The Existence of Sticky Wages in the Labor Market

Abstract

This essay will analyze, according to Neo-Classical and New Keynesian economic theory, the wage rigidities in the labor market and the role of labor unions. This line of research emerged following recent experiences in the labor force during the winter and summer of 1999. Neo-Classical economists believe in the price mechanism and flexible wages. The price mechanism is a device said to bring the economy back to full employment and to the equilibrium wage. In this analysis, wages are not sticky and allow the price mechanism to raise or lower the wage level in order to achieve equilibrium, adjusting to either excess demand or excess supply in the labor market. In the real world, however, we observe that wages are anything but flexible. New Keynesians seek to develop models that explain the inflexibility, or stickiness, of wages. Among the several reasons why wages are sticky, New Keynesians explain that there are non-contractual relationships between workers and employers that keep the wage higher than the equilibrium wage rate. These social contracts are in effect, insurance policies for the workers, in return for their loyalty to the firm. Another model is the idea of efficiency wages, wages that are set above the equilibrium level for the purpose of promoting the increase of morale and productivity among the work force. Efficiency wages also attract the best workers in the labor market to the firm because of the attractive wage level. Having better workers apply will cut down the effects of asymmetric information iv in the labor market, which can lead to increased labor turn over costs. An efficiency wage can also reduce hiring and firing costs, with a high wage level the opportunity cost of a worker losing his/her job increases. This can have a positive effect on productivity and decrease the amount of goofing off('shirking') by workers. New Keynesians though very similar to Neo-Classical economists believe in wage rigidity within the labor market. It is observed that labor unions create sticky wages with the formation of explicit contracts for union members. Explicit contracts set a higher wage for union members and last for up to three years. These contracts hold the wage at a stable level and it cannot be reduced. Contracts are long term because of costly negotiation expenses. With a stable wage rate the wage is observed to be sticky. This analysis explains some of the opposing views of sticky wages in economic theory as well as the effects of labor unions on the wage level in the labor market. Essentially, the New Keynesian model along with the existence of Labor Unions explains the insufficient bases of the Neo-Classical model and that wages remain sticky.