Real Rigidities
One important criticism of the menu cost literature noted by Ball et al. (1988)
is that models with nominal frictions can in theory produce large nominal
rigidities but ‘do so for implausible parameter values’. However, Ball and
Romer (1990) demonstrated that substantial nominal rigidities can result
from a combination of real rigidities and small frictions to nominal adjustment.
Indeed, Mankiw and Romer (1991) identify the interaction between
nominal and real imperfections as ‘a distinguishing feature of the new
Keynesian economies’.
If all nominal prices in an economy were completely and instantaneously
flexible, a purely nominal shock would leave the real equilibrium of an
economy unchanged. As Ball and Romer (1990) note, ‘Real rigidity does
not imply nominal rigidity: without an independent source of nominal
stickiness prices adjust fully to nominal shocks regardless of the extent of
real rigidities.’ However, rigidity of real prices and wages will magnify the
non-neutralities which result from small nominal frictions. The importance
of this point can be seen by considering the impact of a decline in the
money supply. Suppose initially that the presence of menu costs deters
firms from reducing their prices in response to this nominal disturbance.
With the price level unchanged real output will decline. Each monopolistically
competitive firm will find that its demand curve has shifted to
the left. Because each firm is producing less output, the effective demand
for labour declines (see Abel and Bernanke, 2001). If labour supply is
relatively inelastic, the shift of labour demand implied by the decline in
output will cause a large fall in real wages; that is, the nominal wage rate
declines to bring this about (see Ball et al., 1988; Gordon, 1990; D. Romer,
1993). This decline in the real wage rate implies a decline in marginal cost,
a decline which will be strongly reinforced if the marginal product of
labour rises sharply as the labour input decreases. As is evident from Figure
7.2, an upward-sloping marginal cost curve would greatly increase the
incentive to reduce price and would ‘swamp any plausible barriers to nominal
adjustment’ unless the elasticity of demand at the existing price falls as
the firm’s demand curve shifts to the left. The greater the decline in the
elasticity of demand at the existing price as output falls, the more the
marginal revenue curve facing a firm shifts to the left and the less incentive
there is for a firm to reduce its price.
David Romer (1993) sums up the essence of this issue as follows: ‘Thus if
the classical dichotomy is to fail, it must be that marginal cost does not fall
sharply in response to a demand-driven output contraction, or that marginal
revenue does fall sharply, or some combination of the two.’ Real price rigidity
is high the greater is the cyclical sensitivity of the elasticity of demand and
the smaller is the cyclical sensitivity of marginal cost. Hence nominal shocks
have large real consequences the greater the degree of real rigidity (see D.
Romer, 2001).
The points discussed above can be more easily understood by referring to
the familiar mark-up pricing equation facing a profit-maximizing monopolistically
competitive firm (see Pindyck and Rubinfeld, 1998, p. 340). Profit
maximization requires that the firm produces that level of output where
marginal revenue (MR) equals cost (MC). Marginal revenue can be expressed
in the form shown by equation (7.5):
MR = P + P(1/η) (7.5)
where P is the firm’s price and η is the price elasticity of demand. Profit
maximization therefore requires that:
P + P(1/η) = MC (7.6)
By rearranging equation (7.6) we get equation (7.7):
P MC
P
− = −1/η (7.7)
This equation can also be rearranged so as to express price as a mark-up on
marginal cost. The mark-up equation is given by (7.8):
P = MC
+
1
1 1/η
(7.8)
Since marginal cost is the nominal wage (W) divided by the marginal product
of labour (MPL), we finally get equation (7.9):
P
W
MPL
1
1 1/η
The term inside the brackets represents the mark-up, the size of which varies
inversely with the elasticity of demand (remember η is negative). Equation
(7.9) indicates that P will not fall when MC declines if the mark-up rises
sufficiently to offset this decline (see Stiglitz, 1984). If the elasticity of
demand does not decline, then equation (7.9) also indicates that the incentive
to change price will be small in the presence of menu costs if MPL does not
rise strongly as the labour input is reduced (see Hall, 1991). Rotemberg and
Woodford (1991) suggest that desired mark-ups over marginal cost fall during
a boom because it becomes increasingly difficult to maintain oligopolistic
collusion; that is, industries become more competitive in periods of high
economic activity. During recessions implicit collusion increases, leading to
a countercyclical mark-up that acts as a real rigidity, magnifying the impact
on nominal rigidity of relatively small menu costs (D. Romer, 2001).
1.1 Other sources of real price rigidity
We have already noted that mild sensitivity of marginal cost to variations in
output and procyclical elasticity of demand (implying a countercyclical markup)
will contribute towards real price rigidity. The new Keynesian literature
has also identified several other potential sources of real price rigidity.
Thick market externalities In the real world buyers and sellers are not
brought together without incurring search costs. Consumers must spend time
searching the market for the goods they desire and firms advertise in order to
attract customers. Workers and employers must also spend time and resources
searching the market. When markets are thick during periods of high
economic activity it seems plausible that search costs will be lower than is
the case in a thin market characterized by a low level of trading activity (see
Diamond, 1982). It may also be the case that people are much more willing to
participate in thick markets where a lot of trade is taking place and this leads
to strategic complementary; that is, the optimal level of activity of one firm
depends on the activity of other firms. If these thick market externalities help
to shift the marginal cost curve up in recessions and down in booms, then this
will contribute to real price rigidity.
Customer markets The distinction between auction and customer markets
has been developed by Okun (1975, 1981). The crucial characteristic of a
customer market is a low frequency of search relative to the frequency of
purchase (McDonald, 1992). Most products are sold through a process of
shopping and, providing the costs of searching the market are non-trivial, the
buyer will always have imperfect (limited) information concerning the lowest
price in the marketplace. Because of the search costs associated with the
shopping process, sellers have some monopoly power even though there may
be a large number of firms in the market, each selling a similar product. Since
a large number of customers make repetitive purchases it is in the interests of
any firm to discourage its customers from searching the market in order to
find a better deal. Firms are therefore discouraged from frequently changing
their prices, a practice which will provide an incentive for customers to look
elsewhere. Whereas an increase in price will be noticed immediately by
customers, a decrease in price will produce a much smaller initial response as
it takes time for this new information to reach the buyers at other firms. This
difference in the response rates of customers to price increases and decreases,
and the desire of a firm to hold on to its regular customers, will tend to
produce relative price stickiness (see Phelps, 1985, for an excellent discussion
of customer markets).
Price rigidity and the input–output table Gordon (1981, 1990) has drawn
attention to the complexity of decision making in a world where, typically,
thousands of firms buy thousands of components containing thousands of
ingredients from numerous other firms, many of which may reside overseas.
‘Once decentralisation and multiplicity of supplier–producer relationships
are recognised, no single firm can perform an action that would eliminate the
aggregate business cycle’ (Gordon, 1981, p. 525).
Because a firm is linked to thousands of other firms via a complex input–
output table, it is impossible for it to know the identity of all the other agents
linked together in the web of supplier–producer relationships. Because of this
complexity there is no certainty that marginal revenue and marginal cost will
move in tandem following an aggregate demand shock. There is no certainty
for an individual firm that, following a decline in aggregate demand, its
marginal cost will move in proportion to the decline in demand for its products.
Many of its suppliers may be firms in other countries facing different
aggregate demand conditions. To reduce price in these circumstances is more
likely to produce bankruptcy for the particular firm than it is to contribute to
the elimination of the business cycle because a typical firm will be subject to
both local and aggregate demand shocks as well as local and aggregate cost
shocks. As Gordon (1990) argues, in such a world no firm would be likely to
take the risk of nominal GNP indexation that would inhibit its freedom and
flexibility of action in responding to the wide variety of shocks which can
influence the position of its marginal revenue and cost curves. Since indexation
is undesirable when there is substantial independence of marginal cost
and aggregate demand, Gordon’s input–output theory not only provides an
explanation of real price rigidity but also translates into a theory of nominal
rigidity. The fundamental reason for the gradual adjustment of prices is that
this represents the safest course of action for firms operating in an uncertain
world where information is inevitably imperfect.
Clearly the informational requirements necessary for rational pricing behaviour
in every period are enormous for price-setting firms. Not only do
they need to know the position and shape of their demand and cost curves;
they also need to predict the pricing behaviour of all the other firms in the
input–output table. Since the firm’s demand and cost curves are influenced by
aggregate demand, it is also necessary for firms to predict the value of all the
relevant macro variables that influence aggregate demand. In short, the decision
makers within monopolistically competitive firms need to be first-class
general equilibrium theorists with perfect information! Given these complications,
the tendency of firms to follow simple mark-up pricing rules may be
close to optimal. The incentive to follow such rules is reinforced if other
firms do likewise, since this ensures that a firm will maintain its relative
price, which will tend to minimize its losses (see Naish, 1993). Another
simple rule which a firm can follow in a complex input–output world is to
wait until other firms raise or lower their price before initiating a change.
This produces staggering in price setting, which implies that the price level
will take longer to adjust to an aggregate demand shock.
