Sticky Wage Theory

What is the Sticky Wage Theory?

The sticky wage theory is an economic concept describing how wages adjust slowly to changes in labor market conditions. Unlike other markets where prices are dictated by supply and demand, wages tend to remain above equilibrium as employees resist wage cuts.

Wages can remain sticky for a variety of reasons, such as job unions or employment contracts. In economic downturns such as a recession, sticky wages can result in unemployment and disequilibrium in the labor markets, and slow economic recovery efforts.

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.

Related Readings

CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

• Employee Morale
• Economic Equilibrium
• Labor Force KPIs
• Structural Unemployment
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