During the recent downturn, as with every recession that preceded it, companies have responded to declining demand mostly by laying off workers while leaving the salaries of remaining employees largely untouched. This peculiar habit of firing workers rather than cutting wages poses a bit of a challenge to standard economic theory. Workers receive valuable on-the-job training that disappears with layoffs; new hires will need to be trained from scratch when the economy rebounds. Unemployment can be devastating for workers and their families—most would prefer a 10 percent wage cut over a 10 percent chance of getting fired. Consequently, almost any model of rational behavior would have employers and employees renegotiating labor contracts during tight times to push down wages in order to keep more workers employed.
A series of studies in the burgeoning field of behavioral economics provide some insight into why managers seem to prefer handing out pink slips rather than lowering salaries. In experiments where workers were randomly assigned to receive wage cuts, they retaliated by slacking off. If you know that anger and resentment accompany pay cuts, it's easier to understand the response of management during recessions.
To understand why it might be a bad idea to cut wages in recessions, it's useful to know how workers respond to changes in pay—both positive and negative changes. Discussion on the topic goes back at least as far as Henry Ford's "5 dollars a day," which he paid to assembly line workers in 1914. The policy was revolutionary at the time, as the wages were more than double what his competitors were paying. This wasn't charity. Higher-paid workers were efficient workers—Ford attracted the best mechanics to his plant, and the high pay ensured that employees worked hard throughout their eight-hour shifts, knowing that if their pace slackened, they'd be out of a job. Raising salaries to boost productivity became known as "efficiency wages."
A more subtle "behavioral" explanation for a link between pay and effort was proposed by Nobel Prize-winner George Akerlof, who argued in a 1982 article that if employees were paid above the going rate, they'd reciprocate by working hard—a money-for-effort "gift exchange." Pay them less, and they'll reciprocate with less work. If wage cuts sufficiently undermine worker effort and morale, it's easy to see why handing out pink slips to a few might be a better option than demoralizing many.
How much gift exchange really matters to American bosses and workers remained largely a matter of speculation. But in recent years, researchers have taken these theories into workplaces to measure their effect on employee behavior.
In one of the first gift-exchange experiments involving "real" workers, students were employed in a six-hour library data-entry job, entering title, author, and other information from new books into a database. The pay was advertised as $12 an hour for six hours. Half the students were actually paid this amount. The other half, having shown up expecting $12 an hour, were informed that they'd be paid $20 instead. All participants were told that this was a one-time job—otherwise, the higher-paid group might work harder in hopes of securing another overpaying library gig.
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