Archive for the 'search theories' Category

More on Sticky Wages

It’s been over four and a half years since I wrote my second most popular post on this blog (“Why are Wages Sticky?”). Although the post was linked to and discussed by Paul Krugman (which is almost always a guarantee of getting a lot of traffic) and by other econoblogosphere standbys like Mark Thoma and Barry Ritholz, unlike most of my other popular posts, it has continued ever since to attract a steady stream of readers. It’s the posts that keep attracting readers long after their original expiration date that I am generally most proud of.

I made a few preliminary points about wage stickiness before getting to my point. First, although Keynes is often supposed to have used sticky wages as the basis for his claim that market forces, unaided by stimulus to aggregate demand, cannot automatically eliminate cyclical unemployment within the short or even medium term, he actually devoted a lot of effort and space in the General Theory to arguing that nominal wage reductions would not increase employment, and to criticizing economists who blamed unemployment on nominal wages fixed by collective bargaining at levels too high to allow all workers to be employed. So, the idea that wage stickiness is a Keynesian explanation for unemployment doesn’t seem to me to be historically accurate.

I also discussed the search theories of unemployment that in some ways have improved our understanding of why some level of unemployment is a normal phenomenon even when people are able to find jobs fairly easily and why search and unemployment can actually be productive, enabling workers and employers to improve the matches between the skills and aptitudes that workers have and the skills and aptitudes that employers are looking for. But search theories also have trouble accounting for some basic facts about unemployment.

First, a lot of job search takes place when workers have jobs while search theories assume that workers can’t or don’t search while they are employed. Second, when unemployment rises in recessions, it’s not because workers mistakenly expect more favorable wage offers than employers are offering and mistakenly turn down job offers that they later regret not having accepted, which is a very skewed way of interpreting what happens in recessions; it’s because workers are laid off by employers who are cutting back output and idling production lines.

I then suggested the following alternative explanation for wage stickiness:

Consider the incentive to cut price of a firm that can’t sell as much as it wants [to sell] at the current price. The firm is off its supply curve. The firm is a price taker in the sense that, if it charges a higher price than its competitors, it won’t sell anything, losing all its sales to competitors. Would the firm have any incentive to cut its price? Presumably, yes. But let’s think about that incentive. Suppose the firm has a maximum output capacity of one unit, and can produce either zero or one units in any time period. Suppose that demand has gone down, so that the firm is not sure if it will be able to sell the unit of output that it produces (assume also that the firm only produces if it has an order in hand). Would such a firm have an incentive to cut price? Only if it felt that, by doing so, it would increase the probability of getting an order sufficiently to compensate for the reduced profit margin at the lower price. Of course, the firm does not want to set a price higher than its competitors, so it will set a price no higher than the price that it expects its competitors to set.

Now consider a different sort of firm, a firm that can easily expand its output. Faced with the prospect of losing its current sales, this type of firm, unlike the first type, could offer to sell an increased amount at a reduced price. How could it sell an increased amount when demand is falling? By undercutting its competitors. A firm willing to cut its price could, by taking share away from its competitors, actually expand its output despite overall falling demand. That is the essence of competitive rivalry. Obviously, not every firm could succeed in such a strategy, but some firms, presumably those with a cost advantage, or a willingness to accept a reduced profit margin, could expand, thereby forcing marginal firms out of the market.

Workers seem to me to have the characteristics of type-one firms, while most actual businesses seem to resemble type-two firms. So what I am suggesting is that the inability of workers to take over the jobs of co-workers (the analog of output expansion by a firm) when faced with the prospect of a layoff means that a powerful incentive operating in non-labor markets for price cutting in response to reduced demand is not present in labor markets. A firm faced with the prospect of being terminated by a customer whose demand for the firm’s product has fallen may offer significant concessions to retain the customer’s business, especially if it can, in the process, gain an increased share of the customer’s business. A worker facing the prospect of a layoff cannot offer his employer a similar deal. And requiring a workforce of many workers, the employer cannot generally avoid the morale-damaging effects of a wage cut on his workforce by replacing current workers with another set of workers at a lower wage than the old workers were getting.

