Nominal wage rigidity in village labor markets: evidence from India

Main article

Markets for daily wage labor are ubiquitous in poor countries, providing employment for hundreds of millions of workers in India alone. In an exploration of how nominal wages in these markets respond to changing economic conditions, this research finds strong evidence of limited downward adjustment in the face of a negative shock. A key part of the explanation lies in perceptions that wage cuts are unfair and reduce worker productivity. The higher unemployment that results from nominal wage rigidity could be addressed by counter-cyclical employment programs, and by modest levels of inflation that allow real wages to adjust in a way that avoids too much harm to workers.

Do wages adjust in response to positive and negative economic shocks? This is a central question in economics. When there are changes in the economy, wage adjustment is what facilitates the labor market’s response to these shocks: by moving up and down, changes in wages enable the labor market to clear, balancing employers’ demand with workers’ supply of labor.

My study examines whether wage adjustment is imperfect, specifically whether there is downward rigidity of nominal wages. If there are downward rigidities, then wages may not fall when there are negative shocks. This has a broad range of potential implications for the labor market and economy.

For example, if wages remain ‘too high’ (that is, distorted above market clearing levels), too few workers will be employed, leading to increased involuntary unemployment. This can deepen the impact of recessions by increasing the number of layoffs. It can also aggravate business cycle volatility, generating boom and bust cycles.

Wage rigidity in markets for casual daily labor in rural India

I test for wage rigidity in the setting of a developing country: markets for casual daily labor in rural India. Daily wage labor markets are ubiquitous in poor countries, serving as an employment channel for hundreds of millions of workers in India alone. For example, over 98% of hired labor in agriculture – the largest source of employment for the world’s poor – is through such casual labor markets in India.

A first glance at the pattern of wage changes indicates the presence of nominal rigidity. Looking across a set of 256 districts in India, Figure 1 plots distributions of nominal and real wage changes (the percentage change in the wage in a given district from one year to the next). The distribution for nominal wages shows a bunching at zero, with a discontinuous drop to the left of zero; the real wage distribution is more symmetric.

This has been the standard approach in previous work testing for wage rigidity, almost all of which uses data from OECD countries: by examining distributions of wage changes, nominal wage rigidity is isolated as a bunching at zero (and a ‘missing mass’ to the left of zero).

This approach has proved challenging for two reasons. The first is that the patterns could simply reflect measurement error, such as rounding bias in reported wages. This is especially a concern with the use of survey or non-administrative data, as in Figure 1.

Notes:

1. The figures plot year-to-year percentage changes in agricultural wages in the World Bank Climate and Agriculture dataset. The unit of observation is a district-year, with data on 256 districts from 1956-1987.
2. Nominal wage changes are shown for the full sample (7,680 observations).
3. Real wages are computed as the nominal wage divided by the state CPI for agricultural workers, for the years in which state CPI data is available (6,850 observations).
4. Wage changes are top coded at 50% and bottom coded at -50%.

More importantly, to the extent that such evidence supports wage rigidity, it does not provide insight on whether rigidities have any real consequences for employment. Consequently, there is little direct evidence that wage rigidity actually affects employment in the labor market in any setting. This is a major issue, since the primary reason we care about wage rigidity is due to its potential effects on employment levels.

My research develops a different approach to testing for wage rigidity: I isolate shocks to the economy that change how much labor employers demand. I then examine whether wages adjust to these shocks (that is, whether wages are ‘sticky’), and the consequent effects on employment. Holzer and Montgomery (1993) perform analysis in this spirit. They assume sales growth reflects demand shifts, and examine correlations of wage and employment growth with sales growth in the U.S. They find that wages changes are asymmetric and are small compared to employment changes.

I apply this approach in the context of markets for casual daily agricultural labor. In this setting, local rainfall variation generates transitory shocks to labor demand. I investigate responses to these shocks in over 600 Indian districts from 1956 to 2009. My identification strategy relies on the assumption that rainfall shocks are transitory: monsoon rainfall affects total factor productivity (TFP) in the current year, but does not directly affect TFP in future years. I validate this assumption directly (below).

