Original Efficiency-Wage Theorists

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This post places the research of Arthur Okun, the subject of last week’s essay, in the larger context of what came to be known as efficiency-wage (EW) theory. The workplace venue of price-mediated exchange was introduced into macroeconomics by original EW theorists. In particular, Okun (1981), Solow (1979, 1989) and Annable (1980, 1984), working independently, identified relevant axiomatic employee preferences and derived employer optimization conditions in the circumstances of intra-firm information imperfections and consequent feedback between worker on-the-job behavior (OJB) and the nominal wage paid (W).

Along with Okun, Solow and I modeled morale-centric efficiency wage theory. Our objective was to make Early Keynesian nominal wage inflexibility consistent with optimizing, continuous decision-rule equilibrium. We understood that the analysis, if successful, would provide a formal model of employee-employer relations that, to be credible, must be informed by what practitioners and academics had already learned about information-challenged workplace behavior. As a result, original EW theory was constructed with an eye on the best-practices management literature, especially the universal findings that employees once on the job do not inherently want to shirk but do strongly prefer fair treatment by their employers.

The central idea of original efficiency-wage modeling is the now familiar (to Blog readers) nonconvex Workplace Exchange Relation. As portrayed in Annable (1980), LEV firms operating in the two-dimension space relating labor pricing (W) and labor productivity (Ź) minimize unit costs by paying the efficiency wage (W=Wn) consistent with both the dominant radius vector and its labor-market constraint (W≥Wm). That nonconvex representation of workplace exchange, once rooted in optimization and equilibrium, rationally motivates downward nominal wage rigidity and, even more consequentially, chronic labor rent.

Many theorists became interested in efficiency wages, and expectations of a quick derivation of the nonconvex WER were high. But those hopes were dashed, largely because of the difficulty of modeling LEV workplace behavior. Shying away from that hard work, EW research agendas simply continued the Okun-Solow-Annable convenience of focusing on employer optimization, ignoring the more challenging worker-optimization problem posed by nonconvex WERs.

Subsequent EW theory variants reverted to inherent shirking to motivate worker OJB (e.g., Shapiro and Stiglitz (1984)) or abandoned rationality (e.g., Akerlof (1982)). Most of the broad literature gave up attempting to derive DWR, instead producing variants in the now big-tent EW theory that structurally differed from the original morale-centric version. Those variants constitute distinct model classes, designed to answer different questions. It is especially noteworthy that the best known of the EW variations (the Shapiro-Stiglitz shirking theory) derives wages that are downward flexible (falling as market unemployment rises), that cannot generate involuntary job loss – relying instead on discharge for cause, which in practice play a trivial role in actual labor flows and cannot provide a channel through which nominal disturbances induce policy-relevant job loss.

The GEM Project has demonstrated that single-venue (marketplace) general equilibrium is an inadequate platform for stabilization-relevant modeling of highly specialized economies. Pursuant to that thesis, consider two interrelated propositions. In the first, a particular class of wage rigidities is both a necessary condition for the existence of involuntary job loss and inherently nonexistent in mainstream general market equilibrium (GME). In the second, macroeconomics must accommodate involuntary job loss in order to be useful to stabilization policymakers.

First proposition.  In the single-venue GME narrative, employees respond to wage reductions from their market opportunity costs by quitting, voluntarily moving to the alternative, now better-paying positions. Involuntary job loss plays no role. Moreover, if workers are somehow receiving wage rents, they must rationally accept any pay cut, in lieu of losing their jobs, that does not violate their opportunity costs. Forced job separation continues to play no role.

Introducing involuntary job loss into coherent macro modeling requires the textbook labor pricing to be altered in two fundamental ways. First, at least some employees rationally receive wage rents. Second, firms’ capacity to offer wage reductions that reduce or eliminate those rents in lieu of job loss must be rationally suppressed, implying circumstances in which excess labor supply cannot induce labor-price cuts. The two-part wage rigidity is “meaningful”, and the first proposition is: Forced job separation implies the existence of meaningful wage rigidity (MWR).

It is helpful to understand MWR in the context of Barro’s recontracting critique. That critique’s message is MWR nonexistence, absent incoherent free parameters, in mainstream general-market-equilibrium modeling. As noted, rational firms must offer workers wage cuts in lieu of jobs loss; and rational employees must accept any cut that does not violate their opportunity costs. Consistent with GME microfoundations, market opportunity costs strictly govern labor-price recontracting, which then becomes a powerful vehicle for exhausting available gains from trade and helps avoid Barro’s “dollar bills left on the sidewalk”.

An important fact is that MWR nonexistence in mainstream coherent market-centric modeling is not altered by any endogenous frictions that have been (or will be) variously identified by dominant New Keynesians. Such GME-consistent frictions may create a wedge between the marginal labor product and the marginal value of worker time, perhaps inducing voluntary job separation. But coherent frictions cannot derail the overriding role of opportunity costs in the existence or timing of individual employee-employer recontracting in any way that motivates involuntary job loss. That is important. The GME model class, no matter how creatively enriched with endogenous frictions, accommodates neither meaningful wage rigidity nor involuntary job loss.

The will-o’-the-wisp friction that is both GME-coherent and capable of rationally suppressing wage recontracting has been named the Super Friction. From Barro (1989, p.14): “As a theoretical matter, it has long been known that direct costs of adjustment could explain some stickiness in prices. However, the basic misgiving about menu [or recontracting] costs is that the direct costs of adjusting prices are typically trivial relative to the losses from choosing inappropriate quantities.” Herschel Grossman (1983, p.343) similarly argued that general market equilibrium and wage rigidity are inherently inconsistent: “If the predetermined wage implies a level of employment that is less than the quantity supplied, the provision of additional employment at some lower wage will produce a Pareto improvement.” The Barro critique (1977) was fundamental to the largely successful New-Classical challenge to Early Keynesian thinking and has been generally accepted as one of the “rules of the game” by New Keynesians. From Robert Gordon (1990, p.1137): “No new-Keynesian wants to build a model with agents that Barro could criticize as failing ‘to realize perceived gains from trade’.” Finally, from Blanchard and Fischer (1989, pp.373-374): “… nominal rigidities can only go so far. To take an example, if fluctuations in demand lead to unemployment and if being unemployed is much worse than being employed, it is hard to see why individual workers do not take a cut in their wages to gain employment.”

Second proposition.  Policymakers understand that involuntary job loss, partly because of the reduced income resulting from the characteristic absence of alternative employment paying comparable wages, is a socioeconomic problem that is central to business-cycle pathology. In the second proposition, axiomatic policymaker preferences cause them to reject, emphatically, the absence of endogenous forced job loss from models used to support their decision-making. Government and business leaders generally refuse to ignore welfare-relevant facts produced in modern economies that are inconsistent with restricting job separation to be wholly voluntary, forcing theorists to choose between familiar, coherent GME thinking and policy usefulness. In a related message to theorists aspiring to stabilization relevancy, the MWR Channel uniquely microfounds the demand-driven model class that motivates recognizable aggregate fluctuations.

Blog Type: Wonkish San Miguel de Allende, Mexico

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