I think that what I wrote four years ago is clearly right, identifying an important reason for wage stickiness. But there’s also another reason that I didn’t mention then, but whose importance has since come to appear increasingly significant to me, especially as a result of writing and rewriting my paper “Hayek, Hicks, Radner and three concepts of intertemporal equilibrium.”

If you are unemployed because the demand for your employer’s product has gone down, and your employer, planning to reduce output, is laying off workers no longer needed, how could you, as an individual worker, unconstrained by a union collective-bargaining agreement or by a minimum-wage law, persuade your employer not to lay you off? Could you really keep your job by offering to accept a wage cut — no matter how big? If you are being laid off because your employer is reducing output, would your offer to work at a lower wage cause your employer to keep output unchanged, despite a reduction in demand? If not, how would your offer to take a pay cut help you keep your job? Unless enough workers are willing to accept a big enough wage cut for your employer to find it profitable to maintain current output instead of cutting output, how would your own willingness to accept a wage cut enable you to keep your job?

Now, if all workers were to accept a sufficiently large wage cut, it might make sense for an employer not to carry out a planned reduction in output, but the offer by any single worker to accept a wage cut certainly would not cause the employer to change its output plans. So, if you are making an independent decision whether to offer to accept a wage cut, and other workers are making their own independent decisions about whether to accept a wage cut, would it be rational for you or any of them to accept a wage cut? Whether it would or wouldn’t might depend on what each worker was expecting other workers to do. But certainly given the expectation that other workers are not offering to accept a wage cut, why would it make any sense for any worker to be the one to offer to accept a wage cut? Would offering to accept a wage cut, increase the likelihood that a worker would be one of the lucky ones chosen not to be laid off? Why would offering to accept a wage cut that no one else was offering to accept, make the worker willing to work for less appear more desirable to the employer than the others that wouldn’t accept a wage cut? One reaction by the employer might be: what’s this guy’s problem?

Combining this way of looking at the incentives workers have to offer to accept wage reductions to keep their jobs with my argument in my post of four years ago, I now am inclined to suggest that unemployment as such provides very little incentive for workers and employers to cut wages. Price cutting in periods of excess supply is often driven by aggressive price cutting by suppliers with large unsold inventories. There may be lots of unemployment, but no one is holding a large stock of unemployed workers, and no is in a position to offer low wages to undercut the position of those currently employed at  nominal wages that, arguably, are too high.

That’s not how labor markets operate. Labor markets involve matching individual workers and individual employers more or less one at a time. If nominal wages fall, it’s not because of an overhang of unsold labor flooding the market; it’s because something is changing the expectations of workers and employers about what wage will be offered by employers, and accepted by workers, for a particular kind of work. If the expected wage is too high, not all workers willing to work at that wage will find employment; if it’s too low, employers will not be able to find as many workers as they would like to hire, but the situation will not change until wage expectations change. And the reason that wage expectations change is not because the excess demand for workers causes any immediate pressure for nominal wages to rise.

The further point I would make is that the optimal responses of workers and the optimal responses of their employers to a recessionary reduction in demand, in which the employers, given current input and output prices, are planning to cut output and lay off workers, are mutually interdependent. While it is, I suppose, theoretically possible that if enough workers decided to immediately offer to accept sufficiently large wage cuts, some employers might forego plans to lay off their workers, there are no obvious market signals that would lead to such a response, because such a response would be contingent on a level of coordination between workers and employers and a convergence of expectations about future outcomes that is almost unimaginable.

One can’t simply assume that it is in the independent self-interest of every worker to accept a wage cut as soon as an employer perceives a reduced demand for its product, making the current level of output unprofitable. But unless all, or enough, workers decide to accept a wage cut, the optimal response of the employer is still likely to be to cut output and lay off workers. There is no automatic mechanism by which the market adjusts to demand shocks to achieve the set of mutually consistent optimal decisions that characterizes a full-employment market-clearing equilibrium. Market-clearing equilibrium requires not merely isolated price and wage cuts by individual suppliers of inputs and final outputs, but a convergence of expectations about the prices of inputs and outputs that will be consistent with market clearing. And there is no market mechanism that achieves that convergence of expectations.

