Economics 101: When revenues are squeezed options exist beyond downsizing

Trimming the workforce is usually a more productive way to save costs than enforced layoffs

When companies or governments face a squeeze on revenues, they may be forced to slash labour costs.

Traditionally, employers tend to favour downsizing their labour force, rather than decreasing compensation. This principle was adopted by the Bahrain government in October whereby, in response to fiscal pressure, instead of cutting wages in the public sector it launched a voluntary retirement scheme that it hoped would be adopted by a large number of public sector workers. The main reason was the desire to maintain the living standards of Bahraini citizens. However, company managers often avoid wage cuts at all costs, suggesting that some principles of managerial economics may have also played a role in the Bahrain government's decision.

There are two reasons why employers avoid wage cuts. The first is that they may lead to losing the best workers in the company. In large organisations, there is limited scope for allowing different workers to earn different wages, as pay tables rigidly govern compensation. This means that there will be a group of workers earning approximately equal wages but who are quite diverse in their actual productivity - a common occurrence in the government sector in Middle East countries where seniority can matter more than productivity in determining promotions and pay raises.

Under such circumstances, wage cuts may convince high quality workers to aggressively look for alternative employment. This makes layoffs significantly more attractive, since the managers can handpick their weakest employees for dismissal.

The second reason why employers are reluctant to cut wages is the effect on the productivity of workers who do remain with the organisation. If they feel wronged, they may reciprocate by exerting less effort. This may not even be a conscious decision; workers might work less diligently as an unconscious result of lower morale rather than an overt act of retribution.

Again, under such circumstances, layoffs may be preferable, since the affected workers are no longer in a position to take revenge, while the workers retained suffer no financial loss; in fact, they may even tacitly feel grateful that they were among the lucky workers to retain their jobs.

This specific argument was originally made by George Akerlof in 1982, an economist who went on to win the Nobel prize, although for a different contribution. It was the basis of his claim that the importance of interpersonal relations to workplace productivity would exacerbate unemployment at the level of the economy, as employers would favour layoffs over wage cuts. He developed this line of research over the 1990s with his co-author, Janet Yellen, who went on to become the chairman of the Federal Reserve Bank in the US during Barrack Obama’s second term, before Donald Trump replaced her during his first term.

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One mediating factor that relates to this second mechanism is the ability of employers to objectively and transparently measure the effort exerted by workers. When effort is hard to measure, such as in many government jobs, including the police, judges, and clerical workers, then employers will be particularly fearful of covert retribution by their workers as they have no way of holding them accountable for shirking. In contrast, when effort and productivity are easy to gauge, such as in sales positions or for professional athletes, employers do not fear retribution so much as their employment contracts can specify the desired effort/productivity and the punishment for shirking.

A recent paper by Jason Sandvik and Nathan Seegert (University of Utah, US), Richard Eli (Michigan State University, US)  and Christopher Stanton (Harvard University, US) investigated these hypotheses by closely following a firm over several years, including the period before and after an unexpected pay cut.

They find that in the company being studied, the decrease in compensation - brought about by a decrease in sales commission - resulted in a significant decline in the company’s productivity (4 per cent). They also found that the reason was increased turnover among high quality workers, who were 50 per cent more likely to leave the company in the months following the pay cut. In contrast, most of the low-productivity workers exhibited no change in their propensity to leave the firm. Crucially, due to the ease of measuring workers’ output, the company’s performance was not affected by any decrease in effort as workers would have feared punishment for such acts.

Forced layoffs are politically unpopular and Bahrain's offer of early voluntary retirement was a worthwhile move from the perspective of the government even though some high-quality workers might leave.

Moreover, if the good-quality public sector workers retiring early go on to gainful employment in the private sector, then that is a welcome outcome consistent with the country’s economic vision, which targets transforming the private sector into the employer of choice for its labour force. One of the historic challenges faced by private sector employers in Bahrain has been the difficulty of attracting top talent due to the availability of comfortable, high-paying jobs in the public sector.

Seeing an elite civil servant retire early and use their extensive experience to open a private consultancy, for example, would be an excellent outcome, especially if they hire Bahrainis as support staff.

Omar Al-Ubaydli (@omareconomics) is a researcher at Derasat, Bahrain