- Email: [email protected]
The efficiency-wage hypothesis
Journal of Development Economics 20 (1986) 311-323. North-Holland
THE EFFICIENCY-WAGE
HYPOTHESIS
Applying a General Model of the Interaction between Labor Quantity and Quality Carmel U. C H I S W I C K * University of Illinois, Chicago, IL 60680, USA
Received March 1984, final version received August 1984 The efficiency wage is analyzed in the context of a market for labor °quality" units. The model is equivalent to that of a perishable (one-period) form of firm~specific human capital which is most efficiently financed by the employer indirectly through higher wages. The hypothesis also assumes a labor market in which the 'quantity' units have zero price (i.e., labor earns no rent), which can occur in the absence of unemployment only if the supply of some quality attribute is subject to constant costs on the intensive margin. This constant-cost condition is implicit in W.A. Lewis' original description of the traditional sector in a dual economy. Otherwise the zerorent assumption requires unemployment, in which case it can not be used to explain the existence of unemployment. The general applicability of the constant-cost condition and of the efficiency-wage hypothesis is questioned.
1. Introduction In its most general form, the efficiency-wage hypothesis holds that the services employers receive from their workers are a positive function of the wage they offer. Although this notion is something less than a novelty, the efficiency-wage literature focuses on two interesting labor market issues: the mechanism whereby higher wages elicit higher productivity, and the implications of this relationship for the existence of involuntary u n e m p l o y m e n t at equilibrium. As it has evolved, however, the 'efficiency-wage hypothesis' label has become strongly associated with two closely-related inferences drawn from the model: that employers minimize labor costs per efficiency unit and that high wages can coexist with unemployment. It will be argued here that these inferences can be d r a w n only in special circumstances and should be carefully distinguished from the m o r e general version of the hypothesis as stated above. This paper a p p r o a c h e s the efficiency-wage hypothesis as a problem in *The author wishes to acknowledge the helpful comments of an anonymous referee and of my colleagues in the Department of Economics at UtC. 0304-3878/86/$3.50 © 1986, Elsevier Science Publishers B.V. (North-Holland)
312
C.U. Chiswick, The efficiency-wage hypothesis
q u a n t i t y - q u a l i t y trade-offs as applied to labor m a r k e t s J Employers can vary labor inputs by varying the n u m b e r of workers hired at the current wage rate and by raising the productivity of workers through one of the mechanisms associated with higher wages. Such m e c h a n i s m s include improved nutrition, better morale, greater loyalty, reduced turnover, or perhaps simply the prerogative of selecting 'better' workers, e Although originally p r o p o s e d in the context of a labor-surplus L D C [Mirrlees (1975), Stiglitz (1976)1, the efficiency-wage hypothesis has also been suggested as a deveIoped-country p h e n o m e n o n [see, for example, Akerlof (1984), Solow (t980), Yellen (1984)1. E m b e d d i n g the efficiency-wage analysis in a general modal of q u a n t i t y - q u a l i t y trade-offs helps delineate m o r e sharply the implications of the model and its applicability to various types of economies. Part 2 reviews the efficiency-wage model, highlighting its place in m o d e r n labor theory and showing h o w it can be viewed as an application of the m o r e general q u a n t i t y - q u a l i t y m o d e l The analysis shows that an i m p o r t a n t implication of the hypothesis - that employers minimize the wages paid per efficiency unit provided by workers - is the result of a built-in u n e m p l o y m e n t assumption. T o the extent that the efficiency-wage hypothesis is associated with this b e h a v i o r on the part of employers, it is consistent with u n e m p l o y ment but can not be used to 'explain' its existence. Part 3 considers the m i n i m u m set of restrictions required on the m o r e general model for the efficiency wage to be applicable. It argues that a labor-surplus e c o n o m y is a necessary condition and that not all specifications of the relationship between wages and productivity are consistent with such an economy. Part 4 concludes the p a p e r with a s u m m a r y of the a r g u m e n t and of its main conclusions.
2. Efficiency wages and labor quality This section reviews the efficiency-wage model and argues that it is formally equivalent to a model of investment in a special type of firm-specific h u m a n capital. It also shows that the existence of u n e m p l o y m e n t has been
Sin recent years, the fullest development of quantity~luality analysis has been in the context of consumption goods, especially of such unconventional consumer durables as children [Becker and Lewis (1973)1. The issue has also been of some concern in the factor markets, although in the case of physical capital 'quantity' is such an ambiguous concept that its 'amount' is typically measured in efficiency units anyway. Labor quality is usually not treated symmetrically with quantity but rather as an additional dimension which must be added to, or aggregated with, the quantity units so as to achieve a measure of "effective" labor inputs. A recent exception is Chiswick (1984), in which a model similar to the one used here is developed. 2See, for example, Stigiitz (1982) for a list of mechanisms and an argument to the effect that these are different from the usual concepts underlying investments in labor quality. Akerlof (1982, 1984) has proposed a sociological model of 'partial gift exchange' in which the abovemarket component of the wage is viewed as a gift for which the worker reciprocates by providing greater loyalty, effort, or other form of commitment resulting in higher productivity.
c.u. Chiswick, The efficiency-wagehypothesis
313
built into the assumptions of the model. The section concludes with some remarks about the relationship between efficiency wages and modern labor market analysis. Let f(H) be a production function with the usual properties where H denotes the human input. If L is the quantity (e.g., number of workers) and h is the quality (e.g., average number of efficiency units embodied in each worker) of labor, then H = h L by definition. Let T(h) be the total cost per worker of obtaining h efficiency units, with T' > 0 and T" ~0, and let c(h) denote the cost per efficiency unit: c = T/h. The employer's profit function is P = f ( H ) - LT(h),
(1)
which is maximized with respect to L and h when the following conditions are met:
f'h = T
or, equivalently, f ' = c;
f ' = T'.
(2), (3)
Eqs. (2) and (3) may be solved to eliminate f ' . The optimal quality level is thus determined by c = T', the minimum unit cost condition, regardless of the properties of the production function. Fig. 1 illustrates this standard efficiency-wage analysis. The first panel is the wage-requirement curve, in which the quality of labor depends on the dollar amount paid by the employer in the form of wages. (The reader may substitute the currency of choice for the word 'dollar'.) Although the efficiency-wage literature emphasizes the dependent nature of labor quality by placing it on the vertical axis, fig. la conforms to the conventional practice in economics of placing price on the vertical axis even though it is the independent variable. From the employer's perspective, it is clear that the wage-requirement curve is the total cost curve for quality units insofar as it indicates the lowest wage that can be paid to elicit a given level of quality. Employers maximize profits when the average cost per efficiency unit is lowest, at point A where marginal cost equals average cost. The wage determined by this condition is w~, the efficiency wage. The second panel, fig. tb, shows the average and marginal cost curves corresponding to the efficiency curve in fig. la, with h e indicating the quality level corresponding to point A in the upper panel. The efficiency wage is indicated in the second panel as the area of a rectangle defined by h ~ and the height of the average cost curve at its lowest point. The production function does not affect the optimal quality level in tNs analysis because of the implicit assumption that workers per se have no economic value independent of the productive attributes embodied in them. This is an important insight of modern labor economics which is captured here by measuring the human factor of production H in efficiency units. The
C.U. Chiswick, The efficiency-wage hypothesis
314
(a)
$
We
J
rm
(b)
~h
i
0 LABOR
he QUALITY
$/h b..
