Stiglitz's explnations of stickiness of wages(Kaushik Basu)

Kaushik Basu*1 “Stiglitz: Invisible hans is not always there” Shanghai Daily 22 December 2015*2


Columbia University's Joseph Stiglitz, who celebrates 50 years of teaching this year, solved the puzzle. Stiglitz picked up some elementary facts about the economy that lay strewn about like jigsaw pieces, put them together, and proved why some prices were naturally sticky, thereby creating market inefficiencies and thwarting the functioning of the invisible hand “is invisible at least in part because it is not there.”

The intuition behind some of Stiglitz's arguments about rigid prices is simple. We know that people often shirk if there is no penalty for doing so, and that the common penalty in the workplace is the risk of losing one's job.
But if one assumes a full-employment equilibrium, as described in textbooks, with the market working without friction, this penalty is ineffective. Threatening workers with the loss of their job will no effect if they can immediately find another.
The way to create incentives not to shirk is to pay workers above the market wage, making the loss of a job more costly. Of course, if this works for one firm, it will work for others, and wages will rise, and eventually the supply of labor will exceed demand. In other words, there will be unemployment.
And then, even if all firms are paying the same wage, the threat to fire a worker will be effective, because a worker who loses a job will face the risk of remaining unemployed. As a result, the market will reach an equilibrium where unemployment exists, but wages do not drop. This is, in short, the Shapiro-Stiglitz equilibrium.