Distortions in Relative Wages and Shifts in the Phillips Curve

Abstract

T HE micro-economic foundation for most analyses of price and wage decisions is based on the optimizing behavior of familiar objective functions; employers maximizing profit and workers optimizing utility. The functions typically contain variables that measure opportunity cost (the unemployment rate), real income, and price-deflated wages. But neither objective function contains any variable that measures the situation of other actors in the economic system. Behavior in the real world, however, frequently depends on relative wages, profit margins, and so forth. There is a body of literature on the relationship between relative wages and the macro-economic variables of inflation and unemployment. Wachter (1970), finds that low wage workers tend to get relatively larger wage increases in periods of low unemployment, and thus, the interindustry spread among manufacturing wage-rates diminishes with low unemployment and increases with inflation. Wachter deals with the influence of the macro-economic variables on the relative wage structure. number of studies (1962, 1967, 1968, 1969) have been directed to the effect of relative wages on the general wage or price level.1 It is the latter subject that is the primary focus of this paper. Our micro-economic hypothesis is that wage and price behavior is influenced by both general and relative factors. Therefore, we added a measure of the relative wage structure to the typical Phillips curve relationship. This formulation will reflect the idea that under a given set of overall demand conditions, an individual will attempt to obtain a larger wage increase if he feels relatively underpaid. Our second hypothesis is that rapid inflation is unanticipated and leads to the distortions in the relative wage structure. These two hypotheses lead to the following dynamics. given Phillips curve exists at any point in time. If the economy operates at a point of low unemployment and high inflation rates, then distortions are created which move the Phillips curve to the northeast, i.e., the tradeoff is worsened. If the economy operates at a point of high unemployment and low inflation rates then the distortions tend to diminish and the trade-off improves.2 Thus, while a Phillips curve exists, there is only one point on it (i.e., one unemployment and inflation rate) that is stable; moreover, the stable point is determined by the previous historical experience which has created the distortions in the economy. This series of stable points defines a long-run trade-off that is steeper than the shortrun curve but is still less steep than the vertical line hypothesized by the accelerationists. These dynamics suggest that the absence of unanticipated inflation in the early 1960's brought about the stable wage structure of the 1963-1965 period and, with it, the favorable trade-off. The unanticipated inflation of the late sixties, however, again distorted relative wages and produced the worsened trade-off of 1969-1971. The short-term relationships will then take the general form: DP = f (1/U, DST) T ( ) Received for publication May 12, 1972. Revision accepted for publication August 17, 1972. * This work was performed as part of the CED project entitled A Reconsideration of Policies for Economic Stabilization. The authors thank Frank Schiff for his suggestions in the initiation of this work and George Perry, Charles Schultze, Arthur Okun, William Branson, Gary Fromm and the referee for their comments on preliminary drafts. The errors and omissions remain the responsibility of the authors. The views expressed are our own and not necessarily those of the officers, trustees or other members of the Committee for Economic Development. ' See Eckstein and Wilson (1962), Perry (1967, 1968) and Throop (1968). 2 One of the factors that gives an inflationary bias to our economy is the asymmetrical nature of the distortion process; that is, larger than average wage increases cause the distortion and the return to the normal structure is also achieved by larger than average increases.