Are reductions in wages PROSOCIAL?

When the demand of a good or service increases and supply stays static for a period, then the price will rise and act as a signal to call for more suppliers. The opposite scenario holds true as well. This characteristic of markets is especially important when a crisis hits. The lower price of wages will make the country more competitive in producing goods that will be more probably exported increasing volume and soon returning to prior price levels in the midterm. But when the demand of labor increases due to an economic expansion, reckoning there is unemployment, what should be done regarding labor prices / wages? Should they stay static or increase? And what about a crisis scenario?

The objective of this article is to understand the decision-making of worker unions and infer important information about possible societies' prior beliefs in that they are always prosocial. This is especially important for policymakers since when facing this decision, demystifying such ideas will help set the right policies in place for the good of all avoiding ethical hazard. Now, I only focus on the decision making process of one of the three usual agents involved in setting minimum wages, unions. The state should have a greater common vision and companies should be more "rational" or selfless, yet they deserve their own article.

This entry is inspired by the example provided in Richard Thaler´s (2017 Nobel by his extensive work in behavioral economics evidencing usual deviations from classical economic postulates on rational behavior) book MISBEHAVING. His example ponders over the crisis scenario and minimum wages but it falls short analyzing which biases take place and how deviations from economic predictions emerge. Therefore, I took in on me to try and expand.

The first scenario is the following: formal workers are in a Union, and they face a growth scenario of the economy. Negotiations take place between companies, the Union and the State to analyze and decide whether to raise wages and by how much. The Union feels they are entitled to a share of the windfall produced by the growth of the economy since they became more productive (whether its true or not). If the share of the economic growth entitled unanimously for the Union is a 3% what will they decide? We will consider zero inflation.

In most countries (including Ecuador), the Union usually takes a stance on that all minimum wages should be increased by 3% and so it is implemented. Most of us actually think it is quite logical and see no other way to divide such windfall. This is a risk averse progroup decision as I call it and yes, there are other ways.

It is risk averse because they could have decided on a lottery between all workers earning a minimum wage and select 25% of them as winners. The winners would get an increase 4 times the 3%, or 12% total, and the rest of workers would keep earning their minimum wage. Yes, I know this would be harder to fit between industries that grew more or less than the economy but, there are always complex compensation methods that can be established. We are experts on making things more complex. Yet, for the sake of the argument, we will imagine all industries grew in a 3%. The windfall is still the same but now every individual faces a lottery where they have 25% chances to earn 12% and 75% chances to earn nothing. Here individuals choose to be risk averse instead of risk loving (lottery division) and secure their 3% increase.

I argue that the decision undertaken is progroup and not individualistic or selfish because if the leaders of the Union choose to, they could negotiate under the desk with the companies for a personal retribution of a percentage of the total absolute windfall (corruption), loosing the negotiation for the group on purpose and establishing wages at the same level.

The decision undertaken is not prosocial either. The Union suffers of ingroup bias, that is they will tend to favor the ingroup members at the cost of the outgroup. The Union is not taking into consideration that if they keep wages at the same level and, given the increase of productivity, companies will hire a 3% more workers so as to match total labor salaries to marginal productivity. This way, unemployment will reduce and a 3% of jobless workers will join the ingroup earning a lot (full minimum wages from nothing). But, they are not part of the Union, they are just outsiders. Thinking about the unemployed workers would be prosocial behavior and would show solidarity within workers, employed or not.

Now, when the economy faces a reverse situation, say it decreases and the cut belonging to the labour or Union corresponds to a -2%.

What has happened in most countries (including Ecuador) is that wages are ilegal to be reduced without an explicit acceptance of the employee, if possible at all. Usually minimum wages are fixed, that is why they are minimum. This shows that workers as a society pushed this agenda on legislators and politicians a long time ago so it is now set in the labour laws and the scenario of a reduction is not feasible. This decision taken long time ago and set in legislation is categorized as a risk loving individualistic (or greedy) decision from the Union of workers.

