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What’s it: Wage rigidity refers to a situation where wages are insensitive to changes in supply-demand in the labor market. For instance, when the unemployment rate is high, wages do not fall even though the demand for labor declines and the market faces more available labor. Conversely, wages do not rise immediately when the unemployment rate falls, even though demand increases and the labor market is tighter.
Several reasons explain wage rigidity, including minimum wages and employment contracts. For example, companies cannot automatically adjust wages downward during a recession. They must comply with the minimum wage rules. As a result, they cannot lower wages below the minimum wage even though the economy faces high unemployment.
Understanding wage rigidity
Wages, in addition to other inputs such as raw materials, contribute to operating costs. Therefore, when wages rise, costs increase, depressing profitability. Conversely, if wages fall, operating costs decrease, increasing profitability.
Many companies cannot reduce wages during difficult times, such as a recession. As a result, they have to incur higher operating costs and squeeze their profits, assuming other revenues and costs remain unchanged. For example, ideally, companies would cut their wages by $100 a year because the recession brought the labor market into oversupply.
Say the recession lasts two years. Thus, the company should be able to cut wages by $200 to support profits. But, because wages are rigid, they can’t cut them. As a result, their profits were reduced by $200 over the two years.
The situation may be a consideration for businesses after the economy recovers from the recession. They did not immediately raise wages even though they saw an increase in demand, which increased the need to recruit new workers. They want to compensate for the pent-up wage cut ($200) by not raising it immediately. This situation underlies the relatively slower wage growth during the recovery.
Downward rigidity vs. upward rigidity?
Downward rigidity means wages are difficult to fall when the economy is bad. Ideally, businesses cut wages during a recession as the unemployment rate rises. The labor market is facing a decline in the demand for labor and, at the same time, facing more workers available for recruitment.
Upward rigidity means wages do not rise immediately following the situation in the labor market. As the economy recovers toward expansion, the demand for labor increases. However, businesses did not immediately raise wages in response to a tighter labor market.
The paradox of sticky wages
In the supply-demand model, wages are determined by equilibrium in the labor market. Thus, wages will fall when the market faces more supply per the supply law. On the other hand, wages rise when the demand for labor increases.
From this model, wages should fall when the unemployment rate increases. This is because the market faces more available labor (supply increases).
Conversely, wages rise when the unemployment rate falls. The labor market is becoming tighter and facing less supply.
However, the relationship has been vague since 2008. Wages do not immediately respond to changes in supply demand in the labor market. As a result, wages tend to be sticky to move down during a recession even though the economy faces more supply due to a sharp rise in unemployment. Vice versa, wages tend to be sticky during the recovery to expansion despite a tighter labor market due to a substantially lower unemployment rate.
Economists then tried to explain the phenomenon. For example, companies are reluctant to reduce wages during a recession because they are under contract. Thus, they do not arbitrarily cut wages to lower costs and increase profitability.
On the other hand, workers are reluctant to accept wage cuts during a recession. They may threaten to strike if the company lowers wages. They can carry out these threats because they have strong bargaining power, for example, because they are labor union members.
Flexible wage and its consequence
If nominal wages are not rigid or flexible, they will follow changes in the price level. If the price level rises (inflation), the purchasing power of nominal wages falls. Finally, workers will demand higher nominal wages to compensate for the decline in purchasing power. Thus, the real wage is relatively unchanged.
Likewise, nominal wages also fall immediately when the price level declines during a recession. Flexible wages expose the labor market to excess supply, driving the equilibrium wage down. As a result, real wages have not changed much in this situation either.
The above phenomenon explains why changes in real wages are relatively solid during recessions and economic recovery. Although nominal wages change, real wages tend to be rigid to change.
What are the implications? Because nominal wages respond proportionally to price changes, an increase in the price level does not increase profit margins. Likewise, their profits do not change when the price level rises because the labor cost also rises. Consequently, changes in the price level do not incentivize and disincentive them to change the output.
Conversely, if wages are rigid, firms earn higher profit margins when prices rise because labor costs do not change. Finally, this encourages them to increase output to reap more profits. Vice versa, when the price level falls, firms face increased pressure on profit margins because wages do not fall. As a result, they end up cutting their output to maintain profitability.
