Over the years, economists have offered several stories about why wages might be inflexible.
- One story is that the wage is not allowed to decrease by law. Many economies have minimum wage laws on their books. This could explain some unemployment. A difficulty with this explanation is that the minimum wage affects only low-income workers. Most workers in the economy actually earn a wage above the legal minimum and are unaffected by minimum-wage legislation.
- Another possibility is that firms find it difficult to adjust wages downward. The market for people’s time is not like the market for bread. Pay cuts are very visible to workers and are likely to meet a great deal of resistance. If a firm tries to cut wages, it is likely to find that its workers become demotivated and that its best workers start looking for jobs at other firms.
Both of these stories are really explanations of why nominal wages may be unable to adjust. ***Figure 8.4 "Unemployment in the Labor Market" has the real wage on the axis. Remember that the real wage is calculated as follows:
Minimum wage laws specify a fixed minimum nominal wage. Even if the nominal wage is fixed, the real wage decreases when the price level increases. It follows that rigidities in the nominal wage translate into rigidities in the real wage only if the price level is also sticky.
Prices in an economy may indeed be sticky in the short run, so sticky wages and prices do provide one explanation for short periods of unemployment. Such unemployment is sometimes called cyclical unemployment. In the long run, however, we would expect the labor market to return to an equilibrium with zero unemployment. Cyclical unemployment is the component of unemployment that depends on the business cycle. During a recession, cyclical unemployment is relatively high. In periods of economic expansion, cyclical unemployment is low or nonexistent. But we always observe some unemployment, which tells us that sticky nominal wages and prices cannot be the whole story.
Figure 8.4 "Unemployment in the Labor Market" tells us that the only way to get persistent unemployment in this framework is for the real wage to be permanently above the equilibrium wage. We need to find some reason why market forces will not cause the real wage to adjust to the point where demand equals supply.
One possible story introduces labor unions into the picture. Unions give some market power to workers. Just as we sometimes think about firms having market power, meaning that they have some control over the prices that they set, so we can think about a union having some control over the wage that workers are paid. If there were just a single union representing all workers, then it could choose the real wage, much as monopoly firms choose their price. Firms would then hire as many hours as they wanted at that wage. Generally, unionized workers are paid more than the wage at which supply equals demand, just as in ***Figure 8.4 "Unemployment in the Labor Market". The union accepts some unemployment but believes that the higher wage more than compensates. A problem with this story is that, like the minimum wage, it is relevant only for a relatively small number of workers. In the United States in particular, only a small fraction of the workforce is unionized.
Another story goes by the name of efficiency wages. The idea here is that firms have an incentive to pay a wage above the equilibrium. Workers who are paid higher wages may feel better about their jobs and be more motivated to work hard. Firms may also find it easier to recruit good workers when they pay well and find it easier to keep the workers that they already have. The extra productivity and lower hiring and firing costs may more than compensate the firm for the higher wage that it is paying.
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