# Why do firms losing money almost always reduce labor costs via layoffs instead of pay cuts?

At least in the United States, firms seem to almost always reduce labor costs via layoffs rather than pay cuts. Pay cuts are so rare that they're literally headline news. From an economic standpoint, if workers are being paid more than their marginal product, then either solution fixes the problem - layoffs boost marginal product to match the old wage, while pay cuts lower the wage to match the new marginal product.

But it seems to me that a pay cut is better for both the employer and the employee. From the employer's side, when times get better they don't need to bring in a bunch of inexperienced new employees to replace the ones they laid off. From the employee's side, they still make some money rather than no money, and they are free to leave the company if they can find sufficiently higher pay at another firm to compensate for the inconvenience of switching jobs. Personally, I would always prefer to be offered a pay cut than laid off, and apparently over 90% of workers feel the same way. So why are layoffs so ubiquitous?

Here are four possible reasons:

Reason #1. Fixed costs per employee.

Due to taxes, insurance, 401k plans, etc., the cost of an employee (to the employer) is significantly greater than the employee's take-home pay.

For simplicity, assume an employer must bear an additional lump sum cost per employee that is equal to 20% of each employee's current take-home pay. Assume also that all employees are identical. Then to cut payroll costs by 30%, the employer can either:

A. Fire 30% of the employees; OR

B. Cut each employee's take-home pay by 36%.

Many firms will prefer A to B.

Reason #2. Parkinson's Law

Parkinson's Law is the humorous adage that "work expands so as to fill the time available for its completion".

This may apply also to workers in a firm. Laying off say 5% of employees may make no difference to total production -- especially if a firm was already bloated and overstaffed to begin with.

Reason #3. Keeping employees on their toes.

By occasionally laying off a significant fraction of employees during downturns, one credibly demonstrates that employees should work hard and well or risk being fired.

[There are here two separate questions: (a) Does this tactic really work (in motivating employees)?; and (b) Do there exist employers who believe in this tactic? An affirmative answer to (b) suffices to serve as an explanation to your question.]

Reason #4. Worker morale.

Suppose we ignore Reason #1 and happily, we can save 30% in payroll costs by either:

C. Firing 30% of the employees; OR

D. Cutting each employee's take-home pay by 30%.

Under C, the 30% who are fired will indeed be very heavily demoralized, but they are no longer your problem. As for the remaining 70%, they might be slightly demoralized about losing some of their work buddies. But they might even be reinvigorated after discovering they survive the cut.

In contrast, under D, every employee is rather demoralized about the 30% pay cut.

Many firms will prefer C to D.

I think this can be explained by prisoner's dilemma.

Short answer: if by pay cuts a firm would lose its competitiveness in attracting high quality employees, the best strategy for a firm is to lay off low quality employees.

Suppose a firm has two strategies to reduce cost (not necessary in a bad time): pay cuts ($C$) or layoffs ($L$).

---------------
L      C
L (0, 0) (2,-2)
C (-2,2) (0, 0)
---------------


If other firms in the labor market use the same strategies to cut cost, either by pay cuts ($C$) or layoffs ($L$), we suppose all the firm in the market both would maintain the current productivity. But if other firms choose layoffs ($L$) while the firm chooses pay cuts ($C$), high quality employers would jump to other firms since the salaries are higher there. Thus other firms increases productivity and the firm decreases. Therefore, the equilibrium is (L,L).

• This is a very interesting answer which had not at all occured to me! I wonder if anyone else has proposed this idea. – tparker Sep 15 '18 at 22:58

While workers in the crisis may prefer a pay cut I don't know if long-term they would appreciate their employer for doing so. Employers may feel like it is damaging to the long-term stability of the workforce.

That being said, arguably layoffs can be equivalent to pay cuts when the workers laid off are on the higher end of the wage scale. After laying off relatively more senior employees an employer has both fewer employees and a lower rate of compensation.

I read an argument recently about the opposite scenario: why aren't wages increasing right now? One explanation was that even though the data says wages are flat this is because hiring interns and additional entry-level positions waters down the actual wage increases to existing employees.

Why do firms losing money almost always reduce labor costs via layoffs instead of pay cuts?

Although anyone individually assesses that a pay cut would be less catastrophic than being laid off, it is necessary to look at the "psychology" surrounding the notions of utility and survival. Much of this answer admittedly sounds cruel, but I aim at describing an agent's "survival" reaction.

An employee receiving lower compensation is prone to feel shortchanged because workload remains --or is perceived to remain-- constant. For instance, even if the workload decreases, the employee usually still has to meet his full-time schedule and be available. Consequently, employees' imminent dissatisfaction from a pay cut tends to lower their morale and productivity.

By contrast, seeing other layoffs encourages an employee to maintain his productivity for fear of he himself being terminated. Likewise, an unemployed person is likelier to accept disadvantageous conditions for a while than the employee who --understandably-- will expect a reversal of his pay cut as soon as business conditions improve.

Where compensation includes benefits, one layoff is likely to conduce to a greater reduction of costs than applying a 50% pay cut to two employees with same pay level. At first glance, the layoff increases the employer's exposure to a bottleneck risk with respect to the remaining employee (for instance, that the latter might get sick), but that risk is mitigated by the latter's interest not to be laid off as well. Where the number of layoffs is big enough, the reduction of costs would be reflected even in semi-fixed costs, such as the premium for group insurance.

Fiscal policy/stimulus might also influence an employer's propensity to decide for layoffs [and subsequent hires] in lieu of maintaining steady workforce via pay cuts.

It would not be fair to top employees that would not be cut. Those are employees that you don't want to lose and they are employees that can find a better job.

A 10% pay cut is lay off 1/10. Do you want to risk losing your top 10% or get rid of the bottom 10%?

Where the industry has tanked you do see taking a pay cut some time.

Another option is if it is hourly just cut the hours.

The union auto industry years back had high pay for blue collar. They just laid off and then contracted the work to shops that were not union.