As street wisdom goes, workers’ incomes dwindle when the firms that employ them suffer losses in revenue and profits; conversely, they increase when their firms post higher sales and profits. Such wage volatility is not set in stone, though. In a paper titled “Insurance Inside and Outside the Firm,” Wharton finance professor Martin Souchier has developed a model where “optimal wage contracts” can provide workers “insurance” within a firm to reduce wage volatility, and insurance outside the firm with the ability for workers to borrow in the financial markets.
The premise of the paper is that firms face risks with “productivity shocks,” where their sales fluctuate. “When their sales go up or down, they get to choose what to do with the wages of their workers,” Souchier said. “If sales go up by 20%, do they want to increase wages by 20%, and vice versa when the sales go down by 20%? Or, would they want to keep wages constant even as their sales revenues fluctuate?”
Souchier found in his data that firms tend to absorb most of those fluctuations in sales, and thus provide stability to their workers’ compensation. For every 10% increase or decrease in sales, firms increase or decrease wages by only 1%, on average. “We academics see that as a way where firms provide insurance to workers against the risk that they face with fluctuating revenues,” he said. Here, the word “insurance” doesn’t refer to an insurance contract; instead, it is used in a generic sense of protection from wage volatility, he explained.
At the firm level, it may be easier to provide its workers insurance with wage stability than if its fortunes fluctuate along with those of an entire industry, or even the broader economy, such as during a boom or a recession. During such “aggregate shocks,” wages increase or fall by a lot more than 1%. That volatility is larger in the U.S. (about 1.5%) than in France (0.5%) or other European countries, Souchier said. Those data points are based on empirical studies conducted by others covering a 30-year period between the 1990s and late 2010s.
Not All Workers Are Equal
The insurance workers get in wage contracts can vary between wealthy workers and relatively poorer workers, or “hand-to-mouth” workers as Souchier described them. He defined the wealth of a worker as the total of their liquid assets — all cash holdings and investments, excluding the value of their home.
Using that benchmark, the data showed that not all workers are equal in terms of the insurance they receive from firms. When a firm’s sales or profits increase, it increases the wage of wealthy workers by more than the average of 1%, and conversely, firms lower the wages of wealthy workers by more than the average when their sales or profits decline. Poorer workers, on the other hand, see their wages go up or down by smaller amounts along with the firm’s fortunes.
“During boom times, a firm would want to increase stock options and reduce cash bonuses.”— Martin Souchier
In other words, the wages of poorer workers are “more constant” than those of wealthier workers, Souchier noted. “Firms will keep the wages of poor workers a lot more constant, and vary the wages of wealthy workers a lot more.” The upshot of that constancy is that the wages of poorer workers are more insured — and therefore less volatile — than those of wealthier workers. Put another way, firms protect wealthier workers a lot less against downside risks than they do for poorer workers.
Why Firms Provide Insurance Against Wage Volatility
With his model, Souchier set out to find an explanation for why firms provide more insurance against downsides to poorer workers than to wealthier workers.
Firms have two considerations in deciding how much to index their wages to their sales, Souchier said. One is they want to provide wages without too much volatility, or more constancy, in order to be perceived as desirable employers, or employers where workers feel more secured even as the fortunes of their firms fluctuate. The other goal firms have is to optimize worker retention, which essentially means retaining workers when they are most needed, such as during boom times when they want to increase production.
“Firms don’t want workers’ wages to be so volatile, because otherwise workers will perceive their jobs as super risky,” Souchier explained. “I don’t want to work in a firm that is going to pay me plus 30% when things go well, but also minus 30% when things go bad, because I have a mortgage to pay and so forth.”
According to Souchier, firms want to retain their workers when they need them the most, which is when they have a lot of demand for their products, and they want to increase production to capitalize on that demand. They can achieve this by paying workers a little more when sales are up, and a little less when sales are down. That means that firms cannot keep the wages of their workers always constant, even if this is what workers would prefer. Instead, they index wages on sales to optimize worker retention and insure workers against risk, but not too much.
Souchier’s optimal wage contract also factors in the “marginal propensity to consume” of workers, which measures how workers increase their consumption when their income or liquidity increases. When poorer workers get higher wages, they are likely to increase their consumption a lot more than their wealthier counterparts.
