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Tuesday, August 16, 2011

Sticky wages?

A major back-and-forth has kicked up in the econ blogosphere, initiated by a post by Tyler Cowen at Marginal Revolution (for example, here, and here, and here, and here, and here, and here, and here).

What's interesting to me it that there is actual research on the question of wage stickiness, as I commented on Cowen's post:

There is, as it turns out, some actual research on this issue in the job search literature. The bottom line is that reservation wages appear to fall relatively quickly with duration of unemployment. One common conclusion is that wage stickiness comes from the behavior of *employers.* Some citations:

“Reservation Wages, Offer Wages, and Unemployment Duration–Some New Empirical Evidence”
The authors conclude that offer wages fall faster than do reservation wages (not that reservations wages do not fall).

“The Relationship Between Unemployment Spells and Reservation Wages as a Test of Search Theory,” by Stephen R. G. Jones, QJE, V. 104, N. 4, 1988.
“…the main finding is that reservation wages play a significant role in the determination of duration.”
“Short-Run Equilibrium Dynamics of Unemployment, Vacancies, and Real Wages,” by C. A. Pissarides, AER, V. 75, N. 4, 1985.

“Efficiency Wage Models and Unemployment,: by J. L. Yellen, AER, V. 72, N2., 1984.
The stickiness of wages is attributed to the reluctance of *employers* to reduce wages.
“Unemployment, Wage-Setting, and Insider-Oursider Relationships,” by A. Lindbeck, AER V. 76, N. 2, 1986. 
The stickiness of wages is again attributed to the reluctance of *employers* to reduce wages.

“Wage Dynamics: Reconciling Theory and Evidence,” by O. Blanchard and L. Katz, 1999.
“In this paper, we ask whether one can reconcile the empirical evidence with theoretical wage relations. We reach three main conclusions. First, we derive the condition under which the two can indeed be reconciled. We show the constraints that such a condition imposes on the determinants of workers’ reservation wages as well as the relative importance of workers’ outside options as opposed to match specific productivity in wage determination. Second, in the light of this condition, we reinterpret the presence of an “error correction” term in macroeconomic wage relations for most European economies but not in the United States. Third, we show that whether this condition holds or not has important implications for the effects of a number of variables — from real interest rates to oil prices to payroll taxes — on the natural rate of unemployment.”

“An Empirical Test Job-Search Model, with a Test of the Constant Reservation-Wage Hypothesis,” N. Keifer and G. Neumann, JPE, V. 87, N. 1m 1979.
“Reservation wages are found to decline significantly with duration.”

“An Econometric Analysis of Reservation Wages,” by T. Lancaster and A. Chesher, Econometrica, V. 51, N. 6, 1983. Their table A-IV clearly shows reservation wages falling with duration of unemployment, from 21.28 pounds per week for durations less than 13 weeks to 17,74 pounds per week for durations exceeding 52 weeks,

Interestingly the research shows that unemployed workers reduce their reservation wages fairly rapidly and by fairly large amounts.  Why, then, the debate?  Well, because wages are sticky, but they are apparently sticky because of employer behavior.  How can this be?

Consider how job search works.  A worker seeking a job makes contact with an employer (fills out an application, interviews, and so on).  The employer decides whether to make an offer to the applicant, including terms (compensation, etc.) of employment.  The applicant decides whether to take the offer.  (And, also from the job-search literature--almost all "first-offers" to applicants are accepted.)  If the employer does not make an offer, how common is it for the applicant to say, "Well, how about I work for 10% less than what you're currently paying people"?

Here's my take on why that doesn't happen:  This is a signaling problem. If the prevailing wage (which, incidentally, needs to be seen as including all the costs of employing an additional worker, not just the direct compensation of that worker) is currently $x, then offering to work for $(x – a) signals the employer that you, the applicant, do not believe that your productivity is worth $x. Which does not mean that the employer should accept that your productivity is worth at least $(x – a). I would suggest that such a signal reduces the probability of an employer accepting your offer to work.  So applicants have little or no incentive to offer to work at below-prevailing wages.

But, then, why don't employers reduce their wage offers?  Here the standard response ranges from morale issues (cutting everyone's wages may lead to increased turnover and/or reduced effort and productivity--an "efficiency wage" argument) to salience issues (reducing wages only for new hires is a trivial reduction in employment costs, compared with the cost of continuing workers).  There may even be legal issues ("equal-pay for equal-work" considerations).

So sticky (downward) wages appear to be real, but a reality based on employer behavior; the willingness of job-seekers to reduce their reservation wages is just too well documented.


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