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shirking their responsibilities are fired. But not all shirkers are caught immediately because monitoring workers is costly and imperfect. A firm can respond to this problem by paying wages above the equilibrium level. High wages make workers more eager to keep their jobs and, thereby, give workers an incentive to put forward their best effort.
This particular type of efficiency-wage theory is similar to the old Marxist idea of the “reserve army of the unemployed.” Marx thought that employers benefited from unemployment because the threat of unemployment helped to discipline those workers who had jobs. In the worker-effort variant of efficiency-wage theory, unemployment fills a similar role. If the wage were at the level that balanced supply and demand, workers would have less reason to work hard because if they were fired, they could quickly find new jobs at the same wage. Therefore, firms raise wages above the equilibrium level, causing unemployment and providing an incentive for workers not to shirk their responsibilities.
WORKER QUALITY
A fourth and final type of efficiency-wage theory emphasizes the link between wages and worker quality. When a firm hires new workers, it cannot perfectly gauge the quality of the applicants. By paying a high wage, the firm attracts a better pool of workers to apply for its jobs.
To see how this might work, consider a simple example. Waterwell Company owns one well and needs one worker to pump water from the well. Two workers, Bill and Ted, are interested in the job. Bill, a proficient worker, is willing to work for $10 per hour. Below that wage, he would rather start his own lawn-mowing business. Ted, a complete incompetent, is willing to work for anything above $2 per hour. Below that wage, he would rather sit on the beach. Economists say that Bill’s reservation wage—the lowest wage he would accept—is $10, and Ted’s reservation wage is $2.
What wage should the firm set? If the firm were interested in minimizing labor costs, it would set the wage at $2 per hour. At this wage, the quantity of workers supplied (one) would balance the quantity demanded. Ted would take the job, and Bill would not apply for it. Yet suppose Waterwell knows that only one of these two applicants is competent, but it does not know whether it is Bill or Ted. If the firm hires the incompetent worker, he will damage the well, causing the firm huge losses. In this case, the firm has a better strategy than paying the
DILBERT® By Scott Adams
F Y I
The Economics
of Asymmetric
Information
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equilibrium wage of $2 and hiring Ted. It can offer $10 per hour, inducing both Bill and Ted to apply for the job. By choosing randomly between these two applicants and turning the other away, the firm has a fifty-fifty chance of hiring the competent one. By contrast, if the firm offers any lower wage, it is sure to hire the incompetent worker.
In many situations in life, information is asymmetric: One person in a transaction knows more about what is going on than the other person. This possibility raises a variety of interesting problems for economic theory. Some of these problems were highlighted in our description of the theory of efficiency wages. These problems, however, go beyond the study of unemployment.
The worker-quality variant of efficiency-wage theory illustrates a general principle called adverse selection. Adverse
selection arises when one person knows more about the attributes of a good than another and, as a result, the uninformed person runs the risk of being sold a good of low quality. In the case of worker quality, for instance, workers have better information about their own abilities than firms do. When a firm cuts the wage it pays, the selection of workers changes in a way that is adverse to the firm.
Adverse selection arises in many other circumstances. Here are two examples:
Sellers of used cars know their vehicles’ defects, whereas buyers often do not. Because owners of the worst cars are more likely to sell them than are the owners of the best cars, buyers are correctly apprehensive about getting a “lemon.” As a result, many people avoid buying cars in the used car market.
Buyers of health insurance know more about their own health problems than do insurance companies. Because people with greater hidden health problems are more likely to buy health insurance than are other people, the price of health insurance reflects the costs of a sicker-than-average person. As a result, people with average health problems are discouraged by the high price from buying health insurance.
In each case, the market for the product—used cars or health insurance—does not work as well as it might because of the problem of adverse selection.
Similarly, the worker-effort variant of efficiency-wage theory illustrates a general phenomenon called moral hazard. Moral hazard arises when one person, called the agent, is performing some task on behalf of another person, called the principal. Because the principal cannot perfectly monitor the agent’s behavior, the agent tends to undertake less effort than the principal considers desirable. The term moral hazard refers to the risk of dishonest or otherwise inappropriate behavior by the agent. In such a situation, the principal tries various ways to encourage the agent to act more responsibly.
