Efficiency Wages in Heterogeneous Labour Markets

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1 Efficiency Wages in Heterogeneous Labour Markets Jan Průša, Pavel Ryska Institute of Economic Studies Charles University in Prague, Czech Republic ISEO, 24th June 2011 Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 1/20

2 Research topic Research question Do efficiency wages lead to unemployment? Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 2/20

3 Contents 1 Efficiency wages 2 Model with homogeneous labour 3 Model with heterogeneous labour 4 Conclusions Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 3/20

4 Contents 1 Efficiency wages 2 Model with homogeneous labour 3 Model with heterogeneous labour 4 Conclusions Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 4/20

5 The Idea of an Effort function A bit of intuition... Definition The existence of an effort function assumes increasing relationship between wages and effort. This means that the productivity of a worker increases with higher wage. Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 5/20

6 Notes on unemployment Mises on unemployment Unemployment in the unhampered market is always voluntary. Ludwig von Mises: Human Action Unemployment in positive science We only care about involuntary unemployment. Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 6/20

7 Contents 1 Efficiency wages 2 Model with homogeneous labour 3 Model with heterogeneous labour 4 Conclusions Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 7/20

8 Simple efficiency wage model Solow (1979) and Shapiro-Stiglitz (1984) propose: 1 Existence of an effort function higher wage higher effort and productivity 2 Firms have to set higher wages 3 Equilibrium wage is higher than market clearing wage 4 There is involuntary unemployment as market outcome Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 8/20

9 Firm optimization The logic of firm optimization does not change in the presence of an effort function. Market clearing condition: unit wage per unit effort = marginal product of effort Intuitive logic The firm is now choosing units of effort and then hires the appropriate amount of labour which can supply this effort. Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 9/20

10 Consequences of effort optimization Impact on the labour market Firm can choose labour with high or low effort. Hence labour is not homogeneous. Market clearing price is the effort price, not hourly wage. Does the model really result in unemployment? Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 10/20

11 Contents 1 Efficiency wages 2 Model with homogeneous labour 3 Model with heterogeneous labour 4 Conclusions Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 11/20

12 Effort-types of labour Market interaction with heterogeneous labour: 1 Workers voluntarily choose their effort This implies T discrete labour markets 2 Firms know these effort markets 3 Each effort-type (sub-)market has its own market clearing wage 4 There is no involuntary unemployment Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 12/20

13 Lancaster model (1966) Goods market: Goods have characteristics Labour market: Workers have characteristics Example: Cars Comfort, speed, fuel efficiency... Consumers demand characteristics Example: Economic analyst Knows statistical methods, is entertaining... Firms demand characteristics Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 13/20

14 Lancaster model: Market interaction Firms demand characteristics, but they can only hire workers. The characteristics input is not perfectly divisible. The resulting market clearing is non-trivial. Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 14/20

15 Lancaster model: Key results There are two important results of the Lancaster model. Potential for unemployment Not all labour types are demanded. (!) Market clearing mechanism If workers want to find a job, they need to substantially change: their effort; their price (wage). Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 15/20

16 Wrap-up Zero unemployment Unemployment in this model is voluntary, stemming from wage-characteristic mismatch. Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 16/20

17 Contents 1 Efficiency wages 2 Model with homogeneous labour 3 Model with heterogeneous labour 4 Conclusions Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 17/20

18 Reasons for unemployment Why do we see unemployment? It is voluntary Effort-wage mismatch Market frictions: Wage rigidity (unions and strikes) Labour regulations (minimum wage) Taxation (capital labour substitution) Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 18/20

19 Conclusions Relationship between wages and productivity is natural and such an optimization does not cause involuntary unemployment. Models of labour market need to take heterogeneity into account. Demand for labour characteristics offers a much more realistic approach to labour markets. Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 19/20

20 Conclusions Thank you for your attention. Jan Průša, Pavel Ryska Efficiency Wages in Heterogeneous Labour Markets 20/20

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