E ciency Wages. Lecture notes. Dan Anderberg Royal Holloway College January 2003

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1 E ciency Wages Lecture notes Dan Anderberg Royal Holloway College January Introduction Question: Why is there unemployment? Question: How come wages do not fall? ² Union power? (Next lecture) ² Could it be in the rm s interest not to lower wages? Motivate/Induce e ort Retain workers Recruit workers De nition. E ciency wage: A wage that a ects productivity. Question: Suppose we accept these arguments, can this lead to unemployment? ² Yes! Question: Does the theory have any empirical support? 2 Basic Theory 2.1 E ort/motivation ² Higher pay ) More e ort by workers. Two possible reasons: ² Gift exchange a notion of fairness (Akerlof, 1982) Increase the workers identi cation with the rm and willingness to co-operate I treat you well and you treat me well Especially when there are high pro ts 1

2 ² Shirking (Shapiro and Stiglitz, 1984) E ort cannot be monitored and is costly to the worker Worker is red if detected as shirking A wage above market clearing generates unemployment, and thus a loss to the worker who becomes red. ² Let e ort be e = e (w) : Fig 2.1 Fig The Solow Condition ² Ignore unemployment for now and consider just wage-setting by a rm. ² Solow (1979) wanted to understand wage-stickiness. ² Firm s pro ts are ¼ = pf (ee) we where E is the number of workers employed, p is the product price, and e is e ort per worker. ² The rm chooses (i) how many workers to hire, E, and (ii) the wage w, to maximize ¼. ² The rst order conditions are: pf 0 (ee) e = w pf 0 (ee)e 0 (w) = 1 ² Combining the two yields the Solow condition : w e e0 (w) = 1 Result: Solow condition : The elasticity of e ort with respect to the wage is unity. Question: What is the intuition behind the Solow condition? ² A one percent increase in the wage ) a one percent increase in e ort. ² The e ciency wage minimizes cost per unit of e ort, w=e (w). ² This can easily be seen graphically. Fig 2.2 ² The wrong wage w 1 yields e ort e 1 = e (w 1 ) and cost/unit of e ort w 1 =e 1, indicated by the slope of ray from the origin through (e 1 ;w 1 ). ² But increasing w beyond w 1 reduces the cost/unit of e ort. 2

3 ² The e ciency wage satis es w=e = 1=e 0 (w) minimizing the cost/unit of e ort. Question: Why is this interesting? ² Shows that wage depends only of the wage-e ort relationship e ( ). ² Suppose e.g. that p increases ) larger scope for pro ts Question: Will the rm expand by (i) hiring more workers, or (ii) increase e ort by existing workers? Answer: It will simply hire more workers (leaving w e unchanged). ² Similarly, if p decreases due to contracting demand the rm will simply lay o workers (not reduce the wage). 2.3 Unemployment Equilibria ² Shapiro and Stiglitz (1984) sought to explain unemployment (Shirking model). ² Some simplifying assumptions: Fixed supply L of identical workers E ort e is either e = 0 or some xed e > 0. Shirkers (e = 0) are detected with probability q (per unit of time) Workers are risk neutral: utility u = w e Unemployment bene t b Question: When will a worker put in e ort? ² A shirker alternates between employment and unemployment ² Suppose the fraction of time that a shirker is employed is µ: Utility to a non-shirker = u N = w e Utility to shirker = u S = µw + (1 µ)b ² The worker will not shirk if u N > u S ; i.e. if the following no-shirking condition holds: w e > µw + (1 µ)b, w > b + ² The wage must be higher than unemployment bene ts b. ² Moreover, the di erence w b must be larger the larger is µ. e (1 µ) 3

4 Question: Can we relate µ to unemployment? ² Let a be the probability (per unit of time) of nding a new job. ² Then we have that for shirkers Expected duration of a job = 1 q Thus Expected duration of an unemployment spell = 1 a µ = 1=q 1=q + 1=a or 1= (1 µ) = 1 a=q. Replacing in the no-shirking condition we have w > b + e µ 1 a q w e Insight at this stage : E ciency wage w e is high when 1. Unemployment bene ts are high 2. The probability of nding a new job, a, is high 3. The probability of detecting a shirker, q, is low. ² Suppose there are some exogenous turnover rate ² Number of unemployed workers L E ² Number of vacancies (per unit of time) E ² This gives that a = No. Vacancies No. Unemployed = E L E ² Using this to replace a we can write the no-shirking condition as ² This constraint is shown in Fig 2.3 w > w e = b + e e q E (L E) Fig 2.3 ² Note: the e ciency wage increases as employment E increases. ² In the limit as E! L (no unemployment) w e! 1: no wage can prevent shirking since there is no unemployment! 4

