Wednesday, March 25, 2009

Why wages are "sticky" downwards

It is an established fact of economic life that wages are “sticky” downwards. That is, that sacking people is typically resorted to more than cutting wages to existing employees. There is no doubt a vast economic literature on this, one that I have not read. Nevertheless, as part-owner of a business that pays some people a regular weekly salary, others are on an agreed number of hours at an agreed rate and still others on an “offer and accept” basis, I have some observations about why wages are sticky downwards.

The short answer is that it is much better to terminate a working relationship than to poison continuing ones.

An employee and employer are not engaged in one-off interactions as in a “spot” market. They are in a continuing interaction. The more mutually beneficial the interaction, the longer and stronger it is likely to be. How they behave towards each other is going to both determine and reflect the quality of that interaction. What they have is an ongoing, even evolving, contract: one more defined by their interactions than by any written agreement.
For an employer to cut wages without cutting hours is to expect the same level of work (a benefit for the employer) for less benefit to the worker. It also signals a subordination of the employee to the convenience of the employer. That is, it signals both power and disregard: that the employment contract is one that the employer can determine unilaterally to the employer’s benefit and against the employee’s benefit. Which, in a fundamental sense, makes it not a contract at all: for any sense of mutual consent becomes enormously and openly attenuated. If a contract is to function, it must be at the very least, agreed (or implied) restraints on adverse behaviour towards by the parties to the contract each other on matters covered by the contract. And how much pay for how much work is basic to a contract of employment.

So, for an employer to cut that rate is to poison—perhaps irrevocably—their relationships with their employees by undermining the notion that there is any contract the employee can rely on at all. Sacking people merely ends the contract, and therefore the interaction. Cutting wages poisons a continuing interaction by undermining any notion of there being a contract. And an employer simply does not, and cannot, fully control an employee. Not only can they seek an alternative position, but they have at least some control over how hard they work.

That inability to completely control employees is also why, I would argue, large firms which find it difficult to monitor the contribution of each employee to overall output tend to pay more than smaller firms which have less difficulty doing such: the extra pay creates a “hostage premium” that makes employees more likely to be self-policing.

Increasing pay (either by increasing the rate or by paying bonuses) improves the situation of the employee and sends positive signals. Nor does it undermine their basic contract. A contract, after all, does not generally preclude one side choosing to do more for the other than agreed. Increasing the rate changes the contract, but one to the benefit of the employee. It does not undermine the notion of a continuing contract. Attempting to force them provide more work for a given amount of pay fundamentally undermines the notion of there being any contract.

It is theoretically possible to renegotiate the contract to reduce pay rates. But the employee has limited information about total financial flows of the business they are working for. This “information asymmetry” makes the implied asymmetry of benefit (employer gets same work for less pay) even harder to sell. It will generally be easier to cut hours while keeping the rate the same than cutting the rate while keeping the hours the same since merely cutting hours does not provide a pure benefit to the employer—an extension of it being easier to sack people than to reduce pay rates.

Employees, after all, have a standard pattern of expenditures that they wish to cover (and some of which they have to cover to maintain a certain basic standard of living). They can be expected to have some idea about likely alternative employment positions: in particular, how much pay would be gained for how much work. Cutting wages both makes alternatives more attractive in simple comparative terms while undermining the stability of presumed income from the current job.

The effect is less severe if the downward pressure on wages is clearly happening across an industry, rather than in just one firm. But, since each firm has the above considerations, there will be significant lags before any such change manifests and it still makes exiting that industry more attractive.

To summarise, because employment is a continuing interaction and it is fundamental to a contract to include agreed restraints on adverse behaviour, wages will be much “stickier” downwards than will levels of employment.

ADDENDA 1. My attention has been drawn to Arnold Kling's post on the issue. It strikes me as too removed from the reality of the employment relationship itself. Yes, cutting wages will make working for you less attractive than places which pay higher wages but the damage done to any notion of there being any sort of contract between employer and employee seems to me to be much more to the point.

An example a work colleague provided to me of a factory he knew of which announced to its workforce they could not continue to trading as they were so they offered all their workers the choice of one (1) resigning and collecting their redundancy payment or (2) going casual and receiving a higher hourly rate but no sick leave, etc and no guarantee of the same hours fits nicely in with my analysis above. It was a way of cutting both the expense of employing people and (given the shortening of hours) a cut in their total wages but not in a way which undermined the notion of having a contract.

ADDENDA 2. Richard Posner includes a discussion of why wages are "sticky" downwards in his critique of recent economic text. We reach similar conclusions, though, ironically, I (as a small employer) are more struck by the importance of contracts than Mr Justice Posner.

ADDENDA 3: That people resent nominal wage cuts is noted here :
Employers almost never cut their employees' wages because they fear that doing so would cause serious morale and staff retention problems. Studies of popular sentiment suggest why. Most people consider it unfair for a firm to cut wages, except in extreme circumstances. On the other hand, most do not consider it unfair if a firm fails to raise wages in the face of high inflation.
And further discussed here.


  1. Hey, saw your comment over at Money Illusion. Totally agree, a good bock that pretty much says what you said at greater length is Bewley 'Why Wages Don't Fall During A Recession' A telling quote from a manager (on redundancies vs wage cuts): "it gets the misery out the door".