Money neutrality theory
According to the money neutrality theory, changes in the money supply only affect prices and nominal variables. In contrast, they do not impact real variables such as real wages, unemployment, or output.
Thus, according to this theory, monetary policy – a policy to change the money supply – will only result in price changes (inflation) but have no impact on economic output and employment. Likewise, even though nominal wages increase, real wages remain relatively unchanged.
Wage rigidity during the business cycle
Wages are insensitive in response to changes in labor demand and supply. Since the labor market is affected by the current cycle, we can say that wages tend to be rigid during the business cycle.
During a recession, the economy faces downward nominal wage rigidity. Thus, nominal wage rigidity does not go down even though the price level declines and unemployment increases. Instead, rigidity keeps wages high, reducing the demand for labor.
The recession left the company facing a decline in sales. As a result, their revenue decreases. Combined with the downward wage rigidity, businesses face pressure on their profitability. Finally, this situation forces them to cut their workforce, leaving the labor market facing excess supply and more unemployment in the economy.
In contrast, during the recovery, the economy faces upward nominal wage rigidity. This prevents businesses from immediately raising wages despite the increasing need for more workers to increase output. As a result, wages are slowly rising even though the unemployment rate declines as the demand for labor increases.
Causes of wage rigidity
Economists offer several reasons to explain wage rigidity. The three reasons discussed here are:
- Worker-employer contract
- Minimum wage
- Efficiency wage theory
Employment contract
Companies do not necessarily revise their contracts to respond to business situations. Usually, they tie up wages in an employment contract that is valid for several years.
In addition, companies generally avoid deducting nominal wages. Pruning can demoralize existing workers, lowering their productivity, which could put more pressure on their profitability.
Then, the employment contract also explains the real wage rigidity. It is often indexed to account for rising inflation. For example, it is through a Cost-Of-Living Adjustment (COLA) in the United States. Thus, nominal wages follow changes in inflation, keeping real wages stable.
In addition, changes in real wages are also relatively slow because contracts are valid for some time. As a result, they change only when a new contract is negotiated.
Minimum wage
The minimum wage is the lowest payment companies can provide their workers. Companies can’t pay workers less than that.
The minimum wage is a price floor. The government sets it above the equilibrium wage to prevent businesses from underpaying. The wages are considered sufficient to meet the workers’ decent needs.
However, the labor market faces excess supply because it is set above the equilibrium wage. At this wage level, fewer workers are demanded by businesses than the labor market provides.
Then, during the recession, job creation falls, and the demand for labor decreases. As a result, the unemployment rate increases, and the market faces more labor supply. Ideally, the market wage should fall. However, the minimum wage prevents that from happening.
Efficiency wage theory
The efficiency wage theory underscores that labor productivity depends on the wages given. If paid higher, workers become more productive and vice versa. For this reason, companies prefer to pay higher wages to get higher productivity from their workers.
Wage efficiency theory explains why firms will not lower wages during a recession. Lower wages will only lead to lower productivity. As a result, they get output per unit at a higher cost per unit, depressing profit margins. For this reason, they prefer to lay off workers rather than lower wages.
Impact of wage rigidity on aggregate supply
Aggregate supply (AS) refers to the total amount of goods and services produced in an economy at a given price level. Wage rigidity, the slow adjustment of wages to economic conditions, can significantly impact the short-run aggregate supply curve (SRAS). Here’s how:
Reduced output in response to demand shocks: If aggregate demand falls due to factors like decreased consumer spending, firms may be reluctant to cut wages to maintain worker morale or due to negotiation difficulties with unions. This inflexibility keeps production costs high, disincentivizing firms from producing as much, leading to a leftward shift of the SRAS curve and a decrease in output at any given price level.
Slower adjustment to inflation: When the price level rises (inflation), firms with rigid wages experience a decline in real wages (wages adjusted for inflation). This might lead to demands for wage increases to restore purchasing power. However, the rigidity can cause a delay in wage adjustments, keeping production costs and the price level artificially high. This creates a flatter SRAS curve, meaning larger price increases for a given output change.
Higher unemployment: In the short run, wage rigidity can lead to higher unemployment. When firms face a decrease in demand, they may be more likely to lay off workers rather than cut wages. This can create a situation where the economy is operating below its potential output, with higher unemployment and lower overall production.
