Are Wage Cuts the Answer? Theory and Evidence

This paper investigates the possibility of using wage cuts to lower unemployment. The paper first discusses the role of wages in various economic models (neoclassical, models with imperfect competition, efficiency wage models, insider-outsider models). It argues that in many of these models it is not rational for firms to cut wages as it would decrease their profits, while in some models wages are endogenous. It then considers how a government can cut wages in a market economy and argues that it is not feasible for the government to cut wages. The next section discusses the evidence on labour market flexibility and unemployment. The paper concludes with the argument that wage cuts do not lead to a decrease in unemployment.“When the rich argue that tax cuts for the rich and wage or social benefit cuts for workers are the only way to cure unemployment about which the rich care deeply, every economist’s eyebrows should rise.” (Freeman, 1998, p. 15)