T'
T~ >I--J
o co rt,,
.
.
,
.
.
"
•
.
,
•.we.~:i
.J _J
o
. . ,
'., O
.
- . . ,i 2~ h
~,.h
LABOR QUAUTY
Fig. I. T h e wage-requirement curve.
F-$/h z
23 3.. _J
C
U3 [g ..3 .,.J
O
0
he
h°
h*
LABOR QUALITY Fig. 2. O p t i m a l quality levels.
tabor-quality supply curve is effectively T' for wages above the efficiency wage (i.e., h>h ~) and the vertical axis for lower wages, being discontinuous at we itself. The labor-quality demand curve is simply the marginal product curve, f ' . A demand curve like f~ in fig. 2 crosses the supply curve in its discontinuous portion; the employer must reduce the totat amount of H (by
C.U. Chiswick, The efficiency-wage hypothesis
315
reducing the number of workers) and adjust other factors so as to raise the entire marginal product curve until it crosses the supply curve at T'=c. A demand curve like f~, crosses the supply curve where there is economic rent, indicated by the shaded area in fig. 2. As long as workers per se have no market value, employers capture the entire rent as profits; they thus have an incentive to hire more workers until the marginal productivity curve has been shifted down to the zero-rent point where T'=c. The assumption that workers per se have no economic value is key to this result. While eq. (3) is the usual profit-maximizing condition, requiring employers to adjust the quality level on the intensive margin so as to equalize marginal productivity with marginal cost, eq. (2) reflects the zerorent assumption insofar as it requires the marginal product of labor (hence wages) to be exhausted by the cost of forming productive attributes. Yet human capital must be embodied in a worker. Increasing costs on the intensive margin imply that workers can become a scarce resource, with firms bidding against each other for 'empty vessels', as it were, in which to embody various productive attributes. [f this happens, the wage rate must incorporate the workers' economic rent as well as the cost of quality units. 3 Thus full employment typically implies wages that exceed the wage-requirement function. Viewing the wage-requirement function as a cost curve not only helps bring out the role of economic rent, it also suggests a relationship between the efficiency-wage hypothesis and human capital investment analysis. The efficiency wage is relevant for quality attributes which employers finance indirectly (but fully) by paying workers a higher wage. It is dear that employers are willing to pay this higher wage only insofar as it increases worker productivity, making it a kind of investment. The analysis is essentially static, however, so all productivity gains are realized during the period covered by the wage contract. The willingness of employers to finance the investment suggests that the quality attribute must be firm-specific, while the short duration of the productivity gain suggests perishability. Perishability also helps explain why the employer is willing to finance the entire cost of a firm-specific investment; whereas employers usually share the benefits (and hence costs) to give employees an incentive to remain with the firm, this is not necessary if all gains are realized during the period of the wage contract. The firm-specific nature of the quality attributes usually listed in the efficiency-wage literature is readily apparent. Firm loyalty, for example, may 3This rent is analogous to the pure location value of land, a value which is derived from the need for an enterprise to be fixed in space rather than from any functional complementarity between the plant and the land itself. It is not the same as the earnings of 'raw' or unskilied labor, since labor quantitity units do not enter into the production function directly; in order to earn this scarcity premium, a worker must have skills embodied in him (or her) and it is only the marginal product of those skills that determine the value of labor.
C.U. Chiswick, The efficiency-wagehypothesis
316
be 'bought' with higher wages, a clear example of an investment (in lower turnover and greater commitment) made by the ' employer in a quality not transferable to other firms. Almost any perishable quality, like honesty or motivation, which depends on higher wages for its existence may be viewed as specific to the firm and time period specified in the wage contract. Another quality dimension usually cited is improved nutrition. Although elsewhere this is considered a 'general' quality for which the worker would bear the cost, the efficiency-wage literature specifically views good nutrition as higNy perishable and not generally valued by all firms. Those firms which value it pay 'above-market' wages and capture the full benefit of higher productivity during the current time period. Much of the literature on human capital investment focuses on the case of general training, where individuals finance investments in themselves; wages, determined solely by marginal product, incorporate a normal return on the investment along with whatever economic rent the market will bear. 4 In contrast, the efficiency-wage literature focuses on a particularly interesting class of firm-specific investments, where the investment is highly perishable and is completely financed in one period by incorporating a premium in the wage to cover its cost. In both cases the wage is the sum of two components, one covering investment costs and the other an economic rent earned by workers because they themselves constitute a scarce factor of production.
A generalization The efficiency-wage literature focuses on a zero-rent economy, but there are insights to be gained by considering a more general model. Consider an economy with three factors of production, physical capital K and two t ~ e s of human inputs, H~ and Hz. The human factors are embodied in workers drawn from a single pool. Each factor H i is embodied in L i number of workers with average quality levels h i (i=1,2) and L~+L2=L. The perworker cost of attaining various quality levels is given by functions T~(h3, where T'~>0 and T~'>O, and unit costs are ci(h3=Ti/hi (i= 1,2). The cost of an efficiency unit of physical capital, c~, is assumed to be independent of K. Finally, relax the 'perishability' assumption, allowing quality attributes to persist for more than one period and letting r denote the rate of interest appropriate for estimating the current-period cost of capital. The economy may be thought of in terms of a three-factor production function Y with value-added expressed as
V= Y - r ( L 1 T 1+L2T2+cKK),
where
(4) Y=f(H1, H2, K ) and
Hi=hiL i,
i=1,2.
"*This rent is usually also assumed to be negligible, leading to the odd notion that any discrepancy between earnings and normal returns on investment somehow disproves the notion of human capital.
