Efficiency Wages: A Critical Assessment

By Westley, Christopher; Schmidt, Bill H. | The Journal of Social, Political, and Economic Studies, Summer 2006 | Go to article overview

Efficiency Wages: A Critical Assessment


Westley, Christopher, Schmidt, Bill H., The Journal of Social, Political, and Economic Studies


Efficiency wage models of the labor market have become one of the key elements of the New- and Post-Keynesian schools of thought. In this paper, we argue that the concept of efficiency wages is not traditional to Keynesian economics, and that these schools developed the theory's modern relevance only after orthodox Keynesian theory had lost credibility in the 1970s and 1980s. The theory persists as a justification for an economy riddled with inherent real market imperfections, thus legitimizing continued interventionist macro policy.

Key Words: Efficiency wages; New Keynesian economics; New Classical economics.

1. Introduction

One of the conclusions of the New Classical theory of employment relies on the assumption that real wages adjust automatically to disequilibria in the labor market, based on the (unrealistic) assumption that there are zero transaction and learning costs (Lucas 1975, Lucas 1977, Kydland and Prescott 1982). When the quantity of labor supplied is too low, firms raise the real wage in order to attract workers to supply their labor. Likewise, when the quantity supplied is too high, firms lower real wages in order to reduce the level of employment once again. These adjustments are eventual, according to Classical and Neoclassical theory, and instantaneous, according to New Classical theory.

However, it is a central tenet of Keynesian theory that real wages tend to be rigid, regardless of the level of disequilibrium in which the labor market may find itself. Indeed, Keynes wrote in The General theory of Employment, Interest, and Money, that "ordinary experience tells us, beyond doubt, that a situation where labor stipulates (within limits) for a money-wage rather than a real wage, so far from being a mere possibility, is the normal case. Whilst workers will usually resist a reduction of money-wages, it is not their practice to withdraw their labor whenever there is a rise in the price of wage-goods." (Keynes, 1936, p. 9.)2 Keynes' belief that nominal wages do not adjust downward seemed to be vindicated through the post-World War II economy which saw real and nominal wages increase steadily until the early 1970s.

For the derivative Keynesian schools (and others that believe in extra-market-based macroeconomic policy), sticky wages are the primary cause of what Keynes called "involuntary unemployment." (Keynes, 1936, p. 6.)3 The New Classical answer to the problem of unemployment - allow the real wage to fall to levels that reflect rational expectations in the economy - can be rebutted if wages are shown to be sticky, just as Keynes wrote in 1936. It is not surprising, therefore, that the popularity of Keynesianism among mainstream economists waned in the 1970s, at around the same time the real wage began its present decline. If the real wage has declined for the last three decades,4 corresponding with a fall in the natural rate of unemployment - then it is reasonable to wonder how much the labor market has exhibited a tendency toward a market-clearing level, if indeed it has not approached such a level already.

The decline in the real wage has an obvious neoclassical explanation. If we accept that wages are a function of worker productivity, then it would only be logical that the real wage increased for the three decades following World War II, when the United States enjoyed a comparative advantage in productive capacity relative to its trading partners. Furthermore, once the rest of the world's productivity recovered relative to that of the United States, neoclassical theory would predict a decline in real wages in the U.S.

Our thesis is that the various Keynesian schools of thought that have developed since the early 1970s, and the New Keynesians in particular, dusted off an existing theory of efficiency wages in order to defend the existence of involuntary unemployment, regardless of how low the real wage may fall, at a time when the mainstream was beginning to doubt the very existence of this type of unemployment at all. …

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