Efficiency wages

Introduction
In a competitive market equilibrium occurs
where the quantity demanded of labour is
equal to the quantity supplied of labour.
Introduction, cont.
In a competitive labour market the wage has an
equilibrating function: it equilibrates the
quantity demanded and the quality supplied of
labour. Said differently, the wage will reach a
level that clears the labour market.
When labour markets clear, i.e. when ns = nd,
we say that there is no involuntary
unemployment: everybody who wants to work
for wage w* can get a job!
In the real world we observe nearly always
involuntary unemployment, i.e. we observe the
following:
Involuntary unemployment
Nearly always, the labour market
does not clear at w*, but we observe
a wage w, where firms want to hire
n
d
(w) workers and n
s
(w) workers
would like to have a job at this high
wage w. The difference n
s
(w)n
d
(w)
is then involuntary unemployment.
Introduction, cont.
The question now becomes, how can a high wage like w
persist? For society as a whole there would be clear
gains if we moved the employment level from nd(w) to
n*.
Think of the labour demand curve as a Marginal Benefit
curve for society (recall that the labour demand curve is
the value that the marginal worker produces if
employed). The labour supply curve in turn reflects the
opportunity cost (of leisure) for the marginal worker who
decides to offer his/her labour to the market. So, the
labour supply curve is a marginal cost curve to society
brought about by increasing employment by one worker.
At n
d
(w) marginal benefit > marginal cost of increasing
employment. We add more to benefits than to costs
when increasing employment. And we do this up to the
employment level n* (beyond n* marginal cost >
marginal benefit).
Introduction, cont.
Why do we get an equilibrium wage, w, that is
not market clearing?
We shall look at two scenarios where we can get
a non-market clearing equilibrium wage:
There are no trade unions that matter.
Trade unions are powerful and do matter when it
comes to wage and employment determination.
The efficiency wage literature tries to explain a
wage w that will persist even in the absence of
strong trade unions. In other words, this
literature tries to understand why it is in the
interest of firms to pay a wage w that is above
the competitive wage, w*.
Solow model of efficiency wages
Assume we are in the short-run, i.e. capital is fixed at,
lets say, one unit per firm, i.e. K=1.
The main point of Solow has to do with the production
function, output is not just a function of the number of
workers used as in the simple competitive model (q =
f(n)), but output is a function of the number of
effective/efficient workers used. So, what matters is
not how many workers are used, but how hard these
workers work, or how productive these workers are.
Let e = e(w), where e = effort, which is a function of the
wage. We assume above threshold wL, e(w)>0 and
e(w)<0, i.e. a rise in the wage increases effort, but at a
decreasing rate.
We can graph the relationship between wage and effort
as follows:
Solow model of efficiency wages,
cont.
Here, we assume a lower bound of wages, wL, below which no effort is
forthcoming.
Solow model of efficiency wages,
cont.
For a firm, the relevant production function now
becomes:
q = f(e(w)n), where f()>0, f()<0

Which wage level should the firm choose that maximises
profits, given that effort enters the production function?

Assume K=1 and the price of output, p=1.
The profit function then becomes:
= q w n or
= f(e(w)n) w n
The firms decision problem is now as follows:
Choose the wage that maximises profits; once the wage
is chosen choose the employment level that maximises
profits.
Solow model of efficiency wages,
cont.
We take the derivative of the profit function w/r to w
and n and set these partial derivatives equal to zero.

(1) = 0 or = f(e(w)n) e(w)n n = 0

(2) = 0 or = f(e(w)n) e(w) w = 0

(1) f(e(w)n) e(w) = 1
(2) f(e(w)n) e(w) = w
Then divide (2) by (1):

or = (3)

Let e(w) = .
w c
t c
w c
t c
n c
t c
n c
t c
1 ) ( ' ) ) ( ( '
) ( ) ) ( ( ' w
w e n w e f
w e n w e f
=
1 ) ( '
) ( w
w e
w e
=
dw
de
Solow model of efficiency wages,
cont.
(3) can be written as:

(3) Solow condition

(3) is the famous Solow condition; it is an elasticity and
says:
Assuming that effort enters the production function, the firm
will maximise profits by choosing that wage, where the
elasticity of effort with respect to the wage equals 1.
There are two other simple ways by which we can derive
the Solow condition:
by minimising the wage per unit of effort
By using a graph of effort function.