So, this brings me back to Keynes and the idea of sticky wages as the key to explaining cyclical fluctuations in output and employment. Keynes writes at the beginning of chapter 19 of the General Theory.

For the classical theory has been accustomed to rest the supposedly self-adjusting character of the economic system on an assumed fluidity of money-wages; and, when there is rigidity, to lay on this rigidity the blame of maladjustment.

A reduction in money-wages is quite capable in certain circumstances of affording a stimulus to output, as the classical theory supposes. My difference from this theory is primarily a difference of analysis. . . .

The generally accept explanation is . . . quite a simple one. It does not depend on roundabout repercussions, such as we shall discuss below. The argument simply is that a reduction in money wages will, cet. par. Stimulate demand by diminishing the price of the finished product, and will therefore increase output, and will therefore increase output and employment up to the point where  the reduction which labour has agreed to accept in its money wages is just offset by the diminishing marginal efficiency of labour as output . . . is increased. . . .

It is from this type of analysis that I fundamentally differ.

[T]his way of thinking is probably reached as follows. In any given industry we have a demand schedule for the product relating the quantities which can be sold to the prices asked; we have a series of supply schedules relating the prices which will be asked for the sale of different quantities. .  . and these schedules between them lead up to a further schedule which, on the assumption that other costs are unchanged . . . gives us the demand schedule for labour in the industry relating the quantity of employment to different levels of wages . . . This conception is then transferred . . . to industry as a whole; and it is supposed, by a parity of reasoning, that we have a demand schedule for labour in industry as a whole relating the quantity of employment to different levels of wages. It is held that it makes no material difference to this argument whether it is in terms of money-wages or of real wages. If we are thinking of real wages, we must, of course, correct for changes in the value of money; but this leaves the general tendency of the argument unchanged, since prices certainly do not change in exact proportion to changes in money wages.

If this is the groundwork of the argument . . ., surely it is fallacious. For the demand schedules for particular industries can only be constructed on some fixed assumption as to the nature of the demand and supply schedules of other industries and as to the amount of aggregate effective demand. It is invalid, therefore, to transfer the argument to industry as a whole unless we also transfer our assumption that the aggregate effective demand is fixed. Yet this assumption amount to an ignoratio elenchi. For whilst no one would wish to deny the proposition that a reduction in money-wages accompanied by the same aggregate demand as before will be associated with an increase in employment, the precise question at issue is whether the reduction in money wages will or will not be accompanied by the same aggregate effective demand as before measured in money, or, at any rate, measured by an aggregate effective demand which is not reduced in full proportion to the reduction in money-wages. . . But if the classical theory is not allowed to extend by analogy its conclusions in respect of a particular industry to industry as a whole, it is wholly unable to answer the question what effect on employment a reduction in money-wages will have. For it has no method of analysis wherewith to tackle the problem. (General Theory, pp. 257-60)

Keynes’s criticism here is entirely correct. But I would restate slightly differently. Standard microeconomic reasoning about preferences, demand, cost and supply is partial-equilbriium analysis. The focus is on how equilibrium in a single market is achieved by the adjustment of the price in a single market to equate the amount demanded in that market with amount supplied in that market.

Supply and demand is a wonderful analytical tool that can illuminate and clarify many economic problems, providing the key to important empirical insights and knowledge. But supply-demand analysis explicitly – but too often without realizing its limiting implications – assumes that other prices and incomes in other markets are held constant. That assumption essentially means that the market – i.e., the demand, cost and supply curves used to represent the behavioral characteristics of the market being analyzed – is small relative to the rest of the economy, so that changes in that single market can be assumed to have a de minimus effect on the equilibrium of all other markets. (The conditions under which such an assumption could be justified are themselves not unproblematic, but I am now assuming that those problems can in fact be assumed away at least in many applications. And a good empirical economist will have a good instinctual sense for when it’s OK to make the assumption and when it’s not OK to make the assumption.)

So, the underlying assumption of microeconomics is that the individual markets under analysis are very small relative to the whole economy. Why? Because if those markets are not small, we can’t assume that the demand curves, cost curves, and supply curves end up where they started. Because a high price in one market may have effects on other markets and those effects will have further repercussions that move the very demand, cost and supply curves that were drawn to represent the market of interest. If the curves themselves are unstable, the ability to predict the final outcome is greatly impaired if not completely compromised.

