Labour Economics Pt. 2 - wage efficiency models

Question 1

What are the macro implications of the Solow condition?

Answer 1

1. Wages experience rigidities

2. There is involuntary unemployment

Question 2

What does the Solow condition state?

Answer 2

The profit-maximising wage is where the elasticity of the effort function with respect to wage is unity (=1).

de/dw w/e = 1

OR
de/dw = e/w tangency condition
Where the ratio of effort to wage (e/w) is equal to the slope of the effort-wage relationship. (Check out slides for visual representation)

Question 3

Why do higher wages positively correlate to higher effort?

Answer 3

1. The worker’s morale is hightened: being offered a ‘gift’, they are motivated to work harder
2. The shrinking effect: the cost of job loss is higher, so the worker will extort a higher effort.

Question 4

How is the Solow condition derived?

Answer 4

The production function of a firm is assumed to depend on N and effort of N (which positively depends on wage). Using this production function, the firm sets its profit maximising problem. The result is the Solow condition: the point at which the elasticity of the effort function with respect to wage is equal to 1.

Question 5

What is the Shapiro-Stiglitz model?

Answer 5

It is a particular wage efficiency model that focuses on the impact of imperfect information and moral hazard. The efficiency wage in this model depends on: unemployment rate, unemployment benefits, disutility of work and cost of monitoring. It features involuntary unemployment and a wage embodying a rent in equilibrium.

Question 6

When does moral hazard arise?

Answer 6

When individuals cannot be made to bear the full costs of their actions due to imperfect information.

Question 7

What is the efficiency wage in the Shapiro-Stiglitz model? What is the optimum wage formula called?

Answer 7

w*= b + ( a(upperbar) / τ(1-h) ) = b + ( a(upperbar) / τu)
Because the unemployment rate u = 1- h

The optimal wage formula is known as the “No-Shirking Condition”

Question 8

What does the no-shirking wage depend on?

Answer 8

1. Positively on b (higher unemployment benefits, higher efficiency wage)
2. Positively on a upper-bar (higher disutility of work, higher efficiency wage)
3. Negatively on the unemployment rate (more people unemployed, lower efficiency wage)
4. Negatively on τ (higher monitoring efficiency, lower efficiency wage)

Question 9

Is there involuntarily unemployment in the Shapiro-Stiglitz model?

Answer 9

Yes. Because w* = b + ( a(upperbar) / τu) > b + a(upperbar), the employee receives a rent (wage is higher than the opportunity cost of working). Thus, the unemployed worker is involuntarily unemployed.

Question 10

The WS curve in the wage efficiency model:

Answer 10

1. The No-Shirking Condition is the wage-setting relationship (it gives the wage that maximizes firm profits at each unemployment rate)
2. wWS = b + a/τu

The efficient wage falls with unemployment, so the WS curve is upward sloping in the real wage-employment diagram. As u tends to 0, wWS tends to infinity, so full employment is never reached.

Question 11

The PS curve in the wage efficiency model:

Answer 11

wPS = (η-1/η) x ε

Where η is the price elasticity of demand

Question 12

What pushes u* up in the efficiency wage model?

Answer 12

• an increase in b since it reduces the costs of shirking
• an increase in the disutility of work since it increases the cost of non shirking
• an increase in τ since it decreases the expected value of shirking (if you are better monitored, it is more likely to be fired if shirking, losing the utility w)