Question

Are labor costs a major fraction of the typical firm’s overall production costs? How does wage stickiness cause price stickiness? Discuss why firms are averse to cutting wages and salaries during a business downturn.

Short answer

Yes, labor costs form a significant portion of a firm’s overall production costs.

A firm cannot cut or increase wages in the short run, which leads to price stickiness.

The firm does not cut wages and salaries to avoid resentment from workers. Any form of resentment among workers will damage the production process of the firm.

Step-by-step solution

Share of labor cost in total production cost

For an average firm, the labor cost is estimated to be 70 percent of production costs. In other words, two-thirds of production cost comes from the wage and salaries of the employees. Thus, they are a significant fraction of a firm’s overall production costs.

Wage stickiness leading to  price stickiness

Suppose a firm wants to reduce its costs to increase profits or survive an economic downturn in the short run. It cannot reduce the average cost due to the wage stickiness that arises because the employees resist declining wages. To maintain the flow of work and supply of inputs, the firms will have to look for other options like decreasing production and employment level. This leads to a fall in output but no change in price.

Thus, the stickiness of wages is converted into price stickiness.

Reason behind wage rigidity

If the management of a firm decides to cut the salaries and wages of its employees to cut the production cost, the workers will feel that they are paid less for the same work. This psychological feeling will create a bad impression about the management among the workers, and they will retaliate to this decision.

The workers might go on protest against the management and stop production. Some workers might go violent and start vandalizing the company property. The lower wage rate will discourage existing workers, which will reduce their productivity level. Some might start stealing from the supply lines of the company.

Any of the above possibilities will increase the production cost instead of decreasing it. To avoid these possibilities, firms avert the decision of cutting the wage and salaries of their workers.