In an employment relationship, the firm is the principal and the worker is the agent. The moral-hazard problem is the temptation of imperfectly monitored workers to shirk their responsibilities. According to the worker-effort variant of efficiency-wage theory, the principal can encourage the agent not to shirk by paying a wage above the equilibrium level because then the agent has more to lose if caught shirking. In this way, high wages reduce the problem of moral hazard.
Moral hazard arises in many other situations. Here are some examples:
A homeowner with fire insurance buys too few fire extinguishers. The reason is that the homeowner bears the cost of the extinguisher while the insurance company receives much of the benefit.
A babysitter allows children to watch more television than the parents of the children prefer. The reason is that more educational activities require more energy from the babysitter, even though they are beneficial for the children.
A family lives near a river with a high risk of flooding. The reason it continues to live there is that the family enjoys the scenic views, and the government will bear part of the cost when it provides disaster relief after a flood.
Can you identify the principal and the agent in each of these three situations? How do you think the principal in each case might solve the problem of moral hazard?
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This story illustrates a general phenomenon. When a firm faces a surplus of workers, it might seem profitable to reduce the wage it is offering. But by reducing the wage, the firm induces an adverse change in the mix of workers. In this case, at a wage of $10, Waterwell has two workers applying for one job. But if Waterwell responds to this labor surplus by reducing the wage, the competent worker (who has better alternative opportunities) will not apply. Thus, it is profitable for the firm to pay a wage above the level that balances supply and demand.
CASE STUDY HENRY FORD AND THE VERY GENEROUS $5-A-DAY WAGE
Henry Ford was an industrial visionary. As founder of the Ford Motor Company, he was responsible for introducing modern techniques of production. Rather than building cars with small teams of skilled craftsmen, Ford built cars on assembly lines in which unskilled workers were taught to perform the same simple tasks over and over again. The output of this assembly process was the Model T Ford, one of the most famous early automobiles.
In 1914, Ford introduced another innovation: the $5 workday. This might not seem like much today, but back then $5 was about twice the going wage. It was also far above the wage that balanced supply and demand. When the new $5-a-day wage was announced, long lines of job seekers formed outside the Ford factories. The number of workers willing to work at this wage far exceeded the number of workers Ford needed.
Ford’s high-wage policy had many of the effects predicted by efficiencywage theory. Turnover fell, absenteeism fell, and productivity rose. Workers were so much more efficient that Ford’s production costs were lower even though wages were higher. Thus, paying a wage above the equilibrium level
WORKERS OUTSIDE AN EARLY FORD FACTORY
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was profitable for the firm. Henry Ford himself called the $5-a-day wage “one of the finest cost-cutting moves we ever made.”
Historical accounts of this episode are also consistent with efficiency-wage theory. An historian of the early Ford Motor Company wrote, “Ford and his associates freely declared on many occasions that the high-wage policy turned out to be good business. By this they meant that it had improved the discipline of the workers, given them a more loyal interest in the institution, and raised their personal efficiency.”
Why did it take Henry Ford to introduce this efficiency wage? Why were other firms not already taking advantage of this seemingly profitable business strategy? According to some analysts, Ford’s decision was closely linked to his use of the assembly line. Workers organized in an assembly line are highly interdependent. If one worker is absent or works slowly, other workers are less able to complete their own tasks. Thus, while assembly lines made production more efficient, they also raised the importance of low worker turnover, high worker quality, and high worker effort. As a result, paying efficiency wages may have been a better strategy for the Ford Motor Company than for other businesses at the time.
QUICK QUIZ: Give four explanations for why firms might find it profitable to pay wages above the level that balances quantity of labor supplied and quantity of labor demanded.
