Efficiency wage
[citation needed] A theory in which employers voluntarily pay employees above the market equilibrium level to increase worker productivity.
The shirking model begins with the fact that complete contracts rarely (or never) exist in the real world.
Methods such as piece rates are often impracticable because monitoring is too costly or inaccurate; or they may be based on measures too imperfectly verifiable by workers, creating a moral hazard problem on the employer's side.
Thus, paying a wage in excess of market-clearing may provide employees with cost-effective incentives to work rather than shirk.
[5] Equilibrium then entails unemployment, because to create an opportunity cost to shirking, firms try to raise their wages above the market average (so that sacked workers face a probabilistic loss).
[5] This creates a low, or no income alternative, which makes job loss costly and serves as a worker discipline device.
Shapiro and Stiglitz point out that their assumption that workers are identical (e.g. there is no stigma to having been fired)[5] is a strong one – in practice, reputation can work as an additional disciplining device.
Conversely, higher wages and unemployment increase the cost of finding a new job after being laid off.
When workers are at risk of losing their jobs, they tend to increase their productivity and efficiency by working harder, thus improving their chances of employment.
One criticism of the efficiency wage hypothesis is that more sophisticated employment contracts can, under certain conditions, reduce or eliminate involuntary unemployment.
[6] The upward tilt in the age-earnings profile here provides the incentive to avoid shirking, and the present value of wages can fall to the market-clearing level, eliminating involuntary unemployment.
[7] However, a significant criticism is that moral hazard would be shifted to employers responsible for monitoring the worker's efforts.
The seriousness of this employer moral hazard depends on how much effort can be monitored by outside auditors, so that firms cannot cheat.
These models can easily be adapted to explain dual labor markets: if low-skill, labor-intensive firms have lower turnover costs (as seems likely), there may be a split between a low-wage, low-effort, high-turnover sector and a high-wage, high effort, low-turnover sector.
The selection effect of higher wages may come about through self-selection or because firms with a larger pool of applicants can increase their hiring standards and obtain a more productive workforce.
[citation needed] Self-selection (often referred to as adverse selection) comes about if the workers’ ability and reservation wages are positively correlated.
Firms may also be able to design self-selection or screening devices that induce workers to reveal their true characteristics.
[18] Some attention has been paid to the idea that people may be altruistic, but it is only with the addition of reciprocity and norms of fairness that the model becomes accurate.
In addition, similar norms of fairness will typically lead people into negative forms of reciprocity, too – in retaliation for acts perceived as vindictive.
Rabin (1993) offers three stylised facts as a starting point on how norms affect behaviour: (a) people are prepared to sacrifice their material well-being to help those who are being kind; (b) they are also prepared to do this to punish those being unkind; (c) both (a) and (b) have a greater effect on behaviour as the material cost of sacrificing (in relative rather than absolute terms) becomes smaller.
In other words, in people's intuitive "naïve accounting" (Rabin 1993), a key role is played by the idea of entitlements embodied in reference points (although as Dufwenberg and Kirchsteiger 2000 point out, there may be informational problems, e.g. for workers in determining what the firm's profit is, given tax avoidance and stock-price considerations).
Solow (1981) argued that wage rigidity may be partly due to social conventions and principles of appropriate behaviour, which are not entirely individualistic.
Using a variety of evidence from sociological studies, Akerlof argues that worker effort depends on the work norms of the relevant reference group.
Concerns such as high turnover and poor worker morale appear to have played an important role in the five-dollar decision.
There is also evidence that other firms emulated Ford’s policy to some extent, with wages in the automobile industry 40% higher than in the rest of manufacturing (Rae 1965, quoted in Raff and Summers).
Given low monitoring costs and skill levels on the Ford production line, such benefits (and the decision itself) appear particularly significant.
Fehr, Kirchler, Weichbold and Gächter (1998) conduct labour market experiments to separate the effects of competition and social norms/customs/standards of fairness.
It appears that in complete contract situations, competitive equilibrium exerts a considerable drawing power, whilst in the gift exchange market it does not.
Fehr et al. stress that reciprocal effort choices are truly a one-shot phenomenon without reputation or other repeated-game effects.
But Leonard finds that wages for narrowly defined occupations within one sector of one state are widely dispersed, suggesting other factors may be at work.
