Macro chapter 11 efficiency wages summary
this chapter is concerned with the causes and consequences of a minimal departure
from the competitive labour market model. We keep all the traditional characteris-
tics that are usually seen as underlying competitive market behaviour such as a
multiplicity of buyers and sellers, a homogeneous product. etc. We then just add the
feature that the productivity of labour may depend positively on the wage. We
demonstrate that there are good justifications for this idea. and that the macroeconomic
consequences. mainly with respect to structural unemployment, are important.
We start out in Section 1 by giving a simple example of elllciency wages. In Section 2
we then consider the consequences of efficiency wages in a partial equilibrium frmnework,
focusing on the optimal wage setting in the individual firm . Section 3 tal<es one step
back to discuss the reasons for efllciency wages in more detail. that is, the reasons why
paying higher wages may be a way for an employer to increase the productivity of his
employees. This section also considers some empirical evidence in support of elllciency
wage theory. Section 4 analyses elllciency wages in a macroeconomic setting, developing
a general equilibrium model determining the equilibrium real wage and the structural
rate of unemployment. On this basis we discuss some possible structural policies to fight
involuntary unemployment.
1. Under the standard assumption that labour productivity does not depend on the wage rate, a
profit-maximizing firm that can choose the wage it pays would never set the wage higher than
strictly required for recruiting the workers it wants. Otherwise the wage could be lowered
without reducing the labour supply to the firm, which would lower costs and raise profits. The
firm would thus always position itself on the labour supply curve, creating full employment
through its optimizing behaviour.
2. If labour productivity depends positively on pay, the above argument breaks down. Raising
the wage above the level required to recruit the desired workforce has two counteracting effects on profits: the cost of labour increases, but at the same time productivity also
increases. It may be that the second impact on profits is the strongest. The phenomenon
that labour productivity (or effort) depends positively on the wage is referred to as efficiency
wages. With a positive link from wages to productivity, it is a logical possibility that an
individual firm will want to raise wages above the market-clearing level.
3. When labour productivity depends on real wages, each firm will set its real wage in accordance
with the Solow condition saying that the elasticity of productivity with respect to the real wage
should be equal to 1, and set employment at the optimal level given this wage rate. In a partial
equilibrium model of the labour market, this behaviour could well imply a total level of employment
smaller than the total labour supply induced by the efficiency wages set by firms. Under efficiency
wages, unemployment in a full equilibrium with adjusted real wages is therefore a possibility, but
in a partial labour market model unemployment is not a necessary feature of equilibrium.
4. In the partallabour market model analysed in the chapter, the equilibrium real wage rate is
insensitive to supply and demand shocks to the revenue functions of firms, so employment
bears the full burden of adjusting to such shocks. Efficiency wage models can therefore help to
explain the fact that real wages fluctuate much less than employment over the business cycle.
5. There are at least four reasons why productivity should depend positively on pay. For the
individual firm, setting a relatively high wage can be a way of (i) keeping good workers in the
firm, thereby reducing recruiting and training costs, (ii) getting applications from relatively
good workers in hiring situations, (iii) motivating workers to comply with a high level of
required effort, because a larger difference between the wage paid and what can be earned
outside the firm increases the cost to a worker of being fired for 'shirking', and (iv) motivating
workers to exert a high level of effort for pure reasons of reciprocity.
6. Under plausible assumptions on the effort cost function, the 'shirking' model of efficiency
wages implies that the efficiency function linking effort to pay should be an increasing,
concave function of the excess of the real wage over the outside option, defined as the normal
income a worker can expect to earn outside the firm where currently employed. The other
motivating factors for the efficiency wage phenomenon point to similar curves.
7. The efficiency wage effect may be built into a general equilibrium macroeconomic model where
the revenues of firms derives from consumer demand, and where the individual worker's
outside option is a mixture of the general wage level and the unemployment benefit received in
case of unemployment. In such a model unemployment is a necessary property of a macroeconomic
equilibrium with fully adjusted real wages: if there were no unemployment, the
outside option from the point of view of each firm would be the general wage level. To induce
any effort at all, each firm would then have to set its own wage above the general wage level,
but not all firms' wages can be above the average level. The upward pressure on wages would
make labour so expensive that firms would not want to buy all the labour supplied.
Unemployment would arise, and with positive unemployment it is possible for each firm to set
a wage above the common outside option, since unemployment benefits are lower than
wages.