C.U. Chiswiek, The efficiency-wagehypothesis
317
While each firm may adjust the number of workers so as to bring productivity in line with costs, the size of the total labor force is viewed as fixed. Maximizing the Lagrangian function,
~=V-2(L~+L2-L), V=f(H1,
H 2,
Hi-h~L i,
where
K)-r(L1T1 +LaT2 +crK),
and
(5)
i = 1,2,
yields the first-order conditions
f~hi-rT~=2, f~=rcK,
f~--rTi, LI + L2 = L.
i = 1,2,
(6), (7) (8), (9)
The second-order conditions for a maximum are met for any quasi-concave production function whenever T'~> 0 and T~' > 0. Since ,~h~ is the shadow price of a labor quantity unit (the shadow wage, denoted w~) and rT~ is the current-period cost of human capital embodied in a worker earning that wage, the Lagrangian multiplier 2 is the current-period 'profit' or economic rent earned by a worker of type i. Labor quantity is limited only for the whole economy and not for any one attribute; it will be optimally allocated if equal rents are received by all workers. Once these rents have been netted out of earnings, the ratios of marginal product to unit cost are equalized for all inputs. This implies (with the help of some straightforward simplifying assumptions) that the rates of return to investments in each factor be equal to each other and to the interest rate r. Moreover, if eqs. (6) are solved to eliminate 2 it may be shown that W2 - - W t
----=r. r2-r~
(10)
The left-hand side of this equation may be interpreted as the rate of return to an ex ante redistribution of workers between L~ and L> Optimality requires that this rate of return also be equal to the appropriate rate of interest r. Eqs. (6)--(9) imply simultaneous satisfaction of the efficiency conditions for allocation of resources (equalization of the ratios of marginal product to marginal factor costs) and of investments (equalization of rates of return). The multiplier 2 is the current-period rent accruing to labor quantity units and must be the same for all workers. Second-order conditions for a maximum are met for any quasi-concave production function whenever quality is subject to rising costs on the intensive margin. There are effectively
3 ~8
C.U. Chiswick, The eJ]~ciency-wage hypothesis
four different types of investment in this modek each of the three factors of production may be increased bY new capital formation (deepening) and workers may be shifted ex ante from one group to another. If the production function were to include n different types of labor there would be n + 1 types of capital deepening and n(n- ~)/2 ways of shifting workers between groups. To each labor factor would correspond one pair of equations like (6) and (7) and n - 1 equations analogous to (10). Whether zero or positive, labor-market equilibrium requires that worker rents be the same for all workers drawn from the same pool, regardless of the nature and level of productive attributes embodied in them. This is because there is no utility derived from employment; if there were, the efficiency wage could be further reduced by making the worker bear part of the cost of productive attributes. Workers are thus rent-maximizers and will change employment in favor of higher rents until these are the same in all firms. By way of corollary, the absence of economic rent in any firm or group of firms drawing on the same labor pool (including 'unemployment' as a possible state) implies that there can be no rent for any worker in that pool, no matter how high the observed wage rate. This is in fact .the appeal of the efficiency-wage hypothesis, for it explains high wages coexisting with unemployment: the observed wage is actually 'gross' of costs, costs which are implemented by workers themselves even though financed by employers, while the 'net' wage is the same - zero - in aH activities. Too often the presumption is that workers prefer employment at these zero-rent wages to unemployment. Yet if workers are rent maximizers there is no reason to prefer a zero-rent wage to a state of unemployment.
3. The efficiency wage and unempleyment This section explores the restrictions required to reduce the general quantky-quality model to the formal equivalent of the efficiency-wage model. Part 2 showed that efficiency wages persist in equilibrium only if labor rents are zero everywhere. A sufficient condition is that there be some group of workers for whom economic rents are effectively zero. One such group, of course, may be the unemployed; indeed, the efficiency-wage hypothesis purports to explain the coexistence in equilibrium of high wages and unemployment among workers drawn from the same labor pool. Disguised unemployment, or self-employment at a subsistence level, is sometimes viewed as equivalent to structural unemployment insofar as labor earns no economic rent. Both of these possibilities will be explored here. Referring to the general model developed in part 2, a change in the size of the labor force would generate the following changes in the variables relevant
C.U, Chiswiek, The efficiency-wagehypothesis
319
for growth and income distribution:
xlx2(h2Fti+ hlF2~)hj
dLt dL
xjh2F-
dK dL
-xlxahlh2(h2F1Kq-hlF2K ) D*
d,~ dL
-(h~h2)2xlx2F D* '
D*
dhi -- (hlh2)xjhf dL LiD* '
,
i--pj= t, 2,
(11)
(13)
i#j= 1, 2,
(14)
where F is the Hessian determinant of the production function f, F u is a cofactor of F, i,j= 1,2, K, xi-fJHiei where si is the elasticity of the T'i curve, i = 1, 2, and
D* =(x~h~ + x2h~)F- xix2(h2Flx + 2hlhzF~2 + h~F22). For a quasi-concave production function, d2/dL is non-positive so that increases in the labor force would generally be associated with a decline in the rent to workers. Once the labor force has reached the size where this rent is zero, any additional increase in L would lead to the crisis of negative rent. It is difficult to conceive of an economy in long-run equilibrium with a negative labor rent, no matter how large the labor force. Certainly if efficiency units per worker depend on such basic factors as nutrition, strength or even morale, a wage lower than the efficiency wage would not permit labor to sustain itself and so would be untenable. Similarly if efficiency units depend on investments in skill-formation (whether financed by the worker or by the employer), the negative rent implied by a wage lower than the efficiency wage would remove the incentive to acquire that skill. The usual solution to this diIemma is to posit structural unemployment: if every firm employs just enough workers so that the efficiency wage prevails, rent will be zero and any left-over workers will be unemployed. This has dismal long-run implications that are rarely faced, for unless the employed workers are sufficiently altruistic that they view supporting their unemployed brethren as a voluntary consumption expenditure, any transfers of income to the unemployed will be perceived as a tax on real wages and hence result in a negative rent. The alternative is a Malthusian crisis of some sort which effectively reduces the size of the labor force until the rent is zero, but it is precisely the absence of such a crisis that motivates the efficiency-wage hypothesis in the first place.
320
C.U. Chiswick, The efficiency-wage hypothesis
Fortunately, there is a special case in which negative rents never occur: the case where one skilt exhibits constant costs per efficiency unit on the intensive margin. 5 For example if the marginal cost curve for type-1 efficiency units, T'~, is perfectly elastic, rent would be zero in that sector and therefore the economy as a whole would be in equilibrium only when 2 =0. For this case, ~ --- oe and eqs. (11)-(14) reduce to dLl . . dL
. . I,
dhl . . dL
h~ , L~
dL2 dh2 dK d2 . . . . . . . . dL dL dL dL
0.
(i5)
Any increase in L would be allocated entirely to the constant-cost attribute, making firms that use that attribute the employer of last resort. There would be a corresponding decline in the quality of that type of labor (e.g., the 'effort' put forth by each worker). The magnitude of this decline would be such that dhl/h~ -- - d L 1 / L ~ , so the total number of efficiency units, H a, would remain the same. Since there would be no change in the optimal amount of any other factor of production either, total output would also remain the same. It is in this sense that the additional workers contribute nothing to production and hence that the marginal product of labor is zero. Although Lewis (t954) was not considering costs explicitly in his analysis of a labor surplus economy, this case is in fact the only one consistent with his analysis. It will be helpful to recall Lewis' (i954) original definition of a labor surplus economy: '... an unlimited supply of labour may be said to exist in those countries where population is so large relatively to capital and natural resources, that there are large sectors of the economy where the marginal productivity is negligible, zero, or even negative . . . if some members of the family obtained other employment the remaining members could cultivate the holding just as well (of course they would work harder: the argument includes the proposition that they would be willing to work harder in these circumstances).' Let type-1 labor be the category associated with the traditional-sector labor force. Lewis' description suggests that labor quality, hi, may be measured in hours worked or in effort put forth. Now suppose that some members of L~ find other employment as L2; for example, an exogenous increase in modernsector physical capital might shift upward the demand curve f2/r in the righthand panel of fig. 3, causing modern-sector firms to hire additional workers until the efficiency wage once again prevails. This movement of workers out ~Ifh~is interpretedas hours of work in the peasant economy,this conditionis equivalentto the one developed in Sen (1966). The remainder of this section may be viewed as an amplification and generalization of part 2 of that paper.
