Labour force shrinkflation is coming. What can companies do about it?

Companies need to take a leaf out of their executive compensation playbook and provide skilled workers with the right kind of incentives, writes UNSW Business School's Mark Humphery-Jenner

Millions of Australians are experiencing declining real wages. Employers have resisted increasing salaries, citing margin pressure. However, this will create significant issues within the skilled workforce that ultimately could harm companies’ bottom line.

Declining real wages – and stagnant nominal wages – have led to an alleged trend of ‘quiet quitting’ or labour force shrinkflation where people merely do their duties but do not go above and beyond.

Imagine the following situation: You have been slogging away at work, going above and beyond at your job. You know your market value and can see a tight labour market and can see that you add value to an organisation. Perhaps you have been doing unpaid overtime, working nights or weekends, or have become super-normally efficient. You have gone through the pandemic with increasing workloads or stress, but with stagnant or falling wages.

This is the situation many highly skilled workers find themselves in. But how do they respond?

The humble Tim Tam packet is an apt analogy, and indicator. Shrinkflation involves keeping the price the same but reducing the quantity supplied. For example, the price of a packet of Tim Tams might not change, but you get fewer biscuits per dollar. Here, we risk labour force shrinkflation; wages stagnate but workers provide fewer units of effort per dollar.

Why is workforce shrinkflation coming and why is it rational?

Wage growth is significantly under inflation. This has become a significant issue 2022, where inflation has soared and wages have only increased marginally. CPI inflation recently hit 6.1 per cent. The Treasurer, Jim Chalmers, indicates it could rise to 7.5 per cent. Wage growth has stalled, increasing only 2.4 per cent.

This is an even greater problem when we consider 2020 and 2021: during these years, companies often kept pay unchanged, reduced pay, or increased employees’ workloads. Employees are unsurprisingly pushing back against corporations that seem to be taking advantage of them. This is especially the case when dealing with highly skilled labour with outside opportunities.

Utility theory tells us how workers would respond, especially when they have outside options. Utility theory aims to model factors that increase individual ‘utility’ (i.e., welfare or sense of wellbeing). However, it boils down to the idea that welfare increases with money and decreases with effort and risk. This is intuitive and the intuition is hardly surprising.

Read more: Are we seeing the Great Resignation – or the Great Exhaustion?

The conclusion is obvious: if wages are decreasing, then the only way for workers to maintain their sense of wellbeing is to work less. That is, they will stop doing extra unpaid tasks or going above and beyond. When unemployment is high, workers must often stomach this, knowing that they have limited outside options. But, the unemployment is at decade lows at 3.6 per cent in the US and 3.5 per cent in Australia.

This can harm companies. Falling effort levels will clearly reduce output quality and/or quantity. That is, if a talented employee could have produced an item, closed a sale, or otherwise improved revenue, but now stops working those extra hours, revenue will fall. Or, perhaps talented workers will be less conscientious, causing them to devote less time to clients and value creation.

This has been clear in the CEO compensation literature for decades. Indeed, it is well established that an ‘entrenched’ CEO might decide ‘live the quiet life’ when they are poorly incentivised. A badly motivated CEO might also undertake ill-disciplined investments. For example, entrenched CEOs might overpay when doing takeovers, safe in the knowledge that such transactions will not harm their future careers. Or they might just focus attention on pet projects, such as philanthropy designed to cater to their own interests or ego.

It is well known that firms incentivise CEOs with stock and equity in order to align their goals and objectives with those of shareholders. There is no reason to believe that other skilled employees would act differently.

What can companies do about it?

Companies’ margins are under pressure. It is not always realistic to expect a company to increase wages. This is especially for small and medium enterprises. Indeed, tying wages to inflation can trigger a wage-price spiral. How then to motivate employees?

Companies have a clear solution: incentives linked to performance and value creation. This is especially obvious when employees produce discrete pieces of work or have clear measurable outcomes. For example, if that employee creates, sells, or runs a product that might create value, provide commissions, a slice of revenue, or a slice of gross profits. Or, if doing a better job – which takes more effort – helps the bottom line, incentivise that effort.

This is a clear link to executive compensation theory. Companies motivate CEOs with equity, options, and bonuses. The goal is to incentivise CEOs to create more value by linking their objectives with those of the shareholders. Companies that fail to do this often have demotivated CEOs that fail to create shareholder wealth. Talented and skilled employees are not stupid: they can see this.

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Companies should not bury their head in the sand. If skilled employees are baulking at falling wages, increased workload demands, and are less willing to work additional hours, ignoring the problem will make it worse. Top talent will leave. And this ultimately will harm the bottom line. Companies can be part of the solution and can grow the pie for themselves and talented workers. But, ignoring workers’ concerns will undermine profitability long-term.

Mark Humphery-Jenner is an Associate Professor in the School of Banking & Finance at UNSW Business School. He has been published in leading management journals and his research interests include corporate finance, venture capital and law. For more information please contact A/Prof. Humphery-Jenner directly.