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

CRITICALLY EVALUATE THE EXTENT TO WHICH EFFICIENCY WAGE THEORY CAN PROVIDE AN EXPLANATION OF UNEMPLOYMENT

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 profitр (р=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=зew. 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

w

A e(w)

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

W1

B

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

Lf

W Involuntary Ls

Unemployment

w*

w1

Ld=MRP

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