Capital market imperfections An important obstacle to firms seeking external
finance is the problem of asymmetric information between borrowers and
lenders; that is, borrowers are much better informed about the viability and
quality of their investment projects than lenders. One consequence of this
will be that external finance will be more expensive to a firm than internal
finance. During booms when firms are making higher profits there are more
internal funds to finance various projects. Hence during recessions the cost of
finance rises as the result of a greater reliance on external sources. If the cost
of capital is countercyclical, this too will tend to make a firm’s costs rise
during a recession (see Bernanke and Gertler, 1989; D. Romer, 1993).
Judging quality by price Stiglitz (1987) has emphasized another reason
why firms may be reluctant to reduce price when faced with a decline in
demand. In markets where customers have imperfect information about the
characteristics of the products which they wish to buy, the price may be used
as a quality signal. By lowering price a firm runs the risk that its customers
(or potential customers) may interpret this action as a signal indicating a
deterioration of quality.
Having examined several potential sources of real rigidity in the product
market, we will now turn to real rigidities in the labour market. If real wages
are rigid in the face of demand disturbances, this substantially reduces a
firm’s incentive to vary its price as a response to such disturbances.
1.2 Real wage rigidity
Economists have been much better at explaining the consequences of nominal
wage rigidity than they have at providing a generally acceptable
theoretical explanation of the causes of such inertia. Nominal rigidities
allow fluctuations of aggregate demand to have real effects and contribute
to a non-market-clearing explanation of business cycles. However, Keynesian
economists are also concerned to explain the persistently high levels of
unemployment that have been a major feature of the labour markets of the
major industrial countries since the early 1970s and particularly in Europe
during the 1980s (see Table 1.4). In new classical monetary and real business
cycle models all agents are price takers. Perfect and instantaneous
price and wage flexibility ensures that the labour market always clears at a
Walrasian market-clearing real wage. In a new Keynesian world, where
price makers predominate, an equilibrium real wage can emerge which
differs from the market-clearing real wage. Stiglitz (1987) defines a market
equilibrium as ‘a state where no agents have an incentive to change their
behaviour’ and in new Keynesian models of real wage rigidity equilibrium
may not be characterized by market clearing; that is, demand equals supply.
Models involving real wage rigidity are capable of generating involuntary
unemployment in long-run equilibrium, in contrast to new classical models
where, with everyone on their labour supply function, unemployment in
equilibrium is a voluntary phenomenon. Whereas Lucas (1978a) argues for
the abandonment of the idea that a large part of unemployment is involuntary,
Solow (1980) believes that ‘what looks like involuntary unemployment
is involuntary unemployment’ (see also Hahn, 1987; Blinder, 1988a).
New Keynesian explanations of real wage rigidity fall into three main
groups: (i) implicit contract theories; (ii) efficiency wage theories; and (iii)
insider–outsider theories. Since new Keynesian theorists have been mainly
associated with the second and third of these, we will provide only a brief
comment on implicit contract theory. The reader should consult Rosen (1985)
and Timbrell (1989), who provide comprehensive surveys of the implicit
contract literature. It should also be noted that Phelps (1990, 1994) treats
theories of real wage rigidity as a separate category from new Keynesian
theory, belonging instead to what he calls the ‘Structuralist school’.
Implicit contract models The original implicit (non-union) contract models
were provided by Bailey (1974), D.F. Gordon (1974) and Azariadis (1975).
Following the development of the natural rate hypothesis (Friedman, 1968a;
Phelps, 1968), economists devoted more attention to modelling labour market
behaviour as the outcome of maximizing behaviour. The main contribution
of the ‘new’ microeconomics literature (Phelps et al., 1970) was to explain
why the natural rate of unemployment was positive. However, there appears
to be much less turnover in the labour market than search theory implies.
Furthermore, wages frequently diverge from marginal productivities. Implicit
contract theory seeks to understand what it is that forms the ‘economic glue’
that keeps workers and firms together in long-term relationships since such
arrangements, rather than the Walrasian auctioneer, dominate the labour market.
Because firms seek to maintain the loyalty of their workforce they find it
necessary to enter into unwritten (implicit) understandings with their workers.
This ‘invisible handshake’ provides each worker with assurances
concerning the terms of the working relationship under a variety of working
circumstances. The models of Bailey, Gordon and Azariadis examine the
consequences of optimal labour contracts established between risk-neutral
firms and risk-averse workers. In these circumstances the wage rate not only
represents payment for labour services but also serves as an insurance against
the risk of variable income in the face of shocks. A constant real wage
smooths the individual worker’s consumption stream and firms provide this
‘insurance’ since they are in a better position than workers to weather economic
fluctuations, given their better access to capital and insurance markets.
Because firms provide stable wages over time, workers, for their part, accept
a real wage which is lower on average than the highly varying rates that
would be dictated by market forces.
A major problem with this approach is that it predicts work sharing
rather than lay-offs when the economic climate deteriorates. The theory
also fails to explain why the firm does not pay lower wages to new recruits.
In attempting to remedy these and other weaknesses of this explanation of
real wage rigidity, new Keynesian economists have developed efficiency
wage and insider–outsider models of wage inertia (see Manning, 1995).
Efficiency wage models Any acceptable account of involuntary unemployment
must explain why unemployed workers are unable to bid down wages to
a level that will generate full employment. Efficiency wage theories suggest
that it is not in a firm’s interest to lower real wages because the productivity
(effort or efficiency) of workers is not independent of the wage, rather real
wages and worker effort are interdependent, at least over some meaningful
range. Efficiency wage theory, described by Gordon (1990) as the ‘rage of the
80s’, is surveyed by Yellen (1984), Akerlof and Yellen (1986), Katz (1986,
1988), Haley (1990), and Weiss (1991); see also Akerlof (1979, 2002), and
Stiglitz (2002).
Solow (1979) provides the basic structure of efficiency wage models. In
Solow’s model, wage stickiness is in the employer’s interest because wage
cutting would lower productivity and raise costs. Because the wage enters a
firm’s short-run production function in a labour-augmenting way, a costminimizing
firm will favour real wage rigidity. This can be demonstrated as
follows (see Yellen, 1984; Katz, 1988). Assume an economy with identical
perfectly competitive firms, each of which has a production function of the
form shown in equation (7.10):
Q = AF[e(w)L], e′(w) > 0 (7.10)
Here Q is the firm’s output, A represents a productivity shift factor, e is effort
per worker, w is the real wage and L is the labour input. Effort is assumed to
be an increasing function of the real wage and all workers are assumed to be
identical. The firm aims to maximize its profits (π), which are given by
equation (7.11):
π = AF[e(w)L]− wL (7.11)
Since effort enters the profit equation as e(w), a cut in the real wage below
that which generates maximum worker effort will lower the firm’s profits. If
the firm can hire all the labour it desires at the wage it offers, it will maximize
its profits by offering an efficiency wage of w* which satisfies two conditions.
The first condition is that the elasticity of effort with respect to the wage is
unity. Restated, this means that the firm should set a wage which will minimize
labour costs per efficiency unit of labour. This is illustrated in Figure
7.5. In panel (a) the effort curve indicated by E shows the relationship
between the effort of workers and the real wage. The higher the real wage,
the greater the effort of workers. Initially there is a region of increasing
returns where increases in the real wage rate elicit a more than proportionate
increase in worker effort (productivity). Effort per pound (dollar) of real
wage is measured by e/w. This ratio is maximized at point M, where 0X is
tangential to the effort function. Since the slope of the effort curve (e/w) is
the inverse of wage costs per efficiency unit (w/e), as the slope of E increases
the wage cost per efficiency unit falls and vice versa. The relationship between
w/e and w is shown in panel (b) of Figure 7.5. Since e/w is maximized
at M with an efficiency wage of w*, the wage cost per efficiency unit also
reaches a minimum at a real wage of w* (see Stiglitz, 1987, p. 5).
The second condition for profit maximization is that the firm should hire
labour up to the point where its marginal product is equal to the efficiency
wage. If the aggregate demand for labour at w* is less than the aggregate supply
of labour, then the market equilibrium will entail involuntary unemployment.
Since the optimal wage rate w* does not depend on either the level of employment
or the productivity shift parameter (A), a shock which shifts the aggregate
demand for labour will lead to a change in employment but no change in the
rigid real (efficiency) wage. These points are illustrated in Figure 7.6. Here DL1
shows the marginal product of labour for a given level of effort (e*). If the
efficiency wage exceeds the market-clearing wage (w), then the market equilibrium
is consistent with involuntary unemployment shown by U. If a shock
shifts the labour demand curve to DL2, then involuntary unemployment will
increase, since the efficiency wage remains at w*. Only if the market-clearing
(Walrasian) wage exceeds the efficiency wage will involuntary unemployment
be absent (see Abel and Bernanke, 2001). With w > w* firms would be forced to
pay the market-clearing wage but, for reasons discussed in the following section,
w* is always likely to be greater than the market-clearing wage. If an
increase in unemployment influences the effort of employed workers, then the
effort curve will shift up, which lowers the wage at which e/w is maximized.
This possibility is illustrated in Figure 7.5 by a shift of the effort curve from E
to E1. The e/w ratio is now maximized at M1, with a new efficiency wage of w1
So far we have assumed that effort is positively related to the real wage
rate. Now we must examine the reasons that have been advanced by new
Figure 7.6 Involuntary unemployment in the efficiency wage model
Keynesian theorists to explain this relationship. The idea that worker productivity
and real wages might be positively related over some range was clearly
recognized by Alfred Marshall, who observed that ‘highly paid labour is
generally efficient and therefore not dear labour’ (Marshall, 1920). Much
later, the efficiency wage idea reappeared in the literature relating to developing
economies (Leibenstein, 1957; Bardhan, 1993). In this context higher
wages increase the physical well-being of workers through higher nutrition,
and by reducing malnourishment higher real wages improve labour efficiency.
