During the recent downturn, as with every recession that preceded it, companies have responded to declining demand mostly by laying off workers while leaving the salaries of remaining employees largely untouched. This peculiar habit of firing workers rather than cutting wages poses a bit of a challenge to standard economic theory. Workers receive valuable on-the-job training that disappears with layoffs; new hires will need to be trained from scratch when the economy rebounds. Unemployment can be devastating for workers and their families—most would prefer a 10 percent wage cut over a 10 percent chance of getting fired. Consequently, almost any model of rational behavior would have employers and employees renegotiating labor contracts during tight times to push down wages in order to keep more workers employed.
A series of studies in the burgeoning field of behavioral economics provide some insight into why managers seem to prefer handing out pink slips rather than lowering salaries. In experiments where workers were randomly assigned to receive wage cuts, they retaliated by slacking off. If you know that anger and resentment accompany pay cuts, it's easier to understand the response of management during recessions.
To understand why it might be a bad idea to cut wages in recessions, it's useful to know how workers respond to changes in pay—both positive and negative changes. Discussion on the topic goes back at least as far as Henry Ford's "5 dollars a day," which he paid to assembly line workers in 1914. The policy was revolutionary at the time, as the wages were more than double what his competitors were paying. This wasn't charity. Higher-paid workers were efficient workers—Ford attracted the best mechanics to his plant, and the high pay ensured that employees worked hard throughout their eight-hour shifts, knowing that if their pace slackened, they'd be out of a job. Raising salaries to boost productivity became known as "efficiency wages."
A more subtle "behavioral" explanation for a link between pay and effort was proposed by Nobel Prize-winner George Akerlof, who argued in a 1982 article that if employees were paid above the going rate, they'd reciprocate by working hard—a money-for-effort "gift exchange." Pay them less, and they'll reciprocate with less work. If wage cuts sufficiently undermine worker effort and morale, it's easy to see why handing out pink slips to a few might be a better option than demoralizing many.
How much gift exchange really matters to American bosses and workers remained largely a matter of speculation. But in recent years, researchers have taken these theories into workplaces to measure their effect on employee behavior.
In one of the first gift-exchange experiments involving "real" workers, students were employed in a six-hour library data-entry job, entering title, author, and other information from new books into a database. The pay was advertised as $12 an hour for six hours. Half the students were actually paid this amount. The other half, having shown up expecting $12 an hour, were informed that they'd be paid $20 instead. All participants were told that this was a one-time job—otherwise, the higher-paid group might work harder in hopes of securing another overpaying library gig.
The experimenters checked in every 90 minutes to tabulate how many books had been logged. At the first check-in, the $20-per-hour employees had completed more than 50 books apiece, while the $12-an-hour employees barely managed 40 each. In the second 90-minute stretch, the no-gift group maintained their 40-book pace, while the gift group fell from more than 50 to 45. For the last half of the experiment, the "gifted" employees performed no better—40 books per 90-minute period—than the "ungifted" ones. The goodwill of high wages took less than three hours to evaporate completely—hardly a prescription for boosting long-term productivity. (Another study rewarded short-term employees with a surprise gift of thermoses, which seemed to generate longer-lived benefits—this may be why companies sometimes hand out baubles like mugs and T-shirts rather than $20 bills.)
Of course, wage cuts are a different story. In one recently released study, which arguably stretches the bounds of what can be (ethically) done to human subjects, temporary employees signed on to sell nightclub entrance cards on the street in two German cities. The sellers worked in pairs, covering two shifts over the course of a couple of weekends, and were told they'd be paid 12 euros an hour.
After the first weekend's shift, some of the workers were told—with no explanation—that they'd receive a 3-euro wage cut. Workers retaliated by selling 15 percent fewer cards in their second eight-hour shift, compared with a group of control employees who kept their 12-euro wage rate. Evidently, the sting of lower wages doesn't fade so quickly with time. (For a third group of employees, only one worker in each pair got a wage cut, again with essentially no explanation provided, beyond the manager's whim. In this case, the lower-paid worker sold 30 percent fewer cards.)
So it seems bosses are smart not to cut wages. It's bad for morale, which is bad for productivity. Sending out pink slips might seem similarly demoralizing, and thus bad for productivity, but layoffs have a more complicated effect on the lucky employees who hang on to their jobs. Layoffs can even boost productivity by giving workers a bit of extra motivation to prove their value, in the same way that Ford's high salaries encouraged hard work. And it might not be so crazy for workers to respond to wage cuts with suspicion—in the current recovery, corporate profits have sprung back, even as wages have stagnated. What could be more unfair, from the worker's perspective, than a cut in wages accompanied by higher profits?
Yet this aversion to pay cuts isn't good for workers or the American economy more broadly. More people end up losing their jobs than if wages were more flexible, and there are serious long-term consequences for the workers who lose their monthly paychecks. The negative impact on a worker's earnings, health, and even the earning prospects of his children lasts decades beyond the pink slip's arrival. Creative solutions—like the furloughs that cut government salaries in California and elsewhere—might help to make lower pay more palatable, by presenting the cut as a temporary measure and by creating at least the illusion of a lower workload. If we can find other ways of overcoming the simmering resentment that naturally accompanies wage cuts, workers themselves will be better for it in the long run.