would require all prices to adjust downward by, say, 10%, it takes time and effort for that information to be revealed to all the relevant suppliers, and for prices to adjust. In the meantime, some jobs are not worth maintaining, even if employers could cut the wage to zero.

PrometheeFeu writes:

@Bryan:

I don't see where you are getting this interaction from. In my admittedly limited experience, you go to an interview and at some point they ask you for your salary requirements. Depending upon how your job search is going, you give a different number. So this is where you give your low or high price. I have never had an employer give me a number first. By the time I got their number, it came with a job offer so it would be quite foolish for me to ask for a lower salary at that point. So I think there is a mechanism for the price of new hires to drop.

PS: Figuring out what my salary requirements were was very educational if very stressful. It taught me 3 things very clearly:

1) Prices are sticky in the Friedman sense. You can do all the research you want, you really don't have a clear idea of what the market clearing price is and you just have to experiment for a while. Most interviewers never gave me the slightest hint of whether I was asking for too much or too little money. However, at the interview for my first job, the recruiter responded with: "With those requirements you don't have to be flexible." I'm pretty sure that means I could have gotten more, but it was too late and I was starting to get pretty desperate anyways. So pricing is not about drawing indifference curves. It's about stumbling around in the dark for the light-switch.

2) Your reservation price will change all the time. When I had a series of 4 interviews scheduled, my first interview I asked for X, when I got a no, I asked for X - Y at next interview, then X - 2Y and so on. Some of that was learning, but some of it was just the fact that my options were diminishing. On the other hand, when I was working for a year and got a call for a job that seemed interesting, I was perfectly comfortable asking for a 15% raise. So once you've hit a point at which you are selling, it becomes much easier to find other points where you are also selling.

3) The social conventions of how long you're supposed to hold a job depress wages. For my two first jobs, 2 weeks after getting hired, I got a call with offers for respectively 20% and 30% more. I however turned them down because after asking around friends and family, I was told in no uncertain terms that quitting after 2 weeks is seen as unacceptable and that there are serious social repercussions which could adversely affect my ability to work in the future. Having been an econ undergrad, I had seriously considered walking up to my boss and saying something along the lines of: "So, thank you for hiring me, I really appreciate, but someone else made me a higher offer and so I will take it unless of course you can outbid them. Is your reservation price high enough?" (Who knew it was such a big no-no?)

About wage negotiation, I have the impression that most mid-sized and larger organizations divide the decision to hire into two steps. The first step, to create a new position, is made by mid-management. The second step, to interview and recommend a new hire, is made by lower-level management. The lower-level manager is probably told to find someone within a range of wages. The lower-level manager who hears an offer to work for low wage does not stand to save any of his own money.

But in small firms, where the proprietor does the interviewing, we may see that an offer to work for less gets results.

OneEyedMan writes:

The wage schedule might be rigid in some ways, but there are many ways that firms make them somewhat flexible. Just to name a few, they can control the amount of overtime, the use of incentive pay tied to the business cycle (like a sales commission), bonuses, the size of 401k matches, quantity of unpaid vacations, cut back on shifts, the level of employer contribution to health insurance, and lowered pension generosity. I grant that the need for such indirect methods suggest that there is a core problem about wage rigidity, but these tools makes me skeptical about the aggregate consequences attributed to nominal wage rigidity.

In the question with respect to housing, the firm makes ongoing costly investment in the employee that goes way beyond just the compensation. They have rent, insurance, training, adding to salary to form what we called "seat cost" at my old job. How much do you really save if you keep a position, cut the salary 25% and leave benefits and other seat costs unchanged? At my old firm seat costs were on the order of 3 times salary, so even a huge pay cut like that only cut the expense of that employee by 8%. If the seat costs really are marginal (perhaps a big if) then it isn't a surprise they'd rather fire one employee than cut the pay of 12 employees by 25% given concerns about morale and firm reputation that others raise.

Having worked for employment agencies, both fulltime and temporary staffing, I wrote an article about job hunting for a computer magazine and then spoke on the subject to a user group. Also at that dinner meeting was a programmer who tripled his wages in two years by negotiating upward with each change. He was a contractor; very common in tech; short-term assignments. That was my own experience from 1977-2001 in computing as a programmer and especially a technical writer. So, I have had a lot of experience at negotiating.

You can ask what the job pays right after you shake hands and say "Hello." When they ask you how much you want, you can remain silent. You have that control. We do not always take it. The psychology of negotiation does not always demand it. But, as with any contract, you have the right - and owe it to yourself - to ask for the terms you want.

Public education - including "private" really - only teaches us to be employees, not to be entrepreneurs with a monopoly on our own labor.

I agree 100% with liberty's explanation of waiting tables and add, also, that as a waitress my wife always went for the upsell: more expensive desserts; more expensive drinks; plus the restaurant has rewards for selling promotions. Waiting tables is very free market. (I met a woman who said she worked her away around Europe for several years. "How do you work in Europe without papers?" I asked. "You ask the owner of the restaurant if he needs a waitress," she replied.)

At the Michigan State Numismatic Society educational forum one convention a couple years back, we had a lawyer from Heritage Auctions explain the book Getting to Yes. Arguing price (wage) is the wrong strategy, though price (wage) might be your main concern.