In the developed-country context, where most workers have adequate
nutrition, a different rationale is needed.
The modern efficiency wage theories which have been put forward relate
in general to the issues of selection and incentives and four categories of
efficiency wage theory can be identified: (i) the adverse selection model (for
example, Weiss, 1980); (ii) the labour turnover model (for example, Salop,
1979); (iii) the shirking model (for example, Shapiro and Stiglitz, 1984); and
(iv) the fairness model (for example, Akerlof, 1982). We will examine each of
these in turn. The reader should note that the papers referred to above (i–iv)
are all collected in Akerlof and Yellen (1986).
The adverse selection model In the adverse selection model, firms that offer
higher wages will attract the best workers. Because the labour market is
populated by heterogeneous individuals, firms have imperfect information
about the productivity characteristics of job applicants; the labour market is
an excellent example of a market where asymmetric information predominates.
When there is asymmetric information one party to a transaction has
more information than the other party. In this case workers have more information
about their own abilities, honesty and commitment than employers
before they are hired and will attempt to send signals to potential employers
that convey information about their qualities, such as educational qualifications,
previous employment record and current wage if employed (see Spence,
1974, for a discussion of job market signalling). Because of the non-trivial
hiring and firing costs firms prefer not to hire workers and then find they need
to fire those with low productivity. The firm may also need to invest considerable
resources in training new employees before it becomes clear that they
are not up to scratch. One way of avoiding this problem is for the firm to send
a signal to the labour market in the form of offers of high wages. In the model
presented by Weiss (1980) the wage offered by a firm influences both the
number and quality of job applicants. If workers’ abilities are closely connected
to their reservation wage, then higher wage offers will attract the most
productive job applicants and any applicant who offers to work for less than
the efficiency wage will be regarded as a potential ‘lemon’. Firms will also be
reluctant to lower wage rates even if faced with an excess supply of labour
wishing to work at the prevailing wage offer because this would in all likelihood
induce the most productive workers to quit voluntarily. As a result of
these influences an underemployment equilibrium is attained. To avoid adverse
selection problems firms will attempt to introduce screening devices,
but these measures involve costs, as will the continuous monitoring of workers
after they have been appointed.
The labour turnover model A second reason why firms may offer an efficiency
wage in excess of the market-clearing wage is to reduce costly labour
turnover. This approach received inspiration from the pioneering work of Phelps
(1968) and Phelps et al. (1970) in the development of explanations of the
natural rate of unemployment and search behaviour. The idea here is that
workers’ willingness to quit a job will be significantly reduced if a firm pays
above the going rate. With quitting rates a decreasing function of the real wage,
firms have an incentive to pay an efficiency wage to reduce costly labour
turnover. In the model developed by Salop (1979), labour market equilibrium
entails involuntary unemployment since all firms need to raise their wages to
deter workers from quitting. In situations where unemployment increases, the
wage premium necessary to deter labour turnover will fall.
The shirking model In most occupations labour contracts are incomplete,
which allows workers to exercise discretion with respect to their effort levels.
Because contracts cannot specify every aspect of a worker’s performance and
duties there is ‘effort discretion’ (see Leibenstein, 1979, for a similar approach).
Since the collection of information relating to the productivity of
individual workers and the continual monitoring of workers is very costly to
the firm, the payment of an efficiency wage in excess of the market-clearing
equilibrium wage can act as an incentive which will deter the worker from
shirking. Such behaviour may be particularly difficult to detect and monitor
when teamwork characterizes the workplace.
The possibility that workers may vary their effort is a further example of
the type of problem that can arise when there is an informational asymmetry
present. Workers know more about their effort levels than do their employers.
This asymmetry creates a ‘principal–agent’ problem. An agency relationship
develops whenever there is a relationship between economic actors and the
welfare of one person depends on the actions of the other party; that is, when
the welfare of the principal is influenced by the action (or inaction) of the
agent. In the labour market case the principal is the owner of an enterprise
and the managers and other workers are the agents. One way of reducing the
problem of shirking in this context is to pay an efficiency wage.
The threat of dismissal is not an effective deterrent in a labour market
where workers can quickly find a new job at the same wage rate. However, if
a firm pays a wage in excess of that available elsewhere, or if there is
unemployment, workers have an incentive not to shirk, since there is now a
real cost to being fired and shirking becomes more risky for each worker. In
the Shapiro–Stiglitz (1984) model, the payment of an efficiency wage acts as
a disincentive to shirking, and involuntary unemployment in equilibrium is
an outcome of the problems firms face when monitoring is imperfect: ‘With
imperfect monitoring and full employment workers will choose to shirk.’ By
being paid more than the going rate, workers now face a real penalty if they
are caught shirking. But, as Shapiro and Stiglitz (1984) note, ‘if it pays one
firm to raise its wage it will pay all firms to raise their wages’. Since a rise in
the general level of real wages raises unemployment, even if all firms pay the
same efficiency wage, workers again have an incentive not to shirk because if
caught they will now face the possibility of prolonged unemployment. The
‘reserve army’ of the unemployed act as a disincentive device. Hence the
effort (productivity) of the worker hired by the ith firm, ei, is a function of the
wage it pays, wi, the wage paid by all other firms, w–i, and the rate of
unemployment, u. This is shown in equation (7.12):
ei = ei (wi ,w−i ,u) (7.12)
When all firms pay the same wages (wi = w–i) shirking depends positively on
the level of employment. The no-shirking constraint (NSC) indicates the
minimum wage at each level of employment below which shirking will
occur, and is shown in Figure 7.7. In Figure 7.7 the market-clearing wage is
w. However, as is evident from the diagram, no shirking is inconsistent with
full employment. As an incentive not to shirk, a firm must offer an efficiency
wage greater than w. With all firms offering a wage of w*, workers are
deterred from shirking by the risk of becoming unemployed. The diagram
also shows that the need to pay a wage greater than w decreases as unemployment
increases and that the efficiency wage w* and level of employment L0
are associated with an equilibrium level of involuntary unemployment indicated
by LF – L0. As the NSC will always lie above and to the left of the
labour supply curve, there will always be some involuntary unemployment in
equilibrium.
The NSC will shift to the left if the firm reduces its monitoring intensity
and/or the government increases unemployment benefit. In each case the
wage necessary to deter shirking at each level of employment is higher. A
change in the NSC brought about by either of the above reasons is shown in
Figure 7.7 as a shift of NSC from NSC0 to NSC1. The equilibrium following
this shift is indicated by E1, showing that the model predicts an increase in
the efficiency wage and an increase in the equilibrium rate of involuntary
unemployment as a result of these changes.
The fairness model In recent years several economists have examined the
adverse effects of ‘unfair wages’ and wage cuts on worker effort via the impact
such cuts will have on the morale of the workforce. Sociological models stress
such factors as the importance of wage relativities, status, relative deprivation,
loyalty, trust and equity. In a series of papers, Akerlof (1982, 1984) and Akerlof
and Yellen (1987, 1988, 1990) responded to Solow’s (1979, 1980) ‘piece of
home-made sociology’ and developed models where feelings about equity and
fairness act as a deterrent to firms to offer too low wages in the labour market.
Thurow (1983), Blinder (1988a) and Solow (1990) have also indicated that this
socioeconomic line of enquiry could prove fruitful as an explanation of persistent
unemployment. Recently, in his Nobel Memorial Lecture, George Akerlof
(2002) presented a strong case for strengthening macroeconomic theory by
incorporating assumptions that take account of behaviour such as ‘cognitive
bias, reciprocity, fairness, herding and social status’. By doing so Akerlof
argues that macroeconomics will ‘no longer suffer from the “ad hockery” of the
neoclassical synthesis which had overridden the emphasis in the General Theory
on the role of psychological and sociological factors’. Since in Akerlof’s view
Keynes’s General Theory ‘was the greatest contribution to behavioural economics
before the present era’, it would seem that economists need to rediscover
the ‘wild side’ of macroeconomic behaviour in order to begin the construction
of ‘a not too rational macroeconomics’ (Leijonhufvud, 1993).
Many economists share Akerlof’s concerns and are critical of models
where the labour market is modelled in much the same way as a commodity
or financial market. The flexible price–auction model employed by new classical
economists does not seem to resemble observed labour market behaviour.
There are fundamental differences between labour inputs and other nonhuman
inputs into the production process:
1. Workers have preferences and feelings; machines and raw materials do
not.
2. Workers need to be motivated; machines do not.
3. The productivity of a machine is reasonably well known before purchase,
so that problems of asymmetric information relating to quality are
much less significant.
4. Workers can strike and ‘break down’ because of ill health (stress and so
on); machines can break down but never strike for higher pay or more
holidays.
5. The human capital assets of a firm are more illiquid and risky than its
capital assets.
6. Workers normally require training; machines do not.
7. Human capital cannot be separated from its owner; non-human capital
can.
