Fighting the recession: cutting wages or laying off workers?

Posted by: Ananish Chaudhuri

(A version of this blog appeared in Section C2 of the Dominion Post on Thursday, May 21, 2009.)

Recently, the Chief Executive of Air New Zealand announced a freeze on wage increases and said his goal was "to do everything I can to minimise the risk of job losses…". Freezing wages is a way of containing costs. The implication here is that if costs keep rising and freezing wages don’t do the trick then the next – inevitable- step is to lay off workers.

A pertinent question to ask in this context is this: why not cut wages across the board rather than lay off some people? In January of this year Radio New Zealand reported that some business leaders including the Chief Executive of Business New Zealand were calling for a freeze in the minimum wage. In February, Business New Zealand, in its recommendations to the jobs summit, suggested that cutting the hourly wage rate should be considered as one of the options for preventing job losses. Even if the wage is only frozen rather than cut, as long as increases in the minimum wage do not keep pace with rising prices, then the net effect is to reduce the “real” wages of workers because with rising prices their wages are worth less than before. In fact, during recessions one often hears calls for cuts in the minimum wage, or even doing away with it completely. The argument is that the presence of the minimum wage prevents employers, faced with falling revenues, from lowering wages to get the cost-savings they need to justify maintaining their workforces. Under this view, unemployment must increase because the minimum wage blocks the needed adjustments in costs.

However the fact remains that all over the world employers tend to show a strong preference for laying off workers rather than cutting wages. So why is this? If the primary aim is to save on costs, then pay-cuts across the board for all workers might actually save more money than laying off an unfortunate few, especially given that laid off workers often get severance pay.

Based on hundreds of interviews with managers at a variety of firms in the north-eastern United States, Truman Bewley of Yale University found that the managers of most enterprises were reluctant to enact a reduction in wages even though, given the extensive unemployment, they could then pick up new workers willing to work for less. But in fact top management is extremely reluctant to enact wages cuts and the main reason they gave for this is that such cuts hurt morale and therefore reduce workers’ productivity.

OK, wage cuts hurt in the wallet, but what is the link with morale more generally? Morale has a number of different components including identifying with the firm and its objectives as well as a mood that is conducive to good work. Psychologists say that most of us engage in what is called “anchoring”, whereby our current wages become a reference point for us to measure future developments against. Furthermore, most of us are “loss averse” in that a $10 loss makes us more than twice as unhappy as a $10 gain makes us happy. Therefore, pay-cuts are psychologically painful. Workers are used to receiving regular pay increases as a reward for good work and loyalty and so interpret a pay cut as an affront and a breach of implicit reciprocity. The morale of existing employees is hurt by pay cuts because of an insult effect. This explains how a general cut in pay can indeed lead to serious losses in productivity via its detrimental effect on worker morale.

There are two other factors at work here as well. First, pay-cuts can often lead to a problem of “adverse selection” whereby a general cut in pay may lead to the most productive members of the firm leaving, resulting in a much greater than proportional fall in productivity. In this case the savings from lower wages are outweighed by the resulting loss in productivity. The second factor has to do with the concept of “efficiency wages”. In a variety of jobs monitoring workers is difficult and the cost to the firm from workers shirking is high. In such cases, firms routinely pay workers more than the minimum amount that they have to pay. This higher pay is certainly desirable but workers also understand that being fired from the job now comes with the potentially high penalty of having to settle for an alternative that pays much less. Efficiency wages have the effect of fostering loyalty on the part of the employee and therefore reducing the possibility of workers shirking or even leaving. Firms paying efficiency wages are always reluctant to cut wages even in the face of pervasive unemployment, because of its detrimental effect on worker loyalty and productivity.

General pay cuts hurt everybody and can cause lasting resentment and loss of morale. Layoffs affect morale as well but that effect seems relatively short-lived since the laid-off workers are no longer around. This implies that with jobs where workers are hard to monitor including jobs in customer service or information systems or jobs that require close cooperation among groups of workers, we would not expect to see any pronounced cuts in wages. To the extent workers use the minimum wage as an anchor, cuts in this wage may have a tremendously detrimental effect on morale and may not have any impact on job losses in any case.