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An Analysis Efficiency Wage Models Economics Essay

In efficiency wage models, firms choose to pay high wages to reduce turnover, eliminate shirking, increase morale, or in other ways enhance productivity. If wages exceed the market-clearing rates, unemployment results. Any further increase in wages, caused by some government policy, would likely worsen the unemployment problem but also further enhance productivity. Combining the two effects, would the wage increase raise or lower output and welfare? In other words, where and where not you would expect firms to pay efficiency wages? That is the question this paper seeks to answer.

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Economists typically assume that the efficiency wage is too high and so leads to unemployment that is also too high. Regarding a model of costly labor turnover, Stiglitz [1] writes, firms are likely to pay too high wages. But it should be emphasized that it is possible that the competitive wage is too low.

Since the 1970s, the persistently high unemployment rates in many industrial economies have made more and more economists believe that involuntary unemployment is one of the major stylized facts of modern economies. Therefore, a satisfactory macroeconomic labor model should explain well such a stylized fact. The efficiency wage theory has in recent years generally been regarded as a powerful vehicle for explaining why involuntary unemployment has persisted in the labor market. In constructing a business cycle model, “a potential problem of the efficiency-wage hypothesis is the absence of a link between aggregate demand and economic activity” [2] . Hence, until Akerlof and Yellen (1985) presented the near-rational model, efficiency wage theories still left unanswered the question of how changes in the money supply can affect real output.

In macroeconomic theory, the wage is simply regarded as the amount of money that employees receive and is assumed to be exactly equal to the average cost of labor to employers. In practice, the components of wages are more complicated than the simple economic setting would suggest. There exist some gaps between the amounts that trading partners pay and receive. For example, the actual average cost of labor to employers is equal to the wage that employees receive after the addition of hiring and training costs, firing (severance pay) and retirement (pension) costs, various taxes and insurance fees, sometimes traffic and housing outlays, and so on. Some of these costs, especially taxes, insurance, and traffic fees, are set by the process of political negotiations. The resetting processes relating to these costs are always time-consuming and controversial in modern democratic societies, and these costs are not as flexible as other components of wages determined by competitive markets or monopsonists. Since some components of wages are always inflexible, partial rigidity of wages is thus a realistic specification for economic modeling. When we recognize that wages have the property of partial rigidity, it is logical to expect that money nonneutrality will hence result.

The basic tenet of the efficiency wage theory is that the effort or productivity of a worker is positively related to his real wage and firms have the market power to set the wage. Therefore, in order to maintain high productivity, it may be profitable for firms not to lower their wages in the presence of involuntary unemployment. The main reasons that are provided for the positive relationship between worker productivity and wage levels include nutritional concerns [3] , morale effects [4] , adverse selection [5] , and the shirking problem [6] . The shirking viewpoint proposed by Shapiro and Stiglitz (1984) is the most popular version of the theory. Its essential feature is that firms cannot precisely observe the efforts of workers due to incomplete information and costly monitoring; equilibrium unemployment is therefore necessary as a worker discipline device. I thus adopt a shirking model as the analytical framework of this paper to examine the effects of partial rigidity of wages.

The earliest theoretical work on efficiency wages by Shapiro and Stiglitz and Bowles contends that competitive firms may rationally pay wages greater than workers’ opportunity costs if labor intensity is a positive function of wages. Relative to a nonexistent counterfactual in which firms do not pay efficiency wages, labor intensity, wages, and profits are greater in the world of efficiency wage payments, but so too is unemployment. [7] Note, however, that because labor effort is a working condition which leads to worker disutility, any increase in labor intensity will call forth a compensating payment for the increased disutility of work. Thus, the full magnitude of the wage difference between the (counterfactual) market-clearing and (actual) nonmarket-clearing equilibria incorporates both efficiency wage and compensating payments components. This point has not been fully appreciated in the literature. Even when efficiency wage theorists discuss the issue of wage differences across firms or industries they often make the mistake of ignoring the theory of equalizing differences. For example, in a discussion of efficiency wages, Stiglitz begins by cautioning the reader that “we are comparing the wages paid by firms for workers with a given set of observable qualifications.” He then goes on to argue that if firms face different internal costs of generating labor intensity, then they will be found to pay different wages for workers of identical characteristics.

