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Thoughts on Sticky Wages

2010-02-06

I was watching the astonishing Keynes Vs. Hayek music video a few days ago, and the rapper Keynes mentions the problem of sticky wages.

I had to remind myself about sticky wages — I vaguely remembered the term from economics in business school — and I ended up reading quite a few interesting articles on the topic.

The essential principle of sticky wages is that employers rarely lower wages for existing workers, so wage adjustment is not a common response to economic recession. But why don’t they lower wages? The phenomenon is actually the result of quite complex microeconomic psychology.

The responses that a business makes to a revenue downturn are few in number, but complex in origin. Of course, if they have cash on hand, they can always pour money into drumming up sales (through advertising, sales channels, expansion, etc) and into process improvements to reduce costs. If their business already had high profit margins, they can reduce re-investment or dividends as an austerity measure.

But if they do not have enough cash on hand, or if they try those options and the situation doesn’t improve sufficiently, they have to deal with day-to-day operations costs. Essentially, the firm’s options boil down to:

(1) Lower wages.

(2) Reduce time worked.

(3) Eliminate workers.

All three options are bound up with the psychological concept of equity. Equity is the sense that you are being treated fairly, that you’re getting what you deserve, you’re not being singled out for punishment, others are not getting unearned rewards, etc. The emotion is so fundamental to human society that I personally think humans are hardwired to recognize equitable and inequitable arrangements, much the same way bats use an implicit scoring system to share food, or the way that some mammalian infants instinctively share nursing time when there are too many pups for one mother.

The most effective immediate means to repair profit margins is to reduce wages. With the same number of workers, productivity can be maintained and prices can be lowered to spur demand. That’s the quick path to recovery, it leads to the quickest recovery of the economy, and will allow the company to rebuild its finances so it can return to its original wages when the time is right.

The problem is that workers won’t tolerate it. Workers find the whole concept of lower wages inequitable, because it allows the firm to maintain its profit margin while the workers suffer. Unless the economic downturn is profound, the best workers — the few who lead their peers and are responsible for enhanced productivity all-around — will immediately seek positions with other firms. That loss will take some time, but it may be very difficult to make up, as prospective replacements may also find the firm’s choice suspicious, especially if the firm’s hiring wages are still anomalously low.

The middle road is work furlough: require workers to take unpaid days off, or lay down a rule eliminating overtime work. Workers find this solution less offensive, because the firm suffers just as much as the workers. Productivity drops, and the workers get a little something in return: time off which can be used for whatever they need. But with the same number of workers, and reduced productivity, the cost benefit to the company is much less. In addition, the fixed costs of employment (health care contributions, etc.) won’t go down if the firm keeps all its workers, and the firm may still lose its best people.

The last option is releasing workers, either temporarily (a layoff) or permanently.  The advantage is that the company enjoys a certain amount of latitude in selecting the workers to release — the “problem” workers are easier to let go when the economy is in the toilet. Of course, union rules may complicate matters, and if only junior employees can be released, that means that only the senior, higher-paid employees stay on. Seniority is only slightly correlated to productivity, with the result that the company must release many junior employees to save money, and take a large productivity hit.

More importantly, the workers who feel most betrayed by the decision are no longer present in the workplace, eliminating most concerns about inequitable treatment. The workers who are kept are likely to view the process as equitable, as they continue to enjoy full work weeks and their original wages.

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