"I can change less because I am more efficient than most other people in this line of work. I can charge less because I am spartan and careful with my own resources and so you know that I will not waste any of yours. I can charge less because actively interviewing with your competitors, I have a pretty good feel for the real ceilings." Say whatever you want, but say it. (And as a friend of mine told me about getting hired at Microsoft: "If you know how to juggle, tell them that you know how to juggle.")

Having held a real estate license, I could go on about houses; but I never did well at it because ultimately, houses are boring.

BZ writes:

OneEyedMan makes a great point and stole most of my thunder, though I have a few more points to contribute.

Inflation takes care of nominal wage rigidity. Just by cancelling automatic raises, limiting them, cancelling bonuses and other incentives, inflation causes real wages go down while nominal base pay stays the same. Employees, especially since 2009, are quite used to this. My value meal at McDonalds has doubled in price; my salary has gone up 10%.

My understanding is that, if inflation is taken out of the mix, wages can and do go down in nominal terms, and people are good with that. I believe I read somewhere that the depression of 1921 exhibited this rather dramatically.

Daublin writes:

The main issue is for salaried work, which for whatever reason seems to be the norm in most of the developed world. With salaried work, you only do a major renegotiation when you take a new job. If salaries are going down in your area, you don't will simply hold on to your current job for dear life. Thus, the wages don't go down until people start getting fired.

Contract work, as others have pointed out, should more adjust to supply and demand.

tjames writes:

I have just gone through selling a house and buying another. From a pyschological standpoint, it was much easier, as the seller, to take a hit on the sale price because I knew that as a buyer, I would be able to negotiate a similar hit on the house I bought. This turned out to be roughly true. The many people I came into contact with during this process seemed to readily accept this reality.

This is not really comparable to the normal wage worker, who is a seller only. A more comparable situation would be someone who is only a house seller, and is seeking to maximize the return. I wonder if the "seller-only" people are more reluctant to lower selling price than the "seller-buyer" people.

Don Lloyd writes:

"... Workers resent nominal wages cuts, and resentful workers are unproductive workers..."

This may well be true, but it is not the fundamental issue.

The fundamental issue is often framed as "Why do wages not fall in a recession?"

I wouldn't have believed it, but even economists often seem to think that a recession should be dealt with by a reduction in wages. This just goes to show why you seldom find economists running large businesses.

The most important characteristic of a recession, from the POV of a firm, is almost always a reduction in the output quantity that can be sold at a sufficient level of profit.

With a reduced production level, less direct labor is required. Why in the world would anyone think for an instant that it makes sense to cut wage rates instead of cutting capacity through layoffs?

In addition, layoffs give you the chance to prune your labor force of those workers with the highest ratio of cost to productivity. This tends to mean that the most experienced and highest paid workers are retained, but this is what you want and the overall cost of production is less.

It is true that you want to pay non-direct labor less, but this is best handled automatically through profit-sharing, and by fringe benefit adjustment, not wage rates.

Regards, Don

Floccina writes:

BTW there are exceptions interestingly construction is one of them. I have a friend who is a plumbing contractor, in 2007 he was paying plumbers $20/hour in 2008 he almost went bankrupt but started to pay $10/hour and that enabled him to survive. the plumbers were happy to get the work even at $10/hour.

Bryan Willman writes:

It seems that all analysis of "sticky prices" seems to focus on behavoiral issues, and ignore various practical ones.

If I owe $Z on my house, and have no cash reserves, it may be literally impossible for me to sell for less than $Z, because the bank won't let me unless I pay the difference between the mortgage and the value of the house. There is a great deal of this going on right now.

If I own a somewhat peculiar house (I do), it will take a long time to sell *at any reasonable price*, simply because it's a costly house on the water and the market is thin. Lowering the price by some sensible number like 10% won't actually make the sale go any faster, and may make it go slower by failing to signal what a wonderful place it is.

If I am paid $X per year and that's enough to cover my debts, so be it. Why not take $X-10%? Well, I'll then default on my expenses, but do so while still being employed. So I look like a person who just doesn't pay, because I lack the iron-clad justification of having been laid off. What's more, I might have some kind of insurance against lay-offs that doesn't cover simple reduced wages.

Consider also sunk costs - the cost of selling something I produce is NOT in general set in the 30 seconds before I sell it. Rather, it was set over the previous 6 months, most of those costs are already paid, and if it's not too costly to store it, I'll store it for a really long time rather than sell it for a loss. Having sub-normal-wage employees standing around staring at it doesn't help. A free market will eventually clear (perhaps by my leaving it), but not in 30 minutes and sometimes not in 30 days.

(And of course, as an employer, if you need fewer people what you want is fewer people, not the same people standing around for less money. Well explained above.)

So, yes, only a few very thick and liquid markets clear quickly, in all others clearing is constrained by all sorts of path dependencies.

PS: I hired a number of people for Microsoft, I never cared about juggling, but the guy next door did. So it depended on who you interviewed. And salary was the smallest part of real long term compensation there from 1986 until 2000, so negotiations got really complicated.

Comments for this entry have been closed
Return to top