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CASE STUDY EXTENSION
7-7 Minimum Wages and Efficiency Wages
One of the biggest controversies in macroeconomics during the last decade concerns the effects of an
increase in the minimum wage on unemployment. Standard analysis suggests that an increase in the
minimum wage will increase unemployment. But studies by David Card, Lawrence Katz, and Alan
Krueger of fast–food restaurants in New Jersey and Pennsylvania found—surprisingly—that an increase in
the state minimum wage in New Jersey was accompanied by an increase in employment at fast–food
restaurants in that state.1 Restaurants across the state line in Pennsylvania, where there was no change in
the minimum wage, did not increase employment.
Many economists are skeptical about the Card–Katz–Krueger results because they do not see any
good explanation of why an increase in the minimum wage would increase employment. One explanation
is that firms might have monopsony power in labor markets. As a monopsonist hires more workers, it
ADVANCED TOPIC
7-8 Implicit Contracts
In the mid–1970s, a number of authors provided another explanation of wage rigidity: Firms and workers
might find it in their mutual best interest to write wage contracts that specified a fixed wage.1 The basic
intuition is that in an uncertain world, contracts may serve more than one function. As well as being the
means whereby workers are remunerated for their services, they may also be a means for the firm to insure
research first appeared, many economists thought that it would provide a good microeconomic theory of
unemployment that was immune from the Lucas $500 bill criticism.2
Let us consider the environment in which such contracts make sense. The first idea is that the world is
uncertain so that, in the absence of contracts, workers’ wages fluctuate: In good “states of the world,”
workers’ productivity, and hence their wage, is high; in bad states of the world, their wage is low.3
this implies unemployment—in an optimal contract, the wage and employment decisions are separated. It
turns out that, overall, contract theory does not really explain unemployment very easily: Optimal
contracts often imply higher employment than would occur in an auction market.
Early models also included some important unexplained restrictions on the form of contracts, such as
no work–sharing or severance pay. When these assumptions were relaxed, the models no longer generated
1 The seminal papers are C. Azariadis, “Implicit Contracts and Underemployment Equilibria,” Journal of Political Economy 83 (1975): 1183–1202;
and M.N. Baily, “Wages and Employment Under Uncertain Demand,” Review of Economic Studies 83, no. 41 (1974): 37–50. There are also many
good surveys of this literature; see, for example, R. Cooper, Wage and Employment Patterns in Labor Contracts: Microfoundations and
Macroeconomic Implications (Chur, Switzerland: Harwood Academic Publishers, 1987); C. Davidson, Recent Developments in the Theory of
Involuntary Unemployment (Kalamazoo, MI: Upjohn, 1990); and J. Stiglitz, “Theories of Wage Rigidity,” in J. Butkiewicz et al., eds., Keynes’
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ADDITIONAL CASE STUDY
7-9 The Two Views of Unions
The discussion of unions in the textbook focuses on the fact that they may use their bargaining power to
raise wages above the competitive level, giving rise to unemployment. Union members—insiders—benefit
from the higher wages, but those not protected by unions—outsiders—suffer because of the consequent
unemployment. This view of unions stresses that unions, through their monopoly power, distort the price
system and lead to misallocation of resources.
Such a view of unions is incomplete because it ignores the fact that unions may make positive
contributions to the workplace and to society. Labor economists Richard Freeman and James Medoff
suggest that unions’ ability to improve employer–employee communications and hence productivity and
efficiency counterbalances their adverse monopoly effects.1 Unions provide a collective voice that allows
workers to communicate and discuss working conditions or other problems with management. As such,
ADVANCED TOPIC
7-10 Efficiency Wages I: The Solow Condition
Suppose that a firm has a production function
Y = F(K, E × L),
where E represents the efficiency (perhaps effort) of labor. Efficiency–wage theories suggest that E may
depend on the real wage. To keep things simple, suppose that the price level (P) equals 1, so the real wage
(Note that F( ) equals the firm’s revenue since P = 1.) Whereas we previously thought about the firm as
simply choosing the quantity of labor, we now think about the firm choosing both W and L. The firm
recognizes that a higher wage makes its workers more productive.
Think first about the wage the firm would want to set. If it raises the wage a little bit, each worker will
work a little bit harder. Call the amount of extra effort brought forth by a $1 increase in the wage the
marginal effort (ME = ∆E/∆W). Since each worker will work harder, the total change in labor, measured in
effective workers, is equal to ME × L. To get the extra output that this implies, we must multiply by the
marginal product of labor. Thus, the extra revenue brought forth by a $1 increase in the wage equals
MPL × ME × L.
