Misunderstood Efficiency-Wage Theory

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Costly misunderstanding. Efficiency wages, particularly the original morale-centric formulation that Solow and I pioneered, outlined how theorists could have gone 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, providing the framework for stabilization-relevant macroeconomics that features both optimization and equilibrium. After the original articles, Solow’s most complete EW statement was his Royer Lectures, The Labor Market as a Social Institution (1990); mine was The Price of Industrial Labor (1984). Both failed to microfound meaningful wage rigidity (MWR).

The development of efficiency-wage theory was greatly damaged by that failure. Original EWT is today universally misunderstood by economists. In their otherwise exemplary history of economic thought, Scepanti and Zamagni (2005, p.369) provide an illustratively off-base description: “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 worker 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” incorrectly describe Solow-Annable morale-centric EWT. The Scepanti-Zamagni depiction is relevant only to the Shapiro-Stiglitz (1984) shirking variant of efficiency wages. Despite being best known of all the EWT branches, Shapiro-Stiglitz fails to microfound MWR and therefore satisfies none of the grand objectives of original EWT. Instead, S&S generates flexible labor pricing, confines job loss to dismissal for cause (a trivial category), doesn’t come close to explaining business cycles, and provides only dangerously wrong advice to stabilization authorities. Keynes, whose goal was to usefully model involuntary job loss, is simply pushed aside in the textbook S&S New Keynesian model. For elaboration on the curious (and, let’s admit it, embarrassing) S&S “contribution”, see Chapter 9 of the website’s e-book.

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 significant job downsizing to justify cooperative acceptance of wage reductions. Labor productivity that is simply increasing in labor pricing is a very different, nonintuitive process, badly complicating model stability and, outside of the limiting case of nutrition and health, supported by neither practitioner testimony nor the otherwise available evidence. It is a silly assumption. In the GEM model class, the efficiency wage (Wn) is rationally and powerfully independent of contemporaneous unemployment as well as market opportunity costs.

As already noted, Scepanti and Zamagni mistook as general the subset of follow-up EWT models pioneered by Shapiro and Stiglitz. Reflecting the dominating mainstream preference for marketplace exchange, S&S and others attempt to analyze 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. Central roles for firing and fear is a nineteenth-century practice that has had, for good reason, little place in best-practices labor-management relations in highly-specialized firms for generations. Reiterating for emphasis, S&S nominal labor pricing is downward flexible over the business cycle and does inform the channel through which nominal disturbances induce (temporary) layoffs and (permanent) job downsizing.  Such models do not justify discretionary demand management. The substitution of a tiny-incidence joblessness (dismissal for cause) for the vastly higher incidence layoffs and downsizing is indicative of the practical irrelevance of the S&S efficiency-wage model.

Deep roots of original efficiency-wage theory.  The original morale-centric EWT literature has deep roots in actual behavior. In his study of the transition of the Lancashire cotton-spinning industry from at-home piecework to factories employing an on-site workforce, historian Michael Huberman traces the roots of modern OJB management to the early nineteenth century. The Second Industrial Revolution, motivating new corporate forms in order to effectively manage high-volume, rapid through-put production, began in earnest later in the late nineteenth century. But it was anticipated by a vanguard of larger-establishment, specialized industries. If employees do indeed have an axiomatic preference for fair treatment and that preference influences their OJB, there should be supportive evidence prior to the large, highly-specialized firm-reorganization of production.

From Huberman (1996, pp.6,13-14): “Workers entered the factories with customary notions of a fair day’s pay for a fair day’s work [from experience with at-home production] and would expend optimal effort only if they were assured this rate…. Cooperation between firms and workers was not immediate. Pressed by competitive forces, firms initially challenged workers’ control. But changes in work organization and constant attempts to cut rates of pay only raised unit costs. It took one generation for firms and workers to recognize the benefits of cooperation…. Fair wages took hold in large firms in the leading industrial centers of Manchester and Bolton. By 1850, firms in other areas adopted these policies, although there were important exceptions. Firms needed to show their commitment to the fair wage, and to this end they introduced work-sharing and a layoff strategy that protected senior workers. These arrangements were initially rules of thumb, but standard piece rates themselves became codified in written lists…. Yet all rules, whether formally stipulated or not, were governed by community standards of what was just and fair.”

Blog type: New Keynesians

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