Bonus Question: How Does Flexible Incentive Pay Affect Wage Rigidity?
Overview: In the paper “Bonus Question: How Does Flexible Incentive Pay Affect Wage Rigidity?" NYU Stern Professor Abdoulaye Ndiaye, along with co-authors Meghana Gaur (Princeton University), John Grigsby (Princeton University), and Jonathon Hazell (London School of Economics), studies how incentive pay affects our understanding of macroeconomic behavior.
Why study this now: Since the 1930s, economists have believed that wages that don't change much during good or bad economic times (wage rigidity) play a big role in how the macroeconomy works. When wages remain constant, it can cause more unemployment during economic downturns. Additionally, about half of US workers get some form of incentive pay – which can change often – making it an important aspect to analyze when studying the economy.
What the authors found: The researchers developed a new model of inflation and unemployment dynamics. The model shows that incorporating incentive pay can mimic the same economic responses (unemployment and inflation) as models with fixed wages. This is because changes in wages and incentives balance out to keep marginal costs stable.
What does this change: The study highlights the importance of, and a proper way of accounting for, incentive pay in economic models to better understand labor market behavior and inflation during booms and busts. Understanding how incentive pay influences wage rigidity can help policymakers and economists better predict and manage employment and inflation responses to economic changes.
Key insight: “These results suggest that researchers should assess the extent to which wage cyclicality is due to incentives when calibrating their models,” say the authors. “We offer one attempt at such measurement through a calibrated model and find that approximately 46% of the wage cyclicality in the data arises because of firms’ procyclical desire to incentivize worker effort. Models that do not feature incentive pay should therefore target a value of wage cyclicality significantly lower than that in the data to correctly reproduce the impulse response of unemployment.”