Sticky Wage Theory

DEFINITION of 'Sticky Wage Theory'

An economic hypothesis theorizing that the pay of employed workers tends to have a slow response to the changes in the performance of a company or of the broader economy. According to the theory, when unemployment rises, the wages of those workers that remain employed tend to stay the same or grow at a slower rate than before rather than falling with the decrease in demand for labor. Specifically, wages are often said to be sticky-down, meaning that they can move up easily but move down only with difficulty.

Stickiness in general is also often called “nominal rigidity” and the phenomenon of sticky wages is also often referred to as “wage stickiness.”

BREAKING DOWN 'Sticky Wage Theory'

Stickiness is a theorized condition in the market, and can apply to more areas than wages alone. Stickiness, simply put, is a condition wherein a nominal price resists change. While it can often apply to wages, stickiness may also often be used in reference to prices within a market, which is also often called price stickiness. Prices, however, are generally thought of as not being as sticky as wages are, as the prices of goods often change easily and frequently in response to changes in supply and demand.

The aggregate price level, or average level of prices within a market, can become sticky due to a mixture of rigidity and flexibility in pricing. This means that price levels will not respond to large shifts in the economy as quickly as they otherwise would. Wages are often said to work in the same way: some are sticky, causing aggregate wage levels to become sticky as well.

While wage stickiness is a popular theory, one increasingly accepted by economists, though some purist neoclassical economists doubt the robustness of the theory. Proponents of the theory have posed a number of reasons as to why wages are sticky. These include the idea that workers are much more willing to accept pay raises than cuts, the idea that some workers are union members with long-term contracts and the idea that a company may not want to expose itself to the bad press associated with wage cuts.

Sticky Wage Theory in Context

According to sticky wage theory, when stickiness enters the market it will cause change to become favored in one direction over another and will trend in the favored direction. Since wages are held to be sticky-down, wage movements will trend in an upward direction more often than downward, leading to an average trend of upward movement in wages. This tendency is often referred to as “creep” (price creep when in reference to prices) or as the ratchet effect. Some economists have also theorized that stickiness can, in effect, be contagious, spilling from an affected area of the market into other unaffected areas.

This idea holds that there are generally many jobs in one area of the market that are similar to other areas of the market and, because of this, the entry of wage-stickiness into one area will bring stickiness into other areas due to competition for jobs and companies’ efforts to keep wages competitive. Stickiness is also thought to have some other relatively wide-sweeping effects on the global economy. For example, in a phenomenon known as overshooting, foreign currency exchange rates may often overreact in an attempt to account for price stickiness, which can lead to a substantial degree of volatility in exchange rates around the world.

Stickiness is an important concept in macroeconomics, particularly so in Keynesian macroeconomics and New Keynesian economics. Without stickiness, wages would always adjust in more or less real time with the market and bring about relatively constant economic equilibrium. With a disruption in the market would come proportionate wage reductions without much job loss. Instead, due to stickiness, in the event of a disruption wages are more likely to remain where they are and, instead, firms are more likely to trim employment. This tendency of stickiness may explain why markets are slow to reach equilibrium, if ever.

Sticky Wages and Sticky Employment

Employment rates are also affected by the distortions in the job market produced by sticky wages. For example, in the event of a recession, like the Great Recession of 2008, nominal wages didn't decrease, due to the stickiness of wages. Rather, companies laid off employees in an effort to cut costs without reducing wages paid to the remaining employees. Later, as the economy began to come out of the recession, both wages and employment will remained sticky.

Due to the fact that it can be difficult to determine when a recession is ending, in addition to the fact that hiring new employees may often represent a higher short-term cost than a slight raise to wages, companies will often be hesitant to begin hiring new employees. In this respect, in the wake of a recession employment may often be “sticky-up.” On the other hand, according to the theory, wages will often remain sticky-down and employees who made it through may see raises in pay.

For more on the sticky wage theory, read Why Wages Stick When The Economy Shifts. For more on Keynesian economics and its relationship to stickiness, read Can Keynesian Economics Reduce Boom-Bust Cycles?

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