Relative Prices, Wage Indexation and Unemployment

Abstract

When a firm and its workers try to agree now on contingent wages and employment at some future date, potential movements in several different prices enter into consideration. The firm's revenue depends on the selling price of its product. The workers have concerns about the price of the bundle of goods they buy, and the firm's owners may buy a different bundle of goods having still another price index. Unless owners want to acquire their firm's own output or are fairly risk averse relative to workers, wages will be indexed primarily to variations in the firm's selling price. This prediction, which has been reported to be the typical pattern empirically, does not depend on whether the agreement also calls for possible layoffs. For any strictly concave utility function for workers, potential relative price variations must be quite sizeable before contingent layoffs will be planned, unless laid-off workers, without direct compensation for the firm, are almost as well off as when employed. If there are some layoffs, then increased relative price dispersion will raise the average unemployment rate.