The working assumption of the bread and butter partial-equilibrium analysis that constitutes econ 101 is that markets have closed borders. And that assumption is not always valid. If markets have open borders so that there is a lot of spillover between and across markets, the markets can only be analyzed in terms of broader systems of simultaneous equations, not the simplified solutions that we like to draw in two-dimensional space corresponding to intersections of stable supply curves with stable supply curves.

What Keynes was saying is that it makes no sense to draw a curve representing the demand of an entire economy for labor or a curve representing the supply of labor of an entire economy, because the underlying assumption of such curves that all other prices are constant cannot possibly be satisfied when you are drawing a demand curve and a supply curve for an input that generates more than half the income earned in an economy.

But the problem is even deeper than just the inability to draw a curve that meaningfully represents the demand of an entire economy for labor. The assumption that you can model a transition from one point on the curve to another point on the curve is simply untenable, because not only is the assumption that other variables are being held constant untenable and self-contradictory, the underlying assumption that you are starting from an equilibrium state is never satisfied when you are trying to analyze a situation of unemployment – at least if you have enough sense not to assume that economy is starting from, and is not always in, a state of general equilibrium.

So, Keynes was certainly correct to reject the naïve transfer of partial equilibrium theorizing from its legitimate field of applicability in analyzing the effects of small parameter changes on outcomes in individual markets – what later came to be known as comparative statics – to macroeconomic theorizing about economy-wide disturbances in which the assumptions underlying the comparative-statics analysis used in microeconomics are clearly not satisfied. That illegitimate transfer of one kind of theorizing to another has come to be known as the demand for microfoundations in macroeconomic models that is the foundational methodological principle of modern macroeconomics.

The principle, as I have been arguing for some time, is illegitimate for a variety of reasons. And one of those reasons is that microeconomics itself is based on the macroeconomic foundational assumption of a pre-existing general equilibrium, in which all plans in the entire economy are, and will remain, perfectly coordinated throughout the analysis of a particular parameter change in a single market. Once you relax the assumption that all, but one, markets are in equilibrium, the discipline imposed by the assumption of the rationality of general equilibrium and comparative statics is shattered, and a different kind of theorizing must be adopted to replace it.

The search for that different kind of theorizing is the challenge that has always faced macroeconomics. Despite heroic attempts to avoid facing that challenge and pretend that macroeconomics can be built as if it were microeconomics, the search for a different kind of theorizing will continue; it must continue. But it would certainly help if more smart and creative people would join in that search.

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Roger and Me

Last week Roger Farmer wrote a post elaborating on a comment that he had left to my post on Price Stickiness and Macroeconomics. Roger’s comment is aimed at this passage from my post:

[A]lthough price stickiness is a sufficient condition for inefficient macroeconomic fluctuations, it is not a necessary condition. It is entirely possible that even with highly flexible prices, there would still be inefficient macroeconomic fluctuations. And the reason why price flexibility, by itself, is no guarantee against macroeconomic contractions is that macroeconomic contractions are caused by disequilibrium prices, and disequilibrium prices can prevail regardless of how flexible prices are.

Here’s Roger’s comment:

I have a somewhat different take. I like Lucas’ insistence on equilibrium at every point in time as long as we recognize two facts. 1. There is a continuum of equilibria, both dynamic and steady state and 2. Almost all of them are Pareto suboptimal.

I made the following reply to Roger’s comment:

Roger, I think equilibrium at every point in time is ok if we distinguish between temporary and full equilibrium, but I don’t see how there can be a continuum of full equilibria when agents are making all kinds of long-term commitments by investing in specific capital. Having said that, I certainly agree with you that expectational shifts are very important in determining which equilibrium the economy winds up at.

To which Roger responded:

I am comfortable with temporary equilibrium as the guiding principle, as long as the equilibrium in each period is well defined. By that, I mean that, taking expectations as given in each period, each market clears according to some well defined principle. In classical models, that principle is the equality of demand and supply in a Walrasian auction. I do not think that is the right equilibrium concept.