Wage adjustment is consistent with downward rigidities

First, adjustment is asymmetric. Relative to no shock, nominal wages rise in response to positive shocks, but are no lower during negative shocks on average.

Second, transitory positive shocks generate ratcheting. When a positive shock in one year is followed by a non-positive shock in the following year, nominal wages do not adjust back down – they are higher than they would have been in the absence of the lagged transitory positive shock.

Third, particularly consistent with nominal rigidity, inflation moderates these wage distortions. In the presence of nominal rigidities, inflation will enable real wages to adjust downward without requiring any nominal wage cuts: employers can simply keep the nominal wage the same, and inflation will lead the real wage to fall. Because local rainfall shocks do not affect inflation, this enables a causal test of whether inflation affects real wage adjustment.

I find that when the presence of nominal rigidities, inflation will enable real wages to adjust downward without requiring any nominal wage cuts. Because local rainfall shocks do not affect—and are therefore uncorrelated with—inflation, this enables a causal test of whether inflation affects real wage adjustment. I find that when inflation is higher, negative shocks are more likely to result in lower real wages, and previous transitory positive shocks are less likely to have persistent wage effects. When inflation is above 6%, I cannot reject that lagged positive shocks have no impact on current real wages. In contrast, inflation has no differential effect on upward real wage adjustment to current positive shocks – consistent with downward nominal rigidities.

These findings support the hypothesis that inflation ‘greases the wheels’ of the labor market.

Wage rigidities and employment

A benefit of this approach is that it enables a test of whether wage rigidity actually affects employment levels. To construct a clean test for this, I compare districts that had positive shocks in the previous year (and therefore inherited a wage ratcheted above market clearing levels) with districts that had non-positive shocks in the previous year (and therefore are less likely to have an upwardly distorted wage). This allows for a comparison across districts that have the same level of rainfall (TFP) this year, but differ in whether wage rigidity binds due to their shock history.

I find that when wage rigidities bind, this distorts employment. Specifically, if a district experiences a transitory positive shock (and therefore has a ratcheted wage in the following year), total agricultural employment is 9% lower in the following year than if the lagged positive shock had not occurred.Total agricultural employment is total worker-days spent in farm work—whether on one’s own land or as hired labor on someone else’s land. This effect is driven by a decreased in hired employment. In contrast, these shocks have no effect on non-agricultural hiring.

Overall, these employment dynamics are consistent with boom and bust cycles in village economies. They also match observations from other contexts that labor markets exhibit relatively large employment volatility and small wage variation.

The brunt of the employment decreases after lagged positive shocks is borne by poorer individuals – the landless and small landholders – who are the primary suppliers of hired agricultural labor. When they are rationed out of the external labor market, small landholders increase labor supply to their own farms.

These findings are consistent with the prediction that labor rationing will lead to ‘disguised unemployment’ and separation failures, with smaller farms using labor more intensively in production than larger farms (Singh et al, 1986; Benjamin, 1992). These findings are consistent with the idea that in an economy with labor rationing, there will be misallocation of labor across firms (farms) within an area, further reducing the efficiency of output.

Other potential influences on employment

In the presence of rationing, a household’s labor supply decision will not be separable from its decision of how much labor to use on its farm. This is a prominent hypothesis for why smaller farms tend to use more labor per acre and have higher yields per acre than larger farms—a widely documented phenomenon in poor countries (e.g. Bardhan 1973, Udry 1996). These results lend some support to this hypothesis. Behrman (1999) reviews the empirical literature on separation failures.

Could these findings be explained by factors other than nominal wage rigidity? There are two categories of potential concerns. The first is a violation of the assumption that shocks are transitory.

This is contradicted by the results: if positive shocks have persistent positive effects in the following year (explaining the wage ratcheting results), then they should also have persistently positive employment effects; in contrast, I find that their effects on employment are negative – consistent with negative employment effects of downward rigidity.

Similarly, the fact that wage effects only persist when inflation is low and dissipate when it is high is also consistent with nominal rigidity, and not persistence in how shocks affect soil quality, which should not be affected by inflation.

