The long and short of wage flexibility

The inflexibility of the labour market has become a common scapegoat to explain the low rate of employment and the muted growth of firms, especially small ones. It is argued that employee-friendly labour laws put workers in a strong position vis-à-vis employers to bargain for high wages despite a crippling unemployment rate and a low growth of labour productivity.

The World Competitiveness Report of the World Economic Forum (WEF) consistently rates the South African labour market among the least efficient in the world. Many argue that liberalising the labour market to allow greater wage flexibility and reduce the constraints on firing workers would go a long way towards solving the unemployment problem.

Yet the WEF rankings, which have been criticised in other contexts, are based on the opinions of a small group of local business leaders – these “official” statistics may poorly reflect the real importance of labour-market inflexibility.

In addition, in his article in the American Economic Journal: Applied Economics of 2012, Jeremy Magruder emphasises that, whereas wage inflexibility may result in short-term job losses, it can hardly explain the long-run, structural inability of the labour market to absorb the jobless into the workplace.

Research evidence is mixed on whether wage inflexibility is the central constraint on the reduction of unemployment. For example, although bargaining councils appear to reduce employment creation, according to Magruder, minimum wages do not necessarily destroy jobs in all industries.

The Harvard group of economists, commissioned by the national treasury between 2006 and 2008, concludes that youths have been priced out of the labour market; nevertheless they show that there is substantial movement in and out of jobs over short time periods.

Geeta Kingdon and John Knight, in their 2006 article in the Industrial and Labour Relations Review, show that wages moderate when regional unemployment is high; competition for existing jobs is pronounced, which weakens the wage-bargaining position of employees. These findings are not consistent with the view that wages are inflexible or that firms cannot readily adjust their workforces.

What should one then believe regarding allegations of labour-market inflexibility and that excessive wage demands are a major cause of low employment growth? This article reports on striking new evidence.

In a recent Research Project on Employment, Income Distribution and Inclusive Growth paper, I explore the degree of wage flexibility in the labour market in a novel way, also updating previous estimates.

In particular, I seek to ascertain whether workers are willing to accept lower wages when the unemployment rate in the area where they live is high or whether workers are so protected by labour market legislation that they can demand high wages even if others are having difficulty finding jobs in their geographic vicinity – that is when there is a local surplus of workers.

The research has two important characteristics. First, its analysis of wage behaviour finds and recognises that “the labour market” tends to function as a multitude of smaller, local labour markets – not as a single, national labour market. The effect of a labour surplus – or shortage – on wages and employment tends to be localised in areas or regions. From the data, it appears that these correspond roughly to district councils.

Second, and more pertinently, the analysis distinguishes between flexibility in the long and short run. It appears that wage and employment behaviour may be very different over these time horizons.

The analysis uses data on wages and employment from labour force surveys from 2000 to 2004.

Statistical models of the behaviour of the labour market were developed to simulate the likely wage demands under conditions of low to high local unemployment.

These models were based on data for each of the 55 district council areas (see graphic). The process generates a picture of typical wage behaviour in South Africa.

It suggests that wage demands, either from individual workers or through formal wage-setting institutions, are sensitive to local labour market conditions. On average, wages are about 35% higher in regions with no unemployment than in regions where the whole labour force is without work.

More specifically, in areas where workers live, the statistical correlation between wages and unemployment rates is negative. It is remarkably similar to the pattern in most countries. Wages do appear to be flexible – they respond to local unemployment rates.

This conclusion hides an important difference. Further analysis shows that this pattern is a combination of short- and long-run processes that are different in nature. They must be distinguished from each other. In the graphic, the blue and green curves show the relationship for the short and long run respectively.

The short-run curve is obtained by removing persistent time trends from the data in each locality, so that it represents wage adjustments over periods of six months (the interval between labour force surveys).

The roughly horizontal blue line reflects short-run wage responses to unemployment. It suggests that, in the short run, there is no causal relationship between local labour market conditions and wages.

This implies that wage demands are largely made with no consideration that jobs are scarce and competition for jobs is high in a particular region. This evidence is consistent with a view of an inflexible labour market, perhaps reflecting that, in the short run, labour market institutions such as collective bargaining councils are more influential in determining wages than underlying labour market forces.

In the long run – any period longer than six months – the situation appears different.

As the green curve in the graphic shows, in the long run, average wages tend to be significantly lower in areas where labour market conditions are persistently slack: long-run wages are more than 50% higher in areas of zero unemployment compared with what wages would be in regions where the entire labour force were jobless. This evidence suggests that wage demands do take local labour market conditions appreciably into account in the long run, even if they do not in the short run.

Wages appear to be flexible in the long run. A possible reason is that wage agreements can enforce rigidity in the short term; new agreements concluded at a later stage take local conditions into account when these are unfavourable to high wage growth.

Are these effects the same for all workers? The evidence suggests not. Although, on average, wages are rigid in the short run, certain workers nevertheless experience some form of flexibility even over this limited time horizon.

A negative relationship between short-run wages and unemployment is present only if workers are nonunionised. For unionised workers, high wages apparently coexist with unemployment in the short run – and probably contribute to such unemployment. Where nonunionised workers are concerned, there is wage flexibility in the short run, indicating that they adjust more speedily to poor labour market conditions compared with unionised workers; the latter only accept such changes in the long run, probably owing to their desire to have binding wage agreements that extend over relatively long periods.

A similar story holds for firms of different sizes, regardless of whether they are unionised or not. In the graphic, the uppermost dashed line shows that the wages of workers who are employed by small firms (fewer than five employees) in the formal and informal sectors are highly responsive to poor labour market conditions. This probably reflects:

• That workers in small firms in the formal sector are typically not party to collective bargaining council agreements, except in the cases where the minister of labour has extended these agreements to entire sectors; and
• How informal sector firms function outside bargaining structures and pay market-driven wages.

In contrast, the wages of workers employed by larger firms show few signs of short-run wage flexibility, with the curves remaining flat for all unemployment rates. This can reflect collective bargaining or simply the greater rigidity and complexity associated with wage decision-making in large corporates.

Talking about “labour market inflexibility” as a single concept, as though there is one homogenous, national labour market in South Africa, is misguided.

First, to a large extent the labour market functions as a multitude of smaller, area-based or local labour markets. In this smaller spatial context, wages are much more flexible and responsive to labour market conditions than they appear from national studies, suggested in articles by Johannes Fedderke (2012) and Nir Klein (2012).

Second, and crucially, the distinction between the short run and the long run explains some of the conflicting findings from earlier empirical studies.

Although many South African workers are inflexible in their wage demands in the short run, in the long run they are flexible and they do factor local labour market conditions into wage negotiations.

Even in the short run, workers in small firms and those who are nonunionised show significant signs of wage flexibility, indicating that their bargaining power is constrained.

Wage rigidity in specific contexts (short run and unionised) remains a concern regarding the ability of the labour market to absorb workers – union-bargained wages are likely to contribute to higher unemployment in the short run. In the longer run, wages appear to be flexible and one must look to structural factors to explain the unemployment puzzle.

The debate on unemployment and wage flexibility needs to take these subtleties into account.

Dieter von Fintel is a senior lecturer in the department of economics at Stellenbosch University. This piece was first published on Online Policy Forum Econ3x3.