8. Workers’ utility functions are interdependent, not independent.
Because of these crucial differences, worker productivity is a discretionary
variable; the effort or output of a worker is not given in advance and fixed for
the future, irrespective of changes which take place in working conditions
(see also Leibenstein, 1979). A machine does not get angry when its price
fluctuates, nor does it feel upset if it is switched off. In contrast, workers are
not indifferent to their price, nor are they unmoved by becoming unemployed
against their will. For these and other reasons, the notion of fairness would
seem to be an important factor in determining outcomes in the labour market.
As Solow (1990) has argued, ‘The most elementary reason for thinking that
the concept of fairness, and beliefs about what is fair and what is not, play an
important part in labour market behaviour is that we talk about them all the
time.’ The words ‘fair’ and ‘unfair’ have even been used by neoclassical
economists at university departmental meetings!
The first formal model to bring in sociological elements as an explanation
of efficiency wages was the seminal paper by Akerlof (1982), where issues
relating to fairness lie at the centre of the argument. According to Akerlof, the
willing cooperation of workers is something that must usually be obtained by
the firm because labour contracts are incomplete and teamwork is frequently
the norm. The essence of Akerlof’s gift exchange model is neatly summed up
in the phrase ‘A fair day’s work for a fair day’s pay’. Everyday observation
suggests that people have an innate psychological need to feel fairly treated,
otherwise their morale is adversely affected. In Akerlof’s model, workers’
effort is a positive function of their morale and a major influence on their
morale is the remuneration they receive for a given work standard which is
regarded as the norm. If a firm pays its workers a wage above the going
market rate, workers will respond by raising their group work norms, providing
the firm with a gift of higher productivity in exchange for the higher
wage.
In subsequent work Akerlof and Yellen (1990) have developed what they
call the ‘fair wage–effort hypothesis’, which is derived from equity theory. In
the workplace personal contact and potentially conflicting relationships within
a team of workers are unavoidable. As a result issues relating to fairness are
never far away. Since there is no absolute measure of fairness, people measure
their treatment by reference to other individuals within their own group.
Fairness is measured by making comparisons with workers similarly situated
(inside and outside the firm). Thus an individual worker’s utility function can
be summarized as equation (7.13):
U = U(w/ω,e,u) (7.13)
The utility of this worker (U) is dependent on the real wage (w) relative to the
perceived ‘fair’ wage (ω), the worker’s effort (e) and the unemployment rate
(u). Assuming the worker wishes to maximize this function, the effort expended
will depend on the relationship between w and ω for a given level of
unemployment. Workers who feel unfairly treated (w < ω) will adjust their
effort accordingly. ‘The ability of workers to exercise control over their
effort, and their willingness to do so in response to grievances, underlies the
fair wage–effort hypothesis’ (Akerlof and Yellen, 1990, p. 262). Just as firms
face a no-shirking constraint in the Shapiro–Stiglitz model, they face a ‘fair
wage constraint’ in the fairness version of the efficiency wage model. Since
the fair wage exceeds the market-clearing wage, this framework generates an
equilibrium with involuntary unemployment.
The essence of this innovative approach to explaining real wage rigidity is
that the morale of a firm’s human capital can easily be damaged if workers
perceive that they are being unfairly treated. Firms that attach importance to
their reputation as an employer and that wish to generate high morale and
loyalty from their workforce will tend to pay efficiency wages which are
perceived as fair.
It appears that American entrepreneur Henry Ford shared Marshall’s insight
that ‘highly paid labour is generally efficient and therefore not dear
labour’. In the autumn of 1908, Henry Ford launched the production of the
famous Model T Ford. During the period 1908–14, he pioneered the introduction
of mass production techniques that characterized the ‘American System
of Manufactures’ (Rosenberg, 1994). The assembly line production methods
introduced by Ford required relatively unskilled workers rather than the
skilled craftsmen he had previously needed to assemble automobiles one by
one. The first moving assembly lines began operation in April 1913 but
unfortunately for Ford, the introduction of these mass production techniques
drastically changed the working environment and led to a massive and costly
increase in absenteeism and the turnover of workers. In 1913 the annual
turnover of workers at Ford was 370 per cent and daily absenteeism was 10
per cent. In January 1914 Ford responded to this problem by introducing a
payment system of $5 for an eight-hour day for male workers over the age of
22 who had been with the company for at least six months. Previously these
same workers had been working a nine-hour day for $2.34. For a given level
of worker productivity an increase in the wage paid was certain to increase
unit labour costs and, to contemporary observers, Ford’s policy seemed to
imply a certain reduction in the firm’s profits. However, the result of Ford’s
new wage policy was a dramatic reduction in absenteeism (down 75 per
cent), reduced turnover (down 87 per cent), a massive improvement in productivity
(30 per cent), a reduction in the price of the Model T Ford, and an
increase in profits. It appears that Ford was one of the first entrepreneurs to
apply efficiency wage theory. Later, Henry Ford described the decision to pay
his workers $5 per day as ‘one of the finest cost cutting moves we ever made’
(see Meyer, 1981; Raff and Summers, 1987). There is no evidence that Ford
was experiencing trouble recruiting workers before 1914 or that the new
wage policy was introduced to attract more highly skilled workers. The most
plausible rationale for the policy is the favourable impact that it was expected
to have on workers’ effort, turnover and absenteeism rates, and worker morale.
Raff and Summers (1987) conclude that the introduction by Ford of
‘supracompetitive’ wages did yield ‘substantial productivity benefits and
profits’ and that this case study ‘strongly supports’ the relevance of several
efficiency wage theories.
Insider–outsider models Why don’t unemployed workers offer to work for
lower wages than those currently paid to employed workers? If they did so,
wages would be bid down and employment would increase. There appears to
be an unwritten eleventh commandment: ‘Thou shalt not permit job theft by
underbidding and stealing the jobs of thy comrades.’ The insider–outsider
theory also attempts to explain why wage rigidity persists in the face of
involuntary unemployment (see Ball, 1990, and Sanfey, 1995 for reviews).
The insider–outsider approach to real wage rigidity was developed during
the 1980s in a series of contributions by Lindbeck and Snower (1985, 1986,
1988a, 1988b). In this model the insiders are the incumbent employees and
the outsiders are the unemployed workers. Whereas in efficiency wage models
it is firms that decide to pay a wage higher than the market-clearing wage,
in the insider–outsider approach the focus shifts to the power of the insiders
who at least partially determine wage and employment decisions. No direct
effects of wages on productivity are assumed.
Where does the insider power come from? According to Lindbeck and
Snower, insider power arises as a result of turnover costs (Vetter and Andersen,
1994). These include hiring and firing costs such as those associated with
costs of searching the labour market, advertising and screening, negotiating
conditions of employment, mandatory severance pay and litigation costs.
Other important costs are production-related and arise from the need to train
new employees. In addition to these well-known turnover costs, Lindbeck
and Snower (1988a) also emphasize a more novel form of cost – the insider’s
ability and incentive to cooperate with or harass new workers coming from
the ranks of the outsiders. If insiders feel that their position is threatened by
outsiders, they can refuse to cooperate with and train new workers, as well as
make life at work thoroughly unpleasant. By raising the disutility of work,
this causes the outsiders’ reservation wage to rise, making it less attractive for
the firm to employ them. To the extent that cooperation and harassment
activities lie within the control of workers, they can have a significant influence
on turnover costs by their own behaviour.
Because firms with high rates of turnover offer both a lack of job security
and few opportunities for advancement, workers have little or no incentive to
build reputations with their employers. Low motivation damages productivity
and this represents yet another cost of high labour turnover.
Because it is costly to exchange a firm’s current employees for unemployed
outsiders, the insiders have leverage which they can use to extract a
share of the economic rent generated by turnover costs (the firm has an
incentive to pay something to avoid costly turnover). Lindbeck and Snower
assume that workers have sufficient bargaining power to extract some of this
rent during wage negotiations. Although unions are not necessary for insider
power, they enhance it with their ability to threaten strikes and work-to-rule
forms of non-cooperation (For a discussion of union bargaining models and
unemployment, see McDonald and Solow, 1981; Nickell, 1990; Layard et al.,
1991.)
Although the insider–outsider theory was originally put forward as an
explanation of involuntary unemployment, it also generates some other important
predictions (see Lindbeck and Snower, 1988b). First, insider–outsider
theory implies that pronounced aggregate shocks which shift the demand for
labour may have persistent effects on wages, employment and unemployment.
In countries with large labour turnover costs and powerful unions, this
‘effect persistence’ will be significant. Second, in cases where the shocks are
mild, firms with high turnover costs have an incentive to hoard labour, and
this reduces employment variability. Third, the insider–outsider model can
provide a rationale for many features associated with ‘dual labour markets’.
Fourth, this model has implications for the composition of unemployment.
Lindbeck and Snower (1988b) argue that ‘unemployment rates will be comparatively
high for people with comparatively little stability in their work
records’. This offers an explanation for the relatively high unemployment
rates which are frequently typical among the young, the female population
and various minority groups.
While the insider–outsider theory and efficiency wage theories provide different
explanations of involuntary unemployment, they are not incompatible
but complementary models, since the amount of involuntary unemployment
‘may depend on what firms are willing to give and what workers are able to get’
(Lindbeck and Snower, 1985).
