Which of the scenarios below is a consequence of sticky wages?

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The sticky wage theory hypothesizes that employee pay tends to respond slowly to changes in company performance or to the economy. According to the theory, when unemployment rises, the wages of those workers that remain employed tend to stay the same or grow at a slower rate rather than falling with the decrease in demand for labor. Specifically, wages are often said to be sticky-down, meaning that they can move up easily but move down only with difficulty.

The theory is attributed to the economist John Maynard Keynes, who called the phenomenon “nominal rigidity" of wages.

• Sticky wage theory argues that employee pay is resistant to decline even under deteriorating economic conditions.
• This is because workers will fight against a reduction in pay, and so a firm will seek to reduce costs elsewhere, including via layoffs, if profitability falls.
• Because wages tend to be "sticky-down", real wages are instead eroded through the effects of inflation.
• A key piece of Keynesian economic theory, "stickiness" has been seen in other areas as well such as in certain prices and taxation levels.

Stickiness is a theoretical market condition wherein some nominal price resists change. While it often apply to wages, stickiness may also often be used in reference to prices within a market, which is also often called price stickiness.

The aggregate price level, or average level of prices within a market, can become sticky due to an asymmetry between the rigidity and flexibility in pricing. This asymmetry often means that prices will respond to factors that allow them to go up, but will resist those forces acting to push them down. This means that levels will not respond quickly to large negative shifts in the economy as they otherwise would. Wages are often said to work in the same way: people are happy to get a raise, but will fight against a reduction in pay.

Wage stickiness is a popular theory accepted by many economists, although some purist neoclassical economists doubt its robustness. Proponents of the theory have posed a number of reasons as to why wages are sticky. These include the idea that workers are much more willing to accept pay raises than cuts, that some workers are union members with long-term contracts or collective bargaining power, and that a company may not want to expose itself to the bad press or negative image associated with wage cuts.

Stickiness is an important concept in macroeconomics, particularly so in Keynesian macroeconomics and New Keynesian economics. Without stickiness, wages would always adjust in more or less real-time with the market and bring about relatively constant economic equilibrium. With a disruption in the market would come proportionate wage reductions without much job loss. Instead, due to stickiness, in the event of a disruption, wages are more likely to remain where they are and, instead, firms are more likely to trim employment. This tendency of stickiness may explain why markets are slow to reach equilibrium, if ever.

Prices of goods are generally thought of as not being as sticky as wages are, as the prices of goods often change easily and frequently in response to changes in supply and demand.

According to sticky wage theory, when stickiness enters the market a change in one direction will be favored over a change in the other. Since wages are held to be sticky-down, wage movements will trend in an upward direction more often than downward, leading to an average trend of upward movement in wages. This tendency is often referred to as “creep” (price creep when in reference to prices) or as the ratchet effect. Some economists have also theorized that stickiness can, in effect, be contagious, spilling from an affected area of the market into other unaffected areas. Economists have also warned, however, that such stickiness is only an illusion, since real income will be reduced in terms of buying power as a result of inflation over time. This is known as wage-push inflation.

The entry of wage-stickiness into one area or industry sector will often bring about stickiness into other areas due to competition for jobs and companies’ efforts to keep wages competitive.

Stickiness is also thought to have some other relatively wide-sweeping effects on the global economy. For example, in a phenomenon known as overshooting, foreign currency exchange rates may often overreact in an attempt to account for price stickiness, which can lead to a substantial degree of volatility in exchange rates around the world.

Employment rates are thought to be affected by the distortions in the job market produced by sticky wages. For example, in the event of a recession, like the Great Recession of 2008, nominal wages didn't decrease, due to the stickiness of wages. Instead, companies laid-off employees to cut costs without reducing wages paid to the remaining employees. Later, as the economy began to come out of recession, both wages and employment will remain sticky.

Because it can be challenging to determine when a recession is actually ending, and in addition to the fact that hiring new employees may often represent a higher short-term cost than a slight raise to wages, companies tend to be hesitant to begin hiring new employees. In this respect, in the wake of a recession, employment may actually be “sticky-up.” On the other hand, according to the theory, wages themselves will often remain sticky-down and employees who made it through may see raises in pay.

Further Analyzing Sticky Wages

In a typical marketplace, prices of goods are determined by the forces of supply and demand. When demand increases, prices also increase. When demand falls, we would also expect prices to fall. The concept dictates how prices adjust to ensure that the number of sellers matches the numbers of buyers. When market supply equals demand, the market is at equilibrium.

The concept of supply and demand applies to most goods, but sticky wages are an exception. In the labor market, labor is the “good,” and wages are the “price.” In a perfectly competitive labor market, we would assume that changes in supply or demand would result in a change in wages.

For example, if the demand for labor decreases, the assumption is that wages would also decrease. In such a case, wages would continue to decrease until the market equilibrium, where every worker would be employed based on the wage they are willing to accept. Yet, in reality, it is not the case.

During an economic downturn, demand for labor tends to fall, yet wages remain the same. Instead of falling to equilibrium, wages tend to remain sticky. Since wages are sticky, corporations are hesitant to cut wages. Instead, many corporations will choose to lay off employees, resulting in unemployment.

Why Wages are Sticky

In a perfectly competitive labor market, the forces of supply and demand should affect wages. However, both employers and workers tend to resist wage cuts. There are several explanations for the fact:

• Unions: Employees in unions can resist wage cuts, as they hold collective bargaining power. Although there are unemployed workers who are willing to accept lower wages, employed union members can fight against any proposed wage cuts.
• Efficiency Wage Theory: The theory states that higher wages can improve worker morale and increase loyalty toward the company. In return, workers are willing to work harder and increase productivity. When wages are cut, workers may experience a psychological decline in morale, resulting in decreased productivity.
• • Minimum Wage Laws: Legislation regarding minimum wages results in employers being unable to cut wages below that level.
  • Employment Contracts: Wages are often calculated on an annual basis and are therefore fixed in the short term. Employers typically abide by the terms of the employment contract.

  Costs Associated with Labor: Unlike other goods, labor involves costs associated with the hiring and firing of workers. If an employee has already been trained, cutting wages may result in the employee quitting, which would result in costs associated with the training of new employees.

Sticky Wage Theory and Unemployment

During an economic downturn, one of the most common byproducts is an increase in the unemployment rate. A potential explanation for increasing unemployment is the sticky wage theory. Since wages are slow to adjust to changing market conditions, it results in disequilibrium in the labor market.

In a recession, the demand for goods decreases, reducing the demand for production and labor. Since corporations and employees are resistant to wage cuts, corporations may decide to lay off employees instead, increasing unemployment.

Even with sticky wages, the labor market gradually returns to equilibrium. It results from inflation slowly cutting nominal wages, providing a way for employers to lower wages without taking any action. When inflation occurs, real wages decrease, which reduces the demand for labor. It helps the labor market gradually reach equilibrium.

However, in instances of very low inflation, the gradual decrease in real wages may not be enough to bring the market back to equilibrium. Therefore, when wages are sticky in a low inflation environment, economic recovery tends to be slower.

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