Increasing the wage, though, also increases the firm’s costs. If the wage is increased by $1, the firm’s costs
will rise by $L. By now we are familiar with the idea that the firm will want to increase the wage until the
extra benefit just matches the extra cost:
The firm thus will want to choose the wage such that the elasticity of effort with respect to the wage equals
1. This is known as the Solow condition.1 The resulting wage is the efficiency wage W*. Once the firm has
found this wage, it then chooses employment such that the marginal product of labor equals the wage.
The key point about this is that wages and employment are no longer determined in the labor market
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ADVANCED TOPIC
7-11 Efficiency Wages II: The Shapiro–Stiglitz Model
We consider here a simplified version of the efficiency–wage model of Shapiro and Stiglitz.1 The
Shapiro–Stiglitz model takes as its starting point the idea that firms may not be able to monitor workers’
activity on the job. Suppose that workers can decide to shirk on the job—and they prefer this to working.
Suppose also that the labor market is perfectly competitive. If a worker is caught shirking on the job, then
he is fired. But if the labor market is competitive, the worker can always be rehired at another firm, at no
cost. Therefore, the optimal thing would be for workers to shirk. In an attempt to prevent this, the firm will
want to pay a wage in excess of the wage offered at other firms, since this would generate a cost to
shirking.
Every day, there is some probability b that a worker is separated from his job. Think of this as
retirement (and suppose that the firm also employs new, young workers to take the place of retired
workers). We assume, however, that this probability is outside the worker’s control. If the worker shirks,
there is an additional probability (q) that he will be caught and fired. If the worker is separated from his
168
Now suppose, instead, that I shirk. What is my job worth? Each day I will earn W instead of W – E. But
each day, the probability that I lose my job is b + q, so I can expect to keep my job for only 1/(b + q) days.
So the value of my job if I shirk is:
So I am only going to work if it’s worth my while—if Vw ≥ Vs.”
Since the firm can figure all this out, the firm will want to make sure that Vw ≥ Vs. This is called the no–
shirking condition (NSC). (We will suppose that if Vw = Vs, the worker chooses to work.)
Now:
Vw ≥ Vs
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worker–discipline device. The main change this makes to the model is that the NSC schedule is now
upward sloping, as shown in Figure 3.2
ADDITIONAL CASE STUDY
7-12 Efficiency Wages and Wage Differentials
One piece of evidence that supports efficiency–wage theory is that wages vary across industries. Numerous
researchers have documented the presence of such wage differentials. For example, Alan Krueger and
Lawrence Summers look at data on individuals working in different industries.1 They attempt to explain
workers’ wages on the basis of workers’ characteristics in the manner suggested by human capital theory.2
That is, they use variables such as education, age, occupation, and union membership; a number of
demographic variables such as race, gender, marital status, and region of the country; and a number of
other interaction variables. They then look to see whether, after they control for all these effects,
systematic differences in wages in different industries still exist. They do.
Table 1
Industry
Differential (1984)
Construction
0.108
Manufacturing
0.091
Transportation and public utilities
0.145
0.055
Mining
0.222
These findings tell us that there are industry–specific differences in wages that cannot be explained by
standard variables. Such results are at best indirect evidence in support of efficiency wages; they certainly
do not “prove” that efficiency–wage models are a good description of the labor market. Krueger and
Summers discuss the possibility that these wage differentials might be the result of differences in labor
quality not captured by their human capital variables or differences in job attributes (some jobs may be
less pleasant and so require the payment of compensating differentials). They do not, however, believe that
such effects explain the data. Their conclusion is that a competitive view of the labor market cannot
explain interindustry wage patterns, and so we need theories that explain why firms might pay wages that
differ from their competitive level. Efficiency wages provide such a theory.
There is still relatively little evidence that bears directly on efficiency–wage theories. A recent study
1 A. Krueger and L. Summers, “Efficiency Wages and the Interindustry Wage Structure,” Econometrica 56 (March 1988): 259–93.
2 See Supplement 3–2, “What Is Capital?” for a brief discussion of human capital.
47.
6 Ibid., 332.
CASE STUDY EXTENSION
7-13 More on Henry Ford
Daniel Raff and Lawrence Summers place Henry Ford’s decision to institute a $5 day in the context of
Ford’s adoption of assembly–line manufacture.1 The resultant specialization made workers’ tasks more and
more routine and menial. Perhaps as a consequence, employee turnover at the Ford Motor Company in
1913 reached 370 percent per annum: Ford hired over 50,000 workers that year, although the average
work force was under 14,000. Over 7,000 workers left Ford in March of that year alone.
