Wage stickiness

Why do firms lay off a tenth of their staff in a slump rather than cut everyone's pay a tenth?

Payroll has to come down by a tenth. Two routes reach the same number: send a tenth of the staff home, or pay everyone a tenth less. On paper the second looks strictly better — it keeps every trained person, spares the firm severance and rehiring, and spreads a small loss thinly rather than dropping a catastrophic one on a few households. Yet employers overwhelmingly choose the first, and the distribution of observed wage changes shows it: a great spike of workers whose pay changed by exactly zero, and remarkably few below it.

So the puzzle is not that firms dislike cutting pay. It is that they dislike it enough to pay a large, visible price to avoid it. What is the cut costing them that the sacking is not?

The first answer to try is that they are not allowed — contracts, unions, minimum wages. That is real, but it cannot carry the weight. The rigidity shows up among non-union, at-will, well-paid workers whose pay a firm could plainly renegotiate, and it shows up across countries with quite different labour law. Something in the employer's own interest is holding the line.

Truman Bewley went and asked them. His interviews with several hundred managers, recruiters and labour leaders through the recession of the early 1990s produced an answer economists had not been giving: morale. Not sentiment for its own sake — managers meant something quite specific and quite hard-headed.

Think about what an employment contract actually buys. It buys attendance. What the firm needs is effort, judgement, and the willingness to fix a problem nobody assigned you — none of which can be written down. It is supplied because the relationship feels worth sustaining, and a pay cut is a direct attack on that feeling.

Now put the two options side by side and ask where the aggrieved person is standing afterwards. Cut everyone's pay and the entire workforce is inside the building tomorrow, each of them holding a grievance and each of them in daily possession of the discretionary effort the firm cannot compel. Lay off a tenth and the people who bore the loss are gone; those who remain are, if anything, relieved. The layoff does not make the pain smaller. It removes the pain from the premises.

Notice a second asymmetry once you ask who leaves under each route. A pay cut is an undirected shove towards the exit, and the people who take it are those with the best alternatives elsewhere — which is to say the ones the firm most wanted to keep. A layoff lets the firm choose. One route sheds workers by selection against itself; the other sheds them by decision.

And a third thing is going on, in the workers' heads rather than the firm's. Kahneman, Knetsch and Thaler put a question to survey respondents in the 1980s: is it fair to cut pay by seven per cent when unemployment is high and prices are stable? Most said no. Is it fair, when inflation is running at twelve per cent, to raise pay by only five? Most said yes. The real cut is identical. What people object to is the nominal number falling.

Which hands the economy a quiet escape hatch, and explains why the rigidity is described as downward and nominal rather than absolute. A firm that cannot cut pay can freeze it and let inflation do the cutting, invisibly, at whatever pace prices are rising. James Tobin's phrase was that a little inflation greases the wheels. The corollary is unwelcome: the closer inflation runs to zero, the more binding the constraint becomes, and the more firms reach for the quantity margin instead.

How much of aggregate unemployment this actually explains is genuinely disputed. Rigidity for people already on the payroll is well documented; but the wage that governs whether a firm hires is arguably the wage on a new match, and pay for newly hired workers looks considerably more flexible and more cyclical than pay for incumbents. So the micro fact is solid and its macro consequences are argued about.

Three refinements.

The stark choice is a caricature: firms reach for every other margin first — overtime, bonuses, hours, hiring freezes, letting leavers go unreplaced — and only then for layoffs. Bonuses matter especially, because a variable component that was never promised can fall without breaking anything.

Rigidity is about the nominal figure on the payslip, not the purchasing power behind it. Real wages fall in slumps all the time, by the price level rising while the payslip stands still.

And this is not the claim that firms pay above the going rate to buy effort. That is about the level of the wage; this is about why the level will not move down.

• Why bonuses and hours are cut long before base pay, and what that says about which promise workers think they were given.
• Whether the flexibility of wages for newly hired workers undoes the macroeconomic bite of incumbent rigidity.
• What happens to wage setting in economies where inflation is high enough that a nominal freeze is a large real cut.

Every term the collection defines is gathered in the glossary.