Sticky Buns and Sticky Wages

One explanation often found in textbooks for the relatively slow pace of price adjustment in the macroeconomy is ‘sticky wages’. The idea is that, due to long term contracts and other structural impediments, firms cannot reduce wages when the demand for their product falls. 

Microeconomic theory tells us that firms will hire workers up to the point where the marginal product of labour is equal to the real wage rate. When the demand for a firm’s product falls, the price of their product falls and the real wage rises. In order to restore the cost minimizing solution, firms must either cut nominal wages or increase the marginal product. Increasing marginal product of labour requires using less labour. So firms must cut jobs or cut wages. Both of these can prove difficult to accomplish in the short run. 

This is the unfortunate circumstance that Hostess Brands was facing late last year. A Reuters article in the Montreal Gazette tells of the demise of the Twinkie. As people have become more health conscious the demand for the 150 calorie high-fat snack has decreased. At the same time, droughts and agriculture policy have increased the price of the flour used to produce the Twinkies. Both of these circumstances have led to a decrease in the production of Twinkies, and Hostess was faced with either laying off employees or reducing wages. 

Faced with a staggering 300 different labour contracts, the company had no success in reducing wages. The article quotes one baker as saying he would rather be unemployed than take a wage cut. This is consistent with an upward sloping labour supply curve. With no opportunity to cut labour costs and no control over flour prices, Hostess decided that the only way to preserve its cash was to shut down production. This is what our theory suggests will happen if price falls below the average variable cost of production.  

Hostess has now filed for bankruptcy protection in the United States and has ceased production of the infamous Twinkie. While Hostess could not profitably produce Twinkies, it may be possible for another company, with lower labour costs, to do so. Hostess still owns the rights to the Twinkie and is currently seeking a buyer for the recipe and brand name. If and when the Twinkie returns to the US, there is no doubt that it will be manufactured and shipped by workers with lower wages than those that worked at Hostess. 

Sticky wages in the sticky bun business. Result: unemployment.