Sticky wages and unemployment

by on August 15, 2011 at 4:51 pm in Economics | Permalink

In my post ZMP vs. sticky wages I argued:

By the way, the problem of sticky wages is often misunderstood. The big problem is not that the wages of unemployed workers are sticky, the big problem is that the wages of employed workers are sticky. This is why stories of the unemployed being reemployed at far lower wages are entirely compatible with the macroeconomics of sticky wages.

At lunch with Tyler today discussing his recent post I expanded on this point arguing that since a large fraction of GDP is wages that a 5% cut in the wage bill is a very big number and that even a large cut in the wages of the unemployed just isn’t enough. Scott Sumner wasn’t at lunch but nails it with a simple example:

Nominal wages are fixed for the employed. NGDP falls 5%, and 5% of workers are laid off. Now the unemployed workers lower their wage demands by 20%. Why not by even more? Because of minimum wage laws, unemployment insurance, fear of loss of prestige, etc.

Suppose companies are not worried about workers making invidious comparisons (a big if, but I’ll grant this point to my opponents.) In the best case scenario firms lay off 4% percent of their workers and hire back the 5% who are unemployed at the same total wage bill. The excess unemployment is now 4% instead of 5%. The total unemployment rate falls from 10% to 9% (assuming 5% is the natural rate.) No big deal, we are still deep in recession. Thus wage flexibility among the unemployed doesn’t really help very much. If all employed workers accepted a 5% pay cut (or if the government ordered such a cut) and the Fed kept targeting inflation, we’d experience rapid economic growth.

See Scott’s post for more.

Note that this doesn’t mean that I think sticky wages are necessarily “the answer” or even the most important problem (sticky debt is an issue as well etc.) but the evidence for sticky wages for the employed is very strong and it certainly is a problem.

R.Dave August 15, 2011 at 5:24 pm

I guess I don’t see what the big mystery is here. A drop in demand pinches a company’s revenues, so the company decides to lower costs, including, say, a 5% cut in wage costs. An across-the-board 5% wage cut would cause morale problems because of the perceived unfairness to the more productive workers, whereas laying off the least-productive 5% not only avoids that problem but likely encourages those who remain to work even harder than usual to prove their own value and thus avoid the chopping block. From the company’s perspective, they’ve shed their least-productive (possibly even zero marginal product) employees and inspired extra productivity from everyone else, so they save 5% in wage costs but only lose maybe 3% of their production capacity. And if they later decide to go out and hire some additional employees, the generally high unemployment rate allows them to cherry-pick new employees who are more productive than the low-productivity ones they fired before. So, when all is said and done, the company can get back to the same production capacity (or even exceed it) while employing fewer people than they did before the lay-offs.

TurtleBay August 15, 2011 at 6:20 pm

This pay cut vs. personnel also doesn’t take into account turnover. When pay is cut 5%, those who can leave do. The bank I am currently working for got its bonuses all wrong at the start of this year. 1/3rd of my group jumped ship. There was a big decline in productivity as it took several months to recruit for all of those positions. Even when restaffed with very qualified professionals, it took time for them to integrate with the relationship managers and get to know the clients and deals. The knowledge economy is not a machine that can have pieces yanked out and replaced, institutional knowledge is lost.

That doesn’t even include the shirking that occurred among the people who stayed that wanted to make a point (not working outside business hours getting deals done).

AMW August 16, 2011 at 12:34 am

If the unemployment rate is high due to the least productive workers being laid off, then the average company can’t cherry-pick from among the unemployed, because there aren’t many cherries.

On the other hand, if companies are laying off the least productive, and they think the other companies are doing the same, then they may be reluctant to hire currently unemployed workers. The fact that they are unemployed in an economic downturn is a signal of their quality.

dirk August 15, 2011 at 5:32 pm

Question: Does belief that too little AD is a big part of the employment problem require one to buy into the sticky wage theory?

Manoel Galdino August 15, 2011 at 8:30 pm

Yep! Keynes thought you didn’t need the sitck wage assumption, but he was (logically, though i’m not sure if inr reality) wrong.

Dan Hill August 15, 2011 at 5:34 pm

Put another way, if an employer needs to reduce his wages bill by 10% there are two options:
1) 100% of the workforce can take a 10% paycut
2) 10% of the workforce can take a 100% paycut.

Bill August 15, 2011 at 5:39 pm

Since a business is concerned with total compensation when making output decisions, and since executive comp is not only high but also increases with a firms downturn, I am happy to see this website urging the reduction of executive salary and perks to stimulate the economy.

Brian August 15, 2011 at 5:44 pm

The me this point feels like it supports the ZMP theory more than sticky wages. Scott and Alex showed that replacing current workers with a greater quantity of less-expensive workers has a small effect on unemployment. It then seems likely that many of these people became unemployed because whole jobs were cut and not reallocated to remaining workers.

Beth August 15, 2011 at 6:05 pm

Conservatives are funny: Scott handily glosses over “commute costs” and “childcare costs” as possible reasons not to accept a lower-wage job (much less “debt” or “cost of living”). Especially when considering second incomes, it is very easy for marginal wage to slip negative.

