Technical Report Optimal Combination of Wage Cuts and Layoffs : The Unexpected Side Effect of a Performance-based Payment System

YOKOYAMA, Izumi  ,  OBARA, Takuya

2015-10 , Graduate School of Economics, Hitotsubashi University
We analyze the optimal combination of wage cuts and layoffs from the viewpoint of behavioral economics. First, we theoretically show that with the increase in the parameter representing a firm's estimate of the degree to which nominal wage cuts damage worker morale, the firm becomes less likely to impose wage cuts and instead implements layoffs. We show empirically that there is a trend whereby a firm under a performance-based payment system is unlikely to implement wage cuts because the system acts as a device for strengthening the relationship between wages and worker morale. Given this first-order regression, the status of a performance-based payment system is employed as an instrumental variable (IV) for wage cuts in a layoff regression model, and the IV estimate for the impact of wage cuts on layoffs becomes significantly negative. This supports the theoretical implication that implementing wage cuts can be a potential device to reduce layoffs. These results may imply an unexpected side effect of the increasing use of a performance-based reward system in Japan: as the system becomes more widespread, layoffs will increase because companies will become less likely to impose wage cuts. This in turn may lead to a high unemployment rate in Japan, where the fluidity of the labor market is not as advanced as that in the United States.

Number of accesses :  

Other information