The Sticky-Wage Theory

The first explanation of the upward slope of the short-run aggregate-supply curve is the sticky-wage theory, an economic concept describing how wages adjust slowly to changes in labor market conditions.

This theory is the simplest of the three approaches to aggregate supply Opens in new window, and some economists believe it highlights the most important reason why the economy in the short run differs from the economy in the long run. Therefore, it is the theory of short-run aggregate supply that we emphasize in the series.

According to the sticky-wage theory, the short-run aggregate-supply curve slopes upward because nominal wages are slow to adjust to changing economic conditions. In other words, wages are “sticky” in the short run.

To some extent, the show adjustment of nominal wages is attributable to long-term contracts between workers and firms that fix nominal wages, sometimes for as long as 3 years. In addition, this prolonged adjustment may be attributable to slowly changing social norms and notions of fairness that influence wage setting.

An example can help explain how sticky nominal wages can result in a short-run aggregate-supply curve that slopes upward. Imagine that a year ago a firm expected the price level today to be 100, and based on this expectation, it signed a contract with its workers agreeing to pay them, say, $20 an hour. In fact, the price level turns out to be only 95.

  • Because prices have fallen below expectations, the firm gets 5 percent less than expected for each unit of its product that it sells.
  • The cost of labor used to make the output, however, is stuck at $20 per hour.
  • Production is now less profitable, so the firm hires fewer workers and reduces the quantity of output supplied.

Over time, the labor contracts will expire, and the firm can negotiate with its workers for a lower wage (which they may accept because prices are lower), but in the meantime, employment and production will remain below their long-run levels.

The same logic works in reverse.

Suppose the price level turns out to be 105 and the wage remains stuck at $20. The firm sees that the amount it is paid for each unit sold is up by 5 percent, while its labor costs are not. In response, it hires more workers and increases the quantity of output supplied.

Eventually, the workers will demand higher nominal wages to compensate for the higher price level, but for a while, the firm can take advantage of the profit opportunity by increasing employment and production above their long-run levels.

In short, according to the sticky-wage theory, the short-run aggregate-supply curve slopes upward because nominal wages are based on expected prices and do not respond immediately when the actual level turns out to be different from what was expected.

This stickiness of wages gives firms an incentive to produce less output when the price level turns out lower than expected and to produce more when the price level turns out higher than expected.