Principles of Macroeconomics / Unit 5 MAC 0414 review, 2 to 3 minutes
Why Wages Are Sticky Downward
The idea
If wages fell whenever labor demand fell, the labor market would clear and involuntary unemployment would barely exist. It does exist, so wages must resist falling, and economists offer five explanations that compete rather than exclude one another. The first is implicit contracts: employers hold wages up in bad times and hold them back in good times, which is a kind of insurance running in both directions. The second is efficiency wages: paying above the market raises effort and retention and saves the cost of hiring and training replacements, so cutting pay can cost more than it saves. The third is adverse selection: an across-the-board pay cut drives out the best workers first, because they have the most alternatives, so firms lay off a few rather than cut everyone. The fourth is the insider and outsider problem: the people already employed keep the firm running, and cutting their pay damages it, whatever an outsider would accept. The fifth is relative wage coordination: no worker wants to be the one whose pay falls while others hold, and there is no decentralized way to cut everyone at once.
In practice
Worked example: a firm's sales fall by a fifth and it must cut its wage bill. It could cut every wage by a fifth, or lay off a fifth of its workers. Cutting every wage sends its best engineers to competitors who did not cut, leaves the rest resentful and less productive, and breaks an understanding those workers accepted lower raises in good years to secure. Laying off a fifth keeps the remaining wage structure and the remaining workers' effort intact. The firm lays off, and the economy records involuntary unemployment rather than a general fall in wages.
Where people slip
Three cautions. These are competing explanations, not an agreed list, and the course reports them as such rather than choosing one. Laws and unions cannot carry the explanation alone, because the minimum wage and union contracts together cover only part of the workforce, and stickiness appears well above both. And the consequence is what makes this matter for the rest of the course: because the wage does not clear the market, a fall in demand shows up as lost jobs rather than lower pay, which is why the short-run aggregate supply curve in unit eight slopes upward instead of standing vertical.
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