One important criticism of the menu cost literature noted by Ball et al. (1988)
is that models with nominal frictions can in theory produce large nominal
rigidities but ‘do so for implausible parameter values’. However, Ball and
Romer (1990) demonstrated that substantial nominal rigidities can result
from a combination of real rigidities and small frictions to nominal adjustment.
Indeed, Mankiw and Romer (1991) identify the interaction between
nominal and real imperfections as ‘a distinguishing feature of the new
Keynesian economies’.
If all nominal prices in an economy were completely and instantaneously
flexible, a purely nominal shock would leave the real equilibrium of an
economy unchanged. As Ball and Romer (1990) note, ‘Real rigidity does
not imply nominal rigidity: without an independent source of nominal
stickiness prices adjust fully to nominal shocks regardless of the extent of
real rigidities.’ However, rigidity of real prices and wages will magnify the
non-neutralities which result from small nominal frictions. The importance
of this point can be seen by considering the impact of a decline in the
money supply. Suppose initially that the presence of menu costs deters
firms from reducing their prices in response to this nominal disturbance.
With the price level unchanged real output will decline. Each monopolistically
competitive firm will find that its demand curve has shifted to
the left. Because each firm is producing less output, the effective demand
for labour declines (see Abel and Bernanke, 2001). If labour supply is
relatively inelastic, the shift of labour demand implied by the decline in
output will cause a large fall in real wages; that is, the nominal wage rate
declines to bring this about (see Ball et al., 1988; Gordon, 1990; D. Romer,
1993). This decline in the real wage rate implies a decline in marginal cost,
a decline which will be strongly reinforced if the marginal product of
labour rises sharply as the labour input decreases. As is evident from Figure
7.2, an upward-sloping marginal cost curve would greatly increase the
incentive to reduce price and would ‘swamp any plausible barriers to nominal
adjustment’ unless the elasticity of demand at the existing price falls as
the firm’s demand curve shifts to the left. The greater the decline in the
elasticity of demand at the existing price as output falls, the more the
marginal revenue curve facing a firm shifts to the left and the less incentive
there is for a firm to reduce its price.
David Romer (1993) sums up the essence of this issue as follows: ‘Thus if
the classical dichotomy is to fail, it must be that marginal cost does not fall
sharply in response to a demand-driven output contraction, or that marginal
revenue does fall sharply, or some combination of the two.’ Real price rigidity
is high the greater is the cyclical sensitivity of the elasticity of demand and
the smaller is the cyclical sensitivity of marginal cost. Hence nominal shocks
have large real consequences the greater the degree of real rigidity (see D.
Romer, 2001).
The points discussed above can be more easily understood by referring to
the familiar mark-up pricing equation facing a profit-maximizing monopolistically
competitive firm (see Pindyck and Rubinfeld, 1998, p. 340). Profit
maximization requires that the firm produces that level of output where
marginal revenue (MR) equals cost (MC). Marginal revenue can be expressed
in the form shown by equation (7.5):
MR = P + P(1/η) (7.5)
where P is the firm’s price and η is the price elasticity of demand. Profit
maximization therefore requires that:
P + P(1/η) = MC (7.6)
By rearranging equation (7.6) we get equation (7.7):
P MC
P
− = −1/η (7.7)
This equation can also be rearranged so as to express price as a mark-up on
marginal cost. The mark-up equation is given by (7.8):
P = MC
+
1
1 1/η
(7.8)
Since marginal cost is the nominal wage (W) divided by the marginal product
of labour (MPL), we finally get equation (7.9):
P
W
MPL
1
1 1/η
The term inside the brackets represents the mark-up, the size of which varies
inversely with the elasticity of demand (remember η is negative). Equation
(7.9) indicates that P will not fall when MC declines if the mark-up rises
sufficiently to offset this decline (see Stiglitz, 1984). If the elasticity of
demand does not decline, then equation (7.9) also indicates that the incentive
to change price will be small in the presence of menu costs if MPL does not
rise strongly as the labour input is reduced (see Hall, 1991). Rotemberg and
Woodford (1991) suggest that desired mark-ups over marginal cost fall during
a boom because it becomes increasingly difficult to maintain oligopolistic
collusion; that is, industries become more competitive in periods of high
economic activity. During recessions implicit collusion increases, leading to
a countercyclical mark-up that acts as a real rigidity, magnifying the impact
on nominal rigidity of relatively small menu costs (D. Romer, 2001).
1.1 Other sources of real price rigidity
We have already noted that mild sensitivity of marginal cost to variations in
output and procyclical elasticity of demand (implying a countercyclical markup)
will contribute towards real price rigidity. The new Keynesian literature
has also identified several other potential sources of real price rigidity.
Thick market externalities In the real world buyers and sellers are not
brought together without incurring search costs. Consumers must spend time
searching the market for the goods they desire and firms advertise in order to
attract customers. Workers and employers must also spend time and resources
searching the market. When markets are thick during periods of high
economic activity it seems plausible that search costs will be lower than is
the case in a thin market characterized by a low level of trading activity (see
Diamond, 1982). It may also be the case that people are much more willing to
participate in thick markets where a lot of trade is taking place and this leads
to strategic complementary; that is, the optimal level of activity of one firm
depends on the activity of other firms. If these thick market externalities help
to shift the marginal cost curve up in recessions and down in booms, then this
will contribute to real price rigidity.
Customer markets The distinction between auction and customer markets
has been developed by Okun (1975, 1981). The crucial characteristic of a
customer market is a low frequency of search relative to the frequency of
purchase (McDonald, 1992). Most products are sold through a process of
shopping and, providing the costs of searching the market are non-trivial, the
buyer will always have imperfect (limited) information concerning the lowest
price in the marketplace. Because of the search costs associated with the
shopping process, sellers have some monopoly power even though there may
be a large number of firms in the market, each selling a similar product. Since
a large number of customers make repetitive purchases it is in the interests of
any firm to discourage its customers from searching the market in order to
find a better deal. Firms are therefore discouraged from frequently changing
their prices, a practice which will provide an incentive for customers to look
elsewhere. Whereas an increase in price will be noticed immediately by
customers, a decrease in price will produce a much smaller initial response as
it takes time for this new information to reach the buyers at other firms. This
difference in the response rates of customers to price increases and decreases,
and the desire of a firm to hold on to its regular customers, will tend to
produce relative price stickiness (see Phelps, 1985, for an excellent discussion
of customer markets).
Price rigidity and the input–output table Gordon (1981, 1990) has drawn
attention to the complexity of decision making in a world where, typically,
thousands of firms buy thousands of components containing thousands of
ingredients from numerous other firms, many of which may reside overseas.
‘Once decentralisation and multiplicity of supplier–producer relationships
are recognised, no single firm can perform an action that would eliminate the
aggregate business cycle’ (Gordon, 1981, p. 525).
Because a firm is linked to thousands of other firms via a complex input–
output table, it is impossible for it to know the identity of all the other agents
linked together in the web of supplier–producer relationships. Because of this
complexity there is no certainty that marginal revenue and marginal cost will
move in tandem following an aggregate demand shock. There is no certainty
for an individual firm that, following a decline in aggregate demand, its
marginal cost will move in proportion to the decline in demand for its products.
Many of its suppliers may be firms in other countries facing different
aggregate demand conditions. To reduce price in these circumstances is more
likely to produce bankruptcy for the particular firm than it is to contribute to
the elimination of the business cycle because a typical firm will be subject to
both local and aggregate demand shocks as well as local and aggregate cost
shocks. As Gordon (1990) argues, in such a world no firm would be likely to
take the risk of nominal GNP indexation that would inhibit its freedom and
flexibility of action in responding to the wide variety of shocks which can
influence the position of its marginal revenue and cost curves. Since indexation
is undesirable when there is substantial independence of marginal cost
and aggregate demand, Gordon’s input–output theory not only provides an
explanation of real price rigidity but also translates into a theory of nominal
rigidity. The fundamental reason for the gradual adjustment of prices is that
this represents the safest course of action for firms operating in an uncertain
world where information is inevitably imperfect.
Clearly the informational requirements necessary for rational pricing behaviour
in every period are enormous for price-setting firms. Not only do
they need to know the position and shape of their demand and cost curves;
they also need to predict the pricing behaviour of all the other firms in the
input–output table. Since the firm’s demand and cost curves are influenced by
aggregate demand, it is also necessary for firms to predict the value of all the
relevant macro variables that influence aggregate demand. In short, the decision
makers within monopolistically competitive firms need to be first-class
general equilibrium theorists with perfect information! Given these complications,
the tendency of firms to follow simple mark-up pricing rules may be
close to optimal. The incentive to follow such rules is reinforced if other
firms do likewise, since this ensures that a firm will maintain its relative
price, which will tend to minimize its losses (see Naish, 1993). Another
simple rule which a firm can follow in a complex input–output world is to
wait until other firms raise or lower their price before initiating a change.
This produces staggering in price setting, which implies that the price level
will take longer to adjust to an aggregate demand shock.
