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Critically Evaluate the Extent to Which Efficiency Wage Theory Can Provide an Explanation of Unemployment

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Unemployment of workers is a comment and recurrent problem in the labour market in most of the countries. Unemployment is defined as an excess supply of labour at prevailing wage. It means that the labour market is unable to be clear. A lot of the economists attempt to find out the cause of it. And the efficiency wage theory is widespread acceptable for explaining the involuntary unemployment in the modern theory, which is defined as the proportion of the labour force which is actively seeking a job at the existing wage level, but unable to get one. As Akerlof and Yellon(1986) pointed out, the common factor in efficiency wage models is that "in equilibrium, an individual firm's production costs are reduced if it pays a wage in excess of market clearing and thus there is equilibrium involuntary unemployment." Some authors support this explanation for unemployment. Unfortunately, some others, however, criticize that explanation from different points. In the following, the efficiency wage models, some of the supporting and the critiques are illustrated respectively.

The efficiency wage was developed and formulated by Solow(1979), known as the Solow Condition. It presents the relationship between the wage and productivity. This model is assumed an economy which consists of a large number of identical perfectly competitive firms with a production function and the workers are same, which means there the existence of persistent, non-compensation wage differentials across firms, and the firm is a profit maximiser, being able to set the flexible wage. The Solow Condition show that in order to maximise profitÑ€ (Ñ€=pF[e(w)N]-wN, Where F[e(w)N] is product function, p is the price of output, N is the number of workers). Subject to w>v (where v is the workers' alternative wage), the firm's optimal strategy is to set an efficiency wage w*, and hire workers up to that point where the value of their marginal product at that wage equals the efficiency wage. So the condition give us [w*/e(w*)]*e`(w*)=1=Ð*ew. It shows a direct and increasing relationship between the wages paid by firms and the level of effort provided by workers. In equilibrium, it states firms may find it profitable to set its wages at the level at which the elasticity of worker effort with respect to the real wage is one. That is to say lowing the wage would reduce worker productivity to such an extent that firm profits would fall. Obviously, the efficiency wage only depends on the characteristics of the relationship P(w). It can be seen clearly from the wage-effort function, illustrated in Figure 1. Wage is on the vertical axis so the slope of the curve is 1/e`(w). The firm should choose the point A, where the wage-effort curve has a slope of 1/e`(w*)=w*/e*,that is slope is 1. Otherwise, at other points, such as point B, 1/e`(w1)< w1/e1, the percentage increase in wage is smaller than the increase in effort.

Figure 1 wage-effort function


A e(w)

W* w*/e*=1/e`(w*)



e1 e* e

By the maximisation, the unemployment is generated, because each firm will want to hire the workers up to optimal level A. At point A the labour demanded is L2. Though the aggregate labour demand depends on that number and the number of firms in the industry and e*>e1, which means that under certain production, the labour demanded at w* must be less than that at w1. Then the labour supply at the wage w* exceeds labour demand, there will be unemployment. Seen as Figure 2.

Figure 2


W Involuntary Ls





L2 L1 L3 L

As firms set the efficiency wage(w*) above the market clearing level(w1), the natural unemployment rate is the workforce Lf minus L3, and there is additional unemployment L3-L2, which is clearly involuntary in that unemployed workers earning V would prefer to be working at the wage w*.

In order to make maximum profit, there are several motives for firms pay the efficiency wage. As the worker's wage falls, worker's effort falls and his marginal product falls by a large percentage. At the efficiency wage theory, the firm is breaking even on the marginal worker, so that at a lower wage the firm would make a loss. The efficiency wage theory maximizes the firm's profit and explains the employment rate by some views:

First of all is shirking model. It assumes that firms are only able to monitor worker performance imperfectly in the homogenous labour and goods market. Workers who shirk will face a non-zero probability of detection and if detected they are fired. If they are fired from the firms paying efficiency wage and have accept the vacancies in other firms paying lower wage or if there are no vacancies and unemployment is the consequence. As all firms cannot increase relative wage, the unemployment result is a more likely outcome. "Equilibrium unemployment as a worker discipline device." This penalty is less severe the lower the unemployment rate and the higher the unemployment benefit. If the unemployment benefit is higher, less people want to work, labour demand increase, lower the efficiency wage and the involuntary unemployment rate, making this device ineffective. Thus the higher wage increase the cost to a worker of being fired and then work harder to make sure keeping the job, the productivity can be increase, at the lease does not fall.

Secondly, there is turnover model. When workers quit, fired, the firms should face the recruitments, training cost. For the firm, when doing so, it is costly. Especially during the training, the productivity is lower. So, they are wiling to pay high wage to keep the labour force stable. For the workers, the probability of quits is reduce by



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