Here in Canada, the recent episode with Electro-Motive (a Caterpillar subsidiary), giving its workers an ultimatum for accepting a 50 percent reduction in wages has sparked a lot of comment. The fact that those workers did not accept the ultimatum, resulting in the closing of the plant by Caterpillar and the relocation of the jobs to a US plant with much lower wage rates, has added fuel to the fire.
The fact is that wages are slow to adjust to changes in GDP output. Whenever gaps between actual and potential GDP appear, whether they be recessionary or inflationary gaps, wages are always slow to adjust.
Wages are the largest costs of production in the aggregate economy. In Canada, the data shows that employment income was more than 60 percent of the factor costs of production in 2008. Sluggish wage adjustment is the main cause of slow adjustment of prices and output to equilibrium at potential output of GDP.
Why are wages slow to adjust? Mainly because for both firms and workers, a job is a long-term commitment. Firms entail additional costs when they have to fire, hire and train workers, and workers incur costs looking for new employment. Thus, over the medium-term, firms and workers reach understanding and agreements, including explicit and implicit labour contracts, about wages and working conditions.
In a recessionary gap, aggregate demand falls and firms find themselves with idle capacity and increased inventories. Given the costs of hiring and firing, most firms react to lower demand by first reducing the hours of work for employees. Overtime ends, and businesses may close early or work less than full weeks. If the output gap persist, and demand does not recover or declines further, firms may then start to lay off workers.
Wage rates are not set in a daily auction in which the equilibrium wage rate in effect clears the market. In Canada, wage rates are covered under explicit or implicit agreements, whose period covers the term of employment, or in unionized contractual situations, often extends to cover periods of three to five years.
Wage flexibility or rigidity is very important for the size and duration short-run fluctuations in real GDP and employment. In the recession which began in 2009, the recessionary gap causes employment to fall and puts downward pressure on prices and wage rates.
Conditions in labour markets and the adjustment of labour markets to disequilibria are shown by the Phillips curve. Changes in employment and unemployment rates that reflect disequilibrium in the labour market cause changes in the rate of increase of money wages. In the short-run, money wages adjust slowly to changes in unemployment rates.
The Electro-Motive case shows the pressures that recessionary gaps can exert on wages. Some firms will try to exploit higher unemployment in a recessionary gap to seek further concessions from workers. Only when the economy has had enough time to adjust all wages and prices and begin moving back towards potential output will these downward pressures cease. The key policy question for governments is to decide whether they wish to intervene with sensible policy which can reduce the duration and extent of the downturn. In the absence of sound policy, the downturn will last and wage and price adjustments will occur very slowly, inflicting much pain in the process.