1 =
e
w
dw
de
Solow model of efficiency wages, cont.
w
) w ( e
Where ray 1 hits the effort curve (point B) we can read off the average effort per
wage . A firm maximises profits if it maximises this average effort per

wage. A and C are not optimal, as in A we can increase effort per wage by
increasing wages and in C we can increase it by decreasing wages.
is maximized in B, where that can be rearranged to

get the Solow condition.
w
) w ( e
.
dw
de
w
w e
=
) (
w
) w ( e
Solow model of efficiency wages,
cont.
The Solow condition gives the profit-
maximising wage to the firm, lets call it, .
Then plugging into equation (2):

and solving for n, the firm finds the level of
employment that will maximise profits,
Assume that we have M identical firms,
the quantity demanded of labour will then
be:
w
~
w w e n w e f
~
)
~
( ) )
~
( ( ' =
). w
~
( n
( ) w n w n M
d
~
)
~
( =
Solow model of efficiency wages,
cont.
Solow model of efficiency wages,
cont.
Note two points about this model:
1. The wage no longer has an equilibrating function
like in the competitive model, i.e. the function of the
wage in the Solow model is to generate maximum
effort per wage unit and not to equilibrate quantity
demanded and quantity supplied of labour. In some
sense the wage can be treated like a constant
here, i.e. no matter what happens to the n
d
and n
s

curves, the profit maximising wage will remain !
2. There is no reason to believe that will ever coincide
with the competitive wage w*, but as long as > w*
we have
U = n
s
( ) n
d
( ) > 0 we always get involuntary
unemployment.
w
~
w
~
w
~
w
~
w
~
Solow model of efficiency wages, cont.
There is a third important point that one can make about the
Solow model. This has to do with the volatility of employment
and wages over the business-cycle. In the real world we observe
the following pictures, where we have taken out the trend
component:
The two pictures say that
employment is actually
more volatile over the
business cycle than wages.
In a world of strong wage
rigidity this makes sense.

In the Solow model we
actually have perfect wage
rigidity, i.e. over the
business cycle the wage
remains the same!
Solow model of efficiency wages, cont.
To see this last point let us introduce a stochastic element into the
labour demand n
d
, i.e. lets have s n
d
as labour demand.
Here s is a random variable that can represent technology, tastes or
price shocks.
s negative shock
s positive shock
The upshot of this analysis is
that shocks are absorbed in
their entirety by employment.

This prediction of the Solow
model is somewhat extreme,
and later models have tried to
generate a less extreme
prediction, i.e. have tried to
generate some wage flexibility
(see the shirking model by
Shapiro and Stiglitz discussed
below).
Microfoundations of efficiency
wage theory
The Solow model stipulates a connection between the
wage and the effort, but gives no reasons why this
connection should exist. Models embellishing the simple
Solow model have tried to give reasons or
microfoundations for this nexus between wages and
effort.
There are four types of efficiency wage models that give
some microfoundations.
1. Labour turnover models
2. Shirking models
3. Adverse selection models
4. Sociological models
Labour turnover models
It seems reasonable to assume that a too high turnover
of the workforce will affect profits in a negative way.
By paying a wage that is higher than the competitive
wage the firm keeps labour turnover at a level that
maximises profits in the medium and long run.
For example, if newly assumed workers have to be
trained or if there are other costs with labour turnover, it
is important to keep workers for longer periods.
The most famous historic example of efficiency wages
paid to workers is Henry Fords attempt to improve
profits by cutting labour turnover drastically. Indeed
labour turnover was dramatically reduced in his Detroit
factory when he raised the daily wage from $ 2.5 to $ 5.
Consequently profits rose in a healthy fashion. (cf.
article by Raff and Summers, Did Henry Ford pay
efficiency wages?)
Shirking models
Assume it is hard to monitor workers effort on the job,
i.e. there is asymmetry of information (workers know
how much they work, management does not know that).
To make workers work and not shirk, firms pay wages
that are above the competitive wage. Why? When
wages are above the competitive level, we have
involuntary unemployment. So when a worker shirks, is
caught and then fired, there is a cost of having shirked,
i.e. unemployment.
If unemployment were zero, workers would pay no
penalty when caught shirking and fired, since they
would immediately find a new job.
The shirking model by Shapiro and Stiglitz will be
discussed in more detail below.
Adverse selection models
Again, assume asymmetry of information, this time
workers know their level of productivity while
managers do not know workers productivity.
This asymmetry of information is particularly relevant
when it comes to hiring new workers as managers
might eventually learn the productivity levels of
workers who have been on the job for some time.
One idea that we already stressed is the idea that
workers who are unemployed might approach the firm
and suggest that they will work for less than the going
wage rate. In the presence of perfect information,
society would gain if firms hired these unemployed
workers. This is because at any wage greater than the
competitive wage the marginal benefit is greater than
the marginal cost of increasing employment by one
more worker (cf. discussion on page 2 of these notes).
Adverse selection models, cont.
So why do firms not accept the underbidding offers of
unemployed workers? Because they are afraid of adverse
selection! This adverse selection can arise in two ways.
1. First, with managers ignorant about workers productivity
levels, managers believe that workers offering to work for
a lower wage reveal their true, i.e. lower productivity.
2. Secondly, if firms hire workers who underbid the going
wage, the going wage rate will fall, i.e. all workers will be
paid a lower wage. But this lower wage will make it
difficult to hire high productivity workers. So, the workers
the firm hires are all low productivity workers who in turn
will depress the firms profits.
Sociological models
Ex. Akerlofs gift exchange model
Firms pay a higher (than competitive) wage
gift to workers who put additional (higher
than average) effort in their work.
Shirking model by Shapiro and
Stiglitz
We have an economy with many firms, each
employing many workers. Firms can only
imperfectly monitor workers! Workers decide
whether to shirk or not.
Some workers are caught shirking and fired,
other workers leave firms for other reasons; firms
hire workers from the pool of unemployed. Note
that workers are homogenous, which also means
here that firms do not know who among the
unemployed had been shirking.
Cost of a worker being fired for shirking: going
through unemployment until hired by another
firm.
Shirking model by Shapiro and
Stiglitz, cont.
What is the optimal wage and employment policy of each
firm and how can we characterise general equilibrium?
The optimal wage policy of each firm should ensure that workers
are not shirking; there is an additional feedback in this model:
unemployment.
When unemployment is low, the firm has to pay a
relatively high wage to ensure that workers do not shirk.
Why?
Because with unemployment low, the cost of being fired is low, as
a fired worker will find new employment relatively soon.
When unemployment is high, the firm only needs to pay a
relatively low wage to ensure that workers do not shirk.
Why?
Because with high unemployment the cost of being fired for
shirking is high as it takes a long time to find new employment.
Shirking model by Shapiro and
Stiglitz, cont.
L
L
= fixed labour force, and
- N = unemployment.

