Helping a Reluctant Theorist: Joe Stiglitz

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Substantial Harm

Efficiency-wage theory (EWT) was our best hope for microfounding meaningful wage rigidity (MWR) before New Keynesians (NK) abandoned that line of research as too difficult. The abandonment was facilitated by the damage caused by Joe Stiglitz’s market-centric version of EWT (coauthored with Carl Shapiro), which became the NK go-to efficiency-wage model.  The original workplace-centric EWT has been crowded out by the the Stiglitz-Shapiro (1984) shirking analysis. Here’s the rub. The workplace version actually microfounds MWR and stabilization-relevant macroeconomics. The S&S effort does not.

In their otherwise exemplary history of economic thought,  Scepanti and Zamagni (2005, p.369) provide an illustrative description of today’s mainstream EWT rooted in the S&S model: “The theory of efficiency wages is based on three principal ideas. The first is that the intensity of work effort of each employee, and therefore the marginal productivity of labour, increases with an increase in wages. The second is that the workers’ effort is also influenced by the level of unemployment, in that the fear of being dismissed for inefficiency increases with an increase in the probability of not immediately finding another job with the same pay – a probability that rises with the level of unemployment. The third hypothesis is that there is a type of asymmetric information, as firms are not able directly to ascertain the intensity of effort of hired workers or the ability of those to be hired. In these conditions, it is in the interest of firms to pay high wages to encourage workers’ effort.”

The first two “principal ideas” are badly inconsistent with original workplace-centric efficiency wages, associated with Solow (1979) and Annable (1977 and 1980). Despite being best known of all the EWT branches, S&S is flawed to the point of incoherence, largely because as noted above it fails to microfound MWR. S&S resort to the standard NK practice of arbitrarily assuming wage rigidity, consequently satisfying none of the grand objectives of the early EWT literature. Their list of sins is substantial. The S&S model generates market-flexible labor pricing, perpetuates the myth that workers inherently prefer to shirk, confines involuntary job loss to dismissal for cause (a trivial category that is not up to explaining millions of layoffs in recession), downplays the role of aggregate demand in business cycles, and provides dangerously wrong advice to stabilization policymakers. Keynes, whose central goal was to make policy-relevant sense of forced layoffs, is simply pushed aside in the S&S theory.

Available evidence strongly indicates that highly specialized bureaucratic employers believe that cooperative on-the-job behavior is damaged by cuts from existing labor pricing that is rationally rooted in employee reference standards (denoted by Ҝj in the GEM Project) that are established over time. The Project demonstrates that rational employees must experience both long lags and significant job downsizing to justify acceptance of wage reductions. Labor productivity that is simply increasing in labor pricing is an analytic dead-end that strips S&S of any practitioner recognition, badly complicates model stability, and is provided no support from actual behavior. It is at best a foolish assumption.

Reflecting the mainstream NK preference for analyzing rational exchange that is arbitrarily restricted to the marketplace, S&S attempt to model workplace exchange within the consensus general-market-equilibrium framework, identifying dismissal for cause as the forced job loss of interest and using fear generated by the high incidence of market unemployment to motivate cooperative labor input. S&S are insufficiently well-read to understand that the centrality of firing and fear is a nineteenth-century labor-management approach that has had, for generations, little place in the profit-seeking behavior of highly specialized firms. From a policymaking perspective, the S&S model is a dangerous failure. It cannot inform the channel through which nominal disturbances induce (temporary) layoffs and (permanent) job downsizing, implying that it cannot rationally justify discretionary demand management. That the market- and workplace-centric models, one useless and the other useful, share the efficiency-wage name has damaged progress toward stabilization-relevant macro theory.

GEM Helping Hand

The GEM Project uses original workplace-centric efficiency wages that Solow and I pioneered to root wage determination in optimization and equilibrium. It shows how theorists need to go about rationally disabling Keynes’s Second Classical Postulate (i.e., the equality between the market wage and the marginal disutility of work). In the circumstances of costly, asymmetric workplace information, we moved labor pricing inside the firm and provided the framework needed for macroeconomics that is both rational and stabilization-relevant. After the original articles, Solow’s most complete EWT statement is his Royer Lectures, published in The Labor Market as a Social Institution (1990); before the success of the GEM Project, mine was The Price of Industrial Labor (1984). Both failed to microfound MWR.

The GEM Project corrects that failure as well as the many more debilitating flaws in S&S shirking theory by replacing the earlier work with generalized-exchange theory. Two reiterate, the two-venue model has huge advantages, notably including the derivation of MWR from axiomatic primitives (which S&S cannot do), its rational suppression of wage recontracting (which S&S cannot do), its derivation of chronic optimal wage rent (which S&S cannot do), its derivation of the rational existence of involuntary job loss (which S&S cannot do), its derivation of recognizably-sized movements in employment and output in response to nominal demand disturbances (which S&S cannot do), its establishment of the primacy of demand management in stabilization policymaking (which S&S cannot do), and its consistency with both the relevant evidence and practitioner testimony (which S&S cannot do).

Is the Game Worth the Candle?

Ridding the macro literature of the embarrassing shirking theory is surely worth worth piles of candles. Cumulative score: Worth it: 17 (Lewis, Solow, Harris-Todaro, Bernanke, Lucas, Samuelson, Kerr et al, Okun, Hicks, Sraffa, Hayek, Keynes, Burns, Robinson, Modigliani, Phelps, Stiglitz). Not worth it: 0.

Blog Type: New Keynesians Saint Joseph, Michigan

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