Wages are said to be flexible when they respond to changes in supply and demand and lead to the market clearing wage being set. It implies that the wage will be set by the MRP of labour and marginal cost of labour. Any change in supply and demand for labour will lead to a change in the wage rate.
Theory of wage determination and flexible wages
With perfectly flexible wages, the wage rate would always be set where MRP of labour = Marginal Cost (MC) at Q1.
Therefore, if a workers, marginal product increased, this would translate into a higher wage rate. This could be achieved through paying workers piecemeal for the amount they produce, e.g. £3 per cartoon of broccoli that you pick.
If there was an increase in supply of workers in the industry, this would push down wages in the industry, leading to an immediate decline in the wage of each worker. Usually this wouldn’t happen, because workers would resist nominal wage cuts, and firms may even be reluctant to cut wages because of impact on morale / costs of changing wages.
Under some circumstances, wages can be sticky downwards. This means trades unions are able to prevent wages falling to the market clearing level. This can lead to classical unemployment with wages above the equilibrium.
Usually wages are set by contracts. For example, £4.50 an hour. Usually pay rates are reviewed every year. These wages are not perfectly flexible because
- Workers are not paid their individual Marginal revenue product (MRP). But, a standard wage rate
- Wages do not change very frequently. But, only at certain time periods.
Market Clearing wage is W1
If wages are flexible, wages would fall to W1.
The flexibility of wages depends on the relations of labour and organised business. If unions are strong and powerful, wages are less likely to be flexible and wages could be maintained at W2 – this would be an inflexible wage.