Roger didn’t explain – at least not here, he probably has elsewhere — exactly why he doesn’t think equality of demand and supply in a Walrasian auction is not the right equilibrium concept. But I would be interested in hearing from him why he thinks equality of supply and demand is not the right equilibrium concept. Perhaps he will clarify his thinking for me.

Hicks wanted to separate ‘fix price markets’ from ‘flex price markets’. I don’t think that is the right equilibrium concept either. I prefer to use competitive search equilibrium for the labor market. Search equilibrium leads to indeterminacy because there are not enough prices for the inputs to the search process. Classical search theory closes that gap with an arbitrary Nash bargaining weight. I prefer to close it by making expectations fundamental [a proposition I have advanced on this blog].

I agree that the Hicksian distinction between fix-price markets and flex-price markets doesn’t cut it. Nevertheless, it’s not clear to me that a Thompsonian temporary-equilibrium model in which expectations determine the reservation wage at which workers will accept employment (i.e, the labor-supply curve conditional on the expected wage) doesn’t work as well as a competitive search equilibrium in this context.

Once one treats expectations as fundamental, there is no longer a multiplicity of equilibria. People act in a well defined way and prices clear markets. Of course ‘market clearing’ in a search market may involve unemployment that is considerably higher than the unemployment rate that would be chosen by a social planner. And when there is steady state indeterminacy, as there is in my work, shocks to beliefs may lead the economy to one of a continuum of steady state equilibria.

There is an equilibrium for each set of expectations (with the understanding, I presume, that expectations are always uniform across agents). The problem that I see with this is that there doesn’t seem to be any interaction between outcomes and expectations. Expectations are always self-fulfilling, and changes in expectations are purely exogenous. But in a classic downturn, the process seems to be cumulative, the contraction seemingly feeding on itself, causing a spiral of falling prices, declining output, rising unemployment, and increasing pessimism.

That brings me to the second part of an equilibrium concept. Are expectations rational in the sense that subjective probability measures over future outcomes coincide with realized probability measures? That is not a property of the real world. It is a consistency property for a model.

Yes; I agree totally. Rational expectations is best understood as a property of a model, the property being that if agents expect an equilibrium price vector the solution of the model is the same equilibrium price vector. It is not a substantive theory of expectation formation, the model doesn’t posit that agents correctly foresee the equilibrium price vector, that’s an extreme and unrealistic assumption about how the world actually works, IMHO. The distinction is crucial, but it seems to me that it is largely ignored in practice.

And yes: if we plop our agents down into a stationary environment, their beliefs should eventually coincide with reality.

This seems to me a plausible-sounding assumption for which there is no theoretical proof, and in view of Roger’s recent discussion of unit roots, dubious empirical support.

If the environment changes in an unpredictable way, it is the belief function, a primitive of the model, that guides the economy to a new steady state. And I can envision models where expectations on the transition path are systematically wrong.

I need to read Roger’s papers about this, but I am left wondering by what mechanism the belief function guides the economy to a steady state? It seems to me that the result requires some pretty strong assumptions.

The recent ‘nonlinearity debate’ on the blogs confuses the existence of multiple steady states in a dynamic model with the existence of multiple rational expectations equilibria. Nonlinearity is neither necessary nor sufficient for the existence of multiplicity. A linear model can have a unique indeterminate steady state associated with an infinite dimensional continuum of locally stable rational expectations equilibria. A linear model can also have a continuum of attracting points, each of which is an equilibrium. These are not just curiosities. Both of these properties characterize modern dynamic equilibrium models of the real economy.

I’m afraid that I don’t quite get the distinction that is being made here. Does “multiple steady states in a dynamic model” mean multiple equilibria of the full Arrow-Debreu general equilibrium model? And does “multiple rational-expectations equilibria” mean multiple equilibria conditional on the expectations of the agents? And I also am not sure what the import of this distinction is supposed to be.

