Steve Bain

Sticky Wages and Prices in Economics

The existence of Sticky Wages and Prices in the economy occurs when there is resistance from workers/sellers to accept the lower wages/prices necessary to restore equilibrium in the market. This usually occurs after a boom-period of growth that allowed some wages and prices to rise above their sustainable level.

The concept was first formalized by John Maynard Keynes in the early 20th century, and it posed a significant challenge to the orthodox view at that time that free-markets were best left alone to auto-correct. Keynes felt that government intervention would often be a better option because any such auto-correction would likely be prolonged, and cause unnecessary suffering in the meantime.

In this article I will delve into the concept of sticky wages and prices, and what implications it might have for economic policy-making.

Sticky Wage Theory

Various attempts have been made from economists of competing schools of thought to explain why wages are sticky, which presupposes that they are indeed sticky, but there is no satisfactory explanation of this phenomenon.

Below I will give an overview of the three main explanations, as well as criticisms of them.

What Causes Sticky Wages?

False Expectations of Inflation

Milton Friedman (see link below) believed that sticky wages occur because of temporarily imperfect information, or mistaken expectations. He argues that when wages rise during periods of inflation, workers will be prepared to work more in the mistaken belief that their work is being better rewarded.

The idea is that workers will mistakenly think that their real wages have risen, not realizing that the increase merely compensates them for the extra cost of living.

It follows that, in the reverse situation, when workers and unions have high inflationary expectations but the actual inflation rate is less than the expected rate, they will demand unrealistically high wage increases in compensation for their mistaken expectations of high inflation.

This can easily happen when inflationary expectations are built on an 'adaptive expectations' model where, whatever the inflation rate was in the previous period, it is expected to continue into the next period. If the actual inflation rate falls, this might not be realized until well after the wage negotiation period is over.

Wage demands will then be higher than the equilibrium wage, and will remain sticky until expectations reflect reality. This will likely result in the loss of some jobs until equilibrium is restored.

The sticky wages explanation here may be the best of the three which I will cover, but it can still be criticized for its implicit idea of how wages are set in the first place.

In particular, wage increases/decreases do not tend to move ahead of whatever inflation turns out to be (with the exception of very high inflation periods, or hyperinflation). It is usually the other way around, whereby wage increases are demanded in compensation for what inflation was in the previous period, not for what inflation is expected to be in the next period.

In other words, wage negotiations are reactive, not proactive, and therefore there is little scope for mistaken expectations about future inflation to influence wage negotiations.

This is not to say that wages cannot remain stubbornly above the market equilibrium rate for prolonged periods of time, but rather that it does not happen on account of false expectations on the part of workers. It might more accurately have been false expectations on the part of employers i.e., they may have overextended themselves in anticipation of higher demand/profits in future, and then subsequently found that market conditions unexpectedly deteriorated.

After all, it is business leaders who are forced to act proactively about market expectations, not workers or unions.

Difficulty in Coordinating Action

The coordination problem focuses on the actions of firms rather than workers, and the way that prices (rather than wages) are changed when market conditions change.

In competitive industries during times when sales are growing due to high demand, there is a need for the industry price level to rise in order to reach equilibrium. However, it is difficult for any one firm to increase its price because it will fear losing sales to competitor firms.

If the entire industry could coordinate a price increase then there would be no difficulty but, since no coordination takes place, prices are slow to adjust i.e. prices are sticky.

In a similar vein, it is difficult for any competitive firm to reduce its wage rate at times when demand/profits are falling, because it fears losing its workers to competitor firms. Sticky wages are the natural result of this.

The main criticism here is that different firms in any industry, even competitive industries, still have different cost structures. This means that some firms have more flexibility to cut wages as required e.g., perhaps they have capacity to replace workers with labor saving machinery. The point is that it only requires a few firms to move first on reducing wages before all firms can do the same, so any wage stickiness should be relatively short-lived.

Insider-Outsider Model

The insider-outsider model recognizes that sticky wages can occur because negotiations between firms and workers exclude the unemployed. Unemployed workers would no doubt be happy to accept lower wages in order to gain employment, but they are outsiders, they cannot directly influence wage negotiations.

Insiders, on the other hand, will not react well if they are forced to accept lower wages. Their productivity can easily fall to a level at which firms would have been better off maintaining higher wages. Thus, wage rates are sticky.

The criticism here is similar to my first criticism in that it assumes that the blame for labor market disequilibrium falls on the shoulders of workers. I would again reiterate that workers and wage negotiations are reactive not proactive.

If there is disequilibrium in the labor market, it occurs because of poor decisions made by other parties. Typically the real blame belongs with the government and/or monetary authority for their woeful mismanagement of aggregate demand.

Final Thoughts on Keynesian Sticky Wages

We have assumed so far that the phenomenon of sticky wages exists for a significant period of time. However, nothing has been said about how long that period of time should be before it can be classified as significant.

For classical economists, any period of time that causes disequilibrium is significant, because their models assume that long-run outcomes are achieved quickly. For Keynesians this is not sufficient, they need the period of time to be long enough to justify an active role for government in demand management.

Keynesian sticky wages and prices have to be so severe as to justify intervention in the free-market because, left to its own devices, disequilibrium will persist longer than would be the case if the government stepped in.

This is my main criticism of sticky wage theory. It is one thing to note that there will be a period of time required for the free market to self-correct, but to argue that this period of time is so severe that government action is needed seems foolish to say the least. Any such action is subject to lengthy time-lags before any corrective influence occurs. The point being that any action taken would likely overshoot the period of disequilibrium in the first place. For details on this, have a look at my article about:

Finally, we should note that wage rates are only one part of what workers are paid. When labor costs are high, firms can cut those costs in many ways without affecting the wage rate. For example, annual bonus payments can be withheld, overtime options can be cut, promotions can be delayed, and so on.

In other words, just because there may be some sticky wages in the short-term, it doesn't mean that markets cannot react in some other way that suffices in the immediate term, or that the period required for a full return to equilibrium need be a lengthy one. 

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