C,U. Chiswick, The efficiency-wage hypothesis
321
$/h 2
~
= C1
(a) TRADITIONAL SECTOR
(b) REST OF ECONOMY
Fig. 3. A labor-surplus economy.
of the traditional sector causes demand in the left-hand panel of fig. 3 to shift upward from f~/r to f]/r. The optimal level of hi would increase regardless of the slope of T'1. But Lewis says that h t increases so as to completely offset the removal of workers. ° That is, dHJdLt =0, a condition which is met only when f ~ = 0 or e 1 = c~. But surely f l is positive, for otherwise why would there be any reason for the remaining members to 'work harder'? In order for the remaining workers to provide the same amount of labor as before, it is therefore necessary that the supply curve T~ be horizontal. At the same time, any loss of workers would shift upward the marginal productivity curve f~/r, resulting in a new equilibrium at a positive rent whenever el < oo and at a zero rent only when e 1 = oo. Lewis' marginal productivity concept is thus not fl, as is sometimes supposed, but rather 2: the economic rent earned by workers regardless of their sector of employment. A labor surplus economy is one for which 2 = 0 , with productivity just high enough to cover the cost of generating and sustaining workers' labor inputs, and this in turn requires that ~1 ~---O0. In order for the efficiency wage hypothesis to be generally valid, it is both necessary and sufficient that there be one sector, or quality attribute, subject to constant costs on the intensive margin. In the absence of such a sector, economic rent will exist and vary with the size of the labor force. This clearly 6There is a tendency in the development literature to assume this condition away by ignoring labor quality in the traditional sector, a tendency shared by the efficiency-wage advocates. Thus Stiglitz (1982) 'simplifies' his analysis of a two-sector labor-surplus economy by 'assuming that efficiency is independent of the wage in the rural sector' and by modeling labor inputs in that sector as though the quality level were fixed. This means that the quality-supply curve is vertical, say at h a in fig. 3, so that any decline in the number of workers would reduce totat labor inputs and make labor rents positive.
322
C.U, Chiswick, The eJficiency-wage hypothesis
places rather more of a restriction on the applicability of the hypothesis than its advocates seem to realize. Further, the implicit constant-cost assumption for a labor surplus economy raises additional questions as to the applicability of the Lewis modek [t is difficult to imagine any dimension of labor quality for which costs might be constant on the intensive margin: certainly not time and effort, the most often-cited quality dimensions for the traditional sector, for which the opportunity cost presumably would be the marginal utility of leisure and/or the marginal productivity of home production. 4, Conclusions
The analysis in this paper approached the efficiency-wage hypothesis from the perspective of modern labor economics. Part 2 showed that this hypothesis is formally equivalent to a model of investment in a highly perishable (one-period), firm-specific attribute of labor quality which the employer finds more convenient to finance indirectly, through higher wages, than directIy. It was also shown that the efficiency-wage hypothesis deals with quantity-quality trade-offs in the labor market for the special case in which quantity has a market price of zero. This zero-price assumption, which is justified by the existence of either open or disguised unemployment, is required for the efficiency-wage solution where employers minimize labor costs per efficiency unit. [t foflows that the efficiency-wage hypothesis is consistent with the coexistence of high wages and unemployment but cannot be used as an explanation of this phenomenon. Part 3 investigated the minimum set of assumptions necessary to obtain the efficiency-wage solution, tt was found that a necessary and sufficient condition is the existence of a labor surplus economy. It was also found that a labor surplus economy could exist if and only if at least one group of firms (e.g., the traditional-sector self-employed) used labor quality attributes which could be increased within the relevant range without increasing unit costs. That is, there must be some quality attribute not subject to increasing costs on the intensive margin, implying that the wage-requirement curve is a straight line. The empirical validity of the efficiency-wage model thus turns on the shape of the wage-requirement function, or (equivalently) on the cost curves for productive attributes of labor. This question, not previously viewed as important, is thus a crucial area for empirical research. While the efficiency-wage hypothesis is both interesting and useful, and the literature on this subject has raised some important issues, it should not be surprising that it fails as an explanation of a phenomenon contrary to neoclassical predictions. This is because there is no assumption embodied in the efficiency-wage model that is not neoclassical. Employers maximize profits, they pay workers according to marginal productivity, and they raise wages if and only if by doing so they received more effective labor inputs.
c.u, Chiswick, The efficiency-wage hypot:hesis
323
W o r k e r s require higher wages if they are to p r o v i d e higher quality labor, a s t a n d a r d feature of neoclassical analysis. The only a d d i t i o n a l a s s u m p t i o n is t h a t there is 'surplus' labor, or u n e m p l o y m e n t , to justify the zero price paid to l a b o r q u a n t i t y units. T h u s the m o d e l is valid for a n a l y z i n g the d i s t r i b u t i o n of wages in a l a b o r surplus e c o n o m y , b u t it is n o t valid as an alternative to the neoclassical p a r a d i g m for e x p l a i n i n g the existence of i n v o l u n t a r y unemployment.
References Akerlof, George, 1982, Labor contracts as partiaI gift exchange, Quarterly Journal of Economics 97, Nov., 543-569. Akerlof, George, 1984, Gift exchange and efficiency-wage theory: Four views, American Economic Review 74, May, 79-83. Becket, Gary S. and Gregg Lewis, [973, On the interaction between quantity and quality of children, Journal of Political Economy, Supplement, March, part [~[,$279-$288. Chiswick, Carmel U., 1984, The impact of education policy on economic development: Quantity, quality and earnings of labor, Economics of Education Review 3, 121-130. Lewis, W. Arthur, 1954, Economic development with unlimited supplies of ~abour, The Manchester School, May, 139-191. Mirrlees, James A., 1975, A pure theory of underdeveloped economies, in: L~oyd G. Reynolds, ed., Agriculture in Development Theory (Yale University Press, New Haven, CT) 84-106. Sen, Amartya, K., 1966, Peasants and dualism with or without surplus labor, Journal of Political Economy 74, 425-450. So~ow~Robert, 1980, On theories of unemployment, American Economic Review 70, March, ~-11. Stiglitz, Joseph E., 1976, The efficiency wage hypothesis, surplus labour, and the distribution of income in LDCs, Oxford Economic Papers 28, 185-207. Stiglitz, Joseph E., 1982, Alternative theories of wage determination and unemployment: The efficiency wage model, in: Mark Gersovitz et ak, eds., The theory and experience of economic development: Essays in honor of Sir W. Arthur Lewis (Alien and Unwin, London) 78-106, Yellen, Janet L., 1984, Efficiency wage models of unemployment, American Economic Review 74, May, 200-205.
