The Importance of Properly Specifying Wages

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It is a tenet of the GEM Project that rational behavior is the productive way to motivate macroeconomic analysis. This is especially true for the critical issue of labor pricing. The generalized-exchange theory has importantly microfounded meaningful wage rigidity (MWR), chronic wage rent (WR), and worker on-the-job behavior (OJB) in workplaces restricted by asymmetric employer-employee information and routinized jobs. We know that venue of rational exchange is where the vast majority of recession-related layoffs occur. We also know that the three innovations are game-changing. This Blog has documented their fundamental impact on the organization and content of macro analysis. Most notably they enable, at long last, the reconciliation of microfounded and stabilization-relevant macroeconomics – the principal objective of the mainstream New Neoclassical Synthesis.

In order to illustrate the case that properly specifying wage determination is crucially important to macro analysis, the following reprints the lengthy abstract of David de la Croix, Gregory de Walque and Rafael Wouters (CWW), “Dynamics and Monetary Policy in a Fair Wage Model of the Business Cycle,” European Central Bank Working Papers (July 2007). Despite being one of the best-intentioned business-cycle models available in the recent literature, it lacks rational labor pricing and is therefore is at best incomplete.

ECB Working Paper

“In the conventional models of the labor market with monopolistic competition, workers set wages unilaterally and provide the labour input that is demanded by the firms. Such modeling of the labor market faces two main shortcomings. The first one is that it fails to produce the macroeconomic stylized fact that wages are acyclical along the business cycle, while employment is highly pro-cyclical. This problem has been circumvented in the literature by adding nominal wage rigidities in the form of multi-period wage contracts. The second trouble raised by the monopolistic worker view is that it cannot generate structural unemployment as all adjustments take place along the intensive margin.

“In reaction to this, labor economists have developed two competing theories. In the first one, called the frictional unemployment view, unemployed workers and labor force seeking firms do not meet at once. Firms have to post vacancies and finding a worker is a costly and time-consuming process. The second theory, which is at the center of our attention in the present paper, is referred to as the efficiency or fair wage assumption. In this setting, workers choose their effort by comparing their current wage with the “outside option” which is function of the opportunity wage and the situation on the labor market. In reaction to this workers behavior, firms have an incentive to offer wages above the market clearing level in order to elicit effort. Even though this is an optimal behavior at the firm level, it generates involuntary unemployment at the aggregate level.

“The advantage of the fair wage assumption is that it allows to meet the empirically observed fact that firms are reluctant to reduce wages. The most often reported explanation is that firms anticipate that workers interpret wage cuts as a sign that their work is not valuated, affecting negatively their incentive to work efficiently. In a static framework, the structural unemployment resulting of the fair wage assumption is viewed as a wage disciplining device. Therefore several authors attempted to introduce this mechanism into dynamic RBC models, in the hope that the real wage rigidities generated this way could help to solve the wage-employment puzzle. However, the general finding is that, in a dynamic framework, the fair wage assumption produces counter-cyclical effort and pro-cyclical wages. Indeed, in “booms”, unemployment is low, reducing the workers’ incentive to work and firms have to consent pay increases in order to maintain effort.

“Faced with this disappointing outcome, a line of research has consisted of introducing a reference to own past wages in the workers fair wage composition. The idea is that the negative effect on effort of a decline in unemployment can be counterbalanced by a wage increase. Furthermore, such intertemporal comparisons within the fair wage reference are supported by a large sociologic and microeconomic literature and they introduce the desired backward-looking features in the macroeconomic wage equation. In contrast with the previous literature, the present paper abandons the logarithmic representation of the fair wage norm which implied that firms find it optimal to keep effort constant over the business cycle. This way, we allow a positive relation between effort and wage in equilibrium with the effect that the returns to wages in terms of effort are less decreasing. In this sense, nonlogarithmic effort may prove to be a useful tool in solving the wage-employment puzzle. In the first part of the paper, we implement this effort specification into a simple RBC model with a closed form solution. We particularly focus on the elasticity of real wages to unemployment and further, on the consequences of this elasticity for inflation persistence.”

A Sketchy Model

The ECB paper is based on the Shapiro-Stiglitz (1984) efficiency-wage theory. The S&S model is familiar to readers of this Blog and is closely examined in Chapter 9 of the website’s e-book. It is shown to be riddled with problems that are the outcome of its irrational wage determination. Its predictions are inconsistent with the evidence. It cannot explain either mild or extreme business cycles. It cannot produce involuntary job loss and does not put aggregate nominal demand at the center of stabilization-relevant analysis. It relies on labor management rooted in fear and firing – 19th-century ideas that human-resource departments have rejected over the entire existence of such departments. It cannot produce clarity in its model explanation, as demonstrated in the Rube Goldberg inspired abstract above. The analytic mess is easily shown to be rooted in the rejection of the guidance from rational behavior in specification of wage determination. CWW rely on guesswork to model behavior in real-world circumstances with which they are unfamiliar. None of those problems plague the rational-behavior generalized-exchange model.

Blog Type: New Keynesians Saint Joseph, Michigan

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