What If Wages Fell During a Recession?

Abstract

Many economies exhibit downward wage rigidity. Surveys of managers by Bewley [1999] and Campbell and Kamlani [1997] indicate that employers hold wages rigid because they believe morale will suffer after a wage cut. Otherwise, there is little evidence for how employers’ beliefs about workers contribute to wage rigidity and whether those beliefs are accurate. We demonstrate that effort falls after workers experience a wage cut and also that workers form reference points from wage contracts. Despite this partial confirmation of the †morale theory†as an explanation for wage rigidity, half of the employers in our experiment cut wages and lose money as a result. Because our design allows us to compare beliefs and effort precisely, we find that when employers don’t believe the morale theory they will not hold wages rigid. In a treatment where a recession is offset by nominal inflation, real wage cuts do not have a significant effect. Loss averse employers are less likely to cut wages and more likely to correctly predict the negative effect of wage cuts.