Capital market imperfections An important obstacle to firms seeking external
finance is the problem of asymmetric information between borrowers and
lenders; that is, borrowers are much better informed about the viability and
quality of their investment projects than lenders. One consequence of this
will be that external finance will be more expensive to a firm than internal
finance. During booms when firms are making higher profits there are more
internal funds to finance various projects. Hence during recessions the cost of
finance rises as the result of a greater reliance on external sources. If the cost
of capital is countercyclical, this too will tend to make a firm’s costs rise
during a recession (see Bernanke and Gertler, 1989; D. Romer, 1993).
Judging quality by price Stiglitz (1987) has emphasized another reason
why firms may be reluctant to reduce price when faced with a decline in
demand. In markets where customers have imperfect information about the
characteristics of the products which they wish to buy, the price may be used
as a quality signal. By lowering price a firm runs the risk that its customers
(or potential customers) may interpret this action as a signal indicating a
deterioration of quality.
Having examined several potential sources of real rigidity in the product
market, we will now turn to real rigidities in the labour market. If real wages
are rigid in the face of demand disturbances, this substantially reduces a
firm’s incentive to vary its price as a response to such disturbances.
1.2 Real wage rigidity
Economists have been much better at explaining the consequences of nominal
wage rigidity than they have at providing a generally acceptable
theoretical explanation of the causes of such inertia. Nominal rigidities
allow fluctuations of aggregate demand to have real effects and contribute
to a non-market-clearing explanation of business cycles. However, Keynesian
economists are also concerned to explain the persistently high levels of
unemployment that have been a major feature of the labour markets of the
major industrial countries since the early 1970s and particularly in Europe
during the 1980s (see Table 1.4). In new classical monetary and real business
cycle models all agents are price takers. Perfect and instantaneous
price and wage flexibility ensures that the labour market always clears at a
Walrasian market-clearing real wage. In a new Keynesian world, where
price makers predominate, an equilibrium real wage can emerge which
differs from the market-clearing real wage. Stiglitz (1987) defines a market
equilibrium as ‘a state where no agents have an incentive to change their
behaviour’ and in new Keynesian models of real wage rigidity equilibrium
may not be characterized by market clearing; that is, demand equals supply.
Models involving real wage rigidity are capable of generating involuntary
unemployment in long-run equilibrium, in contrast to new classical models
where, with everyone on their labour supply function, unemployment in
equilibrium is a voluntary phenomenon. Whereas Lucas (1978a) argues for
the abandonment of the idea that a large part of unemployment is involuntary,
Solow (1980) believes that ‘what looks like involuntary unemployment
is involuntary unemployment’ (see also Hahn, 1987; Blinder, 1988a).
New Keynesian explanations of real wage rigidity fall into three main
groups: (i) implicit contract theories; (ii) efficiency wage theories; and (iii)
insider–outsider theories. Since new Keynesian theorists have been mainly
associated with the second and third of these, we will provide only a brief
comment on implicit contract theory. The reader should consult Rosen (1985)
and Timbrell (1989), who provide comprehensive surveys of the implicit
contract literature. It should also be noted that Phelps (1990, 1994) treats
theories of real wage rigidity as a separate category from new Keynesian
theory, belonging instead to what he calls the ‘Structuralist school’.
Implicit contract models The original implicit (non-union) contract models
were provided by Bailey (1974), D.F. Gordon (1974) and Azariadis (1975).
Following the development of the natural rate hypothesis (Friedman, 1968a;
Phelps, 1968), economists devoted more attention to modelling labour market
behaviour as the outcome of maximizing behaviour. The main contribution
of the ‘new’ microeconomics literature (Phelps et al., 1970) was to explain
why the natural rate of unemployment was positive. However, there appears
to be much less turnover in the labour market than search theory implies.
Furthermore, wages frequently diverge from marginal productivities. Implicit
contract theory seeks to understand what it is that forms the ‘economic glue’
that keeps workers and firms together in long-term relationships since such
arrangements, rather than the Walrasian auctioneer, dominate the labour market.
Because firms seek to maintain the loyalty of their workforce they find it
necessary to enter into unwritten (implicit) understandings with their workers.
This ‘invisible handshake’ provides each worker with assurances
concerning the terms of the working relationship under a variety of working
circumstances. The models of Bailey, Gordon and Azariadis examine the
consequences of optimal labour contracts established between risk-neutral
firms and risk-averse workers. In these circumstances the wage rate not only
represents payment for labour services but also serves as an insurance against
the risk of variable income in the face of shocks. A constant real wage
smooths the individual worker’s consumption stream and firms provide this
‘insurance’ since they are in a better position than workers to weather economic
fluctuations, given their better access to capital and insurance markets.
Because firms provide stable wages over time, workers, for their part, accept
a real wage which is lower on average than the highly varying rates that
would be dictated by market forces.
A major problem with this approach is that it predicts work sharing
rather than lay-offs when the economic climate deteriorates. The theory
also fails to explain why the firm does not pay lower wages to new recruits.
In attempting to remedy these and other weaknesses of this explanation of
real wage rigidity, new Keynesian economists have developed efficiency
wage and insider–outsider models of wage inertia (see Manning, 1995).
Efficiency wage models Any acceptable account of involuntary unemployment
must explain why unemployed workers are unable to bid down wages to
a level that will generate full employment. Efficiency wage theories suggest
that it is not in a firm’s interest to lower real wages because the productivity
(effort or efficiency) of workers is not independent of the wage, rather real
wages and worker effort are interdependent, at least over some meaningful
range. Efficiency wage theory, described by Gordon (1990) as the ‘rage of the
80s’, is surveyed by Yellen (1984), Akerlof and Yellen (1986), Katz (1986,
1988), Haley (1990), and Weiss (1991); see also Akerlof (1979, 2002), and
Stiglitz (2002).
Solow (1979) provides the basic structure of efficiency wage models. In
Solow’s model, wage stickiness is in the employer’s interest because wage
cutting would lower productivity and raise costs. Because the wage enters a
firm’s short-run production function in a labour-augmenting way, a costminimizing
firm will favour real wage rigidity. This can be demonstrated as
follows (see Yellen, 1984; Katz, 1988). Assume an economy with identical
perfectly competitive firms, each of which has a production function of the
form shown in equation (7.10):
Q = AF[e(w)L], e′(w) > 0 (7.10)
Here Q is the firm’s output, A represents a productivity shift factor, e is effort
per worker, w is the real wage and L is the labour input. Effort is assumed to
be an increasing function of the real wage and all workers are assumed to be
identical. The firm aims to maximize its profits (π), which are given by
equation (7.11):
π = AF[e(w)L]− wL (7.11)
Since effort enters the profit equation as e(w), a cut in the real wage below
that which generates maximum worker effort will lower the firm’s profits. If
the firm can hire all the labour it desires at the wage it offers, it will maximize
its profits by offering an efficiency wage of w* which satisfies two conditions.
The first condition is that the elasticity of effort with respect to the wage is
unity. Restated, this means that the firm should set a wage which will minimize
labour costs per efficiency unit of labour. This is illustrated in Figure
7.5. In panel (a) the effort curve indicated by E shows the relationship
between the effort of workers and the real wage. The higher the real wage,
the greater the effort of workers. Initially there is a region of increasing
returns where increases in the real wage rate elicit a more than proportionate
increase in worker effort (productivity). Effort per pound (dollar) of real
wage is measured by e/w. This ratio is maximized at point M, where 0X is
tangential to the effort function. Since the slope of the effort curve (e/w) is
the inverse of wage costs per efficiency unit (w/e), as the slope of E increases
the wage cost per efficiency unit falls and vice versa. The relationship between
w/e and w is shown in panel (b) of Figure 7.5. Since e/w is maximized
at M with an efficiency wage of w*, the wage cost per efficiency unit also
reaches a minimum at a real wage of w* (see Stiglitz, 1987, p. 5).
The second condition for profit maximization is that the firm should hire
labour up to the point where its marginal product is equal to the efficiency
wage. If the aggregate demand for labour at w* is less than the aggregate supply
of labour, then the market equilibrium will entail involuntary unemployment.
Since the optimal wage rate w* does not depend on either the level of employment
or the productivity shift parameter (A), a shock which shifts the aggregate
demand for labour will lead to a change in employment but no change in the
rigid real (efficiency) wage. These points are illustrated in Figure 7.6. Here DL1
shows the marginal product of labour for a given level of effort (e*). If the
efficiency wage exceeds the market-clearing wage (w), then the market equilibrium
is consistent with involuntary unemployment shown by U. If a shock
shifts the labour demand curve to DL2, then involuntary unemployment will
increase, since the efficiency wage remains at w*. Only if the market-clearing
(Walrasian) wage exceeds the efficiency wage will involuntary unemployment
be absent (see Abel and Bernanke, 2001). With w > w* firms would be forced to
pay the market-clearing wage but, for reasons discussed in the following section,
w* is always likely to be greater than the market-clearing wage. If an
increase in unemployment influences the effort of employed workers, then the
effort curve will shift up, which lowers the wage at which e/w is maximized.
This possibility is illustrated in Figure 7.5 by a shift of the effort curve from E
to E1. The e/w ratio is now maximized at M1, with a new efficiency wage of w1
So far we have assumed that effort is positively related to the real wage
rate. Now we must examine the reasons that have been advanced by new
Figure 7.6 Involuntary unemployment in the efficiency wage model
Keynesian theorists to explain this relationship. The idea that worker productivity
and real wages might be positively related over some range was clearly
recognized by Alfred Marshall, who observed that ‘highly paid labour is
generally efficient and therefore not dear labour’ (Marshall, 1920). Much
later, the efficiency wage idea reappeared in the literature relating to developing
economies (Leibenstein, 1957; Bardhan, 1993). In this context higher
wages increase the physical well-being of workers through higher nutrition,
and by reducing malnourishment higher real wages improve labour efficiency.
