No Such Thing as a Free Lunch: Principles of Economics (Part 142)

The cool thing about unemployment is every day is Saturday.

JAROD KINTZ

The Labor Market, Unemployment, and Inflation

(Part C)

by

Charles Lamson

Explaining the Existence of Unemployment

If unemployment is a major macroeconomic problem---and many economists believe it is---then we need to explore some of the reasons that have been suggested for its existence. Among these are sticky wages, efficiency wage theory, imperfect information, and minimum wage laws.

Sticky Wages

The sticky wage explanation of unemployment begs the question. Why are wages sticky, if they are, and why do wages not fall to clear the labor market during periods of high unemployment? Many answers have been proposed, but as yet no one answer has been agreed on. This is one reason macroeconomics has been in a state of flux for so long. The existence of unemployment continues to be a puzzle. Although we will discuss the major theories that have been proposed to explain why wages may not clear the labor market (Market clearing is the process by which the supply of whatever is traded is equated to the demand so that there is no leftover supply or demand.), we can offer no conclusions. The question is still open.

Social, or Implicit, Contracts One explanation for downwardly sticky wages is that firms enter into social, or implicit, contracts with workers not to cut wages. It seems that extreme events---deep recession, deregulation, or threat of bankruptcy---are necessary for firms to cut wages. Wage cuts did occur during the Great Depression, in the airline industry following deregulation of the industry in the 1980s, and recently when some U.S. manufacturing firms found themselves in danger of bankruptcy from stiff foreign competition (Case & Fair, 2004). These are exceptions to the general rule. For reasons that may be more sociological than economic, cutting wages seems close to being a taboo.

A related argument, the relative wage explanation of unemployment, holds that workers are concerned about their wages relative to the wages of other workers in other firms and industries and may be unwilling to accept wage cuts unless they know other workers are receiving similar cuts. Because it is difficult to reassure any one group of workers that all other workers are in the same situation, workers may resist any cut in their wages. There may be an implicit understanding between firms and workers that firms will not do anything that would make their workers worse off relative to workers in other firms.

Explicit Contracts Many workers---in particular, unionized workers---sign 1- to 3-year employment contracts with firms. These contracts stipulate the workers' wages for each year of the contract. Wages set in this way do not fluctuate with economic conditions, either upward or downward. If the economy slows down and firms demand fewer workers, the wage will not fall. Instead, some workers will be laid off.

Although explicit contracts can explain why some wages are sticky, a deeper question must also be considered. Workers and firms surely know at the time a contract is signed that unforeseen events may cause the wages set by the contract to be too high or too low. Why do firms and workers bind themselves in this way? One explanation is that negotiating wages is costly. Negotiations between unions and firms can take a considerable amount of time time that could be spent producing output---and it would be very costly to negotiate wages weekly or monthly. Contracts are a way of burying these costs at no more than 1-, 2-, or 3-year intervals. There is a trade-off between the costs of locking workers and firms into contracts for long periods of time and the costs of wage negotiations. The length of contracts that minimizes negotiation costs seems to be (from what we observe and practice) between 1 and 3 years.

Some multiyear contracts adjust for unforeseen events by cost-of-living adjustments (COLAs) written into the contract. COLAs tie wages to changes in the cost of living: The greater the rate of inflation, the more wages are raised. COLAs thus protect workers from unexpected inflation, although many COLAs adjust wages by a smaller percentage than the percentage increase in prices. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 561-562*

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