Efficiency Wage Models of the Labor Market

One of the more troubling aspects of the ferment in macroeconomics that followed the demise of the Keynesian dominance in the late 1960s has been the inability of many of the new ideas to account for unemployment and, in particular, its cyclical variation. This involuntary unemployment remains unexplained because equilibrium in most economic models occurs with supply equal to demand: If this equality holds in the labor market, there is no involuntary unemployment. Efficiency Wage Models of the Labor Market explores the reasons why there are labor market equilibria with employers preferring to pay wages in excess of the market-clearing wage and thereby explains involuntary unemployment. This volume brings together a number of the important articles on efficiency wage theory. The collection is preceded by a strong, integrative introduction, written by the editors, in which the hypothesis is set out and the variations, as described in subsequent chapters, are discussed. George Akerlof is Professor of Economics at the University of California, Berkeley; Janet Yellen is Professor of Economics at the School of Business Administration, University of California, Berkeley.

Efficiency Wage Models of the Labor Market

Efficiency Wage Models of the Labor Market

Edited by

GEORGE A. AKERLOF AND JANET L. YELLEN University of California, Berkeley

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CAMBRIDGE UNIVERSITY PRESS Cambridge New York Port Chester Melbourne Sydney

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Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo, Delhi, Dubai, Tokyo, Mexico City Cambridge University Press The Edinburgh Building, Cambridge CB2 8RU, UK Published in the United States of America by Cambridge University Press, New York www.cambridge.org Information on this title: www.cambridge.org/9780521312844 © Cambridge University Press 1986 This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 1986 Reprinted 1987,1990 A catalogue recordfor this publication is available from the British Library Library of Congress Cataloguing in Publication Data Main entry under title: Efficiency wage models of the labor market. Includes bibliographies 1. Wages — Econometric models. I. Akerlof, George A., 1940— II. Yellen, Janet L. (Janet Louise), 1946— HD4909.E35 1986 33i.2'i'O724 85-31373 ISBN 978-0-521-32156-5 Hardback

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To our mothers, ROSALIE C. AKERLOF

and ANNA RUTH YELLEN

Contents

Acknowledgments for Reprinted Articles Introduction George A. Akerlof and Janet L. Yellen The Theory of Underemployment in Densely Populated Backward Areas Harvey Leibenstein

Pa8e ' x 1

22

Another Possible Source of Wage Stickiness Robert M. Solow

41

Equilibrium Unemployment as a Worker Discipline Device Carl Shapiro and Joseph E. Stiglitz

45

Involuntary Unemployment as a Principal-Agent Equilibrium James E. Foster and Henry Y. Wan, Jr.

57

Labor Contracts as Partial Gift Exchange George A. Akerlof

66

A Model of the Natural Rate of Unemployment Steven C. Salop

93

Job Queues and Layoffs in Labor Markets with Flexible Wages Andrew Weiss

102

Hierarchy, Ability, and Income Distribution Guillermo A. Calvo and Stanislaw Wellisz

115

Incentives, Productivity, and Labor Contracts Edward P. Lazear and Robert L. Moore

135

Work Incentives, Hierarchy, and Internal Labor Markets James M. Malcomson

157

Acknowledgments for Reprinted Articles

George A. Akerlof, "Labor Contracts as Partial Gift Exchange," Quarterly Journal of Economics, volume 97, pp. 543-69, November 1982. Copyright President and Fellows of Harvard College, 1982. Reprinted by permission of John Wiley & Sons, Inc. Guillermo A. Calvo and Stanislaw Wellisz, "Hierarchy, Ability, and Income Distribution," Journal of Political Economy, volume 87, pp. 991-1010, October 1979. Copyright 1979 by the Unversity of Chicago Press. Reprinted by permission. James E. Foster and Henry Y. Wan, Jr., "Involuntary Unemployment as a PrincipalAgent Equilibrium," American Economic Review, volume 74, pp. 476-84, June 1984. Copyright 1984 by the American Economic Association. Reprinted by permission. Edward P. Lazear and Robert L. Moore, "Incentives, Productivity, and Labor Contracts," Quarterly Journal of Economics, volume 99, pp. 275-95, May 1984. Copyright President and Fellows of Harvard College, 1984. Reprinted by permission of John Wiley & Sons, Inc. Harvey Leibenstein, "The Theory of Underemployment in Densely Populated Back ward Areas," Economic Backwardness and Economic Growth, Chapter 6, 1963. John Wiley & Sons, Inc. Reprinted by permission of the author. James M. Malcomson, "Work Incentives, Hierarchy, and Internal Labor Markets," Journal of Political Economy, volume 92, pp. 486-507, June 1984. Copyright 1984 by the University of Chicago Press. Reprinted by permission. Steven C. Salop, "A Model of the Natural Rate of Unemployment," American Economic Review, volume 69, pp. 117-25, March 1979. Copyright 1979 by the American Economic Association. Reprinted by permission. Carl Shapiro and Joseph E. Stiglitz, "Equilibrium Unemployment as a Worker Discipline Device,'' American Economic Review, volume 74, pp. 433-44, June 1984. Copyright 1984 by the American Economic Association. Reprinted by permission. Robert M. Solow, "Another Possible Source of Wage Stickiness," Journal of Macroeconomics, volume 1, pp. 79-82, Winter 1979. Copyright 1979 by The Wayne State University Press. Reprinted by permission. Andrew Weiss, "Job Queues and Layoffs in Labor Markets with Flexible Wages," Journal of Political Economy, volume 88, pp. 526-38, June 1980. Copyright 1980 by the University of Chicago Press. Reprinted by permission. Janet L. Yellen, "Efficiency Wage Models of Unemployment," American Economic Review, volume 74, pp. 200-5, March 1984. Copyright 1984 by the American Economic Association. Reprinted by permission. [Refers to sections of the Introduction in this book that are based on the Yellen article.]

