Economics For Dummies, 3rd Edition
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When the economy encounters a negative demand shock, price flexibility (or lack of flexibility) determines both the severity and length of any recession that may result. If prices were infinitely flexible — if they could change within seconds or minutes after a shock — the economy would immediately move from Point A to Point C, and all would be right with the world. But if prices are fixed for any period of time, the economy goes into a recession as it moves from Point A to Point B before prices eventually fall and bring it back to full-employment output at Point C.

In the real world, prices are indeed somewhat slow to change, or as economists like to say, prices are sticky. Interestingly, prices tend to be stickier when going downward than upward, meaning that prices appear to have a harder time falling than rising.

The major culprit seems to be one particular price: wages. Wages are the price employers must pay workers for their labor. Unlike other prices in the economy, people are particularly emotionally attached to wages and how they change over time.

Employees don’t like to see their wages cut. They have a strong sense of fairness concerning their wages and usually retaliate against any wage cut by working less hard. As a result, managers typically find lowering wages to be counterproductive, even if a firm is losing money and needs to cut costs.

The following explains how firms’ worries about worker motivation lead to the sticky output prices that prevent the economy from rapidly recovering from recessions. When sales fall as a result of the recession, output prices can’t fall very much because firms choose to lay off workers rather than cut wages.

Cutting wages or cutting workers in a tough economy

During a recession, you see a large increase in unemployment but little decrease in wage rates. The fact that managers are unwilling to cut wages, however, has a nasty side effect: Not cutting wages makes it very hard for firms to cut the prices of the goods and services they sell.

Suppose that a negative demand shock hits an economy and greatly reduces sales at a particular company. The firm is losing money, so managers need to figure out a way to cut costs. About 70 percent of this company’s total costs are labor costs (wages and salaries). Naturally, labor costs are an obvious target for cuts.

But the managers of the firm realize that if they cut wages, employees will get angry and work less hard. In fact, their productivity may fall off so much that cutting wages may make the firm’s profit situation worse: Output may fall so much that sales revenues will decrease by more than the reduction in labor costs. Therefore, cutting wages isn’t really a good option.

So instead, the managers lay off a large chunk of their workforce in order to reduce labor costs. For instance, if sales are down 40 percent, the firm may lay off 40 percent of the workforce. However, any workers who remain employed get to keep their old wages so that they aren’t angry and their productivity doesn’t fall.

Adding up the costs of wages and profits in an economy headed for recession

Obviously, firms need to turn a profit in order to stay in business. And that means making sure that the price per unit that they charge for their products exceeds the cost per unit of making them.

During a recession, lower aggregate demand means that firms reduce production and sell fewer units. Wages are the largest component of most firms’ costs — in fact, they’re a full 70 percent of the average firm’s costs. If a firm can’t cut wages for fear of causing worker productivity to drop, it can’t reduce its per-unit production costs very much, either. In turn, the firm can’t cut its prices very much because prices have to stay above production costs if firms are to break even and stay in business. What does all this mean?

When demand drops off, prices are typically sticky. They stay high even though there’s less demand for output in the economy. With prices sticky because firms can’t quickly or easily cut wages, the negative demand shock results in a recession, with output falling and unemployment rising because so many workers get fired.

Worse yet, unless prices can somehow begin to fall, the economy won’t be able to move from B to C to get back to producing at the full-employment output level (Y*). Prices do eventually fall, but this process can take a long time, meaning that the negative demand shock can cause a long-lasting recession.

One way around this slow adjustment process is for the government to try to offset the negative demand shock. Such attempts may be able to speed recovery by avoiding the need for prices to adjust to bring the economy back to producing at the full-employment output level.

About This Article

This article is from the book:

About the book author:

Sean Flynn, PhD, is an associate professor of economics at Scripps College in Claremont, California. A specialist in behavioral economics, Dr. Flynn has provided economic commentary for numerous news outlets, including NPR, ABC, FOX Business, and Forbes.

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