Business Cycles Explained: Sticky Wages & Prices

Talk about wage stickiness in a little more detail. At first there’s a somewhat technical
distinction in economics known as real wage stickiness versus nominal wage stickiness.
Now let’s assume for the time being the price level is fairly constant, and we’ll
just assume that way. There are few more reasons why wages might be sticky. First, in a lot
of economies, especially, say, in Western Europe, a lot of the workforce is unionized
and there is some collective contract which is enshrined in law and it has been voted
upon, and it’s very difficult to reverse the terms of that contract. So if a lot of
a labor force is unionized, for reasons of contract and/or law, those wages will more
or less automatically be sticky. Now in the United States unions are much smaller part
of the workforce, so that is one reason but not a major reason why we have wage stickiness
here. I think in the United States the main factor behind wage stickiness really has to
do with morale and expectations. And in my textbook with Alex Tabarrok, he and I develop
what we call the parable of the angry professor. This actually comes from a former colleague
of mine or two that I have known, and it’s very interesting. You’d think economists,
if anyone, would react rationally to changes in their wages. But, in fact they do not.
So if you imagine that one year a professor receives a wage cut of 2–3 percent, we have
seen empirically, I have witnessed with my own eyes, when wages are either flat or falling
for long periods of time, those professors, they become disgruntled, they complain more,
their morale falls, they don’t teach nearly as well, maybe they stop publishing, they
make trouble in departmental politics. And those are all going back to this morale reason
why a lot of wages tend to be sticky.
Now of course not everyone’s wage sticky. Let’s say you’re a real estate agent.
You’re used to selling on commission. You don’t expect some very fixed sum of money
flowing into your checking account every month, every year, every six months. Your expectations
are conditioned to put up with a lot of variance in income. Or say you play poker online. You
really don’t make a very fixed plan about what you get, and in fact you can’t control
what you get. It depends how much you win. But nonetheless a lot of people take jobs.
They work for larger employers. Their goal is to limit their risk to their payment stream
and they make a kind of implicit deal with the boss. They say, you keep on paying me,
I’ll keep on showing up. I’ll work really pretty hard. I’ll do a lot to cooperate.
I’ll do even more than really technically I’m called upon to do in the contract. But
in return I expect that I will always be valued, respected, whatever, and my wage will not
go down or not go down too much or will maybe even rise steadily over time. And when people
have those expectations, which may be valuable to build into the system ex ante, but when
the negative shock comes, and maybe some wages ought to fall, it’s often hard to get them
to fall again because of morale and this specific example which Alex and I labeled the parable
of the angry professor.
Menu Costs
Sometimes it’s not just wages that are sticky, but prices too. Menu costs are called menu
costs because of the famous example of a restaurant that needs to print out new menus every time
it wants to change its prices. And no restaurant wants to print out new menus every day or
every week or maybe not even every month. So what they do is they fix prices for some
period of time, maybe six months or a year, and then they just wait. And prices in the
short run often are sticky because it takes some time to adjust them and consumers often
don’t like the price bouncing around a lot, and that’s called menu costs. It is another
part of the Keynesian argument.