THE EFFICIENCY-WAGE
HYPOTHESIS
Applying a General Model of the Interaction between Labor Quantity and Quality Carmel U. C H I S W I C K * University of Illinois, Chicago, IL 60680, USA
Received March 1984, final version received August 1984 The efficiency wage is analyzed in the context of a market for labor °quality" units. The model is equivalent to that of a perishable (one-period) form of firm~specific human capital which is most efficiently financed by the employer indirectly through higher wages. The hypothesis also assumes a labor market in which the 'quantity' units have zero price (i.e., labor earns no rent), which can occur in the absence of unemployment only if the supply of some quality attribute is subject to constant costs on the intensive margin. This constant-cost condition is implicit in W.A. Lewis' original description of the traditional sector in a dual economy. Otherwise the zerorent assumption requires unemployment, in which case it can not be used to explain the existence of unemployment. The general applicability of the constant-cost condition and of the efficiency-wage hypothesis is questioned.
1. Introduction In its most general form, the efficiency-wage hypothesis holds that the services employers receive from their workers are a positive function of the wage they offer. Although this notion is something less than a novelty, the efficiency-wage literature focuses on two interesting labor market issues: the mechanism whereby higher wages elicit higher productivity, and the implications of this relationship for the existence of involuntary u n e m p l o y m e n t at equilibrium. As it has evolved, however, the 'efficiency-wage hypothesis' label has become strongly associated with two closely-related inferences drawn from the model: that employers minimize labor costs per efficiency unit and that high wages can coexist with unemployment. It will be argued here that these inferences can be d r a w n only in special circumstances and should be carefully distinguished from the m o r e general version of the hypothesis as stated above. This paper a p p r o a c h e s the efficiency-wage hypothesis as a problem in *The author wishes to acknowledge the helpful comments of an anonymous referee and of my colleagues in the Department of Economics at UtC. 0304-3878/86/$3.50 © 1986, Elsevier Science Publishers B.V. (North-Holland)
312
C.U. Chiswick, The efficiency-wage hypothesis
q u a n t i t y - q u a l i t y trade-offs as applied to labor m a r k e t s J Employers can vary labor inputs by varying the n u m b e r of workers hired at the current wage rate and by raising the productivity of workers through one of the mechanisms associated with higher wages. Such m e c h a n i s m s include improved nutrition, better morale, greater loyalty, reduced turnover, or perhaps simply the prerogative of selecting 'better' workers, e Although originally p r o p o s e d in the context of a labor-surplus L D C [Mirrlees (1975), Stiglitz (1976)1, the efficiency-wage hypothesis has also been suggested as a deveIoped-country p h e n o m e n o n [see, for example, Akerlof (1984), Solow (t980), Yellen (1984)1. E m b e d d i n g the efficiency-wage analysis in a general modal of q u a n t i t y - q u a l i t y trade-offs helps delineate m o r e sharply the implications of the model and its applicability to various types of economies. Part 2 reviews the efficiency-wage model, highlighting its place in m o d e r n labor theory and showing h o w it can be viewed as an application of the m o r e general q u a n t i t y - q u a l i t y m o d e l The analysis shows that an i m p o r t a n t implication of the hypothesis - that employers minimize the wages paid per efficiency unit provided by workers - is the result of a built-in u n e m p l o y m e n t assumption. T o the extent that the efficiency-wage hypothesis is associated with this b e h a v i o r on the part of employers, it is consistent with u n e m p l o y ment but can not be used to 'explain' its existence. Part 3 considers the m i n i m u m set of restrictions required on the m o r e general model for the efficiency wage to be applicable. It argues that a labor-surplus e c o n o m y is a necessary condition and that not all specifications of the relationship between wages and productivity are consistent with such an economy. Part 4 concludes the p a p e r with a s u m m a r y of the a r g u m e n t and of its main conclusions.
2. Efficiency wages and labor quality This section reviews the efficiency-wage model and argues that it is formally equivalent to a model of investment in a special type of firm-specific h u m a n capital. It also shows that the existence of u n e m p l o y m e n t has been
Sin recent years, the fullest development of quantity~luality analysis has been in the context of consumption goods, especially of such unconventional consumer durables as children [Becker and Lewis (1973)1. The issue has also been of some concern in the factor markets, although in the case of physical capital 'quantity' is such an ambiguous concept that its 'amount' is typically measured in efficiency units anyway. Labor quality is usually not treated symmetrically with quantity but rather as an additional dimension which must be added to, or aggregated with, the quantity units so as to achieve a measure of "effective" labor inputs. A recent exception is Chiswick (1984), in which a model similar to the one used here is developed. 2See, for example, Stigiitz (1982) for a list of mechanisms and an argument to the effect that these are different from the usual concepts underlying investments in labor quality. Akerlof (1982, 1984) has proposed a sociological model of 'partial gift exchange' in which the abovemarket component of the wage is viewed as a gift for which the worker reciprocates by providing greater loyalty, effort, or other form of commitment resulting in higher productivity.
c.u. Chiswick, The efficiency-wagehypothesis
313
built into the assumptions of the model. The section concludes with some remarks about the relationship between efficiency wages and modern labor market analysis. Let f(H) be a production function with the usual properties where H denotes the human input. If L is the quantity (e.g., number of workers) and h is the quality (e.g., average number of efficiency units embodied in each worker) of labor, then H = h L by definition. Let T(h) be the total cost per worker of obtaining h efficiency units, with T' > 0 and T" ~0, and let c(h) denote the cost per efficiency unit: c = T/h. The employer's profit function is P = f ( H ) - LT(h),
(1)
which is maximized with respect to L and h when the following conditions are met:
f'h = T
or, equivalently, f ' = c;
f ' = T'.
(2), (3)
Eqs. (2) and (3) may be solved to eliminate f ' . The optimal quality level is thus determined by c = T', the minimum unit cost condition, regardless of the properties of the production function. Fig. 1 illustrates this standard efficiency-wage analysis. The first panel is the wage-requirement curve, in which the quality of labor depends on the dollar amount paid by the employer in the form of wages. (The reader may substitute the currency of choice for the word 'dollar'.) Although the efficiency-wage literature emphasizes the dependent nature of labor quality by placing it on the vertical axis, fig. la conforms to the conventional practice in economics of placing price on the vertical axis even though it is the independent variable. From the employer's perspective, it is clear that the wage-requirement curve is the total cost curve for quality units insofar as it indicates the lowest wage that can be paid to elicit a given level of quality. Employers maximize profits when the average cost per efficiency unit is lowest, at point A where marginal cost equals average cost. The wage determined by this condition is w~, the efficiency wage. The second panel, fig. tb, shows the average and marginal cost curves corresponding to the efficiency curve in fig. la, with h e indicating the quality level corresponding to point A in the upper panel. The efficiency wage is indicated in the second panel as the area of a rectangle defined by h ~ and the height of the average cost curve at its lowest point. The production function does not affect the optimal quality level in tNs analysis because of the implicit assumption that workers per se have no economic value independent of the productive attributes embodied in them. This is an important insight of modern labor economics which is captured here by measuring the human factor of production H in efficiency units. The
C.U. Chiswick, The efficiency-wage hypothesis
314
(a)
$
We
J
rm
(b)
~h
i
0 LABOR
he QUALITY
$/h b..