My further question is, how does all of this relate to Leijonhfuvud’s idea of the corridor, which Roger has endorsed? My own understanding of what Axel means by the corridor is that the corridor has certain stability properties that keep the economy from careening out of control, i.e. becoming subject to a cumulative dynamic process that does not lead the economy back to the neighborhood of a stable equilibrium. But if there is a continuum of attracting points, each of which is an equilibrium, how could any of those points be understood to be outside the corridor?

Anyway, those are my questions. I am hoping that Roger can enlighten me.

Why Are Wages Sticky?

The stickiness of wages seems to be one of the key stylized facts of economics. For some reason, the idea that sticky wages may be the key to explaining business-cycle downturns in which output and employment– not just prices and nominal incomes — fall is now widely supposed to have been a, if not the, major theoretical contribution of Keynes in the General Theory. The association between sticky wages and Keynes is a rather startling, and altogether unfounded, inversion of what Keynes actually wrote in the General Theory, heaping scorn on what he called the “classical” doctrine that cyclical (or in Keynesian terminology “involuntary”) unemployment could be attributed to the failure of nominal wages to fall in response to a reduction in aggregate demand. Keynes never stopped insisting that the key defining characteristic of “involuntary” unemployment is that a nominal-wage reduction would not reduce “involuntary” unemployment. The very definition of involuntary unemployment is that it can only be eliminated by an increase in the price level, but not by a reduction in nominal wages.

Keynes devoted three entire chapters (19-21) in the General Theory to making, and mathematically proving, that argument. Insofar as I understand it, his argument doesn’t seem to me to be entirely convincing, because, among other reasons, his reasoning seems to involve implicit comparative-statics exercises that start from a disequlibrium situation, but that is definitely a topic for another post. My point is simply that the sticky-wages explanation for unemployment was exactly the “classical” explanation that Keynes was railing against in the General Theory.

So it’s really quite astonishing — and amusing — to observe that, in the current upside-down world of modern macroeconomics, what differentiates New Classical from New Keynesian macroeconomists is that macroecoomists of the New Classical variety, dismissing wage stickiness as non-existent or empirically unimportant, assume that cyclical fluctuations in employment result from high rates of intertemporal substitution by labor in response to fluctuations in labor productivity, while macroeconomists of the New Keynesian variety argue that it is nominal-wage stickiness that prevents the steep cuts in nominal wages required to maintain employment in the face of exogenous shocks in aggregate demand or supply. New Classical and New Keynesian indeed! David Laidler and Axel Leijonhufvud have both remarked on this role reversal.

Many possible causes of nominal-wage stickiness (especially in the downward direction) have been advanced. For most of the twentieth century, wage stickiness was blamed on various forms of government intervention, e.g., pro-union legislation conferring monopoly privileges on unions, as well as other forms of wage-fixing like minimum-wage laws and even unemployment insurance. Whatever the merits of these criticisms, it is hard to credit claims that wage stickiness is mainly attributable to labor-market intervention on the side of labor unions. First, the phenomenon of wage stickiness was noted and remarked upon by economists as long ago as the early nineteenth century (e.g., Henry Thornton in his classic The Nature and Effects of the Paper Credit of Great Britain) long before the enactment of pro-union legislation. Second, the repeal or weakening of pro-union legislation since the 1980s does not seem to have been associated with any significant reduction in nominal-wage stickiness.

Since the 1970s, a number of more sophisticated explanations of wage stickiness have been advanced, for example search theories coupled with incorrect price-level expectations, long-term labor contracts, implicit contracts, and efficiency wages. Search theories locate the cause of wage nominal stickiness in workers’ decisions about what wage offers to accept. Thus, the apparent downward stickiness of wages in a recession seems to imply that workers are turning down offers of employment or quitting their jobs in the mistaken expectation that search will uncover better offers, but that doesn’t seem to be what happens in recessions, when quits decline and layoffs increase. Long-term contracts can and frequently are renegotiated when conditions change. Implicit contracts also can be adjusted when conditions change. So insofar as these theories posit that workers are somehow making decisions that lead to their unemployment, the story seems to be incomplete. If workers could be made better off by accepting reduced wages instead of being unemployed, why isn’t it happening?

