You take my life when you take the means whereby I live.
WILLIAM SHAKESPEARE
The Labor Market, Unemployment, and Inflation
(Part D)
by
Charles Lamson
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Efficiency Wage Theory
Another explanation for unemployment centers on the efficiency wage theory, which holds that the productivity of workers increases with the wage rate. If this is true, firms may have an incentive to pay wages above the wage at which the quantity of labor supplied is equal to the quantity of labor demanded. An individual firm has an incentive to hire workers as long as the value of what they produce is equal to or greater than the wage rate. With no efficiency effects, the market in Figure 1 would produce an equilibrium wage of W*. Suppose, however, the firm could increase the productivity of all its workers by raising the wage rate above W*. The firm's demand for labor would be no lower, but the higher wage rate would cause the quantity of labor supplied to increase. The quantity of labor supplied would exceed the quantity of labor demanded at the new higher wage---the efficiency wage---and the result is unemployment. FIGURE 1  Empirical studies of labor markets have identified several potential benefits that firms receive from paying workers more than the market-clearing wage (Case & Fair, 2004). Among them are lower turnover, improved morale, and reduced "shirking" of work. Even though the efficiency wage theory predicts some unemployment, it is unlikely that the behavior it is describing accounts for much of the observed large cyclical fluctuations in unemployment overtime. Imperfect Information Thus far we have been assuming that firms know exactly what wage rates they need to set to clear the labor market. They may not choose to set their wages at this level, but at least they know what the market-clearing wage is. In practice, firms may not have enough information at their disposal to know what the market-clearing wage is. In this case, firms are said to have imperfect information. If firms have imperfect or incomplete information, they may simply set wrong wages that do not clear the labor market.  If a firm sets its wages too high, more workers will want to work for that firm than the firm wants to employ, and some potential workers will be turned away. The result is, of course, unemployment. One objection to this explanation is that it explains the existence of unemployment only in the very short run. As soon as the firm sees that it has made a mistake, why would it not immediately correct its mistake and adjust its wage to the correct, market-clearing level? Why would unemployment persist? If the economy were simple, it should take no more than a few months for firms to correct their mistakes, but the economy is complex. Although firms may be aware of their past mistakes and may try to correct them, new events are happening all the time. Because constant change---including a constantly changing equilibrium wage level---is characteristic of the economy, firms may find it hard to adjust wages to the market-clearing level. The labor market is not like the stock market or the market for wheat, where prices are determined in organized exchanges everyday. Instead, thousands of firms are setting wages and millions of workers are responding to these wages. It may take considerable time for the market-clearing wages to be determined after they have been disturbed from an equilibrium position. Minimum Wage Laws    Teenagers, who have relatively little a job experience, are most likely to be hurt by minimum wage laws. If some teenagers can produce only $4.50 worth of output per hour, no firm would be willing to hire them at a wage of $7.25. To do so would incur a loss of $2.75 per hour. In an unregulated market, these teenagers would be able to find work at the market clearing wage of $4.50 per hour. If the minimum wage laws prevent the wage from falling below $7.25, these workers will not be able to find jobs, and they will be unemployed. Others who may be hurt include people with very low skills and some recent immigrants.  An Open Question As we have seen, there are many explanations for why the labor market may not clear. The theories we have just set forth are not necessarily mutually exclusive, and there may be elements of truth in all of them. The aggregate labor market is very complicated, and there are no simple answers to why there is unemployment. Much current work in macroeconomics is concerned directly or indirectly with this question, and it is an exciting area of study. Which argument or arguments will win out in the end is an open question. *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 562-564* end |
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