Levon&Sarah

7/28/2019 Levon&Sarah

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Why Wages Dont Fall

During a RecessionExisting Theories

Truman Bewley

Presented by

Levon Balayan and Sarah Kim


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Outline Labor Supply Theories

Wages downwardly rigid because people withdraw their laborwhen wages fall

Worker Bargaining Theories

Workers collective or individual bargaining power causesdownward wage rigidity

Theories Based on Market Interactions Wage rigidity as an outcome of functioning markets

Theories Attributing Wage Rigidity to Firms

Behavior Company policies are responsible for downward wage rigidity

Theories of Recessions as Reallocators ofLabor Unemployment is a cost of adjustment to structural economic change


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Labor Supply Theories

Intertemporal Substitution Theory Lucas andRapping(1969)

Workers quit because wages or salaries fall

below expectations

When wages are unusually low, people

become unemployed to enjoy leisure


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Intertemporal Substitution Theory Criticism

Inconsistent with labor market behavior during recessions: Wage cuts unusual

Quits decreased sharply

Counselors knew of no one who quit because of pay cut

Half of unemployed were laid off Actual pay cuts had little extra turnover

If applicants were holding out for higher pay, it would bedifficult for firms to recruit. However, employers overwhelmedby over-qualified applicants

Applicants are flexible (Only employers of low-paid labor complainedthat applicants wanted too much money)

Unemployed had little leisure, due to the time spent lookingfor work.


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Consumption declines during unemployment, as leisure

is a substitute for goods and services, not because

jobless run out of money (Heckman (1974) Ghez (1975))but

W eakenedby the fact that increases in possession ofliquid financial assets diminishes the drop in consumption


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NYC Cab DriverCamerer et al. (1997)

Cab drivers work more during slow days, whenhourly wages are low

Drivers quit for the day once they reach their

target daily income

This showsEven if wages dropped during arecession, workers would not respond by withdrawing

labor.


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Bottom Line:Most people find joblessness

extremelydisagreeable!


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Labor Supply Theories

Real Business Cycles

Unemployment is interpreted as leisure optimally

selected by workers (similar to IntertemporalSubstitution Theory)


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Real Business Cycles Problem

Difficulty to factor in small wage

fluctuations relative to fluctuations in

employmentSolution (Hansen (1985)):

Assume workers are indifferent between working

and not working

Hence, changes in labor demand only affect

number of employed and not the real wages


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Real Business Cycles Criticism

Indifference may be true for elderly, students, andhousewives However, these groups do not drive unemployment

People are desperate for work

Unemployment = misery

Household production


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Worker Bargaining Theories

The Insider- Outsider Model

Insidersexisting employees

Outsidersunemployed workers

G eneral Modelinsiders prevent outsiders

from taking their jobs or bidding down wages

There are several such models


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The Insider- Outsider Model

Lindbeck and Snower (1988) Unorganized workers bargain individually

with employers

Insiders refuse to train or cooperate withreplacement workers, reducing

productivity of the latter


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The Insider- Outsider Model Criticism

Non-union workers rarely bargain with employers

Only top executives, people with unusual skills bargain

effectively as individuals

Pay rates are set by management and are independent

on competition from workers


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The Insider- Outsider Model Criticism

M AI N PR O BLE MTheory assumes

conflict where there is none

No conflict between insiders and outsiders over pay

cutting

Pay reduction is not an alternate for saving jobs

No conflict between employed and unemployed Firms do not replace employees with unemployed

Wages are independent of the number of employees


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Theories Attributing Wage Rigidity

to Firms Behavior Efficiency Wage Theory

Positive association between pay and efficiency

creates upward pressure on wages that puts themabove the market clearing level

Implies existence of unemployment in equilibrium

Criticism

Only some of the theories explain wage rigidity


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to Firms Behavior The Turnover and Flat Labor Supply Curve Model

(Stiglitz (1974), Schlicht (1978), Salop (1979))

Voluntary turnover in a recession decreases with

wage and increases with labor market tightness

Firms weigh turnover costs against wage costs when

setting pay

Raise wages when unemployment is low to reduce quitting

Low unemployment causes wage inflation


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The Turnover and Flat Labor Supply

Curve Model Criticism Inconsistent with downward wage rigidity during

recessions

Wages fall when unemployment is higher thanequilibrium level and turnover diminishes

Although pay has an effect on turnover, quitting

anticipated was more a response to bad morale

Pay cuts during the recession had little impacton turnover


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Theories Attributing Wage Rigidity to

Firms Behavior

Morale Model (Solow (1979), Akerlof (1982)) Assumes higher pay increases productivity through the impact

on the morale

morale(m-rl')n. - The state of the spirits of a person or groupas exhibited by confidence, cheerfulness, discipline, andwillingness to perform assigned tasks.

C riticism

Pay levels affect productivity through the quality of workersrecruited, but have little impact on morale or work effort

Theory is correct to emphasize morale, but undermines thenegative impact on pay cuts


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to Firms Behavior Menu Costs (Mankiw (1985), Akerlof and Yellen

(1985))

Attributes downward wage rigidity to the expense of cutting

wages

Small deviations of wages from the optimal level derived from

turnover and shirking models have little impact on profits

C riticism

Administrative or negotiation costs never interfered with pay

cutting

Menu costs hardly explain why pay was increased rather than

cut


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Conclusion

The only one of the theories of wage rigidity

that seems reasonable is the morale theory of

Solow and Akerlof. The others fail because ofthe lack of realism of their basic assumptions

-Truman Bewley


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Questions


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Discussion

How seriously can we consider the anecdotal

evidence countering statistical findings?

Which model you think is most realistic? What do you think about Bewleys claim that

Administrative or negotiation costs never interfered

with pay cutting?

Have your wages decreased in this recession?

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