5 ² Add to this a standard labour demand curve. Fig 2.4. Fig 2.4 ² Equilibrium wage w, equilibrium employment E, equilibrium unemployment L E. Result: Any equilibrium has some unemployment E < L! Question: What are the properties of this equilibrium? 1. Unemployment is involuntary. 2. Unemployment bene ts increase unemployment (Fig 2.5) 3. Wages are sticky over the business cycle (Fig 2.6) 3 Evidence on E ciency Wages ² Two types of evidence: Direct and Indirect 3.1 Direct Evidence Empirical Strategy: Link wages to various productivity-aspects. ² Higher wages have been found to lead to: Lower quit rates Less absenteeism Fewer dismissals due to disciplinary reasons ² E ciency wages relate to problems of monitoring workers Krueger (1991) looking a fast-food restaurants found that Company-owned restaurants paid about 9 percent more than franchised restaurants. The owner of the local franchise can supervise his/her employees 3.2 Indirect Evidence Empirical Strategy: Find features of wage-structure that cannot be explained any other way. 5

6 Interindustry Wage Di erentials (Krueger and Summers, 1988) Empirical nding: Huge interindustry wage di erentials (Tab 2.1) ² Two people with the same characteristics (age, gender, education, experience etc.) can receive hugely di erent pay if they work in di erent industries. ² Similar across countries (Fig 2.7) Fig 2.7 Question: Is this compatible with standard supply-demand model? ² Yes if either 1. Pay di erentials are due either to di erences in job-characteristics (Compensating wage differentials) 2. Workers sort in to industries on the basis of their abilities ² Arguments against (1) are: There are fewer quits and longer queues of applicants for high-paying jobs. Even comparing industries with similar characteristics, di erences remain. ² Argument against (2): Tracking workers who switch industry shows that their wages change by about half of interindustry wage di erential. The Wage Curve Empirical nding: Downward-sloping curve that summarizes the relation between wage levels and unemployment. ² Within each country the wage tends to be high (alt. low) in regions where unemployment is low (alt. high). Fig 2.8. Fig 2.8 ² Known as the wage-curve (Blanch ower and Oswald, 1995). Question: Why is this inconsistence with the standard supply-demand model? ² In the standard model, high wages are associated with unemployment Question: How is it consistent with e ciency wage theory? ² A rm located in a region with high unemployment does not need to pay high e ciency wages since unemployment reduces shirking and quitting. 6

7 References Akerlof, G. (1982), Labor contracts as partial gift exchange, Quarterly Journal of Economics 87, Akerlof, G. & Yellen, J. (1986), E ciency Wage Models of the Labor Market, Cambridge University Press, Cambridge. Blanch ower, D. G. & Oswald, A. J. (1994), The Wage Curve, MIT Press, Cambridge MA. Bosworth, D., Dawkins, P. & Stromback, T. (1996), The Economics of the Labour Market, Addison Wesley Longman. Card, D. (1994), The wage curve: A review, Journal of Economic Literature 33, Krueger, A. (1991), Ownership, agency, and wages: An examination of franchising in the fast-food industry, Quarterly Journal of Economics 106, Krueger, A. & Summers, L. (1988), E ciency wages and the inter-industry wage structure, Econometrica 56, Layard, R., Nickell, S. & Jackman, R. (1991), Unemployment: Macroeconomic Performance and the Labour Market, Oxford University Press, Oxford. Ra, M. G. & Summers, L. (1987), Did Henry Ford pay e ciency wages?, Journal of Labor Economics 5, S57 S86. Shapiro, C. & Stiglitz, J. (1984), Equilibrium unemployment as a worker discipline device, American Economic Review 74, Solow, R. M. (1979), Another possible source of wage stickiness, Journal of Macroeconomics 1,