The concept of flexibility generically indicates the capacity of adapting to changes in circumstances. In economics it is typically used to characterize price and quantity adjustments as responses to variations in market forces and organizational and regulatory patterns.
In a perfect competitive market with no transaction costs or attritions, any imbalance between supply and demand triggers an adjustment in prices that clears the market. However, in reality, prices are characterized by a certain degree of rigidity—that is, they do not fully or immediately adjust to changes in supply and demand. These rigidities are typically the result of market imperfections, asymmetric information, cognitive time lags, menu and transaction costs, or departure from a competitive framework. For example, macroeconomists make a distinction between the degree of price flexibility (or rigidity) in the short and the long run. The price of output is generally rigid in the short run because agents need time to adjust to changes in market conditions. As a consequence, an increase in money growth in the presence of rigid prices may have real effects on the economy. However, in the long run, prices are flexible and an increase in money growth translates into an identical increase in the rate of inflation, with no effects on unemployment and output.
Prices are characterized by different degrees of flexibility, even in the short run. For instance, stock prices adjust very quickly to changes in market conditions, whereas wages—that is, the price of labor—adjust much more slowly. Wage rigidity can be explained by the staggering of wage contracts, by the role of unions in the wage bargaining process, or by the firms’ willingness to pay real wages above the equilibrium level in order to attract and maintain the best workers or to reduce shirking (efficiency wage theory).
Economists often use the notion of flexibility when describing labor markets in which firms are free to vary the amount of labor they use in production, for example through dismissals when they are hit by a negative shock. A broader definition of labor market flexibility involves the institutional features that may induce a deviation of labor market outcomes from the perfect competitive equilibrium. A flexible labor market is then characterized by minimal regulations in terms of dismissal costs (or employment protection legislation) and labor standards, limited unemployment benefits, no minimum wages, low taxation, and a marginal role for trade unions. But the dichotomous concept of flexibility (versus rigidity) applied to labor markets can be misleading. Indeed, it does not help in distinguishing the continuum of potential social models, each characterized by a certain degree of flexibility and/or rigidity in certain institutional dimensions.
Each labor market regulation may be rationalized on the basis of political economy considerations. It may also have desirable social and economic purposes. For example, a reasonable degree of employment protection may induce higher productivity if workers decide to invest more in firm-specific skills; a reasonable level of unemployment benefits contingent on effective job search may help smooth consumption patterns in the presence of negative idiosyncratic shocks and financial markets imperfections. However, if employment protection is too strict, firms may be reluctant to hire new workers during economic expansions because it would be more costly to dismiss them during contractions. The negative burden of the rigidity would then fall on new labor market entrants, who would find it harder to be hired in the first place (insider-outsider theory). A flexible labor market, in contrast, would adapt more easily to positive as well as negative shocks. This might result in a larger variance of employment along the business cycle, with ambiguous effects on average employment, but possibly a more efficient allocation of labor in the long run.
