How do firms adjust to falls in demand?

Srdan Tatomir.

How do firms response to falls in demand for their products in the real world?  Do they cut wages?  Or are they able only to freeze them?  What other methods can they use to adjust their labour costs?  And does any of this matter? The answer to the final question is emphatically yes. How firms adjust the quantity and cost of their labour input, particularly in response to a downturn, is relevant for monetary policy. If firms are unable to cut wages – what economists call ‘downward nominal wage rigidity’ (DNWR) – then they have to reduce the number of employees, increasing unemployment, further depressing output and  weighing on inflation.

To explore just how firms adjust to changes in demand conditions, the Bank carried out a wage-setting survey in 2014. This survey is a part of a cross-country European project carried out by the Wage Dynamics Network (WDN).  (Previous reports are available on the ECB’s website). Part of the survey asked a series of questions to gauge how firms adjusted their labour decisions during 2010-2013, following the Great Recession of 2008-2009. This post focuses on our analysis of the answers to these questions. A richer exposition can be found in our recently published Working Paper.

Adjusting labour input downwards

In the survey, around 1/5 of firms reported that they needed to significantly reduce their labour input – staff numbers and/or average hours worked – at some point over 2010-13. Using a simple regression, Chart 1 summarises which characteristics increased the probability of such a significant downward labour adjustment.  The survey suggested that a strong increase in economic volatility increases the probability of a downward adjustment by around 20%, similar in magnitude to a strong decrease in demand for the firm’s product/service.  The presence of a union also increases the likelihood of a significant reduction in labour input – perhaps because unions resist smaller changes in pay and/or employment until a substantial adjustment cannot be avoided.  The effect of foreign ownership is similar, pointing to a form of home bias – a tendency to adjust first in locations outside the home country.  Interestingly, our results also indicate that firms operating in a single location, as opposed to multiple locations, seem less likely to require a significant adjustment. Last but not least, the inability to lower nominal wages (DNWR) is an important factor leading to a higher probability of a significant reduction in labour input.

chart1_2

Downward nominal wage rigidity

One important aspect of adjusting labour costs is via workers’ pay. When asked which methods of adjustment became more difficult over time, firms reported the striking result that they were less able to change wages (Chart 2). During 2010-2013, many firms experienced falls in demand and had to adjust wages downwards.  When wages are perfectly flexible, the distribution of wage changes should be symmetric.  But when there is DNWR, there will be a floor at 0% (Chart 3). According to the survey, the overall incidence of wage freezes was relatively high at around 25% of firms in 2010, although by 2014 this had fallen to around 10%.  The incidence of pay freezes was highest among firms in construction and lowest among firms in finance (Chart 4).  A pay freeze lasted around two and a half years, on average, but for around a quarter of the firms it lasted at least three years.  Pay freezes also lasted the longest in construction.  In contrast, firms reported only a handful of wage cuts.  Anecdotally, where they did cut wages, the median wage cut ranged from 2.5% to 25%.

chart3_4

To understand how wages respond to shocks, it is important to tease out the factors behind the high incidence of wage freezes just after the financial crisis and the lower number of freezes seen more recently.  To explain the likelihood of a pay freeze occurring in a firm, I estimated a probit model, an approach similar to Babecky et al. (2010).  Around 40% of firms in the sample experienced a pay freeze lasting for at least two years during 2010-2013.

The UK WDN survey evidence provides support for some of the theoretical arguments for wage rigidity.  For example, the presence of a union makes a pay freeze significantly less likely.  Tenure or skills, usually associated with more rigidity and a smaller chance of a pay freeze, do not seem to have much explanatory power.  But the share of permanent employees is found to have a positive and statistically significant effect on the likelihood of a pay freeze in 2012, though quantitatively small.  This runs counter to theoretical predictions.  It might point to a compromise between workers and management to reduce labour costs by bearing down on wages instead of cutting jobs.  The statistical analysis also suggests that the higher the share of labour costs as a proportion of total costs (a proxy for capital intensity), the more likely is a pay freeze to occur. Here too, the marginal effect is quite small.  This departs from the theoretical argument put forward by Howitt (2002) which suggests that firms with high labour costs are less likely to lower wages since this would result in lost profits due to a ‘disgruntled’ workforce.

Downward real wage rigidity

Many firms did not freeze pay but increased wages.  Yet nominal wage growth must be assessed against the rate of inflation. The survey also allows the measurement of downward real wage rigidity (DRWR).  In particular, firms were asked whether or not they directly and explicitly linked changes in base wages to inflation over the period 2010-13. My probit estimates suggest that a strong increase in demand is positively associated with inflation-linked pay.  This is perhaps because firms that saw a strong recovery in demand were able to link wage growth explicitly to inflation.  Also, the share of workers with more than five years of tenure is positively associated with DRWR.  This is in line with the predictions of Lindbeck and Snower (1989), where insiders have more bargaining power than outsiders and are more likely to resist any falls in real wages.

 Why the downward rigidity?

While there is evidence of downward wage rigidity among UK firms during 2010-13, our statistical analysis does not uncover the reasons why that might be the case.  That is why the survey also asked those firms that did not cut wages why they did not do so.  Some of the most common answers were that the most productive workers would leave and that outside wage options acted as a constraint on pay (Chart 5). Firms also emphasised the importance of morale and employee effort.  This supports the ‘shirking’ model of Shapiro and Stiglitz (1984) which posits that pay differences have a negative impact on employees’ work effort, and the ‘fair wage-effort’ hypothesis of Akerlof and Yellen (1990), according to which pay differences are perceived as unfair by existing employees, who bid pay up.  In contrast, comparatively less importance was placed on implicit wage contracts i.e. firms ‘smoothing’ through wage changes because workers are risk averse and like wage stability.  And, perhaps unsurprisingly, given the low union density in the United Kingdom, regulations and collective agreements were less important reasons for not cutting wages.

chart5_6

When firms face a fall in demand and they can’t reduce wages, they might end up hiring fewer workers. Survey data suggests that was an important channel of adjustment during 2010-2013 but other measures were used, too (Chart 6). Firms also reduced working hours, decreased their use of agency workers and allocated more work to junior staff. This suggests that there is a variety of ways firms can adjust their labour costs, even in the presence of wage rigidity.

Policy implications

In the United Kingdom many firms tend not to adjust wages downwards. Instead they reduce labour costs in other ways – they appear to be flexible in their use of other measures affecting the quantity of labour input.  But in the presence of downward wage rigidity, firms’ response to changes in demand may well amplify changes in employment, output and inflation. To some extent, this will be cushioned by the UK’s inflation targeting regime. A positive inflation target will help to ‘grease the wheels’ of the labour market, allowing firms to adjust real wages and dampen employment and output volatility.

Srdan Tatomir works in the Bank’s Structural Economic Analysis Division, Monetary Analysis and Chief Economist Directorate

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