CONCLUSION
In this chapter we discussed the measurement of unemployment and the reasons why economies always experience some degree of unemployment. We have seen how job search, minimum-wage laws, unions, and efficiency wages can all help explain why some workers do not have jobs. Which of these four explanations for the natural rate of unemployment are the most important for the U.S. economy and other economies around the world? Unfortunately, there is no easy way to tell. Economists differ in which of these explanations of unemployment they consider most important.
The analysis of this chapter yields an important lesson: Although the economy will always have some unemployment, its natural rate is not immutable. Many events and policies can change the amount of unemployment the economy typically experiences. As the information revolution changes the process of job search, as Congress adjusts the minimum wage, as workers form or quit unions, and as firms alter their reliance on efficiency wages, the natural rate of unemployment evolves. Unemployment is not a simple problem with a simple solution. But how we choose to organize our society can profoundly influence how prevalent a problem it is.
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Problems and Applications
1.The Bureau of Labor Statistics announced that in December 1998, of all adult Americans, 138,547,000 were employed, 6,021,000 were unemployed, and 67,723,000 were not in the labor force. How big was the labor force? What was the labor-force participation rate? What was the unemployment rate?
2.As shown in Figure 14-3, the overall labor-force participation rate of men declined between 1970 and 1990. This overall decline reflects different patterns for different age groups, however, as shown in the following table.
|
|
MEN |
MEN |
MEN |
|
ALL MEN |
16–24 |
25–54 |
55 AND OVER |
|
|
|
|
|
1970 |
80% |
69% |
96% |
56% |
1990 |
76 |
72 |
93 |
40 |
Which group experienced the largest decline? Given this information, what factor may have played an important role in the decline in overall male labor-force participation over this period?
3.The labor-force participation rate of women increased sharply between 1970 and 1990, as shown in Figure 14-3. As with men, however, there were different patterns for different age groups, as shown in this table.
|
ALL |
WOMEN |
WOMEN WOMEN WOMEN |
|
WOMEN 25-54 |
25-34 |
35-44 |
45-54 |
|
|
|
|
|
|
1970 |
43% |
50% |
45% |
51% |
54% |
1990 |
58 |
74 |
74 |
77 |
71 |
Why do you think that younger women experienced a bigger increase in labor-force participation than older women?
4.Between 1997 and 1998, total U.S. employment increased by 2.1 million workers, but the number of unemployed workers declined by only 0.5 million. How are these numbers consistent with each other? Why might one expect a reduction in the number of people counted as unemployed to be smaller than the increase in the number of people employed?
5.Are the following workers more likely to experience short-term or long-term unemployment? Explain.
a.a construction worker laid off because of bad weather
b.a manufacturing worker who loses her job at a plant in an isolated area
c.a stagecoach-industry worker laid off because of competition from railroads
d.a short-order cook who loses his job when a new restaurant opens across the street
e.an expert welder with little formal education who loses her job when the company installs automatic welding machinery
6.Using a diagram of the labor market, show the effect of an increase in the minimum wage on the wage paid to workers, the number of workers supplied, the number of workers demanded, and the amount of unemployment.
7.Do you think that firms in small towns or cities have more market power in hiring? Do you think that firms generally have more market power in hiring today than 50 years ago, or less? How do you think this change over time has affected the role of unions in the economy? Explain.
8.Consider an economy with two labor markets, neither of which is unionized. Now suppose a union is established in one market.
a.Show the effect of the union on the market in which it is formed. In what sense is the quantity of labor employed in this market an inefficient quantity?
b.Show the effect of the union on the nonunionized market. What happens to the equilibrium wage in this market?
9.It can be shown that an industry’s demand for labor will become more elastic when the demand for the industry’s product becomes more elastic. Let’s consider the implications of this fact for the U.S. automobile industry and the auto workers’ union (the UAW).
a.What happened to the elasticity of demand for American cars when the Japanese developed a strong auto industry? What happened to the
elasticity of demand for American autoworkers? Explain.
b.As the chapter explains, a union generally faces a tradeoff in deciding how much to raise wages, because a bigger increase is better for workers
who remain employed but also results in a greater reduction in employment. How did the rise in auto imports from Japan affect the wage-employment tradeoff faced by the UAW?