Efficiency wages, partial wage rigidity, and money nonneutrality.

• Author: Lin, Chung-Cheng

1. Introduction

   Since the 1970s, the persistently high unemployment rates in many industrial economies have made more and more economists believe that involuntary unemployment is one of the major stylized facts of modern economies. Therefore, a satisfactory macroeconomic labor model should explain well such a stylized fact. The efficiency wage theory has in recent years generally been regarded as a powerful vehicle for explaining why involuntary unemployment has persisted in the labor market. In constructing a business cycle model, "a potential problem of the efficiency-wage hypothesis is the absence of a link between aggregate demand and economic activity" (Yellen 1984, p. 204). Hence, until Akerlof and Yellen (1985) presented the near-rational model, efficiency wage theories still left unanswered the question of how changes in the money supply can affect real output.(1) By utilizing the idea of partially rigid wages, this paper interprets why changes in money supply and other demand management policies can cause changes in aggregate employment and output.

   In macroeconomic theory, the wage is simply regarded as the amount of money that employees receive and is assumed to be exactly equal to the average cost of labor to employers.(2) In practice, the components of wages are more complicated than the simple economic setting would suggest. There exist some gaps between the amounts that trading partners pay and receive. For example, the actual average cost of labor to employers is equal to the wage that employees receive after the addition of hiring and training costs, firing (severance pay) and retirement (pension) costs, various taxes and insurance fees, sometimes traffic and housing outlays, and so on. Some of these costs, especially taxes, insurance, and traffic fees, are set by the process of political negotiations. The resetting processes relating to these costs are always time-consuming and controversial in modern democratic societies, and these costs are not as flexible as other components of wages determined by competitive markets or monopsonists. Since some components of wages are always inflexible, partial rigidity of wages is thus a realistic specification for economic modeling. When we recognize that wages have the property of partial rigidity, it is logical to expect that money nonneutrality will hence result.

   The basic tenet of the efficiency wage theory is that the effort or productivity of a worker is positively related to his real wage and firms have the market power to set the wage. Therefore, in order to maintain high productivity, it may be profitable for firms not to lower their wages in the presence of involuntary unemployment. The main reasons that are provided for the positive relationship between worker productivity and wage levels include nutritional concerns (Leibenstein 1957), morale effects (Akerlof 1982), adverse selection (Weiss 1980), and the shirking problem (Shapiro and Stiglitz 1984).(3) The shirking viewpoint proposed by Shapiro and Stiglitz (1984) is the most popular version of the theory.(4) Its essential feature is that firms cannot precisely observe the efforts of workers due to incomplete information and costly monitoring; equilibrium unemployment is therefore necessary as a worker discipline device. We thus adopt a shirking model as the analytical framework of this paper to examine the effects of partial rigidity of wages.

   The rest of this paper is organized as follows. Section 2 derives the effort function of a representative worker. Section 3 examines a typical firm's labor demand and wage-setting behavior. Section 4 studies the labor market equilibrium. Finally, some concluding remarks are presented in section 5.

2. The Worker's Optimization Problem

   Our analysis starts by considering a simple economy where each of many identical firms hires a number of ex ante homogeneous workers to perform some task.(5) The worker enjoys on-the-job leisure and dislikes working hard. Owing to team production or some unobservable disturbances, the firm cannot determine the actual effort of an individual worker. Thus, it is impossible to reward individual workers according to their particular productivity, suggesting that there would be a probabilistic penalty to induce work effort. Such a probabilistic penalty in the shirking model is typically represented by the threat of firing. Employers will therefore monitor the performance of employees and lay off workers who are found not to be working hard.

   The worker's probability of being fired [Rho] is assumed to be negatively related to his work effort e. For simplicity, [Rho] is specified as

   [Rho] = 1 - e; 0 [less than or equal to] e [less than or equal to] 1. (1)

   Effort e is assumed to be the fraction of the standard paid-for hours that the worker actually works, while the number of standard hours is assumed to be fixed and normalized to unity.

   When a worker is fired, he will try to find another job. The probability of finding another job is assumed to be the employment rate (1 - u). The unemployment rate u here is defined to be the ratio of the number of unemployed to the total number of workers.

   Following the static analytical framework of Pisauro (1991), there are three states of nature that an employed worker may face. First, he is not fired and receives a real wage [w.sub.i] with the probability of (1 - [Rho]). Second, he is dismissed but finds another job at a real wage w; the associated probability is [Rho](1 - u). Third, he is fired and cannot find another job; hence, he becomes unemployed (and enjoys all-day leisure, e = 0) and receives unemployment benefits b from the government. The probability in this case is [Rho]u. Moreover, firms are assumed to be identical and to pay the same real wage (w = [w.sub.i]). The three states are thus reduced to two.(6) Accordingly, the expected income of an employed worker, namely [y.sup.e], is

   [y.sup.e] = (1 - [Rho]u)w + [Rho]ub. (2)

   The worker enjoys consumption of goods by spending income y and dislikes putting forth any effort e. For ease of analysis, his utility is specified as

   U(y, e) = v(y) - e; v[prime] [greater than] 0, v [double prime] [less than] 0, v(0) = 0.(7) (3)

   From Equations 1, 2, and 3, the expected utility of a typical worker E[U(y, e)] is

   V [equivalent to] E[U (y, e)] = [1 - (1 - e)u][v(w) - e] + (1 - e)uv(b). (4)

   Since unemployment benefits are not the focus of this paper, in what follows, we will set b = 0.

   A utility-maximizing worker will choose his effort level at which the expected marginal gain from effort equals the expected marginal cost of effort. Taking the first differentials of Equation 4 with respect to e, we have the first-order condition as

   [V.sub.e] = u[v(w) - e] - [1 - (1 - e)u] = 0. (5)

   The second-order...