Academic journal article Economic Inquiry

Efficiency Wages and Equilibrium Wages

Academic journal article Economic Inquiry

Efficiency Wages and Equilibrium Wages

Article excerpt

I. INTRODUCTION

Economists have long sought to explain unemployment in ways consistent with individual agents' optimizing behavior. A recent, although controversial, model in this vein is the efficiency wage paradigm, which focuses on the difficulty of monitoring worker performance when production is organized in teams. To discourage nonperformance by employees, firms monitor their workers and dismiss those who are caught shirking. A firm may further discourage nonfeasance by paying its workers higher wages than they could earn elsewhere. Then workers caught shirking not only become unemployed, but forfeit the rents associated with their jobs. (1) In this scenario, in order to maintain the incentives not to shirk, firms will not cut wages even though equally qualified, unemployed workers are willing to work for less. The result is disequilibrium in the labor market and possibly involuntary unemployment. (2)

A series of theoretical studies have demonstrated the conditions under which efficiency wages may occur. Standard references include Eaton and White [1982; 1983], Shapiro and Stiglitz [1984], Foster and Wan [1984], Bowles [1985], and Calvo [1985]. Yellen [1984] reviews the early literature while Katz [1986], Stiglitz [1987], and Carmichael [1990] discuss more recent work. But, as Carmichael emphasizes in his review, few papers have actually attempted to test the predictions of the efficiency wage models. Most of the existing empirical investigations examine the importance of industrial wage differentials. Krueger and Summers [1987; 1988], Dickens and Katz [1987], and Murphy and Topel [1987a] find that there are substantial unexplained industrial wage differentials, which Bulow and Summers [1986] and Krueger and Summers [1987; 1988] attribute to efficiency wages. However, the magnitude, as well as the interpretation, of these industrial wage differentials is disputed; see Carmichael [1990], Leonard [1987], and Murphy and Topel [1987a; 1987b] for differing views.

This paper extends the efficiency wage model in a straightforward way to address two questions: Will the labor market clear if firms can only imperfectly monitor worker effort, and do industrial wage differentials provide a test for the importance of efficiency wages? We offer two modifications to traditional efficiency wage models. First, we recognize that there may be an explicit cost to being fired. For instance, dismissed workers may find it more difficult to find future employment because of poor references from their previous employer, they may incur high psychic costs as a result of being fired, or they may have to suffer large search costs in locating another job. Second, we let the firm choose the performance standard. (3) It seems only natural that a firm wanting more effort from its employees would hold its workers to a more rigorous performance standard, just as a firm seeking a higher quality labor force may require more schooling of its applicants. While the firm must compensate the worker for the extra effort necessary to meet the higher performance standard, payment of efficiency wages could be avoided. Following the efficiency wage literature, we make the strong assumption that all implicit or explicit bonding mechanisms are prohibitively costly to implement. Our model of the worker's and firm's behavior is specified in section II.

The model includes as special cases a market paying equilibrium wages, one paying non-market-clearing efficiency wages, and a "dual" labor market that is a combination of the two. We demonstrate that the firm need not pay efficiency wages even in the presence of the agency problem. The use of the performance standard gives the firm another instrument (other than the wage) to control worker effort and welfare. There are limits to how high the performance standard will be adjusted, however, before the firm will offer an efficiency wage. We present the details of these arguments in section III. …

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