T'
T~ >I--J
o co rt,,
.
.
,
.
.
"
•
.
,
•.we.~:i
.J _J
o
. . ,
'., O
.
- . . ,i 2~ h
~,.h
LABOR QUAUTY
Fig. I. T h e wage-requirement curve.
F-$/h z
23 3.. _J
C
U3 [g ..3 .,.J
O
0
he
h°
h*
LABOR QUALITY Fig. 2. O p t i m a l quality levels.
tabor-quality supply curve is effectively T' for wages above the efficiency wage (i.e., h>h ~) and the vertical axis for lower wages, being discontinuous at we itself. The labor-quality demand curve is simply the marginal product curve, f ' . A demand curve like f~ in fig. 2 crosses the supply curve in its discontinuous portion; the employer must reduce the totat amount of H (by
C.U. Chiswick, The efficiency-wage hypothesis
315
reducing the number of workers) and adjust other factors so as to raise the entire marginal product curve until it crosses the supply curve at T'=c. A demand curve like f~, crosses the supply curve where there is economic rent, indicated by the shaded area in fig. 2. As long as workers per se have no market value, employers capture the entire rent as profits; they thus have an incentive to hire more workers until the marginal productivity curve has been shifted down to the zero-rent point where T'=c. The assumption that workers per se have no economic value is key to this result. While eq. (3) is the usual profit-maximizing condition, requiring employers to adjust the quality level on the intensive margin so as to equalize marginal productivity with marginal cost, eq. (2) reflects the zerorent assumption insofar as it requires the marginal product of labor (hence wages) to be exhausted by the cost of forming productive attributes. Yet human capital must be embodied in a worker. Increasing costs on the intensive margin imply that workers can become a scarce resource, with firms bidding against each other for 'empty vessels', as it were, in which to embody various productive attributes. [f this happens, the wage rate must incorporate the workers' economic rent as well as the cost of quality units. 3 Thus full employment typically implies wages that exceed the wage-requirement function. Viewing the wage-requirement function as a cost curve not only helps bring out the role of economic rent, it also suggests a relationship between the efficiency-wage hypothesis and human capital investment analysis. The efficiency wage is relevant for quality attributes which employers finance indirectly (but fully) by paying workers a higher wage. It is dear that employers are willing to pay this higher wage only insofar as it increases worker productivity, making it a kind of investment. The analysis is essentially static, however, so all productivity gains are realized during the period covered by the wage contract. The willingness of employers to finance the investment suggests that the quality attribute must be firm-specific, while the short duration of the productivity gain suggests perishability. Perishability also helps explain why the employer is willing to finance the entire cost of a firm-specific investment; whereas employers usually share the benefits (and hence costs) to give employees an incentive to remain with the firm, this is not necessary if all gains are realized during the period of the wage contract. The firm-specific nature of the quality attributes usually listed in the efficiency-wage literature is readily apparent. Firm loyalty, for example, may 3This rent is analogous to the pure location value of land, a value which is derived from the need for an enterprise to be fixed in space rather than from any functional complementarity between the plant and the land itself. It is not the same as the earnings of 'raw' or unskilied labor, since labor quantitity units do not enter into the production function directly; in order to earn this scarcity premium, a worker must have skills embodied in him (or her) and it is only the marginal product of those skills that determine the value of labor.
C.U. Chiswick, The efficiency-wagehypothesis
316
be 'bought' with higher wages, a clear example of an investment (in lower turnover and greater commitment) made by the ' employer in a quality not transferable to other firms. Almost any perishable quality, like honesty or motivation, which depends on higher wages for its existence may be viewed as specific to the firm and time period specified in the wage contract. Another quality dimension usually cited is improved nutrition. Although elsewhere this is considered a 'general' quality for which the worker would bear the cost, the efficiency-wage literature specifically views good nutrition as higNy perishable and not generally valued by all firms. Those firms which value it pay 'above-market' wages and capture the full benefit of higher productivity during the current time period. Much of the literature on human capital investment focuses on the case of general training, where individuals finance investments in themselves; wages, determined solely by marginal product, incorporate a normal return on the investment along with whatever economic rent the market will bear. 4 In contrast, the efficiency-wage literature focuses on a particularly interesting class of firm-specific investments, where the investment is highly perishable and is completely financed in one period by incorporating a premium in the wage to cover its cost. In both cases the wage is the sum of two components, one covering investment costs and the other an economic rent earned by workers because they themselves constitute a scarce factor of production.
A generalization The efficiency-wage literature focuses on a zero-rent economy, but there are insights to be gained by considering a more general model. Consider an economy with three factors of production, physical capital K and two t ~ e s of human inputs, H~ and Hz. The human factors are embodied in workers drawn from a single pool. Each factor H i is embodied in L i number of workers with average quality levels h i (i=1,2) and L~+L2=L. The perworker cost of attaining various quality levels is given by functions T~(h3, where T'~>0 and T~'>O, and unit costs are ci(h3=Ti/hi (i= 1,2). The cost of an efficiency unit of physical capital, c~, is assumed to be independent of K. Finally, relax the 'perishability' assumption, allowing quality attributes to persist for more than one period and letting r denote the rate of interest appropriate for estimating the current-period cost of capital. The economy may be thought of in terms of a three-factor production function Y with value-added expressed as
V= Y - r ( L 1 T 1+L2T2+cKK),
where
(4) Y=f(H1, H2, K ) and
Hi=hiL i,
i=1,2.
"*This rent is usually also assumed to be negligible, leading to the odd notion that any discrepancy between earnings and normal returns on investment somehow disproves the notion of human capital.
C.U. Chiswiek, The efficiency-wagehypothesis
317
While each firm may adjust the number of workers so as to bring productivity in line with costs, the size of the total labor force is viewed as fixed. Maximizing the Lagrangian function,
~=V-2(L~+L2-L), V=f(H1,
H 2,
Hi-h~L i,
where
K)-r(L1T1 +LaT2 +crK),
and
(5)
i = 1,2,
yields the first-order conditions
f~hi-rT~=2, f~=rcK,
f~--rTi, LI + L2 = L.