E. Barandiaran August 15, 2011 at 6:05 pm

Please, explain in detail why sticky wages for the employed would be a problem. In your explanation please take into account why the parties to a labor contract were not expected ex ante to be a problem or, if they were expected to be a problem under special conditions (in emergencies), how the parties were planning to deal with it. Why do the parties sometimes fail to apply what they have agreed? In which types of labor contracts do you expect sticky wages to become a problem (and/or labor becomes a quasi-fix factor as W. Oi argued long ago?).

Regarding the evidence for sticky wages for the employed and taking into account the evidence for sticky prices in many markets in which the parties have agreed on long-term contracts, how do you compare the adjustments to emergencies in labor and in goods&services markets? In other words, if sticky wages are a problem, do you believe that sticky prices are also a problem, at least in some emergencies?

Regarding lay-off workers, what difference do lay-off criteria make? Except for firms to be closed definitively, Sumner’s example of laying off all workers makes no sense because the labor force is heterogenous in more than one dimension and before talking about responses to emergencies we need to know what dimension(s) may be important. Owners and managers must have some lay-off criteria and that could have been reflected in the terms of labor contracts.

Hope you can provide some serious microfoundations for your position.

Paul August 15, 2011 at 6:07 pm

I blame the Jack Welsh “up or out” management philosophy. Pay is tied to performance, the best get bonuses and the bottom 10% are cut each year. If you hire workers for cheaper than others at their level, then you are decoupling pay from performance. If you don’t keep pay increasing on the workers you keep, then you unincentivize them and break the social contract that you agreed to reward your top performers (they are the ones who made it through years of culling the herd afterall).

Nemi August 15, 2011 at 6:18 pm

I´m starting to think that “sticky debt” is the most important problem – and that this stickiness to a rather large extent is there because of government regulations – which in turn is there because the financial systems is to important to fail and the state is there to insure them. Also, without explicit and implicit state guaranties (e.g. the greenspan put) , the financial system would probably (most definitely) be much more volatile.

If you could get a more stable (i.e. one that could take losses without collapsing) and rational ( i.e. one that would take losses when apparent) financial system it seems like a lot would be won. However, to me it seems like such a system either would mean very strict regulations (with heavy state regulations) or very high volatility and constant panics and bankruptcies (without state interventions) – which in turn gets me back to some intermediate position that implies some form of the current system.

mulp August 15, 2011 at 8:52 pm

Isn’t simply the jackboot heavy handed government civil law system that is the problem?

If everyone with debt could simply dictate the new debt balance or interest rate and time they wanted, then everyone could easily accept lower wages.

If we could have tort reform that prohibited banks from going after borrowers in default to take possession of the security asset, government would be a far lower burden on individuals, and get corporations off their backs.

FYI August 15, 2011 at 6:53 pm

again I can only talk about my personal experience but pay cuts do happen kind of often. Specially in the software industry where stock bonus are still a considerable part of your annual salary. By the way, I think it’s kind of funny to think that inflation is really the only way out of this kind of situation. I mean, are we saying companies are ‘smarter’ in giving raises but not so smart in cutting pay? That’s news to me.

mulp August 15, 2011 at 8:46 pm

By inflating, debt service costs and fixed costs are reduced along with real wages.

By employers cutting wages, the fixed costs faced by workers grow relatively larger: rent increases relative to earnings, car payments increase relative to earnings, mortgage payments increase relative to earnings, cell phones bills increase relative to earnings…

With higher inflation, every price for everything must have an individually justified price hike, a lagging process. While the amount of money is increased, with the threat of higher prices to come, more sales will occur, resulting in more work that on the one hand squeezes margins, but on the other hand spreads fixed costs over more units.

Which is easier to manage: forcing every price of everything to be reduced, or forcing every price to be increased? Obviously inflation easily forces every price to be increased.

mulp August 15, 2011 at 8:34 pm

“Now the unemployed workers lower their wage demands by 20%. Why not by even more? Because of minimum wage laws, unemployment insurance, fear of loss of prestige, etc.”

You left out the really important factors:
– the mortgage and auto payment isn’t reduced by 20%
– the price of gas isn’t reduced by 20%
– the cost of maintaining and insuring a car isn’t reduced by 20%
– the cost of food isn’t reduced 20%
– the cost of health insurance isn’t reduced 20%

And individual is no different than a firm. If a firm has fixed costs of X and marginal costs of Y, the minimum price for quantity n=1..1000 is (X+Y*n)/n. The argument an individual can cut their price in order to increase hours of employment is true only if they can pay both their fixed and marginal costs. If a worker loses their car and house, they can only do a job if they can live at work, or live in a cardboard box in the parking lot and still check in for his shift.

