E QUILIBRIUM UNEMPLOYMENT & E FFICIENCY

WAGES

Costanza Naguib
(University of Geneva)
U NEMPLOYMENT AND PERFECT COMPETITION

I In the standard perfectly competitive model of the labour

market there is no unemployment

I The labour force is divided into employed and inactive

I the employed are those whose reservation wage is below
the market wage
I the inactive are those whose reservation wage is above the
market wage. They are not working and not available for
work at the prevailing market conditions

I ...but unemployment is one of the most salient features of

the labour market all over the world!
M ODELS OF EQUILIBRIUM UNEMPLOYMENT

I In perfect competition unemployment can arise only as a

dis-equilibrium phenomenon
I hence it should be a short-term outcome, namely it should
be reabsorbed quickly
I but this is not what is observed in the data. Unemployment
is often high and remains high for long times.

I Equilibrium unemployment can only arise when we move

away from perfect competition, hence when there are
imperfections
1. natural imperfections;
2. institutional imperfections, due to the presence of
institutions (minimum wages, unions, employment
protection, et.);
3. the combination of 1. and 2.
U NEMPLOYMENT IN E UROPE AND IN THE US
NATURAL IMPERFECTIONS : ASYMMETRIC INFORMATION

I We focus on natural imperfections, relaxing some of the

assumptions of the perfectly competitive model.

I We focus on two types of such imperfections, both related

to asymmetric information:
1. efficiency wages: productivity depends on workers’ effort,
which is hard to observe for the employer but observable to
the worker (she decides it)
2. search and matching: workers do not know which
employers are demanding labour and employers do not
know which workers are offering labour, hence it takes
some time and resources for them to search for each other
and match.
E FFICIENCY WAGES : INTUITION

I Output depends on worker’s effort, which is only

imperfectly observed by the employer

I Effort is costly to the worker, hence she has an incentive to

shrink

I The employer finds it optimal to pay a wage above the

market wage in order to incentivize the worker to exert
effort.
I if she is found shirking and looses her jobs she can only get
a lower wage in an alternative job.

I The unemployed would be wiling to work at a wage lower

than the one paid to the employed but it is inefficient for the
firm to hire at such lower wage.
E FFICIENCY WAGES : THE MODEL

I Shapiro and Stiglitz, 1984 - Nobel Prize winner 2001.

I Output depends on worker’s effort, which is only

observable to the employer with a probability q < 1 via a
monitoring system
I impossible to write contingent contracts on effort;
I if output is observable then it is still possible to write
contingent contracts on output. We do not consider this
here.

I There are F identical workers and G identical firms.

E FFICIENCY WAGES : THE MODEL (2)

I Simplifying assumptions:
I workers offer 1 unit of labour inelastically as long as the
wage is positive;
I effort is a dichotomic variable equal to either 0 or 1. If the
worker exerts effort 0 she does not produce output. If she
exerts effort 1 she produces her marginal product.

I New complications:
I firms are not price takers;
I they offer an employment contract to workers who can
either accept or decline;
I the employment contract specifies a wage and a firing
clause (if caught shirking)
T HE WORKER ’ S PROBLEM

I The worker’s utility is:

u(w, e) = w − e

I for simplicity there is no leisure, hence the worker accepts

any positive wage.
I e can be either 0 or 1 and it is chosen optimally by the
worker.

I The unemployment rate is U and employers willing to hire

from the pool of the unemployed pick one at random (all
workers are identical), hence 1 − U is also the probability
that an unemployed worker finds a new job.
T HE WORKER ’ S PROBLEM (2)

The worker needs to decide two things...

1. Whether to work or not:
I if working she gets utility w − e otherwise she gets 0, so
she would only work if w > e.

2. If working (at a wage w > e), then she has to decide

whether to exert effort or not:
I she does so by comparing expected utility if shirking and if
not-shirking;
I the expectation is taken over the probability of being caught
shirking by the employer (q) and over the probability of
finding a new job if caught and fired (1 − U).
T HE WORKER ’ S PROBLEM (3)

I Expected utility if shirking:

E(u|w > e, e = 0) = (1 − q)w + q(U · 0 + (1 − U)w) =

= (1 − q)w + q(1 − U)w

I Expected utility if NOT shirking:

E(u|w > e, e = 1) = w − 1

I The worker decides to exert effort only if

E(u|w > e, e = 1) ≥ E(u|w > e, e = 0), namely if:

1
w ≥ w NSC = (No-Shirking Condition)
qU
T HE FIRM ’ S PROBLEM

I The firm produces using a standard production technology

with decreasing returns to labour:

y = f (n) with f 0 (n) > 0, f 00 (n) < 0

I n is the number of non-shirking workers;

I total employment is L = n + s, where s is the number of
shirking workers.

I The firm needs to choose a wage offer w and a level of

employment L
T HE FIRM ’ S PROBLEM (2)

1. The choice of the wage is obvious:

I choose the lowest wage such that the worker does not shirk
⇒ w = w NSC ;
I at this wage all workers exert effort ⇒ s = 0 and L = n.

2. Then the level of employment is chosen to maximize

profits:
maxL [f (L) − wL] ⇒ w = f 0 (L)
yielding the usual downward sloping labour demand curve
E QUILIBRIUM

I In equilibrium total employment must be on the labour

demand curve and the wage must be set according to the
non-shirking condition.

I We know that labour demand is a downward sloping curve

in the w − L space

I The NSC is (negative) relationship between the wage and

the unemployment rate U:
F −L
I but U = F where F is a constant
I hence, the NSC is ultimately a positive relationship
between w and L
E QUILIBRIUM (2)
E QUILIBRIUM AND FLUCTUATIONS
E QUILIBRIUM (4)

I In equilibrium the wage is above the perfectly competitive

level and there is involuntary unemployment

I Both wages and unemployment respond to aggregate

fluctuations in productivity:
I in a recession wages decline but less than prescribed by
the perfectly competitive model;
I unemployment increases during a recession, as observed
in the real world

I Over the business cycle (booms and recessions)

employment and unemployment adjust a lot more than
wages (wages don’t fall in a recession)