Question

Name and explain some of the reasons why wages are likely to be sticky, especially in downward adjustments.

Short answer

In summary, wages are likely to be sticky, especially in downward adjustments, due to several reasons. These include nominal wage rigidity, implicit contracts, efficiency wages, fairness concerns, and insider-outsider dynamics. Nominal wage rigidity describes employers' resistance to lowering wages in absolute dollars. Implicit contracts comprise unwritten expectations that employers will not cut wages during economic downturns. Efficiency wages are set above market-clearing levels to boost productivity and reduce turnover, and thus are not reduced easily. Fairness concerns illustrate how workers may perceive wage cuts as unjust, leading to demotivation and job searches. Finally, insider-outsider dynamics entail incumbent workers having bargaining power to resist wage cuts, with employers maintaining good relations by avoiding wage reductions.

Step-by-step solution

1. Nominal wage rigidity

Nominal wage rigidity refers to the idea that employers are often resistant to lowering workers' wages in terms of absolute dollars, even during economic downturns or periods of deflation. This may be because workers are more likely to resist wage cuts, since they directly impact their well-being and standard of living.

2. Implicit contracts

Implicit contracts are unwritten rules or expectations between workers and their employers that help to maintain stable relationships and limit turnover. These contracts include the underlying belief that employers will not cut wages in difficult economic times or in response to a drop in a company's profitability. In return, workers may be expected to work harder or more efficiently during good times, which can help to maintain a stable and productive workforce.

3. Efficiency wages

Efficiency wages are wages that are set intentionally above the market-clearing wage to improve worker productivity, loyalty, and retention. By providing a higher wage, employers may motivate their workers to perform better, reduce shirking, and increase the cost of losing the job. This in turn can lead to higher overall productivity for the firm. In this context, downward wage adjustments can be counterproductive, as they would diminish the benefits provided by efficiency wages and potentially lead to lower productivity.

4. Fairness concerns

Workers generally have a strong sense of what they consider fair or equitable compensation for their labor. If workers perceive wage cuts as violating notions of fairness, they may become demotivated or more likely to search for new job opportunities. To maintain a stable workforce and avoid the negative effects of perceived unfairness, employers may be hesitant to reduce wages, even when economic conditions suggest that such an adjustment may be warranted.

5. Insider-outsider dynamics

Insider-outsider dynamics suggest that incumbent workers (the insiders) may possess a certain amount of bargaining power that allows them to resist wage cuts more effectively. This bargaining power can arise from factors such as job-specific skills or experience, union membership, or strong relationships with management. In an attempt to maintain good relations with their insiders, employers may be reluctant to cut wages, and instead prefer to reduce the workforce through layoffs, limiting new hires, or even wage freezes.