Efficiency wages posit a different cause for wage stickiness: that employers have cleverly discovered that by overpaying workers, workers will work their backsides off to continue to be considered worthy of receiving the rents that their employers are conferring upon them. Thus, when a recession hits, employers use the opportunity to weed out their least deserving employees. This theory at least has the virtue of not assigning responsibility for sub-optimal decisions to the workers.

All of these theories were powerfully challenged about eleven or twelve years ago by Truman Bewley in a book Why Wages Don’t Fall During a Recession. (See also Peter Howitt’s excellent review of Bewely’s book in the Journal of Economic Literature.) Bewley, though an accomplished theorist, simply went out and interviewed lots of business people, asking them to explain why they didn’t cut wages to their employees in recessions rather than lay off workers. Overwhelmingly, the responses Bewley received did not correspond to any of the standard theories of wage-stickiness. Instead, business people explained wage stickiness as necessary to avoid a collapse of morale among their employees. Layoffs also hurt morale, but the workers that are retained get over it, and those let go are no longer around to hurt the morale of those that stay.

While I have always preferred the search explanation for apparent wage stickiness, which was largely developed at UCLA in the 1960s (see Armen Alchian’s classic “Information costs, Pricing, and Resource Unemployment”), I recognize that it doesn’t seem to account for the basic facts of the cyclical pattern of layoffs and quits. So I think that it is clear that wage stickiness remains a problematic phenomenon. I don’t claim to have a good explanation to offer, but it does seem to me that an important element of an explanation may have been left out so far — at least I can’t recall having seen it mentioned.

Let’s think about it in the following way. Consider the incentive to cut price of a firm that can’t sell as much as it wants at the current price. The firm is off its supply curve. The firm is a price taker in the sense that, if it charges a higher price than its competitors, it won’t sell anything, losing all its sales to competitors. Would the firm have any incentive to cut its price? Presumably, yes. But let’s think about that incentive. Suppose the firm has a maximum output capacity of one unit, and can produce either zero or one units in any time period. Suppose that demand has gone down, so that the firm is not sure if it will be able to sell the unit of output that it produces (assume also that the firm only produces if it has an order in hand). Would such a firm have an incentive to cut price? Only if it felt that, by doing so, it would increase the probability of getting an order sufficiently to compensate for the reduced profit margin at the lower price. Of course, the firm does not want to set a price higher than its competitors, so it will set a price no higher than the price that it expects its competitors to set.

Now consider a different sort of firm, a firm that can easily expand its output. Faced with the prospect of losing its current sales, this type of firm, unlike the first type, could offer to sell an increased amount at a reduced price. How could it sell an increased amount when demand is falling? By undercutting its competitors. A firm willing to cut its price could, by taking share away from its competitors, actually expand its output despite overall falling demand. That is the essence of competitive rivalry. Obviously, not every firm could succeed in such a strategy, but some firms, presumably those with a cost advantage, or a willingness to accept a reduced profit margin, could expand, thereby forcing marginal firms out of the market.

Workers seem to me to have the characteristics of type-one firms, while most actual businesses seem to resemble type-two firms. So what I am suggesting is that the inability of workers to take over the jobs of co-workers (the analog of output expansion by a firm) when faced with the prospect of a layoff means that a powerful incentive operating in non-labor markets for price cutting in response to reduced demand is not present in labor markets. A firm faced with the prospect of being terminated by a customer whose demand for the firm’s product has fallen may offer significant concessions to retain the customer’s business, especially if it can, in the process, gain an increased share of the customer’s business. A worker facing the prospect of a layoff cannot offer his employer a similar deal. And requiring a workforce of many workers, the employer cannot generally avoid the morale-damaging effects of a wage cut on his workforce by replacing current workers with another set of workers at a lower wage than the old workers were getting. So the point that I am suggesting seems to dovetail with morale-preserving explanation for wage-stickiness offered by Bewley.

If I am correct, then the incentive for price cutting is greater in markets for most goods and services than in markets for labor employment. This was Henry Thornton’s observation over two centuries ago when he wrote that it was a well-known fact that wages are more resistant than other prices to downward pressure in periods of weak demand. And if that is true, then it suggests that real wages tend to fluctuate countercyclically, which seems to be a stylized fact of business cycles, though whether that is indeed a fact remains controversial.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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