Introduction

George A. Akerlof and Janet L. Ye Hen University of California, Berkeley

For more than 60 years, since the long depression of the 1920s in Great Britain, the key problem in macroeconomics has been the explanation of unemployment, which is seemingly involuntary and varies with aggregate demand. Most markets seem to clear, but not the labor market. Why? Even in the absence of major real shocks, such as materials shortages, there are large fluctuations in output that seem to be correlated with aggregate demand. Why? An answer to these questions was given by Pigou and Keynes in the 1930s: With sticky money wages, labor markets will not clear if demand is low, and decreases in demand will usually cause decreases in output and increases in unemployment. But, in economics as in child-rearing, answers usually beget further questions. This challenge, which did not arise until almost 35 years after the publication of The General Theory (Keynes, 1936), resulted in the inevitable questions: Why should money wages be sticky? Do sticky wages correspond to rational economic behavior? And, if sticky wages are not rational, is there another way to explain business cycles in the absence of sticky money wages? Attempts to answer these questions have led to a sequence of important developments: search theory, the new classical macroeconomics, implicit contract theory, and staggered contract theory, all of which have been interesting and some of whose results have been surprising indeed. But, for a variety of both empirical and theoretical reasons, these approaches have failed to explain cyclically fluctuating levels of involuntary unemployment. Recently there has been developed a new class of models - efficiency wage models - which, appropriately adapted, can explain cyclically varying involuntary unemployment. All these models have in common that in equilibrium an individual firm's production costs are reduced if it pays a wage in excess of market-clearing, and, thus, there is equilibrium involuntary unemployment. Without equivocation or qualification, we view efficiency wage models as We would especially like to thank Joseph Stiglitz for valuable conversations that aided our thinking in writing this introduction. We are also indebted to David Estenson, Lawrence Katz, Michael Reich, and James Wilcox for valuable comments. Financial support for this research was provided by the National Science Foundation under grant number SES84-01130.

1

2

George A. Akerlof and Janet L. Yellen

providing the framework for a sensible macroeconomic model, capable of explaining the stylized facts characterizing business cycles. Such a macroeconomic model must have at least five features: It must have involuntary unemployment; shifts in aggregate demand must change equilibrium output and employment, at least in the short run; over the course of the business cycle, productivity must behave procyclically; more skilled workers must have lower unemployment rates; and the quit rates should decrease with higher unemployment. Later in this introduction, we shall indicate how each of these features naturally arises from an efficiency wage framework, although as yet no model has been constructed with all of these features simultaneously. But let us not get ahead of our story. First, let us review the efficiency wage literature and explain the selection of articles in this book. Review of Efficiency Wage Models This book is a primer on efficiency wage models. The ten articles that have been chosen for this volume fall roughly into three groups. The first group offers various rationales for efficiency-wage-generated unemployment; it includes the chapters by Solow (1979), Shapiro and Stiglitz (1984), Foster and Wan (1984), Akerlof (1982), Salop (1979), and Weiss (1980). The second category gives alternative implications, in terms of contract forms and internal labor markets, for the type of assumptions made in some of the efficiency wage models of unemployment; it includes the chapters by Calvo and Wellisz (1979), Lazear and Moore (1984), and Malcomson (1984). The third category, the Leibenstein (1957) chapter, describes the original use of efficiency wage models in development economics.1 Efficiency wage models are all based on a convincing and coherent explanation as to why firms may find it unprofitable to cut wages in the presence of involuntary unemployment. The models surveyed are variants of the efficiency wage hypothesis, according to which labor productivity depends on the real wage paid by the firm. If wage cuts harm productivity, then cutting wages may end up raising labor costs. We shall first describe some of the general implications of the efficiency wage hypothesis in its simplest form and then describe four distinct microeconomic approaches that justify the relation between wages and productivity. These approaches identify four benefits of higher wage payments: reduced shirking of work by employees due to a higher cost of job loss, lower turnover, improvement in the average quality of job applicants, and improved morale. The potential relevance of the efficiency wage hypothesis in explaining 1 The next section describing efficiency wage models is taken from Yellen (1984) with slight modifications.

Introduction

3

involuntary unemployment and other stylized labor market facts can be seen in a rudimentary model. Consider an economy with identical, perfectly competitive firms, each firm having a production function of the form q =f(e(o>)n), where n is the number of employees, e is effort per worker, and o> is the real wage. A profit-maximizing firm that can hire all the labor it wants at the wage it chooses to offer (see Solow, 1979; Stiglitz, 1976a)2 will offer a real wage, to*, satisfying the "Solow condition": The elasticity of effort with respect to the wage is unity. The wage \(8), i(0)