Efficiency wage models were created partly to explain unemployment and wages that exceed market-clearing levels. A common assumption in this literature is that further increases in wages, and therefore further increases in unemployment, would be harmful.

A common explanation of the permanent rise in unemployment rates in European countries since the mid-1970s is that relative wages do not adjust sufficiently in response to relative labor demand shocks. Strong labor unions fighting for a high degree of wage equality have been blamed for this relative wage rigidity. However, when worker effort depends on relative wages, it might well be in the employers’ own interest to pursue an equalizing wage policy. Within our efficiency wage model we demonstrate that under fairly plausible conditions, firms have incentives to reduce within-firm wage inequality when internal wage comparisons are important.

A popular argument for the existence of involuntary unemployment is that a worker’s effort rises with wages, giving employers incentives to set wages above market clearing levels. It is often assumed that the worker’s effort is a function of the wage level, with no reference to the size of the wage in comparison with that received by other workers. Yet, such comparisons are likely to influence an individual in his effort choice. If this is the case, then it seems equally likely that workers compare themselves with others, both internal and external to their place of work.

However, Akerlof and Yellen assume that effort reaches a maximum value when the wage paid equals the fair wage, so that further wage rises have no effect on effort. We extend the Akerlof and Yellen model by letting effort be a continually increasing function of the two relative wage rates. Accordingly, whereas unemployment occurs only for low-skilled workers in the Akerlof and Yellen model, our model generates equilibrium unemployment for both high-skilled and low-skilled workers. According to Nickell and Bell there has been a substantial increase in skilled as well as unskilled unemployment in Europe since the mid-1970s. At this point our model seems to be more in line with the empirical evidence than the Akerlof and Yellen specification.

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An important question is what factors may cause the equilibrium unemployment to change over time? Technological changes working against unskilled workers combined with insufficient relative wage flexibility have been proposed as an explanation for the permanent rise in European unemployment rates since the mid-1970s [8] .

The efficiency wage theory is generally regarded as a plausible explanation as to why wages do not fall to clear labor markets in the presence of involuntary unemployment. Blinder [9] claims that “the simplest, and to me the most appealing, of these is the efficiency wage model. It also seems to accord best with common sense.” In popular macroeconomic textbook authors [10] claim that “in labor markets, notions of efficiency wages have a definite ring of truth.”

However, any efficiency wage model based on pure maximization must, of necessity, be a real model. “They have nothing to say about nominal magnitudes, and hence allow no role for nominal money, until they are altered to include fixed costs of changing nominal wages or prices. Nor, in their current state of development, do they have much to say about fluctuations in employment” (Blinder 1988). I believe that the partial rigidity of wages is a very common phenomenon in our modern democratic societies, and surely such a linkage is also suitable in other macroeconomic models.

The description of wage setting sketched here seems more compelling than the assumption of sticky nominal wages that is contained in “Keynesian” macroeconomics textbooks. Keynesian formulations have been successful in identifying reasons why firms might find it costly or undesirable to vary wages continuously. But most of the reasons they have given for wage rigidity are at least equally plausible as justifications for keeping the level of employment constant and not firing workers during recessions. On the other hand, the misperceptions idea stressed here explains why firms choose to adjust wages slowly and fire workers when adverse shocks come. There is also the further point stressed in some of the implicit contracts literature that layoffs help to educate workers who have jobs about adverse changes in market conditions.

Daylight savings time is purely a change in the “units” used in measuring time. Yet it clearly has real effects in the sense that stores open at a different time relative to the sunrise because of its existence. Why? Probably because most individuals care much more about being on the same time standard as their neighbors than they care about what that time standard is.

Therefore, coordinating actions can succeed in achieving a better outcome in the summertime than the market would generate. Much the same may be true of expansionary policy during recessions.

Efficiency wages are employment rents that result from the strategic decisions of employers to increase work intensity under conditions of costly monitoring. Firms generate increased intensity by raising the cost of job loss to workers. This is well known. So, too, is the notion that if intensity of work is undesirable workers must be compensate.

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