Academic journal article Economic Inquiry

Efficiency Wage Models of Unemployment - One View

Academic journal article Economic Inquiry

Efficiency Wage Models of Unemployment - One View

Article excerpt


Persistent wage rigidity and involuntary unemployment appear to be recurrent problems in most economies. What could be preventing the wage adjustment necessary to clear the labor market? Many recent papers claim to have found the answer in efficiency wage models. This paper surveys this literature and attempts to evaluate its accomplishments. It concludes that the efficiency wage models fail to explain wage rigidity or persistent involuntary unemployment.

Persistent involuntary unemployment of workers is a recurrent problem in labor markets all over the world. Unemployed workers seem unable to find work even though they are willing to accept lower wages than those being paid employed workers with similar skills. What could be preventing wages from adjusting to clear these markets? Many recent papers, known collectively as the efficiency wage literature, now claim to have the answer. This paper will survey the efficiency wage literature and critically evaluate some of its accomplishments.

Efficiency wage models have already been examined by Yellen [1984], Katz [1986] and Stiglitz [1987], and have received generally favorable reviews. This paper is more critical. Its overall conclusion is that efficiency wage models provide some useful insights into the workings of the labor market, but they do not provide a satisfactory account of wage rigidity or involuntary unemployment.

There are at least five separate versions of "the" efficiency wage model. They share a common structure, however, and this is outlined in the first section of the paper. This section also attempts to relate efficiency wage models to other recent models of unemployment. Section II examines and criticizes the different approaches in detail. Section III evaluates the achievements of this approach and suggests some directions for future work.


Efficiency wage models, as the name suggests, are first of all models of wages. They generate unemployment by showing that firms will sometimes want to set wages at non-market clearing levels. It is useful to begin, therefore, by reviewing how wages and employment are determined in some related models. In a perfectly competitive labor market the wage for each type of labor is adjusted constantly to maintain equality of supply and demand. Overall employment fluctuates in response to demand changes as workers move up and down their labor supply curves. Unemployment is voluntary in that anyone who is not working prefers that state to employment at the going wage for people of his skills. As well, the value of a worker's marginal product is equal to the marginal value of his leisure, so there are no unexploited wage bargains between unemployed workers and firms. This model is successful in predicting the long-term response of wages to shifts in demand and supply, but it is clear that in the short run its depiction of voluntary unemployment and flexible wages is unrealistic.

A natural way to generate more realism is to assume that wages are inflexible in the short run. In this case a reduction in demand away from a long-run equilibrium will lead to rationing of jobs by employers as they attempt to stay on their labor demand curves. The unemployment here is involuntary, in that the unemployed would prefer to be working at the going wage, and is inefficient in that there are lost gains from trade between these workers and firms. The weakness of this model is that it is silent about the mechanism that keeps wages rigid. Unemployed workers who offer to work for less than the fixed wage ought to find work.

The early implicit contract models of Azariadis [1975], Baily [1974], and Gordon [1974] provide one explanation for wage rigidity. These models introduced the idea that wages can do more than just clear the market for labor. Wages in an implicit contract model are used to shift the risk generated by uncertain output market conditions from risk averse workers to the risk neutral firm. …

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