Efficiency Wages in
Heterogenous Labour Markets
Pavel Ryska, Jan Průša
Institute of Economic Studies, Charles University Prague
PCPE, March 26, 2010
Outline
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
Motivation
Efficiency wage models
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

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Solow
Shapiro-Stiglitz
General approach to heterogenous markets
Conclusion
Motivation



Efficiency-wage models derive involuntary
unemployment from firm optimization
They serve as a proof of market failure
We show that this result stems from two flaws:


neglecting labour heterogeneity
inner contradiction: voluntary choice of workers
causes involuntary unemployment
Simple Solow model
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Labour efficiency depends on “effort function”,
which itself depends on wages
Then firms choose wage and labour which solves:
max F(e(w)L) – wL
Optimal wage is given by the unit wage elasticity
of effort: e'(w)/(e/w) = 1
Two fundamental errors
1. Different levels of effort constitute labour of
different qualities and hence trade on different
markets with different prices.

Firm optimizes
F(L1, ..., Ln) – w1L1 – ... – wnLn
2. The effort decision of a worker is voluntary and
intentional, so resulting unemployment cannot
by definition be involuntary.

That is, the effort function is worker-endogenous.
Shapiro-Stiglitz model
•
•
•
•
Imperfect monitoring of work effort
Firms know workers may shirk – they offer higher
wages to discourage shirking
s
→ no-shirking condition (NSC), as opposed to L
Equilibrium with involuntary unemployment
s
Problem: inner contradiction about L . Shapiro &
Stiglitz tacitly redefine labour supply and shift its
original meaning into NSC.
Welfare implications of ShapiroStiglitz model

Existence of M identical firms is questionable.
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They dispute income distribution based on marginal
product and would prefer wages equal to average
product.
But then each labourer could be self-employed.
A flavour of Marxist “surplus” arguments in the
model.
General characteristics model (1)

A good may have up to r characteristics, but
different goods may share the same
characteristics.
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
Transformation from goods to characteristics z = Bx
Consumer utility is defined on characteristics
space: max u(z) s.t.
z = Bx
x≥0
px ≤ Income
General characteristics model (2)
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Consumers choose only those goods which have
the most desired characteristics and corner
solutions become the standard.
When x = workers, then unemployment can be
interpreted as a wage-characteristic mismatch.
Workers have to change either their wage or their
characteristic to turn the corner solution in their
favour.
Conclusions
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The theory of efficiency wages can help us
understand heterogeneous labour markets.
To achieve this aim, the theory needs to be
reformulated and get rid of the main
inconsistencies.
When quality-specific labour markets become
separated, unemployment can no longer be
interpreted as involuntary.
Key texts
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
Solow, R. (1979): Another Possible Source of Wage
Stickiness. Journal of Macroeconomics, No. 1., pp. 7982.
Shapiro, C., Stiglitz, J.E. (1984): Equilibrium
Unemployment as a Worker Discipline Device. American
Economic Review, No. 3, pp. 433-444.