Many job posting include “reliable car required” for jobs that don’t seem to require travel, but will be primarily filled by low wage workers, which I’m guessing is an attempt to weed out those who can’t get to work on time because of transportation problems.

astonerii August 15, 2011 at 9:02 pm

Wages are not sticky. Wages have moved up a couple % over the last three years. Inflation has eaten up much more than that, at least for people making $50k a year or less, due to lower cost items they/we consume going up at a faster rate. Then look at the value of the money we are being paid in compared to other currencies, and the argument that wages are sticky becomes much less clear.

yoyo August 15, 2011 at 9:37 pm

Have you every applied for a low-wage job? You show up for the job, and the employer tells you what your wage will be. If it is a semi-professional or senior job, asking for 10% more than offered can work sometimes. There is no such thing as a ZMP who could cut their own wages to find a job.

yoyo August 15, 2011 at 9:44 pm

And signaling explains why professionals wouldn’t offer to work for half price. Didn’t this blog used to talk about signalling?

Mike August 15, 2011 at 10:00 pm

if you’re going to view the world through a macro lens, you have to keep your eye on that kaleidescope.

Yes, the nominal wages of the employed probably stay the same, but that’s a MICRO view.

In the MACRO world, corporations, industries, and the economy restructure to find wage flexibility. Low wage workers may be laid off but high wage workers will have to produce more for the same wages. High wage workers might be laid off and low wage workers will become bargain replacements.

When the economy recovers, low wage workers will be hired back first. This is insurance against an incorrect forecast. High wage workers will be hired back only when demand has been fully restored.

Check the average wages of all the new jobs – mostly lower than the aggregate average. Check the average wages of the jobs lost – mostly higher than the aggregate average. The new low wage workers are asked to do more than the previous low wage workers because they’re easily replaceable. There’s lots of uncompensated efforts which are not reflected in GDP. These represent nominal pay cuts.

You can still apply micro principles, but you have to understand how the macro economy is changing.

Wages are not as flexible as Classical economists wish, but they are far more flexible than Keynesians believe.

Hondo69 August 16, 2011 at 5:23 am

I need a definition of “wages of the unemployed”.

Bill Woolsey August 16, 2011 at 7:30 am

The rest of the story about across the board wage cuts is across the economy price cuts.

Prices and wages fall 5%, and the current volume of money expenditures pruchases 5% more, increasing employment.

The real incomes of all those working stay the same. And the unemployed work too.

If you assume that prices are perfectly flexible and wages sticky, then the price level falls some, money wages stay the same, and real wages rise for everyone who continues to work. Some people are unemployed.

If wages fall, then prices fall by less than wages, and reall wages fall and employment rises. However, compared to the initial state before the unemployment rate rose, wages and prices are falling in proportion.

Bill Woolsey August 16, 2011 at 7:41 am

Your particular firm has a 10% loss in sales. What do you do? Do you cut everyone’s pay? Or do you reduce employment?

Well, if you cut everyone’s pay, you will lose your best workers to the competition, right?

Isn’t that what we are reading? But that assumes that the competition is willing to hire them. In other words, suppose that the reason why your firm has lost 10% of its sales is that the competitors have gained those sales.

Or perhaps your industry has lost 10% of its sales, but some other industry has gained those sales and is hiring.

In other words, suppose we are in a dynamic, growing economy.

In other words, suppose we are not in a recession where a lower prices and wages are what is necessary to keep real expenditures equal to productive capacity.

What is interesting, is how many people don’t get it. And they say that wage cuts are a bad idea for reasons that only apply if the economy is in macroeconomic equilibirum (not net surpluses.) And maybe that is the problem. People develop habits and rules of thumb that make sense when the economy is growing, and when they apply them when there is an aggregate demand shortfall, the result is low output and high unemployment.

Bill Woolsey August 16, 2011 at 7:53 am

Suppose we live in a static world. Normally, the same employees stay at the same firms. Demand falls 10%. Either eveyone takes a 10% pay cut, or 10% of the people are let go.

Now, change the assumption just a bit. Suppose 20% of the workers leave each year. And new workers are hired to replace them. Demand drops 10%. Everyone takes a 10% pay cut, and new workers are hired at the same rate for 10% less.

Or, we only replace half of the workers that leave. Some of those workers who would have been hired are left jobless.

So? Who cares about them?

And so, the 10% pay cut is never on the table.

Unless, of course, the bosses are so greedy that they cut wages because they can. What kind of servant leader would do that?

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Hondo69 August 17, 2011 at 6:08 am

I don’t know why I spend so much time viewing economist’s formulas with their distorted terms such as “sticky wages” and “wages of the unemployed”. Guess that’s probably why so many Ivy League economists can’t make any of thier old formulas work in today’s economy. Theory is fine if you’re killing time, but reality requires an entirely different mind set.

For example:

Despite Pelosi’s theory that extending unemployement benefits is the best method for creating jobs, the unemployed do not earn wages. They collect benefits, benefits that are paid for by you and me. They are takers, not makers. So I’ll go way out on a limb here and pose a question that will throw a wrench into the latest fad of economic theory. What happens when you hire an unemployed person?

Another Ivy League stumper pertains to small business owners. What is the number one roadblock stopping these people from hiring as noted in survey after survey?

And we all know the answers to the questions, of course. Just don’t tell anyone. Nobody, and I mean nobody, wants to hear the most basic of truths. Especially when it could jeopardize that Ivy Leage Dean position.

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