8. The general equilibrium model with efficiency wages implies that more generous unemployment
benefits will increase the natural rate of unemployment, whereas intensified competition
in product markets will lower it. These features have implications for labour market and
competition policies.
from the competitive labour market model. We keep all the traditional characteris-
tics that are usually seen as underlying competitive market behaviour such as a
multiplicity of buyers and sellers, a homogeneous product. etc. We then just add the
feature that the productivity of labour may depend positively on the wage. We
demonstrate that there are good justifications for this idea. and that the macroeconomic
consequences. mainly with respect to structural unemployment, are important.
We start out in Section 1 by giving a simple example of elllciency wages. In Section 2
we then consider the consequences of efficiency wages in a partial equilibrium frmnework,
focusing on the optimal wage setting in the individual firm . Section 3 tal<es one step
back to discuss the reasons for efllciency wages in more detail. that is, the reasons why
paying higher wages may be a way for an employer to increase the productivity of his
employees. This section also considers some empirical evidence in support of elllciency
wage theory. Section 4 analyses elllciency wages in a macroeconomic setting, developing
a general equilibrium model determining the equilibrium real wage and the structural
rate of unemployment. On this basis we discuss some possible structural policies to fight
involuntary unemployment.
1. Under the standard assumption that labour productivity does not depend on the wage rate, a
profit-maximizing firm that can choose the wage it pays would never set the wage higher than
strictly required for recruiting the workers it wants. Otherwise the wage could be lowered
without reducing the labour supply to the firm, which would lower costs and raise profits. The
firm would thus always position itself on the labour supply curve, creating full employment
through its optimizing behaviour.
2. If labour productivity depends positively on pay, the above argument breaks down. Raising
the wage above the level required to recruit the desired workforce has two counteracting effects on profits: the cost of labour increases, but at the same time productivity also
increases. It may be that the second impact on profits is the strongest. The phenomenon
that labour productivity (or effort) depends positively on the wage is referred to as efficiency
wages. With a positive link from wages to productivity, it is a logical possibility that an
individual firm will want to raise wages above the market-clearing level.
3. When labour productivity depends on real wages, each firm will set its real wage in accordance
with the Solow condition saying that the elasticity of productivity with respect to the real wage
should be equal to 1, and set employment at the optimal level given this wage rate. In a partial
equilibrium model of the labour market, this behaviour could well imply a total level of employment
smaller than the total labour supply induced by the efficiency wages set by firms. Under efficiency
wages, unemployment in a full equilibrium with adjusted real wages is therefore a possibility, but
in a partial labour market model unemployment is not a necessary feature of equilibrium.
4. In the partallabour market model analysed in the chapter, the equilibrium real wage rate is
insensitive to supply and demand shocks to the revenue functions of firms, so employment
bears the full burden of adjusting to such shocks. Efficiency wage models can therefore help to
explain the fact that real wages fluctuate much less than employment over the business cycle.
5. There are at least four reasons why productivity should depend positively on pay. For the
individual firm, setting a relatively high wage can be a way of (i) keeping good workers in the
firm, thereby reducing recruiting and training costs, (ii) getting applications from relatively
good workers in hiring situations, (iii) motivating workers to comply with a high level of
required effort, because a larger difference between the wage paid and what can be earned
outside the firm increases the cost to a worker of being fired for 'shirking', and (iv) motivating
workers to exert a high level of effort for pure reasons of reciprocity.
6. Under plausible assumptions on the effort cost function, the 'shirking' model of efficiency
wages implies that the efficiency function linking effort to pay should be an increasing,
concave function of the excess of the real wage over the outside option, defined as the normal
income a worker can expect to earn outside the firm where currently employed. The other
motivating factors for the efficiency wage phenomenon point to similar curves.
7. The efficiency wage effect may be built into a general equilibrium macroeconomic model where
the revenues of firms derives from consumer demand, and where the individual worker's
outside option is a mixture of the general wage level and the unemployment benefit received in
case of unemployment. In such a model unemployment is a necessary property of a macroeconomic
equilibrium with fully adjusted real wages: if there were no unemployment, the
outside option from the point of view of each firm would be the general wage level. To induce
any effort at all, each firm would then have to set its own wage above the general wage level,
but not all firms' wages can be above the average level. The upward pressure on wages would
make labour so expensive that firms would not want to buy all the labour supplied.
Unemployment would arise, and with positive unemployment it is possible for each firm to set
a wage above the common outside option, since unemployment benefits are lower than
wages.
8. The general equilibrium model with efficiency wages implies that more generous unemployment
benefits will increase the natural rate of unemployment, whereas intensified competition
in product markets will lower it. These features have implications for labour market and
competition policies.
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