At N
1
employment is low and
unemployment = - N
1
is
high wage that ensures no
shirking is relatively low at
w
1
.
L
L

- N
2
is low
At N
2
employment is high and unemployment = - N
2
is low wage that
ensures no shirking is relatively high at w
2
. We can find a unique wage
ensuring no shirking at any level of employment. The locus of all these wages
gives the non-shirking condition boundary (NSCB). Points above and on
NSCB are making up the non-shirking region.
L
Shirking model by Shapiro and
Stiglitz, cont.
Note two points about the non-shirking wage:
1. No matter what the level of employment
(unemployment) the non-shirking wage is always
above the competitive wage, w*.
2. I have drawn the NCSB curve in such a way that it
never reaches , i.e. in this model there must be
some unemployment, or said differently, at zero
unemployment the wage would have to be infinite to
ensure no shirking.
The general equilibrium in this model is given by
the intersection of the NSCB curve and the labour
demand curve at (WE, NE).
L
Shirking model by Shapiro and
Stiglitz, cont.
Let us now look at the model more formally
There are identical workers in the economy, the
workers are risk-neutral, i.e. the utility function can be
taken as linear:
U (w,e) = w e,
where w is wage, and e is effort.
There are two levels of effort,
e = 0 worker is shirking
e > 0 worker is not shirking

If worker is employed and shirks U(w, e) = w
If worker is employed and does not shirk U(w, e) = w e
If worker is unemployed U = 0
Worker maximises expected present value of utility over
earning life, V.
L
Shirking model by Shapiro and
Stiglitz, cont.
So we have: V
ES
= expected present value of utility of
employed worker who shirks.
V
EN
= expected present value of utility of employed worker
who does not shirk.
V
U
= expected present value of utility of unemployed
worker. Workers have a subjective discount rate = r.
There are M identical firms, the i-th firm has a production
function of the form sF(N
i
), where N
i
= number of workers
who do not shirk, s is a shock to technology, tastes or
prices.
The firm can only imperfectly monitor workers, monitoring
technology is not made explicit.
There is, however a probability of being caught = q
Shirking model by Shapiro and
Stiglitz, cont.
Also b = separation rate for reasons other than shirking
or

This separation rate is the same for all firms.
a = accession rate out of unemployment
or

This accession rate is the same for all firms.

To find a dynamic general equilibrium is very difficult when s is
a random variable. So what Shapiro and Stiglitz do is to
find a characterisation of general equilibrium in the steady
state when s takes on a given value.
workers employed of number
shirking) than reasons (other s separation of number
b =
unemployed of number
nt unemployme of out hires of number
= a
Shirking model by Shapiro and Stiglitz, cont.
Steady state here means that unemployment is the same for all
periods, i.e.
U = 0 for all t.
Given this set-up, we have then the problem of firm i: Set the
wage at the level which induces a worker not to shirk. This
problem is embedded in the decision problem of a worker in
firm i not to shirk.
For a worker not to shirk,
,
i.e. firm must pay a wage such that the expected present value of
utility of non-shirking must be greater or equal to the expected
present value of shirking. Of course, the firm will pay just that
wage that induces workers not to shirk and will not pay more
than this wage.
is the condition that guarantees that workers in firm i
will not shirk.
Lets look closer at these two Vs.

i i
ES EN
V V >
i i
ES EN
V V =
r
V q b V q b
w V
i
i
ES U
i ES
+
+ + +
+ =
1
)] ( 1 [ ) (
Shirking model by Shapiro and Stiglitz, cont.
The expected present value of utility of an employed shirker has 2
components:
In the first period, s/he will get wage w
i
; from the second period
onwards until the end of his working life, s/he will become
unemployed with probability (b+q) or will stay an employed shirker
with probability 1 (b+q). As this happens in the second period, we
need to discount this by 1 +r.

