Why Corporations (Typically) Prefer Layoffs To Wage Cuts


Every time you read about another round of layoffs that has all employees shaking in their boots wondering if they’ll be next, you might ask whether the employees would’ve preferred an across-the-board wage cut to layoffs. For an employee in this job market, a position that paid 80% of what it did a year ago might be preferable to full pay with a 20% chance of losing your job. Some wage cuts are happening (FedEx, Caterpillar, Motorola — in part via the elimination of corporate 401(k) contributions, but layoffs are still the story of the day, New York Times trend pieces not withstanding.

Free Exchange pointed to this excellent lecture from well-regarded economist Arnold Kling on why companies typically go the layoff route:

My first thought is that most of the time wage cuts are inappropriate. The overall trend is for productivity and living standards to rise. On average, salaries are increasing. One can see, particularly in longitudinal studies, a strong tendency for people to move on a rising escalator of income. (Longitudinal studies examine the same people over time. In contrast, many people wrongly conclude that incomes are stagnating when they examine snapshots of the distribution of income at different points in time, using Census data for example. One might find that the bottom 10 per cent of the income distribution in 2000 is not far from the bottom 10 per cent in 1980. However, many people at the bottom in 1980 moved up, and they were replaced by new workers and immigrants.)

For the most part, the market tells workers that they can expect to maintain or improve their standard of living. Doing so may require a willingness to adapt by changing firms, changing cities, or changing occupations. Overall, however, it is not normal to have to accept a permanent wage cut.

If the long-run trend of wages is upward, then as a manager you know that cutting wages at your firm means cutting them relative to other potential opportunities for your work force. If wages are not falling generally, then an absolute wage cut at your firm means that you are reducing wages relative to the market. Your workers are likely to bleed away, and the workers you lose first are likely to be your best workers. Better to choose which workers to lose and to lay them off.

In other words, keeping the same work force and cutting wages is typically not an option. The choice is between cutting the work force directly or having your work force decline in response to a wage cut. You probably are better off making direct cuts. Most of the time, cutting wages is a bad policy. Read the whole thing >

Kling goes onto discuss situations in which wage cuts are logical — in times of deflation, for example cutting wages may be the most logical route in order to bring labour costs into relative parity. We’ve seen it argued by  free market-oriented economists that the widespread unemployment during the depression was due to minimum wage laws that didn’t adjust for deflation.

The bottom line, though, is that wages aren’t really set by the firm. That’s a fiction. Wages are set by the market, and thus an attempt to adjust these wages by force — violating overall market prices — won’t typically work out so well.