Another interesting detail is that Percival Perry, an associate of Ford’s who opened Ford’s original
1 D. Raff and L. Summers, “Did Henry Ford Pay Efficiency Wages?” Journal of Labor Economics 5 (October 1987): S57–S86. The following
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CASE STUDY EXTENSION
7-14 More on the Duration of Unemployment
The median duration of unemployment measures one facet of the severity of unemployment. The median
is the point that splits the distribution of unemployment duration in half. For example, in December 1998,
half of all unemployed individuals had been without a job for 6.8 weeks or less, and half had been without
a job for 6.8 weeks or more.
Figure 1 shows the unemployment rate and the median duration of unemployment over the past five
decades. The unemployment rate exhibits a cyclical pattern—rising during economic contractions and
falling (with a slight lag) during expansions. The median duration of unemployment has closely followed
the path of the unemployment rate throughout most of this period. During the expansion of the 1990s,
however, the duration of unemployment exhibited a clear break from this pattern. While the
unemployment rate declined steadily after peaking at 7.8 percent in June 1992, the median duration of
unemployment remained stuck at about eight weeks for nearly five years before declining to about six
weeks by the turn of the century.
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During most of the expansion of the 1990s, the long–term unemployed as a percentage of total
unemployment showed only a slight downward trend, causing the stickiness in the duration of
unemployment. Not until late 1997 did the number of long–term unemployed begin a significant decline,
leading to the drop in the median duration of unemployment.
The decline in the duration of unemployment does not necessarily imply that the long–term
unemployed found jobs. It is possible that an increasing number of these job seekers became discouraged
and dropped out of the labor force. However, the number of individuals who were not in the labor force
because of discouragement over their job prospects actually fell during the late 1990s. Thus, the data
provide some support for the notion that the longer–term unemployed were finding jobs.
Although median duration did decline in the late 1990s, it remained above levels reached during
earlier economic expansions. And when the economy headed into recession in 2001, median duration once
LECTURE SUPPLEMENT
7-15 Trends in Unemployment
The average unemployment rate in the United States has fluctuated over the past few decades, from less
than 5 percent in the 1950s and 1960s to more than 6 percent in the 1970s and 1980s, and back to less than
5 percent in the 1990s and 2000s. Three possible explanations for these fluctuations are demographic
changes, sectoral shifts, and changes in productivity growth.
The entrance of the baby–boom generation into the workforce in the 1970s and 1980s lowered the
average age of the workforce, which would tend to increase the unemployment rate. As the baby–boom
workers aged, the average age of the workforce declined, reversing the rise in the unemployment rate.
Sectoral shifts focus on the volatility in oil prices during the 1970s and 1980s. This volatility required
the reallocation of workers between more–energy–intensive and less–energy–intensive industries, leading to
ADDITIONAL CASE STUDY
7-16 The Secrets to Happiness
Why are some people more satisfied with their lives than others? This is a deep and difficult question,
most often left to philosophers, psychologists, and self–help gurus. But part of the answer is
macroeconomic in nature. Recent research has shown that people are happier when they live in a country
with low inflation and low unemployment.
From 1975 to 1991, a survey called the Euro–Barometer Survey Series asked 264,710 people living in
12 European countries about their happiness and overall satisfaction with life. One question asked, “On the
whole, are you very satisfied, fairly satisfied, not very satisfied, or not at all satisfied with the life you
lead?” To see what determines happiness, the answers to this question were correlated with individual and
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LECTURE SUPPLEMENT
7-17 Additional Readings
The study of the labor market is an important subdiscipline of economics, and as a result there are a
number of good textbooks available on the topic. See, for example, Daniel Hamermesh and Albert Rees,
The Economics of Work and Pay (New York: HarperCollins, 1988).
A recent survey of theories of unemployment, including an extensive discussion of search theory, is
C. Davidson, Recent Developments in the Theory of Involuntary Unemployment (Kalamazoo, Mich.:
Upjohn Institute, 1990).
The minimum wage is discussed in C. Brown, “Minimum Wage Laws: Are They Overrated?” Journal
of Economic Perspectives 2, no. 3 (Summer 1988): 133–45.
A recent survey of the economic effects of a minimum wage is John Kennan, “The Elusive Effects of
Minimum Wages,” Journal of Economic Literature (December 1995): 1950–65.
The Spring 1988 issue of the Journal of Economic Perspectives contains a symposium on “Public and
Private Unionization,” with papers by Edward Lazear, Richard Freeman, and Melvin Reder that address
the decline in private sector unionism since the 1950s. A sympathetic portrayal of the role of unions can be
found in R. Freeman and J. Medoff, What Do Unions Do? (New York: Basic Books, 1984).
1990). Another symposium in the same journal discusses European unemployment (Summer 1997).