The expected present value
of utility of an employed non-shirker has 2 components:
In the first period, s/he feels the wage w minus the effort as utility,
from the second period onwards s/he will become unemployed with
probability b or will stay an employed non-shirker with probability
(1 b). Again the second term needs to be discounted by 1 + r.
{Note that a shirker flows into unemployment with prob. (b + q) while
a non-shirker with prob. b only}
r
V b bV
e w V
i
i
EN U
i EN
+
+
+ =
1
) 1 (
Shirking model by Shapiro and Stiglitz, cont.

(5)
In general equilibrium all firms pay the same wage that
induces workers not to shirk, so w
i
= w
After some algebra, and taking into account that
eq. (5) gives a wage equation in terms of the
parameter of the model:
(6)

Eq. 6 gives me the wage firms have to pay to ensure
that there is no shirking, the wage is given in terms of
parameters. To get the NSCB, we need to express eq.
(6) in terms of employment/unemployment.
i i
ES EN
V V =
r
V q b V q b
w
r
V b bV
e w
i i
ES U
i
EN U
i
+
+ + +
+ =
+
+
+
1
)] ( 1 [ ) (
1
) 1 (
q
r b a e
e w
) ( + +
+ =
r 1
aV
V
E
U
+
=
Shirking model by Shapiro and Stiglitz,
cont.
This is where we can use the steady state condition. In
the steady state, inflows into unemployment = outflows
from unemployment, i.e.
bN = aU or
bN = a( N) a = {note in equilibrium there is
no shirking!}, plugging this into (6):

w = e + or

Or (7)
L
N L
bN

q
r b
N L
bN
e
e w
)
`

+ +

+ =
q
N L
bN
e
q
r b e
e w
ercept
|
.
|

\
|
+
+ =

int
) (
Shirking model by Shapiro and Stiglitz,
cont.
According to eq. (7), the wage is an increasing function
of employment, also when = N, i.e. when
unemployment is zero, the wage becomes infinite in this
model.
L
Shirking model by Shapiro and Stiglitz,
cont.
Shifts of the NSCB curve:
Look at the intercept,

When e | NSCB shifts up, i.e. at each level of
employment firms have to pay a higher wage than before
to ensure that workers do not shirk. Intuitively this makes
sense: since the disutility of work has increased, this
increase in disutility has to be compensated by firms.
When b | NSCB shifts up. In the steady state, more
separations imply also more hires from the pool of
unemployed. So, unemployment durations will be shorter
costs of being fired has become lower, so firms need
to pay a higher wage to make sure that nobody shirks.
q
r b e
e
) ( +
+
Shirking model by Shapiro and Stiglitz,
cont.
When r | NSCB shifts up. A rise in r means that a
worker discounts his/her future utility more than before.
However, the consequences of shirking and possibly
being fired are all in the future. As expected future utility
is discounted now more, i.e. the worker cares now less
about what happens to him in future, the firm has to raise
the wage to ensure no shirking.
When q | NSCB shifts down. When it becomes easier
for firms to detect shirkers, it becomes more likely for
shirkers to be pushed into unemployment where a
worker experiences lower utility! So, at each level of
employment/unemployment the firm can lower the wage
and workers still will not shirk.
Shirking model by Shapiro and Stiglitz,
cont.
In the graph on slide 36 ess represents the
competitive supply of labour, where e is the
reservation wage of the -th worker and where
monitoring is perfect.
Each firm will choose employment such that s
F(N
i
) = w
i
.
In general equilibrium N = and s F = w
Aggregate employment is given by this
condition.
L

i
i N |
.
|

\
|
M
N
Shirking model by Shapiro and Stiglitz,
cont.
Comparative Statics: An increase in unemployment benefit shift up
NSCB: as unemployment becomes less costly firms have to pay higher
wage to ensure no shirking. In equilibrium, we get higher unemployment
and a higher wage.
Comparative Statics: A fall in s to s the new equilibrium is (w3, N3).
Unlike in the simple Solow model we observe a fall in wages, but
employment falls here more than does the wage. So the Shapiro/Stiglitz
model does predict more employment volatility than wage volatility.