In the developed-country context, where most workers have adequate
nutrition, a different rationale is needed.
The modern efficiency wage theories which have been put forward relate
in general to the issues of selection and incentives and four categories of
efficiency wage theory can be identified: (i) the adverse selection model (for
example, Weiss, 1980); (ii) the labour turnover model (for example, Salop,
1979); (iii) the shirking model (for example, Shapiro and Stiglitz, 1984); and
(iv) the fairness model (for example, Akerlof, 1982). We will examine each of
these in turn. The reader should note that the papers referred to above (i–iv)
are all collected in Akerlof and Yellen (1986).
The adverse selection model In the adverse selection model, firms that offer
higher wages will attract the best workers. Because the labour market is
populated by heterogeneous individuals, firms have imperfect information
about the productivity characteristics of job applicants; the labour market is
an excellent example of a market where asymmetric information predominates.
When there is asymmetric information one party to a transaction has
more information than the other party. In this case workers have more information
about their own abilities, honesty and commitment than employers
before they are hired and will attempt to send signals to potential employers
that convey information about their qualities, such as educational qualifications,
previous employment record and current wage if employed (see Spence,
1974, for a discussion of job market signalling). Because of the non-trivial
hiring and firing costs firms prefer not to hire workers and then find they need
to fire those with low productivity. The firm may also need to invest considerable
resources in training new employees before it becomes clear that they
are not up to scratch. One way of avoiding this problem is for the firm to send
a signal to the labour market in the form of offers of high wages. In the model
presented by Weiss (1980) the wage offered by a firm influences both the
number and quality of job applicants. If workers’ abilities are closely connected
to their reservation wage, then higher wage offers will attract the most
productive job applicants and any applicant who offers to work for less than
the efficiency wage will be regarded as a potential ‘lemon’. Firms will also be
reluctant to lower wage rates even if faced with an excess supply of labour
wishing to work at the prevailing wage offer because this would in all likelihood
induce the most productive workers to quit voluntarily. As a result of
these influences an underemployment equilibrium is attained. To avoid adverse
selection problems firms will attempt to introduce screening devices,
but these measures involve costs, as will the continuous monitoring of workers
after they have been appointed.
The labour turnover model A second reason why firms may offer an efficiency
wage in excess of the market-clearing wage is to reduce costly labour
turnover. This approach received inspiration from the pioneering work of Phelps
(1968) and Phelps et al. (1970) in the development of explanations of the
natural rate of unemployment and search behaviour. The idea here is that
workers’ willingness to quit a job will be significantly reduced if a firm pays
above the going rate. With quitting rates a decreasing function of the real wage,
firms have an incentive to pay an efficiency wage to reduce costly labour
turnover. In the model developed by Salop (1979), labour market equilibrium
entails involuntary unemployment since all firms need to raise their wages to
deter workers from quitting. In situations where unemployment increases, the
wage premium necessary to deter labour turnover will fall.
The shirking model In most occupations labour contracts are incomplete,
which allows workers to exercise discretion with respect to their effort levels.
Because contracts cannot specify every aspect of a worker’s performance and
duties there is ‘effort discretion’ (see Leibenstein, 1979, for a similar approach).
Since the collection of information relating to the productivity of
individual workers and the continual monitoring of workers is very costly to
the firm, the payment of an efficiency wage in excess of the market-clearing
equilibrium wage can act as an incentive which will deter the worker from
shirking. Such behaviour may be particularly difficult to detect and monitor
when teamwork characterizes the workplace.
The possibility that workers may vary their effort is a further example of
the type of problem that can arise when there is an informational asymmetry
present. Workers know more about their effort levels than do their employers.
This asymmetry creates a ‘principal–agent’ problem. An agency relationship
develops whenever there is a relationship between economic actors and the
welfare of one person depends on the actions of the other party; that is, when
the welfare of the principal is influenced by the action (or inaction) of the
agent. In the labour market case the principal is the owner of an enterprise
and the managers and other workers are the agents. One way of reducing the
problem of shirking in this context is to pay an efficiency wage.
The threat of dismissal is not an effective deterrent in a labour market
where workers can quickly find a new job at the same wage rate. However, if
a firm pays a wage in excess of that available elsewhere, or if there is
unemployment, workers have an incentive not to shirk, since there is now a
real cost to being fired and shirking becomes more risky for each worker. In
the Shapiro–Stiglitz (1984) model, the payment of an efficiency wage acts as
a disincentive to shirking, and involuntary unemployment in equilibrium is
an outcome of the problems firms face when monitoring is imperfect: ‘With
imperfect monitoring and full employment workers will choose to shirk.’ By
being paid more than the going rate, workers now face a real penalty if they
are caught shirking. But, as Shapiro and Stiglitz (1984) note, ‘if it pays one
firm to raise its wage it will pay all firms to raise their wages’. Since a rise in
the general level of real wages raises unemployment, even if all firms pay the
same efficiency wage, workers again have an incentive not to shirk because if
caught they will now face the possibility of prolonged unemployment. The
‘reserve army’ of the unemployed act as a disincentive device. Hence the
effort (productivity) of the worker hired by the ith firm, ei, is a function of the
wage it pays, wi, the wage paid by all other firms, w–i, and the rate of
unemployment, u. This is shown in equation (7.12):
ei = ei (wi ,w−i ,u) (7.12)
When all firms pay the same wages (wi = w–i) shirking depends positively on
the level of employment. The no-shirking constraint (NSC) indicates the
minimum wage at each level of employment below which shirking will
occur, and is shown in Figure 7.7. In Figure 7.7 the market-clearing wage is
w. However, as is evident from the diagram, no shirking is inconsistent with
full employment. As an incentive not to shirk, a firm must offer an efficiency
wage greater than w. With all firms offering a wage of w*, workers are
deterred from shirking by the risk of becoming unemployed. The diagram
also shows that the need to pay a wage greater than w decreases as unemployment
increases and that the efficiency wage w* and level of employment L0
are associated with an equilibrium level of involuntary unemployment indicated
by LF – L0. As the NSC will always lie above and to the left of the
labour supply curve, there will always be some involuntary unemployment in
equilibrium.
The NSC will shift to the left if the firm reduces its monitoring intensity
and/or the government increases unemployment benefit. In each case the
wage necessary to deter shirking at each level of employment is higher. A
change in the NSC brought about by either of the above reasons is shown in
Figure 7.7 as a shift of NSC from NSC0 to NSC1. The equilibrium following
this shift is indicated by E1, showing that the model predicts an increase in
the efficiency wage and an increase in the equilibrium rate of involuntary
unemployment as a result of these changes.
The fairness model In recent years several economists have examined the
adverse effects of ‘unfair wages’ and wage cuts on worker effort via the impact
such cuts will have on the morale of the workforce. Sociological models stress
such factors as the importance of wage relativities, status, relative deprivation,
loyalty, trust and equity. In a series of papers, Akerlof (1982, 1984) and Akerlof
and Yellen (1987, 1988, 1990) responded to Solow’s (1979, 1980) ‘piece of
home-made sociology’ and developed models where feelings about equity and
fairness act as a deterrent to firms to offer too low wages in the labour market.
Thurow (1983), Blinder (1988a) and Solow (1990) have also indicated that this
socioeconomic line of enquiry could prove fruitful as an explanation of persistent
unemployment. Recently, in his Nobel Memorial Lecture, George Akerlof
(2002) presented a strong case for strengthening macroeconomic theory by
incorporating assumptions that take account of behaviour such as ‘cognitive
bias, reciprocity, fairness, herding and social status’. By doing so Akerlof
argues that macroeconomics will ‘no longer suffer from the “ad hockery” of the
neoclassical synthesis which had overridden the emphasis in the General Theory
on the role of psychological and sociological factors’. Since in Akerlof’s view
Keynes’s General Theory ‘was the greatest contribution to behavioural economics
before the present era’, it would seem that economists need to rediscover
the ‘wild side’ of macroeconomic behaviour in order to begin the construction
of ‘a not too rational macroeconomics’ (Leijonhufvud, 1993).
Many economists share Akerlof’s concerns and are critical of models
where the labour market is modelled in much the same way as a commodity
or financial market. The flexible price–auction model employed by new classical
economists does not seem to resemble observed labour market behaviour.
There are fundamental differences between labour inputs and other nonhuman
inputs into the production process:
1. Workers have preferences and feelings; machines and raw materials do
not.
2. Workers need to be motivated; machines do not.
3. The productivity of a machine is reasonably well known before purchase,
so that problems of asymmetric information relating to quality are
much less significant.
4. Workers can strike and ‘break down’ because of ill health (stress and so
on); machines can break down but never strike for higher pay or more
holidays.
5. The human capital assets of a firm are more illiquid and risky than its
capital assets.
6. Workers normally require training; machines do not.
7. Human capital cannot be separated from its owner; non-human capital
can.
