Wage Rigidity: Causes & Consequences of Sticky Wages - Essay Sample

Introduction

Wage rigidity is defined as the situation in which wages are sticky going downwards; hence firms are unable to cut their wages in case of a recession or an economic downturn. It was developed by John Maynard Keyness with the assumption that the nominal wages are rigid and nonmarket-clearing. If the unemployment rate accentuates, the remuneration of employees that are employed in a company tends to remain the same or increase at a slow pace other than decrease with the labor demand reduction. In particular, wages are sticky-down. That means that they increase quickly; however, it is tough to move them downwards.

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The Sticky Wage Theory

Stickiness or rigidity is a situation whereby the nominal prices or wages resist or are slow to adjust to change in the short-run. According to the theory, when stickiness is present in the labor market, it causes the wages to move in one direction, which is upwards while resisting any downward movement. In real life, wages are slow to change. They get sticky above the equilibrium point where the forces of demand and supply meet because most of the laborers are resistant to nominal wage cuts. That is as a result of trade unions fighting for the wages to remain the same, contractual obligations between the firms and the employees, which prevent wage cuts and the reluctance of the employees to renegotiate their wages with the management amicably.

Also, the minimum wages set by the government to prevent exploitation of workers, efficiency wage theories, which state that paying employees well boost their loyalty to the firm, industry, and morale, and the cost of hiring and firing employees serve as a deterrent for wage cuts. In perfectly competitive labor markets, any changes in the aggregate supply or demand will cause a variation in wages. However, that is not the case in real life where the wages are decided and enforced by long term contractual obligations.

Without being sticky, wages will adjust in the market with certainty, resulting in relatively continuous equilibrium. Any disruption in the labor market will result in proportionate wage reductions without any or few job losses. However, due to stickiness, in case of a disruption in the labor market, wages are more likely to remain stagnant. It, therefore, forces the companies to downsize or furlough some of the employees to maintain profitability. That tendency of stickiness explains why the labor markets are prolonged to attain a position of equilibrium, if ever.

Figure 1: A graph Showing wage Rigidity.4

Advantages of The Rigidity of Wages

Rigid wages prevent the exploitation of workers by employers. The goal of any firm is to maximize its profit margin while at the same time, minimize its cost. Wages are part of the production costs that most firms want to minimize. That means that if firms were allowed to have their ways in the labor market without checks and balances, most of them would be employing workers at living wages. However, due to the laws and regulations that prevent the exploitation of workers, firms must employ workers and offer them competitive wages that commensurate with their skills and experience. Another reason why rigid wage is essential is that if a firm pays higher than equilibrium wages, that boosts the worker's loyalty, morale, and the willingness and ability to work extra hard. Any reduction in remuneration will blow their psyche and serve as a disincentive to give their best, which in turn puts a dent on their morale and productivity. Therefore, firms know that all the gains from lower remunerations are offset by a massive productivity decline.

Once an employee is well trained and has gained an essential or rare skillset, any manager will be unwilling to sack him or reducing his wages. That is because most employers tend to avoid the fervor of sacking their workers or trimming the wages because of the high turnover costs of workers involved. Also, they are not guaranteed of getting the best fit if they employ cheaper alternatives; hence it becomes too much of a risk to reduce their salaries.

Disadvantages of The Rigidity of Wages

Rigid wages may force a firm to fold up in an economic downturn due to mega losses. If a firm cannot be able to reduce its cost of production (which includes wages) when it is making losses, then it may go bankrupt, rendering all its workers unemployed. That means that wage rigidity may accentuate unemployment in an economic downturn because the worker refuses to receive a pay cut. Another disadvantage of wage rigidity is creative destruction. When wages take the bulk of the production cost, and the workers refuse to take wage cuts, the employer may opt to mechanize production by substituting the workers with machines. That means more people will be rendered jobless. Another disadvantage of wage rigidity is high prices for products in labour-intensive industries as a result of high wages. It, in turn, leads to high production costs that make the firm lose its comparative advantage that results in a lower sale and thin profit margins.

Benefits of Efficiency Wage Model

Efficiency wage models posit that most companies find it more profitable to pay remuneration above the employee's reservation wages. The idea is that by paying employees higher wages, it boosts their morale and encourages them to be more productive and loyal to the company. It also reduces the costs incurred by employee turnovers in industries where the cost of replacing workers is exceptionally high and takes much time. The increment in productivity as a result of better wages means that the firm can sell more products, get more revenues, and increase its profit margins, and the cycle continues. That explains why firms that pay their employees top wages attract top talents and are usually the most profitable.

