Working Paper Series no. 640: Asymmetric wage adjustment and employment in European firms

This paper empirically explores the behaviour of wages and the impact of wage adjustment on employment in Europe during the years 2010 to 2013, with a focus on the role of nominal rigidities. The analysis is based on new harmonised firm-level survey data from the Wage Dynamics Network – a European System of Central Banks research network. One major advantage of the WDN data when exploring wage and employment adjustments is firm-level information on the change in economic conditions during the 2010-to-2013 period.

Our analysis differs from previous studies in the way we identify downward nominal wage rigidity. We estimate an ordered probit model of wage adjustments and find evidence in favour of the presence of wage rigidities in Europe. First, collective pay agreements increase the probability of a base wage raise and lower the probability of unchanged wages or a decrease in wages. This suggests that the wage bargaining process impacts the degree of downward nominal wage rigidity. This result also implies significantly more downward nominal wage rigidities for countries with much higher shares of employees covered by collective pay agreements (with the latter mainly driven by agreements outside the firm, i.e., national or sectoral, rather than more decentralised firm-level agreements). Second, the rise in the probability of a downward base wage response to a decrease in demand is significantly smaller than the rise in the probability of upward wage responses to an increase in demand.

Furthermore, a strong and moderate fall in demand significantly increases the probability that base wages will remain unchanged. This is further evidence of downward nominal wage rigidity, as the distribution of changes in wages starts to bunch around unchanged base wages when demand falls. By contrast, when there is a moderate or strong increase in demand, there is a lower probability of base wages staying unchanged. We further explore the influence of wage reactions to a fall in demand on employment. To take the endogeneity of wages in the employment equation into account, we use the share of workers covered by a collective pay agreement as an instrumental variable for wage adjustments. Estimation results point to a negative effect of downward wage rigidities on employment at the firm level, when these rigidities are induced by collective pay agreements. We find that wage adjustments have a significant effect on employment within the firm. The probability that employment falls or remains unchanged is significantly lower when wages decrease compared to the reference category of unchanged base wages. If wages increase, the probability of a decrease in employment is higher than under unchanged wages. Wages and employment depend on similar economic circumstances. A decrease in the availability of supplies from the firm’s usual suppliers, in the customers’ ability to pay and meet contractual terms, or in the access to external financing affects wages and employment negatively. Moreover, firms that use flexible wage components are less likely to reduce wages and employment. This suggests that some firms tend to use bonuses as a buffer to avoid base wage cuts or layoffs. We find evidence that employment protection increases workers’ bargaining power as the probability of a base wage rise is higher in firms that report firing costs as relevant obstacles to hiring.