The basic concept

Let us start by recapping the intuition behind DNWR. DNWR means that people dislike nominal wage decreases. The employer, however, is mostly

5 There are also some other approaches such as the earnings-function approach used by Altonji & Devereux (1999) and Fehr & Goette (1999). However, these approaches require quite detailed background data on the people whose wage changes are being analysed. For Estonia, this kind of data is not accessible.

concerned with real wages. Every now and then it happens that the employer has to cut real wages. If this occurs in an environment of high inflation, then it might well be that both parties achieve what they want as high inflation can accommodate both a decline in real wages and a small nominal wage increase, and if the money illusion exists, both employer and employee would be happy with the situation. As a result real wages will adjust without any significant obstacles. However, if real wages must be cut during times of low inflation, the real wage cut must also assume a decline in nominal wages. Employees will oppose the wage cut and real wages cannot adjust sufficiently. The size of DNWR depends on the degree of opposition of the employees to employer-side proposals for wage cuts. As this opposition changes with inflation, this mechanism can be used for assessing the extent of DNWR.

If wages are nominally rigid, the part of the change in real wages that requires nominal wage cuts will not be enacted. In order to use micro-data on wage changes for estimating nominal wage rigidities a distinction must be made between two distributions of wage changes, the observable or factual distribution and the hypothetical or counter-factual distribution of notional changes in wages that would apply if there were no rigidities. Nominal downward rigidity prevents the enforcement of all or at least a part of negative wage changes. This results in some proportion of the probability mass being shifted from the left side of the distribution to zero, showing higher shares of wage freezes (Beissinger & Knoppik, 2001, p. 388).

The rigidity function can have various forms. In order to illustrate the mechanism employed in analysing wage rigidity we may assume a simple form of rigidity, proportional downward rigidity. In this case a constant proportion ( ) = (0 < < 1) of negative wage changes is not enacted because of rigidity. The functional relationship between the factual and counter-factual wage distribution functions is as follows (Beissinger & Knoppik, 2001, p. 389):

( ) = (1 − ) ( ) < 0

ρ- proportion of wage changes not enacted because of rigidity.

Downward nominal wage rigidity can be derived from changes in the location (usually the median) of the distribution. The basic mechanism is shown in Figure 2. Panels a) and b) illustrate the shift in factual distribution. This shift can for example be brought about by changes in inflation, or also in productivity, that result in a lower location for the counter-factual nominal wage earnings change distribution during times of low inflation and an

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equivalently higher location in times of high inflation. The factual and counter-factual distributions do coincide above zero wage growth. Below zero wage growth, the dotted line denotes the counter-factual distribution while the solid line indicates the factual distribution.

The figure shows how changes in location influence the shape of factual distribution. With low location, a substantial proportion of the left side of the factual wage distribution is relocated to zero, while for high location this happens to a significantly lesser extent.

The change in the shape of factual distribution combined with changes in location are the main properties that are used for assessing the presence and in some cases the extent of downward nominal rigidity.

Figure 2. Counter-factual distributions and corresponding factual distributions Source: Beissinger & Knoppik, 2001, p. 390, author’s modifications

There are several ways of analysing the rigidity of wage earnings, starting from looking closely at wage distributions and searching for spikes at the location of zero wage growth and for evident thinning of the left tail of the distribution.

Several parameters of the distribution, such as the skewness coefficient or mean-median difference, have also been used to describe wage change distributions.

However, this kind of approach does not reveal much about the rigidity, because of the lack of reference; it might well be that wage change distributions are by nature positively skewed and this has nothing to do with downward nominal wage rigidity. McLaughlin (1999) proposes at least three reasons why this kind of positive skewness could exist (McLaughlin, 1999, p. 130):

 People can be averse to real wage cuts and this will induce a right skewness of factual nominal wage change distribution;

 Self-selection occurs, as the data used in the analysis of DNWR only includes accepted wage offers, as the offers that were not accepted resulted in resignations or lay-offs. As wage increases are more likely to be accepted than wage cuts, this will induce the skewness to the right;

0 0 freezes

cuts

b) Low median a) High median

 Pooling different symmetric distributions can generate spurious skew-ness, also to the right.

In addition to the reasons already listed, it should be kept in mind that wage cuts are limited to 100%, while there is no technical limit for wage increases, which can also be the reason for skewness to the right, even if there is no DNWR.

To summarise, more systematic approaches are needed for identifying DNWR. Beissinger & Knoppik have proposed three broader categories of non-parametric methods for assessing downward nominal wage rigidities. These are presented in the following sub-chapters.