The Fooling Model

With the emergence of stagflation (high inflation coupled stagnated aggregate demand and high unemployment rate) in the 1970s, new models appeared to explain the instability of the Philips curve. The fooling model developed by Milton Friedman and Edmund Strother Phelp is one of them. It was developed to counter John Maynard Keynes' Philips curve, which explained the unemployment and inflation trade-off. The model explains the stagflation phenomenon (Philips curve's instability) in terms of the influx in inflationary expectations that induce the Phillips curve to shift. The model offers an alternative to the Keynesian assumption that the nominal wages are rigidity and nonmarket-clearing to explain the existence of business cycles.

According to the Friedman-Phelps fooling model, the Phillips curve has been wrongly specified. That is because it is the real wage, not money wage, that responds to excess labor demand. The trade-off in the Philips curve between unemployment and money wage inflation can only exist temporarily so long as the buyers and sellers of labor are fooled. That is so long as they continue to confuse the money wages with real wages and fail to anticipate the inflation rate correctly. The changes in the rates of money wages can offset the unemployment rate in the short run only. The reason is that in the short run, the employers and laborers often confuse the changes in money wage with the real wage changes, thus misinterpreting inflation.

A good example is an expansionary monetary policy. The economy experiences wage and price inflation. That increment in money wages will be misinterpreted by the laborers as an increment in real wages and by producers as the reduction in real wages. The short-run effect will, therefore, be an increment in both the inflation rate and a reduction in the unemployment rate in the Philips curve, albeit temporarily. Eventually, all the producers and laborers will accurately learn about the higher inflation rate. Afterwards, they will incorporate the correct expectation into the new labor contracts, and the jobless rate will return to the natural level. Therefore, the trade-off between inflation and unemployment does not exist.

Therefore, assuming the inflation rate price is equaling the inflation wage rate, and that neither the laborers nor the producers suffer from money illusion (they both precisely anticipate inflation). The Friedman- Phelps model implies that the changes anticipated in price levels will be incorporated fully into the money wage contracts. As a consequence, the rate of change in money wages will be a function of both the anticipated price rates and the unemployment rate.

A Graphic Representation of The Friedman-Phelps Fooling Model

Friedman-Phelps model above distinguishes between the short and the long-run impacts of unanticipated inflation. It assumes that the natural, long-run unemployment level Un is 5%. Phillips curve showcases the inverted short-run relation between the actual unemployment and inflation when both employers and workers anticipate an annual inflation rate at 5%. Along the curve, a temporary trade-off exists between inflation and inflation exists. It is because the actual rate inflation rate differs from the anticipated one, and the workers and employers are fooled. The Friedman-Phelps model policy implication is that the monetary policy or fiscal policy can affect both the output and unemployment in the short-run because these policies can fool people in the short-run. However, in the long-run, such policies will become ineffective reason being that in the long-run, both employees and employers will precisely anticipate the inflation rate, consequently returning unemployment to its natural rate.

The Shortcomings of the Fooling Model

The fooling model by Friedman and Phelps does not satisfy the explanation of cyclical unemployment. It fails to furnish a proper explanation for unemployment persistence at levels either below or above the natural rate or equilibrium. Besides, according to the model, the persistence of unemployment is initiated by the delay in information flows. It is generated endogenously inside the model by the deflationary or inflationary surprises. However, it is unfortunate that the delay is not generated endogenously by the model, and its length is a matter of judgment. Thus, it is a difficult task to test the extent of the observed variance in unemployment. It can be accurately attributed to the deflationary or inflationary surprises.

Also, the model assumes that the expectations will be generated according to an adaptive expectations mechanism, which implies that the current expectations are equal to the weighted average of past rates of inflation. That assumption has been challenged by the recent development of the rational expectations concept. It states that expectations are formed rationally and based on an economic model of the determination of the variable in question. Rather than based on the weighted average of past values of the variable. The model insists that real variables such as output and employment can be affected by monetary policy in the short-run. That is because individuals can only be fooled easily then. However, in the long-run, they cannot be fooled. However, the rational expectations hypothesis posits that stabilization policies are not in a position to fool people systematically.

A good example is a fact that the monetary policy is not in a position to lead individuals to misestimate the rate of inflation; some of them will overestimate while others will overestimate. That implies that output and employment cannot be the stabilization policy cannot systematically be influenced by the stabilization policy even in the short-run. Furthermore, In the case where the wages are determined by collective bargaining, workers may, for one reason or the other, be excuse...