The second category of concerns is that rainfall affects labor supply or demand through other channels, such as migration or capital accumulation. While such explanations could account for a portion of my findings, the full pattern of results – wages, employment, and inflation – is most consistent with downward nominal wage rigidity. In addition, in supplementary analyses, I fail to find evidence in support of such alternate explanations.

The results point to the relevance of nominal rigidities in a setting with few of the institutional constraints that have received prominence in empirical research on wage rigidity. In villages, minimum wage legislation is largely ignored and formal unions are rare (Rosenzweig, 1980, 1988). Wage contracts are typically bilaterally arranged between employers and workers and are of short duration (usually one day), making it potentially easier for contracts to reflect changes in market conditions (Dreze and Mukherjee, 1989).

Perceptions of unfairness

A growing body of evidence argues that nominal wage cuts are perceived as unfair, causing decreases in worker productivity. Individual responses to a range of scenarios suggest the relevance of nominal variables (Shafir, Diamond, and Tversky 1997). Employers express perceptions that nominal wage cuts damage worker morale, with potential consequences for labor productivity (Blinder and Choi 1990; Bewley 1999). See Fehr, Goette, and Zehnder (2009) for a broader discussion of the relevance of fairness preferences in labor markets.  If true, this could explain why employers may not cut wages: if doing so would lead workers to decrease effort, then employers may prefer to keep wages higher (and hire inefficiently fewer workers) than to cut wages and have workers who become less productive.

Following Kahneman et al (1986), I presented 396 agricultural laborers and employers in 34 villages across six districts with scenarios about wage-setting behavior, and asked them to rate the behaviors as fair or unfair on a 4-point scale.

The results suggest that nominal wage cuts violate fairness norms. For example, the majority of respondents thought it was unfair to cut nominal wages after a surge in unemployment (62%) or during a severe drought (64%). In contrast, relatively few people thought that a real wage cut was unfair if it were achieved through inflation (9%). Respondents also expressed a strong belief that workers decrease effort when fairness norms are violated.

My findings indicate that in this setting, real wages do adjust often in response to market forces and play an allocative role. But in cases when nominal rigidities bind, thereby distorting real wages, this affects employment. This in turn leads to increased unemployment levels, higher employment volatility through boom and bust cycles, and the potential for additional labor market imperfections through misallocation of labor across farms.

Economic policy under wage rigidity

Due to these negative effects, the traditional view would be that economic policy should seek to mitigate wage rigidity. One channel through which this is accomplished could be modest levels of inflation – since this undoes the effects of the rigidity. This would lead to fewer cases where rigidity binds, dampening the employment effects observed in the data.

In addition, it would suggest counter-cyclical employment programs. For example, India already devotes a large amount of funds annually to its workfare program, NREGA (the Mahatma Gandhi National Rural Employment Guarantee Act). It would be sensible to increase outlays for this and other similar support programs in years following positive shocks and in years with negative shocks (droughts), since unemployment levels will be exacerbated by downward rigidities in these years.

Moving beyond these basic policy prescriptions requires a view on the microfoundations of rigidity. For example, a recent study that I co-authored (Breza et al, 2019) finds that workers in this setting implicitly collude, acting as informal unions to maintain wage floors in their respective local labor markets. In this case, downward rigidity is being generated by workers themselves as a by-product of their attempts to extract more surplus from employers.

Finding a way to circumvent downwardly rigid wages – if it undermines the ability of these informal ‘unions’ to extract surplus from employers – could leave workers worse off. While this may improve efficiency, it may greatly hurt workers, who otherwise may have low reservation wages.

This illustrates the importance of understanding fully the underlying phenomena that give rise to wage rigidity. Such an understanding would help both in formulating targeted policies and clarifying which segments of the population would be affected by policy interventions.

This article summarizes ‘Nominal Wage Rigidity in Village Labor Markets’ by Supreet Kaur, published in the American Economic Review in 2018.

Supreet Kaur is at the University of California, Berkeley.