i = 1,2,
(6), (7) (8), (9)
The second-order conditions for a maximum are met for any quasi-concave production function whenever T'~> 0 and T~' > 0. Since ,~h~ is the shadow price of a labor quantity unit (the shadow wage, denoted w~) and rT~ is the current-period cost of human capital embodied in a worker earning that wage, the Lagrangian multiplier 2 is the current-period 'profit' or economic rent earned by a worker of type i. Labor quantity is limited only for the whole economy and not for any one attribute; it will be optimally allocated if equal rents are received by all workers. Once these rents have been netted out of earnings, the ratios of marginal product to unit cost are equalized for all inputs. This implies (with the help of some straightforward simplifying assumptions) that the rates of return to investments in each factor be equal to each other and to the interest rate r. Moreover, if eqs. (6) are solved to eliminate 2 it may be shown that W2 - - W t
----=r. r2-r~
(10)
The left-hand side of this equation may be interpreted as the rate of return to an ex ante redistribution of workers between L~ and L> Optimality requires that this rate of return also be equal to the appropriate rate of interest r. Eqs. (6)--(9) imply simultaneous satisfaction of the efficiency conditions for allocation of resources (equalization of the ratios of marginal product to marginal factor costs) and of investments (equalization of rates of return). The multiplier 2 is the current-period rent accruing to labor quantity units and must be the same for all workers. Second-order conditions for a maximum are met for any quasi-concave production function whenever quality is subject to rising costs on the intensive margin. There are effectively
3 ~8
C.U. Chiswick, The eJ]~ciency-wage hypothesis
four different types of investment in this modek each of the three factors of production may be increased bY new capital formation (deepening) and workers may be shifted ex ante from one group to another. If the production function were to include n different types of labor there would be n + 1 types of capital deepening and n(n- ~)/2 ways of shifting workers between groups. To each labor factor would correspond one pair of equations like (6) and (7) and n - 1 equations analogous to (10). Whether zero or positive, labor-market equilibrium requires that worker rents be the same for all workers drawn from the same pool, regardless of the nature and level of productive attributes embodied in them. This is because there is no utility derived from employment; if there were, the efficiency wage could be further reduced by making the worker bear part of the cost of productive attributes. Workers are thus rent-maximizers and will change employment in favor of higher rents until these are the same in all firms. By way of corollary, the absence of economic rent in any firm or group of firms drawing on the same labor pool (including 'unemployment' as a possible state) implies that there can be no rent for any worker in that pool, no matter how high the observed wage rate. This is in fact .the appeal of the efficiency-wage hypothesis, for it explains high wages coexisting with unemployment: the observed wage is actually 'gross' of costs, costs which are implemented by workers themselves even though financed by employers, while the 'net' wage is the same - zero - in aH activities. Too often the presumption is that workers prefer employment at these zero-rent wages to unemployment. Yet if workers are rent maximizers there is no reason to prefer a zero-rent wage to a state of unemployment.
3. The efficiency wage and unempleyment This section explores the restrictions required to reduce the general quantky-quality model to the formal equivalent of the efficiency-wage model. Part 2 showed that efficiency wages persist in equilibrium only if labor rents are zero everywhere. A sufficient condition is that there be some group of workers for whom economic rents are effectively zero. One such group, of course, may be the unemployed; indeed, the efficiency-wage hypothesis purports to explain the coexistence in equilibrium of high wages and unemployment among workers drawn from the same labor pool. Disguised unemployment, or self-employment at a subsistence level, is sometimes viewed as equivalent to structural unemployment insofar as labor earns no economic rent. Both of these possibilities will be explored here. Referring to the general model developed in part 2, a change in the size of the labor force would generate the following changes in the variables relevant
C.U, Chiswiek, The efficiency-wagehypothesis
319
for growth and income distribution:
xlx2(h2Fti+ hlF2~)hj
dLt dL
xjh2F-
dK dL
-xlxahlh2(h2F1Kq-hlF2K ) D*
d,~ dL
-(h~h2)2xlx2F D* '
D*
dhi -- (hlh2)xjhf dL LiD* '
,
i--pj= t, 2,
(11)
(13)
i#j= 1, 2,
(14)
where F is the Hessian determinant of the production function f, F u is a cofactor of F, i,j= 1,2, K, xi-fJHiei where si is the elasticity of the T'i curve, i = 1, 2, and
D* =(x~h~ + x2h~)F- xix2(h2Flx + 2hlhzF~2 + h~F22). For a quasi-concave production function, d2/dL is non-positive so that increases in the labor force would generally be associated with a decline in the rent to workers. Once the labor force has reached the size where this rent is zero, any additional increase in L would lead to the crisis of negative rent. It is difficult to conceive of an economy in long-run equilibrium with a negative labor rent, no matter how large the labor force. Certainly if efficiency units per worker depend on such basic factors as nutrition, strength or even morale, a wage lower than the efficiency wage would not permit labor to sustain itself and so would be untenable. Similarly if efficiency units depend on investments in skill-formation (whether financed by the worker or by the employer), the negative rent implied by a wage lower than the efficiency wage would remove the incentive to acquire that skill. The usual solution to this diIemma is to posit structural unemployment: if every firm employs just enough workers so that the efficiency wage prevails, rent will be zero and any left-over workers will be unemployed. This has dismal long-run implications that are rarely faced, for unless the employed workers are sufficiently altruistic that they view supporting their unemployed brethren as a voluntary consumption expenditure, any transfers of income to the unemployed will be perceived as a tax on real wages and hence result in a negative rent. The alternative is a Malthusian crisis of some sort which effectively reduces the size of the labor force until the rent is zero, but it is precisely the absence of such a crisis that motivates the efficiency-wage hypothesis in the first place.
320
C.U. Chiswick, The efficiency-wage hypothesis
Fortunately, there is a special case in which negative rents never occur: the case where one skilt exhibits constant costs per efficiency unit on the intensive margin. 5 For example if the marginal cost curve for type-1 efficiency units, T'~, is perfectly elastic, rent would be zero in that sector and therefore the economy as a whole would be in equilibrium only when 2 =0. For this case, ~ --- oe and eqs. (11)-(14) reduce to dLl . . dL
. . I,
dhl . . dL
h~ , L~
dL2 dh2 dK d2 . . . . . . . . dL dL dL dL
0.
(i5)
Any increase in L would be allocated entirely to the constant-cost attribute, making firms that use that attribute the employer of last resort. There would be a corresponding decline in the quality of that type of labor (e.g., the 'effort' put forth by each worker). The magnitude of this decline would be such that dhl/h~ -- - d L 1 / L ~ , so the total number of efficiency units, H a, would remain the same. Since there would be no change in the optimal amount of any other factor of production either, total output would also remain the same. It is in this sense that the additional workers contribute nothing to production and hence that the marginal product of labor is zero. Although Lewis (t954) was not considering costs explicitly in his analysis of a labor surplus economy, this case is in fact the only one consistent with his analysis. It will be helpful to recall Lewis' (i954) original definition of a labor surplus economy: '... an unlimited supply of labour may be said to exist in those countries where population is so large relatively to capital and natural resources, that there are large sectors of the economy where the marginal productivity is negligible, zero, or even negative . . . if some members of the family obtained other employment the remaining members could cultivate the holding just as well (of course they would work harder: the argument includes the proposition that they would be willing to work harder in these circumstances).' Let type-1 labor be the category associated with the traditional-sector labor force. Lewis' description suggests that labor quality, hi, may be measured in hours worked or in effort put forth. Now suppose that some members of L~ find other employment as L2; for example, an exogenous increase in modernsector physical capital might shift upward the demand curve f2/r in the righthand panel of fig. 3, causing modern-sector firms to hire additional workers until the efficiency wage once again prevails. This movement of workers out ~Ifh~is interpretedas hours of work in the peasant economy,this conditionis equivalentto the one developed in Sen (1966). The remainder of this section may be viewed as an amplification and generalization of part 2 of that paper.
