Sticky Wages and Prices: Effect on Equilibrium

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  • 0:04 An Economy That Gets Stuck
  • 1:32 Sticky Wages
  • 4:27 Sticky Prices
  • 7:57 Lesson Summary
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Lesson Transcript
Instructor: Jon Nash

Jon has taught Economics and Finance and has an MBA in Finance

With the help of real-world examples, this lesson explains Keynes' important observation that wages and prices often don't adjust quickly to changes in economic conditions

An Economy That Gets Stuck

Before the Great Depression, classical economists thought the economy was always operating at its potential, which they called full employment - where everyone who needs a job has one and all the resources in the economy are fully used. They saw the economy as a self-correcting machine that quickly reacted to changing conditions.

After the Great Depression, however, economist John Maynard Keynes observed that the economy is not always at full employment. In other words, the economy can be below or above its potential. During that time, unemployment was widespread, many businesses failed, and the economy was operating at much less than its potential.

Keynes realized that the economy could be well below its potential for a long time, and that something was causing it to get stuck. It may be self-correcting, like the classical economists were saying, but it was taking way too long. What was it that was causing the economy to get stuck?

Economist John Maynard Keynes
John Maynard Keynes Images

To find out, let's visit the town of Ceelo where Bob the business owner is furiously mowing a gigantic lawn at the home of an oil billionaire, and Margie the cake baker is working on a volcano cake for the surprise birthday party of Bob's son Bobby Jr. Everything has been stable, and the economy has been growing steadily.

Sticky Wages

Now, let's say that demand in the economy slows way down. In Ceelo, this means less demand for lawn cutting and less demand for cakes. This means less profit for Bob and Margie as well. In a perfect economy, Bob and Margie could quickly respond by lowering the wages of their workers. However, they don't. Why not? Well, let's find out.

Bob is out every day with the other guys mowing lawns, like this gigantic one at the home of an oil billionaire. He is not sitting in an office all day thinking about whether or not to raise or lower the wages of his workers. Wages are typically only determined when he hires someone new or when he grants someone a raise.

The most economical thing Bob could do for his own business would be to lower everyone's wage by 10%. That would offset the loss in income from having fewer customers during a recession. As an alternative, he could let one or two workers go. Given these two choices, what do you think Bob's going to end up choosing? He'll let one or two workers go. The last thing he wants to do is to tell all his workers that their wages are going down. That would not be a pretty sight. Here's how that story would play out:

When all the worker's wages are lowered, their income goes down. When their income goes down, their kids can't get the video games that they want for Christmas. When their kids don't get what they want, they scream in the house, making these workers feel crazy. When the workers feel crazy, they create crop circles in the yards they mow that look like aliens have visited from outer space, and then the military shows up and takes them to area 51. What's the lesson here? Don't lower the wages of all the workers! Fire someone instead.

To avoid these unfortunate and costly events, Bob decides to take one of his employees to the board room and say, 'You're fired.' This is an example of what happens in companies across the economy during a recession, except that the guy that fires people may not be named Bob. Because of this reality, unemployment in the economy is higher.

In Margie's cake business, wages are set with employment contracts, which are not easily changed. In addition, some employees are minimum wage employees. That means when economic conditions change, wages in her business don't adjust quickly.

When wages don't respond quickly to changes in economic conditions, economists call this sticky wages - and I'm not talking about the frosting on the cakes that Margie sells. Economists recognize that this is happening in businesses throughout the whole economy, and therefore, wages tend to be sticky. Sticky wages can lead to higher unemployment and an economy that is operating below its potential.

Sticky Prices

Now, let's talk about prices and how they adjust to changing conditions. Just think about this for a minute. When Bob started mowing lawns for all of his customers, he went to their front door and rang the bell. Then he talked with them and gave them a price for his services. Let's say it was $25 per cut. After that, he mows their lawn for a couple of months.

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