8. Workers’ utility functions are interdependent, not independent.
Because of these crucial differences, worker productivity is a discretionary
variable; the effort or output of a worker is not given in advance and fixed for
the future, irrespective of changes which take place in working conditions
(see also Leibenstein, 1979). A machine does not get angry when its price
fluctuates, nor does it feel upset if it is switched off. In contrast, workers are
not indifferent to their price, nor are they unmoved by becoming unemployed
against their will. For these and other reasons, the notion of fairness would
seem to be an important factor in determining outcomes in the labour market.
As Solow (1990) has argued, ‘The most elementary reason for thinking that
the concept of fairness, and beliefs about what is fair and what is not, play an
important part in labour market behaviour is that we talk about them all the
time.’ The words ‘fair’ and ‘unfair’ have even been used by neoclassical
economists at university departmental meetings!
The first formal model to bring in sociological elements as an explanation
of efficiency wages was the seminal paper by Akerlof (1982), where issues
relating to fairness lie at the centre of the argument. According to Akerlof, the
willing cooperation of workers is something that must usually be obtained by
the firm because labour contracts are incomplete and teamwork is frequently
the norm. The essence of Akerlof’s gift exchange model is neatly summed up
in the phrase ‘A fair day’s work for a fair day’s pay’. Everyday observation
suggests that people have an innate psychological need to feel fairly treated,
otherwise their morale is adversely affected. In Akerlof’s model, workers’
effort is a positive function of their morale and a major influence on their
morale is the remuneration they receive for a given work standard which is
regarded as the norm. If a firm pays its workers a wage above the going
market rate, workers will respond by raising their group work norms, providing
the firm with a gift of higher productivity in exchange for the higher
wage.
In subsequent work Akerlof and Yellen (1990) have developed what they
call the ‘fair wage–effort hypothesis’, which is derived from equity theory. In
the workplace personal contact and potentially conflicting relationships within
a team of workers are unavoidable. As a result issues relating to fairness are
never far away. Since there is no absolute measure of fairness, people measure
their treatment by reference to other individuals within their own group.
Fairness is measured by making comparisons with workers similarly situated
(inside and outside the firm). Thus an individual worker’s utility function can
be summarized as equation (7.13):
U = U(w/ω,e,u) (7.13)
The utility of this worker (U) is dependent on the real wage (w) relative to the
perceived ‘fair’ wage (ω), the worker’s effort (e) and the unemployment rate
(u). Assuming the worker wishes to maximize this function, the effort expended
will depend on the relationship between w and ω for a given level of
unemployment. Workers who feel unfairly treated (w < ω) will adjust their
effort accordingly. ‘The ability of workers to exercise control over their
effort, and their willingness to do so in response to grievances, underlies the
fair wage–effort hypothesis’ (Akerlof and Yellen, 1990, p. 262). Just as firms
face a no-shirking constraint in the Shapiro–Stiglitz model, they face a ‘fair
wage constraint’ in the fairness version of the efficiency wage model. Since
the fair wage exceeds the market-clearing wage, this framework generates an
equilibrium with involuntary unemployment.
The essence of this innovative approach to explaining real wage rigidity is
that the morale of a firm’s human capital can easily be damaged if workers
perceive that they are being unfairly treated. Firms that attach importance to
their reputation as an employer and that wish to generate high morale and
loyalty from their workforce will tend to pay efficiency wages which are
perceived as fair.
It appears that American entrepreneur Henry Ford shared Marshall’s insight
that ‘highly paid labour is generally efficient and therefore not dear
labour’. In the autumn of 1908, Henry Ford launched the production of the
famous Model T Ford. During the period 1908–14, he pioneered the introduction
of mass production techniques that characterized the ‘American System
of Manufactures’ (Rosenberg, 1994). The assembly line production methods
introduced by Ford required relatively unskilled workers rather than the
skilled craftsmen he had previously needed to assemble automobiles one by
one. The first moving assembly lines began operation in April 1913 but
unfortunately for Ford, the introduction of these mass production techniques
drastically changed the working environment and led to a massive and costly
increase in absenteeism and the turnover of workers. In 1913 the annual
turnover of workers at Ford was 370 per cent and daily absenteeism was 10
per cent. In January 1914 Ford responded to this problem by introducing a
payment system of $5 for an eight-hour day for male workers over the age of
22 who had been with the company for at least six months. Previously these
same workers had been working a nine-hour day for $2.34. For a given level
of worker productivity an increase in the wage paid was certain to increase
unit labour costs and, to contemporary observers, Ford’s policy seemed to
imply a certain reduction in the firm’s profits. However, the result of Ford’s
new wage policy was a dramatic reduction in absenteeism (down 75 per
cent), reduced turnover (down 87 per cent), a massive improvement in productivity
(30 per cent), a reduction in the price of the Model T Ford, and an
increase in profits. It appears that Ford was one of the first entrepreneurs to
apply efficiency wage theory. Later, Henry Ford described the decision to pay
his workers $5 per day as ‘one of the finest cost cutting moves we ever made’
(see Meyer, 1981; Raff and Summers, 1987). There is no evidence that Ford
was experiencing trouble recruiting workers before 1914 or that the new
wage policy was introduced to attract more highly skilled workers. The most
plausible rationale for the policy is the favourable impact that it was expected
to have on workers’ effort, turnover and absenteeism rates, and worker morale.
Raff and Summers (1987) conclude that the introduction by Ford of
‘supracompetitive’ wages did yield ‘substantial productivity benefits and
profits’ and that this case study ‘strongly supports’ the relevance of several
efficiency wage theories.
Insider–outsider models Why don’t unemployed workers offer to work for
lower wages than those currently paid to employed workers? If they did so,
wages would be bid down and employment would increase. There appears to
be an unwritten eleventh commandment: ‘Thou shalt not permit job theft by
underbidding and stealing the jobs of thy comrades.’ The insider–outsider
theory also attempts to explain why wage rigidity persists in the face of
involuntary unemployment (see Ball, 1990, and Sanfey, 1995 for reviews).
The insider–outsider approach to real wage rigidity was developed during
the 1980s in a series of contributions by Lindbeck and Snower (1985, 1986,
1988a, 1988b). In this model the insiders are the incumbent employees and
the outsiders are the unemployed workers. Whereas in efficiency wage models
it is firms that decide to pay a wage higher than the market-clearing wage,
in the insider–outsider approach the focus shifts to the power of the insiders
who at least partially determine wage and employment decisions. No direct
effects of wages on productivity are assumed.
Where does the insider power come from? According to Lindbeck and
Snower, insider power arises as a result of turnover costs (Vetter and Andersen,
1994). These include hiring and firing costs such as those associated with
costs of searching the labour market, advertising and screening, negotiating
conditions of employment, mandatory severance pay and litigation costs.
Other important costs are production-related and arise from the need to train
new employees. In addition to these well-known turnover costs, Lindbeck
and Snower (1988a) also emphasize a more novel form of cost – the insider’s
ability and incentive to cooperate with or harass new workers coming from
the ranks of the outsiders. If insiders feel that their position is threatened by
outsiders, they can refuse to cooperate with and train new workers, as well as
make life at work thoroughly unpleasant. By raising the disutility of work,
this causes the outsiders’ reservation wage to rise, making it less attractive for
the firm to employ them. To the extent that cooperation and harassment
activities lie within the control of workers, they can have a significant influence
on turnover costs by their own behaviour.
Because firms with high rates of turnover offer both a lack of job security
and few opportunities for advancement, workers have little or no incentive to
build reputations with their employers. Low motivation damages productivity
and this represents yet another cost of high labour turnover.
Because it is costly to exchange a firm’s current employees for unemployed
outsiders, the insiders have leverage which they can use to extract a
share of the economic rent generated by turnover costs (the firm has an
incentive to pay something to avoid costly turnover). Lindbeck and Snower
assume that workers have sufficient bargaining power to extract some of this
rent during wage negotiations. Although unions are not necessary for insider
power, they enhance it with their ability to threaten strikes and work-to-rule
forms of non-cooperation (For a discussion of union bargaining models and
unemployment, see McDonald and Solow, 1981; Nickell, 1990; Layard et al.,
1991.)
Although the insider–outsider theory was originally put forward as an
explanation of involuntary unemployment, it also generates some other important
predictions (see Lindbeck and Snower, 1988b). First, insider–outsider
theory implies that pronounced aggregate shocks which shift the demand for
labour may have persistent effects on wages, employment and unemployment.
In countries with large labour turnover costs and powerful unions, this
‘effect persistence’ will be significant. Second, in cases where the shocks are
mild, firms with high turnover costs have an incentive to hoard labour, and
this reduces employment variability. Third, the insider–outsider model can
provide a rationale for many features associated with ‘dual labour markets’.
Fourth, this model has implications for the composition of unemployment.
Lindbeck and Snower (1988b) argue that ‘unemployment rates will be comparatively
high for people with comparatively little stability in their work
records’. This offers an explanation for the relatively high unemployment
rates which are frequently typical among the young, the female population
and various minority groups.
While the insider–outsider theory and efficiency wage theories provide different
explanations of involuntary unemployment, they are not incompatible
but complementary models, since the amount of involuntary unemployment
‘may depend on what firms are willing to give and what workers are able to get’
(Lindbeck and Snower, 1985).
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