For wealthy workers, wage volatility is not as costly as it is to poorer workers, because they can smooth their consumption by tapping into their savings. “If you’re wealthy, and if you have a lot of cash in the bank, your marginal propensity to consume is low; your income may change, but that doesn’t mean your consumption has to change by that much because you already have some assets in the bank,” Souchier said.
Workers and firms are at opposite ends of the risk spectrum, and Souchier explained how that plays out. Firms want to protect their workers against risk, because that is what workers want — they are risk-averse. It’s not as if only the hand-to-mouth workers care about wage risk; even their wealthier counterparts worry about risk, although a little less. Firms, on the other hand, are risk-neutral, when they don’t care about risk because they have deep pockets. “Unlike workers, firms can diversify risk better; they have a better tolerance, and a better capacity, to absorb risk,” he said.
How Insurance Works Within and Outside the Firm
Workers can protect themselves against risk in two ways. One is with the insurance they receive from their firm, which smooths out their wage volatility. The other is to self-insure against labor income risk with “insurance” outside the firm, which they achieve by accumulating precautionary savings. But accumulating savings is more of an option for wealthier workers than it is for hand-to-mouth workers.
“Promising higher wages in the future is the best strategy to retain workers.”— Martin Souchier
The policy option to help hand-to-mouth workers build savings is to make it easier for them to borrow than their creditworthiness would allow. A bank may be willing to offer loans to poorer workers at higher interest rates to protect itself against defaults. But here, policy intervention in the form of a subsidy could help poorer workers secure those loans, Souchier said. (He hastened to add that he doesn’t advocate any policy reforms in his paper.)
That access to financial markets, however, comes at a cost for poorer workers. Souchier said his model revealed a “surprising implication” of enabling workers to borrow in the financial markets: Firms take advantage of that extra cushion that workers get. In that setting, firms choose to pass on more of their productivity shocks to workers, which means workers’ wages can become more volatile. “The insurance that workers receive outside the firm crowds out the insurance that they receive inside the firm,” the paper stated.
Firms may pass on their productivity shocks to workers in various ways. For instance, firms may offer their workers the option of paying them a portion of their wages at a future date. That idea of backloading wages or deferred wages incentivizes workers to stay, and helps the firm retain them in times of need, such as when they want to increase production. Deferred wages can also take the form of future bonuses or stock options that vest at a future date. “During boom times, a firm would want to increase stock options and reduce cash bonuses,” Souchier said. “Promising higher wages in the future is the best strategy to retain workers.”
Dealing With Income Inequalities
Souchier’s model also points to a new source of income inequality between workers. Wealthy workers begin their careers with jobs that offer wages that are more backloaded; they can afford to delay their earnings because they start off with assets they can use to smooth their consumption. These jobs also happen to pay more, so wealthy workers tend to find better jobs and earn higher wages than their poorer counterparts.
In contrast, poorer workers begin their careers without any assets and with relatively lower wages. “They cannot afford to search for high-paying jobs because they do not have the resources to smooth consumption early on in their career,” the paper noted. This phenomenon explains the persistence of income inequality across generations, where the income of parents sets the initial pattern of the income of their children. “Internships are often the key to a successful career, but you can only afford to do unpaid internships if you have the resources to survive on no income for a while,” Souchier said.
That situation changes when poor workers are able to borrow from the financial markets. “When workers have access to insurance outside firms, firms backload wages more and provide less insurance to workers against productivity shocks,” the paper noted. But hand-to-mouth workers are now able to get jobs with backloaded wages, which pay more on average. Thus, enabling poor workers to borrow can reduce income inequality because it gives them access to the same job opportunities as wealthy workers.
All considered, Souchier said his model showed that giving workers the ability to borrow (such as with a subsidy) will be a good policy. But he had words of caution for such borrowers: They will face more risks as their income will be more volatile. “But that’s okay because at the end of the day, they’re going to get paid more on average, and they’re going to be able to smooth their consumption themselves,” he said. “That is the message for workers, to look like rich workers by letting them borrow.”
