Srdan Tatomir of the Bank of England:
How do firms adjust to falls in demand?: How do firms response to falls in demand for their products in the real world? Do they cut wages? Or are they able only to freeze them? What other methods can they use to adjust their labour costs? And does any of this matter? The answer to the final question is emphatically yes. How firms adjust the quantity and cost of their labour input, particularly in response to a downturn, is relevant for monetary policy. If firms are unable to cut wages – what economists call ‘downward nominal wage rigidity’ (DNWR) – then they have to reduce the number of employees, increasing unemployment, further depressing output and weighing on inflation.
To explore just how firms adjust to changes in demand conditions, the Bank carried out a wage-setting survey in 2014. This survey is a part of a cross-country European project carried out by the Wage Dynamics Network (WDN). (Previous reports are available on the ECB’s website). Part of the survey asked a series of questions to gauge how firms adjusted their labour decisions during 2010-2013, following the Great Recession of 2008-2009. This post focuses on our analysis of the answers to these questions. A richer exposition can be found in our recently published Working Paper. ...
The UK WDN survey evidence provides support for some of the theoretical arguments for wage rigidity. ...
Many firms did not freeze pay but increased wages. Yet nominal wage growth must be assessed against the rate of inflation. The survey also allows the measurement of downward real wage rigidity (DRWR). In particular, firms were asked whether or not they directly and explicitly linked changes in base wages to inflation over the period 2010-13. My probit estimates suggest that a strong increase in demand is positively associated with inflation-linked pay. This is perhaps because firms that saw a strong recovery in demand were able to link wage growth explicitly to inflation. Also, the share of workers with more than five years of tenure is positively associated with DRWR. This is in line with the predictions of Lindbeck and Snower (1989), where insiders have more bargaining power than outsiders and are more likely to resist any falls in real wages.
Why the downward rigidity?
While there is evidence of downward wage rigidity among UK firms during 2010-13, our statistical analysis does not uncover the reasons why that might be the case. That is why the survey also asked those firms that did not cut wages why they did not do so. Some of the most common answers were that the most productive workers would leave and that outside wage options acted as a constraint on pay (Chart 5). Firms also emphasised the importance of morale and employee effort. This supports the ‘shirking’ model of Shapiro and Stiglitz (1984) which posits that pay differences have a negative impact on employees’ work effort, and the ‘fair wage-effort’ hypothesis of Akerlof and Yellen (1990), according to which pay differences are perceived as unfair by existing employees, who bid pay up. In contrast, comparatively less importance was placed on implicit wage contracts i.e. firms ‘smoothing’ through wage changes because workers are risk averse and like wage stability. And, perhaps unsurprisingly, given the low union density in the United Kingdom, regulations and collective agreements were less important reasons for not cutting wages.
When firms face a fall in demand and they can’t reduce wages, they might end up hiring fewer workers. Survey data suggests that was an important channel of adjustment during 2010-2013 but other measures were used, too (Chart 6). Firms also reduced working hours, decreased their use of agency workers and allocated more work to junior staff. This suggests that there is a variety of ways firms can adjust their labour costs, even in the presence of wage rigidity.
In the United Kingdom many firms tend not to adjust wages downwards. Instead they reduce labour costs in other ways – they appear to be flexible in their use of other measures affecting the quantity of labour input. But in the presence of downward wage rigidity, firms’ response to changes in demand may well amplify changes in employment, output and inflation. To some extent, this will be cushioned by the UK’s inflation targeting regime. A positive inflation target will help to ‘grease the wheels’ of the labour market, allowing firms to adjust real wages and dampen employment and output volatility.