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Efficiency Wages and Equilibrium Wages - Essay Example

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This essay "Efficiency Wages and Equilibrium Wages" describes efficiency wage models where firms choose to pay high wages to reduce turnover, eliminate shirking, increase morale, or in other ways enhance productivity. If wages exceed the market-clearing rates, unemployment results…
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Efficiency Wages and Equilibrium Wages
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Download file to see previous pages Since the 1970s, the persistently high unemployment rates in many industrial economies have made more and more economists believe that involuntary unemployment is one of the major stylized facts of modern economies. Therefore, a satisfactory macroeconomic labor model should explain well such a stylized fact. The efficiency wage theory has in recent years generally been regarded as a powerful vehicle for explaining why involuntary unemployment has persisted in the labor market. In constructing a business cycle model, "a potential problem of the efficiency-wage hypothesis is the absence of a link between aggregate demand and economic activity"2. Hence, until Akerlof and Yellen (1985) presented the near-rational model, efficiency wage theories still left unanswered the question of how changes in the money supply can affect real output.
In macroeconomic theory, the wage is simply regarded as the amount of money that employees receive and is assumed to be exactly equal to the average cost of labor to employers. In practice, the components of wages are more complicated than the simple economic setting would suggest. There exist some gaps between the amounts that trading partners pay and receive. For example, the actual average cost of labor to employers is equal to the wage that employees receive after the addition of hiring and training costs, firing (severance pay) and retirement (pension) costs, various taxes and insurance fees, sometimes traffic and housing outlays, and so on. Some of these costs, especially taxes, insurance, and traffic fees, are set by the process of political negotiations. The resetting processes relating to these costs are always time-consuming and controversial in modern democratic societies, and these costs are not as flexible as other components of wages determined by competitive markets or monopsonists. Since some components of wages are always inflexible, partial rigidity of wages is thus a realistic specification for economic modeling. When we recognize that wages have the property of partial rigidity, it is logical to expect that money non-neutrality will hence result.
The basic tenet of the efficiency wage theory is that the effort or productivity of a worker is positively related to his real wage and firms have the market power to set the wage. Therefore, in order to maintain high productivity, it may be profitable for firms not to lower their wages in the presence of involuntary unemployment. The main reasons that are provided for the positive relationship between worker productivity and wage levels include nutritional concerns3, morale effects4, adverse selection5, and the shirking problem6. The shirking viewpoint proposed by Shapiro and Stiglitz (1984) is the most popular version of the theory. Its essential feature is that firms cannot precisely observe the efforts of workers due to incomplete information and costly monitoring; equilibrium unemployment is, therefore, necessary as a worker discipline device. I thus adopt a shirking model as the analytical framework of this paper to examine the effects of partial rigidity of wages.
The earliest theoretical work on efficiency wages by Shapiro and Stiglitz and Bowles contend that competitive firms may rationally pay wages greater than workers' opportunity costs if labor intensity is a positive function of wages. ...Download file to see next pagesRead More
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