Why Wages Dont Fall During a Recession

Existing Theories
Truman Bewley Presented by Levon Balayan and Sarah Kim

Outline

Labor Supply Theories

Wages downwardly rigid because people withdraw their labor when wages fall
Workers collective or individual bargaining power causes downward wage rigidity Wage rigidity as an outcome of functioning markets

Worker Bargaining Theories

Theories Based on Market Interactions

Theories Attributing Wage Rigidity to Firms Behavior

Company policies are responsible for downward wage rigidity

Theories of Recessions as Reallocators of Labor

Unemployment is a cost of adjustment to structural economic change

Labor Supply Theories

Intertemporal Substitution Theory Lucas and

Rapping(1969)

Workers

quit because wages or salaries fall below expectations When wages are unusually low, people become unemployed to enjoy leisure

Intertemporal Substitution Theory

Criticism

Inconsistent with labor market behavior during recessions:

Wage cuts unusual Quits decreased sharply Counselors knew of no one who quit because of pay cut Half of unemployed were laid off Actual pay cuts had little extra turnover

If applicants were holding out for higher pay, it would be difficult for firms to recruit. However, employers overwhelmed by over-qualified applicants

Applicants are flexible (Only employers of low-paid labor complained

that applicants wanted too much money)

Unemployed had little leisure, due to the time spent looking for work.

Intertemporal Substitution Theory

Criticism

Consumption declines during unemployment, as leisure is a substitute for goods and services, not because jobless run out of money (Heckman (1974) Ghez (1975)) but

W eakened by the fact that increases in possession of

liquid financial assets diminishes the drop in consumption

NYC Cab Driver Camerer et al. (1997)

Cab drivers work more during slow days, when hourly wages are low Drivers quit for the day once they reach their target daily income

This shows Even if wages dropped during a

recession, workers would not respond by withdrawing labor.

Intertemporal Substitution Theory

Criticism

Bottom Line: Most people find joblessness

extremely disagreeable!

Labor Supply Theories

Real Business Cycles

Unemployment

is interpreted as leisure optimally selected by workers (similar to Intertemporal Substitution Theory)

Real Business Cycles Problem

Difficulty to factor in small wage fluctuations relative to fluctuations in employment

Solution

(Hansen (1985)):

Assume workers are indifferent between working and not working Hence, changes in labor demand only affect number of employed and not the real wages

Real Business Cycles Criticism

Indifference may be true for elderly, students, and housewives

However, these groups do not drive unemployment

People are desperate for work Unemployment = misery Household production

Worker Bargaining Theories

The Insider- Outsider Model

Insiders

existing employees Outsiders unemployed workers G eneral Model insiders prevent outsiders from taking their jobs or bidding down wages

There are several such models

The Insider- Outsider Model

Lindbeck and Snower (1988)
Unorganized workers bargain individually with employers Insiders refuse to train or cooperate with replacement workers, reducing productivity of the latter

The Insider- Outsider Model Criticism

Non-union workers rarely bargain with employers

Only top executives, people with unusual skills bargain

effectively as individuals

Pay rates are set by management and are independent

on competition from workers

The Insider- Outsider Model Criticism

M AI N PR O BLE MTheory assumes
conflict where there is none
No

conflict between insiders and outsiders over pay cutting

Pay reduction is not an alternate for saving jobs

No

conflict between employed and unemployed

Firms do not replace employees with unemployed Wages are independent of the number of employees

Theories Attributing Wage Rigidity to Firms Behavior

Efficiency Wage Theory

Positive

association between pay and efficiency creates upward pressure on wages that puts them above the market clearing level Implies existence of unemployment in equilibrium

Criticism
Only

some of the theories explain wage rigidity

Theories Attributing Wage Rigidity to Firms Behavior

The Turnover and Flat Labor Supply Curve Model (Stiglitz (1974), Schlicht (1978), Salop (1979)) Voluntary turnover in a recession decreases with wage and increases with labor market tightness Firms weigh turnover costs against wage costs when setting pay

Raise wages when unemployment is low to reduce quitting Low unemployment causes wage inflation

The Turnover and Flat Labor Supply Curve Model Criticism

Inconsistent with downward wage rigidity during recessions

Wages

fall when unemployment is higher than equilibrium level and turnover diminishes

Although pay has an effect on turnover, quitting anticipated was more a response to bad morale Pay cuts during the recession had little impact on turnover

Theories Attributing Wage Rigidity to Firms Behavior

Morale Model (Solow (1979), Akerlof (1982))

Assumes higher pay increases productivity through the impact on the morale morale (m-rl')n. - The state of the spirits of a person or group as exhibited by confidence, cheerfulness, discipline, and willingness to perform assigned tasks.

C riticism

Pay levels affect productivity through the quality of workers recruited, but have little impact on morale or work effort Theory is correct to emphasize morale, but undermines the negative impact on pay cuts

Theories Attributing Wage Rigidity to Firms Behavior

Menu Costs (Mankiw (1985), Akerlof and Yellen (1985))

Attributes downward wage rigidity to the expense of cutting wages Small deviations of wages from the optimal level derived from turnover and shirking models have little impact on profits

C riticism

Administrative or negotiation costs never interfered with pay cutting Menu costs hardly explain why pay was increased rather than cut

Conclusion

The only one of the theories of wage rigidity

that seems reasonable is the morale theory of Solow and Akerlof. The others fail because of the lack of realism of their basic assumptions -Truman Bewley

Questions

Discussion

How seriously can we consider the anecdotal evidence countering statistical findings? Which model you think is most realistic? What do you think about Bewleys claim that
Administrative or negotiation costs never interfered with pay cutting?

Have your wages decreased in this recession?