Inflationary Bias

The labor market is quantitatively the most important factor of production, since it accounts for roughly two-thirds of all income payments by firms. The ‘labor market’ is in fact many different markets, as workers are specialized in many different skills. At any given time, there will probably be some skills that have excess demand while other skills have excess supply. All these markets operate imperfectly, in the sense that wages do not adjust immediately to equate supply and demand. This is particularly evident in many markets where there is excess supply; wage rates are observed not to respond to the downward pressure. Wage rates appear to be ‘sticky’ in the face of high unemployment.

Many reasons are given for this observation. One is that in many labor markets, wages are determined by collective bargaining between unions and management, sometimes for an entire industry. The political nature of union decision-making is such that a reduction in wages is exceedingly difficult to obtain, regardless of economic circumstances. A reduction in wages makes everyone somewhat worse off. However, a failure to reduce wages makes certain people (those laid off) much worse off, to the benefit of others (those who keep their jobs). If the economic downturn is anything short of catastrophic, less than half the workers are likely to be laid off. If the workers have a good idea who will be axed, then the majority of workers, voting in their own self-interest, will elect to keep their current wages. In addition, those workers with the most seniority are the least likely to be laid off, therefore the most likely to oppose wage reductions—but this group of people are also likely to hold the most influential positions within the union. Another explanation is that given that the government will pay unemployment benefits for a while, a typical worker may be better off accepting work at a high wage in the knowledge that there will be occasional layoffs, than accepting work at a lower wage that continues indefinitely.

This rigidity does not occur in the upwards direction. Workers are always generally happy to accept more money. As discussed previously, full employment does not mean zero unemployment. It is still possible (even likely) that under full employment, some labor markets will have excess demand while others will have excess supply. In markets with excess demand, wages can be expected to rise relatively quickly, but in markets with excess supply, wages will only fall slowly, if at all. Firms which face excess demand for labor will expect their costs to rise and will therefore set higher prices. However, firms which face excess supply of labor will not have a reasonable expectation of falling costs, and will therefore leave prices unchanged. This will result in an increase in the average price level.

If unemployment rates are high enough, the downward pressure on wages will be sufficient to overcome downward wage rigidity and wages and prices will fall. There have been very few occasions where this has occurred; the most striking example is the Great Depression in the 1930s, where, in the face of extremely high unemployment rates, the inflation rate was negative for several years on many countries.