C,U. Chiswick, The efficiency-wage hypothesis
321
$/h 2
~
= C1
(a) TRADITIONAL SECTOR
(b) REST OF ECONOMY
Fig. 3. A labor-surplus economy.
of the traditional sector causes demand in the left-hand panel of fig. 3 to shift upward from f~/r to f]/r. The optimal level of hi would increase regardless of the slope of T'1. But Lewis says that h t increases so as to completely offset the removal of workers. ° That is, dHJdLt =0, a condition which is met only when f ~ = 0 or e 1 = c~. But surely f l is positive, for otherwise why would there be any reason for the remaining members to 'work harder'? In order for the remaining workers to provide the same amount of labor as before, it is therefore necessary that the supply curve T~ be horizontal. At the same time, any loss of workers would shift upward the marginal productivity curve f~/r, resulting in a new equilibrium at a positive rent whenever el < oo and at a zero rent only when e 1 = oo. Lewis' marginal productivity concept is thus not fl, as is sometimes supposed, but rather 2: the economic rent earned by workers regardless of their sector of employment. A labor surplus economy is one for which 2 = 0 , with productivity just high enough to cover the cost of generating and sustaining workers' labor inputs, and this in turn requires that ~1 ~---O0. In order for the efficiency wage hypothesis to be generally valid, it is both necessary and sufficient that there be one sector, or quality attribute, subject to constant costs on the intensive margin. In the absence of such a sector, economic rent will exist and vary with the size of the labor force. This clearly 6There is a tendency in the development literature to assume this condition away by ignoring labor quality in the traditional sector, a tendency shared by the efficiency-wage advocates. Thus Stiglitz (1982) 'simplifies' his analysis of a two-sector labor-surplus economy by 'assuming that efficiency is independent of the wage in the rural sector' and by modeling labor inputs in that sector as though the quality level were fixed. This means that the quality-supply curve is vertical, say at h a in fig. 3, so that any decline in the number of workers would reduce totat labor inputs and make labor rents positive.
322
C.U, Chiswick, The eJficiency-wage hypothesis
places rather more of a restriction on the applicability of the hypothesis than its advocates seem to realize. Further, the implicit constant-cost assumption for a labor surplus economy raises additional questions as to the applicability of the Lewis modek [t is difficult to imagine any dimension of labor quality for which costs might be constant on the intensive margin: certainly not time and effort, the most often-cited quality dimensions for the traditional sector, for which the opportunity cost presumably would be the marginal utility of leisure and/or the marginal productivity of home production. 4, Conclusions
The analysis in this paper approached the efficiency-wage hypothesis from the perspective of modern labor economics. Part 2 showed that this hypothesis is formally equivalent to a model of investment in a highly perishable (one-period), firm-specific attribute of labor quality which the employer finds more convenient to finance indirectly, through higher wages, than directIy. It was also shown that the efficiency-wage hypothesis deals with quantity-quality trade-offs in the labor market for the special case in which quantity has a market price of zero. This zero-price assumption, which is justified by the existence of either open or disguised unemployment, is required for the efficiency-wage solution where employers minimize labor costs per efficiency unit. [t foflows that the efficiency-wage hypothesis is consistent with the coexistence of high wages and unemployment but cannot be used as an explanation of this phenomenon. Part 3 investigated the minimum set of assumptions necessary to obtain the efficiency-wage solution, tt was found that a necessary and sufficient condition is the existence of a labor surplus economy. It was also found that a labor surplus economy could exist if and only if at least one group of firms (e.g., the traditional-sector self-employed) used labor quality attributes which could be increased within the relevant range without increasing unit costs. That is, there must be some quality attribute not subject to increasing costs on the intensive margin, implying that the wage-requirement curve is a straight line. The empirical validity of the efficiency-wage model thus turns on the shape of the wage-requirement function, or (equivalently) on the cost curves for productive attributes of labor. This question, not previously viewed as important, is thus a crucial area for empirical research. While the efficiency-wage hypothesis is both interesting and useful, and the literature on this subject has raised some important issues, it should not be surprising that it fails as an explanation of a phenomenon contrary to neoclassical predictions. This is because there is no assumption embodied in the efficiency-wage model that is not neoclassical. Employers maximize profits, they pay workers according to marginal productivity, and they raise wages if and only if by doing so they received more effective labor inputs.
c.u, Chiswick, The efficiency-wage hypot:hesis
323
W o r k e r s require higher wages if they are to p r o v i d e higher quality labor, a s t a n d a r d feature of neoclassical analysis. The only a d d i t i o n a l a s s u m p t i o n is t h a t there is 'surplus' labor, or u n e m p l o y m e n t , to justify the zero price paid to l a b o r q u a n t i t y units. T h u s the m o d e l is valid for a n a l y z i n g the d i s t r i b u t i o n of wages in a l a b o r surplus e c o n o m y , b u t it is n o t valid as an alternative to the neoclassical p a r a d i g m for e x p l a i n i n g the existence of i n v o l u n t a r y unemployment.
References Akerlof, George, 1982, Labor contracts as partiaI gift exchange, Quarterly Journal of Economics 97, Nov., 543-569. Akerlof, George, 1984, Gift exchange and efficiency-wage theory: Four views, American Economic Review 74, May, 79-83. Becket, Gary S. and Gregg Lewis, [973, On the interaction between quantity and quality of children, Journal of Political Economy, Supplement, March, part [~[,$279-$288. Chiswick, Carmel U., 1984, The impact of education policy on economic development: Quantity, quality and earnings of labor, Economics of Education Review 3, 121-130. Lewis, W. Arthur, 1954, Economic development with unlimited supplies of ~abour, The Manchester School, May, 139-191. Mirrlees, James A., 1975, A pure theory of underdeveloped economies, in: L~oyd G. Reynolds, ed., Agriculture in Development Theory (Yale University Press, New Haven, CT) 84-106. Sen, Amartya, K., 1966, Peasants and dualism with or without surplus labor, Journal of Political Economy 74, 425-450. So~ow~Robert, 1980, On theories of unemployment, American Economic Review 70, March, ~-11. Stiglitz, Joseph E., 1976, The efficiency wage hypothesis, surplus labour, and the distribution of income in LDCs, Oxford Economic Papers 28, 185-207. Stiglitz, Joseph E., 1982, Alternative theories of wage determination and unemployment: The efficiency wage model, in: Mark Gersovitz et ak, eds., The theory and experience of economic development: Essays in honor of Sir W. Arthur Lewis (Alien and Unwin, London) 78-106, Yellen, Janet L., 1984, Efficiency wage models of unemployment, American Economic Review 74, May, 200-205.