1. Efficiency Wages in Heterogenous Labour Markets Pavel Ryska, Jan Průša Institute of Economic Studies, Charles University Prague PCPE, March 26, 2010

2. Outline Motivation Motivation Efficiency wage models Efficiency wage models Solow Solow Shapiro-Stiglitz Shapiro-Stiglitz General approach to heterogenous markets General approach to heterogenous markets Conclusion Conclusion

3. Motivation Efficiency-wage models derive involuntary unemployment from firm optimization Efficiency-wage models derive involuntary unemployment from firm optimization They serve as a proof of market failure They serve as a proof of market failure We show that this result stems from two flaws: We show that this result stems from two flaws: neglecting labour heterogeneity neglecting labour heterogeneity inner contradiction: voluntary choice of workers causes involuntary unemployment inner contradiction: voluntary choice of workers causes involuntary unemployment

4. Simple Solow model Labour efficiency depends on “effort function”, which itself depends on wages 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 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 Optimal wage is given by the unit wage elasticity of effort: e'(w)/(e/w) = 1

5. 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(L 1,..., L n ) – w 1 L 1 –... – w n L n Firm optimizes F(L 1,..., L n ) – w 1 L 1 –... – w n L n 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. That is, the effort function is worker-endogenous.

6. Shapiro-Stiglitz model Imperfect monitoring of work effort Imperfect monitoring of work effort Firms know workers may shirk – they offer higher wages to discourage shirking Firms know workers may shirk – they offer higher wages to discourage shirking → no-shirking condition (NSC), as opposed to L s Equilibrium with involuntary unemployment Equilibrium with involuntary unemployment Problem: inner contradiction about L s. Shapiro & Stiglitz tacitly redefine labour supply and shift its original meaning into NSC. Problem: inner contradiction about L s. Shapiro & Stiglitz tacitly redefine labour supply and shift its original meaning into NSC.

7. Welfare implications of Shapiro- Stiglitz model Existence of M identical firms is questionable. Existence of M identical firms is questionable. They dispute income distribution based on marginal product and would prefer wages equal to average product. They dispute income distribution based on marginal product and would prefer wages equal to average product. But then each labourer could be self-employed. But then each labourer could be self-employed. A flavour of Marxist “surplus” arguments in the model. A flavour of Marxist “surplus” arguments in the model.

8. General characteristics model (1) A good may have up to r characteristics, but different goods may share the same characteristics. A good may have up to r characteristics, but different goods may share the same characteristics. Transformation from goods to characteristics z = Bx 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 Consumer utility is defined on characteristics space: max u(z) s.t. z = Bx x ≥ 0 px ≤ Income

9. General characteristics model (2) Consumers choose only those goods which have the most desired characteristics and corner solutions become the standard. 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. 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. Workers have to change either their wage or their characteristic to turn the corner solution in their favour.

10. Conclusions The theory of efficiency wages can help us understand heterogeneous labour markets. 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. 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. When quality-specific labour markets become separated, unemployment can no longer be interpreted as involuntary.

11. Key texts Solow, R. (1979): Another Possible Source of Wage Stickiness. Journal of Macroeconomics, No. 1., pp. 79- 82. Solow, R. (1979): Another Possible Source of Wage Stickiness. Journal of Macroeconomics, No. 1., pp. 79- 82. Shapiro, C., Stiglitz, J.E. (1984): Equilibrium Unemployment as a Worker Discipline Device. American Economic Review, No. 3, pp. 433-444. Shapiro, C., Stiglitz, J.E. (1984): Equilibrium Unemployment as a Worker Discipline Device. American Economic Review, No. 3, pp. 433-444.