It is a risk loving decision because, when price is fixed (minimum wage), and labour demand contracts, having a set labor supply, then there is a excess of supply (rising unemployment) or a shortage of demand given the last equilibrium. So companies will have to reduce -2% wages to get back to the marginal equilibrium where productivity equals marginal wages equilibrium. Exactly the opposite scenario of a economic boom. So here, the Union as a whole decided that every worker will play a lottery with their employer where they will have a 98% chance of not loosing a dollar, and a 2% chance of loosing their job. There will be an unlucky 2% whom will loose all and be sent to the outsiders, the unemployed. So, the Union, is not much of a Union anymore, they actually shout !every man for himself! This is a risk loving individualistic decision.

Is there prosocial or progroup outcomes? Yep. Let's see them.

A progroup and risk averse decision would be where the Union, as a group, care for all of their member, and in solidarity with an unknown 2% of members choose to reduce their salaries in -2% and all of them share the loss in equal parts. Here each employee knows for sure what will happen next month. But, it is illegal in most places.

A prosocial decision would be when the Union decides to reduce their salaries in -5%, not only maintaining the jobs for the currently employed, but a lucky 3% of unemployed could join the Union. Yes it is altruistic, loosing more than needed to serve others. This is possible because given the fact that there is unemployment, it means the market is off balance, so any movement downwards will increase the number of employed. Another positive effect is that products become more competitive and exports will go un in time creating windfalls to be divided again. This doesn't happen, we are way to miopic and greedy for that.

So in conclusion , in a boom the Union will act risk averse and progroup. But in a bust it will decide on risk loving and individualistic behavior.

This finding in behavioral economics is an anomaly of the stable preferences of economic agents, especially regarding risk aversion and ingroup bias. Thanks to Thaler, Khaneman and Tversky behavioral economists have a scientific answer for it. It is called loss aversion. Loss aversion is a bias which prevents us humans, all humans, from deciding according to perfect rationality, because losses loom larger than gains. This means that the amount of happiness exprienced by a win, will be around half the emotional charge generated by an exact loss of the same amount. Say loosing 100 dollars will produce more anguish than winning a 100 dollars. It has been estimated that the emotional charge of winning 200 is similar to loosing 100. Thank you Richard Thaler.

Us humans will risk a lot, not to loose a little bit, we may even put in risk all of our capital to try and avoid loosing some of our actual living conditions. That is one reason why many unemployed will risk their little capital into entrepeneurship. We would rather risk it all and try to break even instead of accepting a lower paid job. Loss aversion, combined with status quo bias, will also prevent many employed with stability to take a leap towards entrepeneurship. It is easier to start a business when you have lost your job than to leave it. In Ecuador this is very true. Ecuador is one of the latin american countries with the higher rate of (forced) entrepeneurs thanks to high unemployment produced by tough hiring and letting go laws. Ecuador has chosen the path of little formal employment wih high costs, instead of going for higher volume.

Finally we have to explain why people are not really solidary with all their fellow mates. Solidarity means you put in not only empathy but you put something in that will cost you be it time, money or effort. It has to do with economic evolution. People are used to living in tribes, we are tribal. In modern age it means that we have a natural trust in in-group members and we tend to favor them. We are not biologically designed to have inter-group trust. In the example above, people are solidary (in a boom) with their fellow members but not with the unemployed eventhough they are still members of the working class yet they are not part of the tighter group. This is one of the biggest problems in society. We will trust others who are similar to us in some way but we do not trust, or trust less, the more different others are from us. In a jungle we may trust an aborigen because he is also a member of the homo sapiens like us while the rest are animals. But in a city we will trust the ones who look and speak like us, and treat all others as the out group. Fertile soil for racism. This is one driver for the growing nationalism world wide. Trump, Bolsonaro and others mark the way.

Behavioral economics by Herbert Simon (Nobel 1978) Khaneman (Nobel 2002), Taversky and Thaler (Nobel 2017) evidenced continuosly many anomalies in respect to the standard economic assumptions about how agents should choose. Some of these include stable preferences, a continuos discount rate, unbounded rationality, selfishness, utility maximization. Those "economic agents" are us, but we are people, humans who make mistakes, who are not computers, who act upon emotions at least a significant part of the times. This is why economists, politicians and policymakers should see a little more towards psychology and biology and mix it up with economics. They would produce much better results and ideologies will start to loose ground to pragmatism, science and common sense.

#behavioraleconomics #prosocialeconomics #minimumwage #decisionmaking #riskaversion #lossaversion