Ever wonder what makes prices fluctuate so frequently? Ever consider why your paycheck rarely does that? Wages are one of the big economic mysteries because they tend to be so rigid, and because wage rates fly in the face of a number of economic principles. Now economists are revisiting this minefield of a question to see if the old adage stands up to a new sort of recession.

Wage Stickiness
Wage stickiness, as an economic concept, has been around for a while. Economists theorized that, as unemployment rose, wages were not as likely to fall. They would simply grow at a slower rate, meaning that the real rate would decrease but the nominal rate would remain about the same. This seems a little counter-intuitive at first. For example, when the demand for oil or copper decreases, the price for those resources will usually fall as well. Why would labor prices be any different?

The idea that wages are fundamentally different from other inputs is at odds with how markets are theoretically supposed to work. If markets are truly competitive, wages should move in step with the demand for labor. In times of growth, wages should rise because demand for labor increases. In a recession, when unemployment results in a larger labor pool, wages should fall. The tricky part about wages is that they don't seem to follow these rules at all.

The Economists' Debate
Economists have been unable to agree as to why wages are so rigid, or even if wages are rigid at all. Neoclassical economists who believe in efficient markets don't think that wages are rigid, since employees unhappy with pay will quit their jobs. This gives employers flexibility, and diminishes the need for pay cuts. The drawback to this is that it implies that unemployment is voluntary, which it certainly doesn't have to be. Keynesian economists have an even less-concrete explanation, and blame everything from unions to efficiency wages. The problem with Keynes' theory is that it assumes that employees know what wages in similar firms are like, which is not necessarily the case. Other economists believe in the idea of an "implicit contract" between the employer and the employee. The options are dizzying, and the answers few. (For more on the controversies surrounding unions, see Unions: Do They Help Or Hurt Workers?)

The Employer/Employee Dance
The interplay between employers and their employees makes the relationship between labor demand and wages a touchier subject. Factors of production other than labor simply don't take wage adjustments to be a signal of potential doom-and-gloom the way employees will (after all, oil isn't going to bad mouth a company if prices fall). Because of the "softer" aspects associated with wages, employers might be more willing to lay off workers, thus reducing labor expenses, then to cut wages. While workers might miss their departed co-workers, they won't feel the same desperation as they would if their boss cuts the number of hours they work or cuts their wages altogether. Wage cuts can erode morale and productivity at a time when employers need it the most. In fact, a cut in nominal wages can be viewed by the employee as a sort of "breach of contract," even if the contract is only implied.

Re-Examining Wage Stickiness
It turns out that some employers are no longer afraid of cutting wages and benefits. They have shown an increased willingness to both lay off workers and cut pay when times are tight, and have introduced furloughs (unpaid, required vacations) as pay cut alternatives. In addition, the threat of a bankruptcy filing by a company can make labor unions more likely to accept pay cuts in order to stave off the company going completely under.

Why is the Shift Taking Place?
Inflation and debt seem to be two of the likeliest culprits. Employers are less likely to cut wages when inflation rates are high because increased prices allow them to keep wages stagnant or raise them slowly while still keeping their doors open. As long as any increase in nominal wages is lower than the rate of inflation, employers can achieve real wage rate decreases without actually reducing the nominal wage rate. This is a clever play on worker psychology, since increased inflation and stagnant pay actually mean that employees earn less, but because employees don't see a lower figure on their monthly statements, they are less likely to notice. This "money illusion" seems to go against rational economic behavior, but because the effects of inflation may be masked or only partially noticed, employees essentially are acting rationally with the information that they have at hand.

Interestingly, a 1999 survey conducted by the International Monetary Fund (IMF) found that employees thought that an actual pay cut was worse than an equivalent reduction in pay through the effects of inflation. (Learn more about inflation in our Inflation Tutorial.)

Personal debt can also exert downward wage rate pressure by increasing the possibility of deflation. As the amount of debt carried by households increases, stagnant or falling wage rates can lead to less consumer expenditure, since more money is spent servicing debt payments. While the focus on debt-reduction is not intrinsically bad, multiply this sudden drop in spending by millions of households and suddenly demand for goods and services takes a big hit. If employers are more willing to cut wages, a decline in demand may result in an even further lowering of wages. A vicious cycle can ensue. (Learn about some strategies consumers can use to combat debt in Digging Out Of Personal Debt.)

Whether wages are truly sticky or if the concept is an illusion is debatable. One of the major hurdles is procuring data necessary to actually make conclusions. While payroll data is available, is that enough? Researchers have interviewed recruiters and employers to see what they have to say about the employment outlook, but sample size issues and reliability can cause problems with this data as well. Eventually, economists looking for an all-unifying theory might throw up their hands and surrender to the unpredictability that is human behavior towards wages.

For additional reading related to wages, learn about the model that depicts the relationship between unemployment and wage inflation in Examining The Phillips Curve.

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