Efficiency Wage Theory, Labor Markets, and Adjustment:

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Populationand HumanResources Department The WorldBank July 1991 WPS 731

Efficiency Wage Theory, Labor Markets, and Adjustment: Luis A. Riveros and LawrenceBouton

Efficiencywage theory suggeststhat wages (and hence labor markets)may be unresponsiveto typical macroeconomicpolicies that seek to lower real wages,changeresourceallocation, and reduceopen unemployment.Under this theory,firms will react to macroeconomicshocksby alteringemployment(laying workersoff), not wages. The Policy, Research, and External Affairs Complex distributes PRE Working Papers to disseminate the findings of woik in progress and to encourage the exchange of ideas among Bank staff and all others interested in dcvclopment issues. These papers carry the names of the authors, rflect only their views, and should be used and cited accordingly. The findings. tnterpretations, and econelusionsare the authors own. They sahouldnot be attributed to the World Bank, its Board of Directors,its management, or any of its member countries.

Policy,Research,and ExternalAffairs

Idcton and Employment WPS 731

This paper- ajoint effort of the Education and Employment Division, Population and Human Resource Department, and the Macroeconomic Adjustment and Growth Division, Country Economics Department -is partof a largereffoit in PRE to identify the role of alternative wage policies in achieving a bettersupply response to adjustment policies. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Valerie Charles, room S6-228, extension 33651 (34 pages). Conventional labor theory argues that wages are determined by the interaction of labor supply and demand - the firm takes the market wage as an exogenous parameter. Under conventional theory, policy analysis on wage rigidity has emphasized distortions arising from exogenous (union and government) intervention. Thus, one emphasis in adjustment lending has been deregulation of labor markets. Efficiency wage models of unemployment try to explain persistent real wage rigidities when unemployment persists. Their central assumption is that higher real wages can impro' e labor productivity. A major implication of .iese theories is that wages (and hence labor markets) may be unresponsive to typical macroeconomic policies that seek to lower real wages, change resource allocation, and reduce open unemployment. Under this theory, firms will react to macroeconomic shocks by cutting back on jobs, not wages. The three central macroeconomic implications of efficiency wage theory are these: a There is an equilibrium "natural" level of open unemployment, which differs among

groups in th" 'abor force and cannot be affected by demand nianagement policies. Workers offering services at a lower wage rate are unable to drive the wage down and to expand employment. * When reducing the level of productionand to the extent that other firms' wages are perceived as given - the typical firm will resort to laying off labor instead of reducing wages, thereby introducing a significant wage inertia and an overshooting of open unemployment. The finn's profit-maximizing wage may exceed the opportunity cost of redundant labor, but lower wages would entail a greater loss associated with the reduction of productivity and the "average quality" of workers than would be gained from reducing per-worker costs.

- Wages do not respond to clear the labor market and are not responsive to macroeconomic policies and microeconomic deregulation. Riveros and Bouton conclude that applying the theory in developing countries requires suitably defining labor costs and tackling the problem of segmentation of the labor market (into formal and informal markets).

The PRE Working Paper Series disseminates the findings of work under way in the Bank's Policy, Rcscarch, and External AffairsComplex. Anobjectiveofthcscries is to getthesc fmdings out quickly, even if prescntations are less than fullypolished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy. Produced by the PRE Dissemination Center

Efficiency Wages, Labor Markets, and Adjustment by Luis A. Riveros and Lawrence Bouton*

Table of Contents





Efficiency Wage Theories



The Labor Market and Macroeconomic Adjustment



EfficiencyWages and Human Resource Development



Microfoundations of EfficiencyWages


Nutritional Theories Shirking Theories Turnover Theories Sociological Theories Adverse Selection Theories Critique of Efficiency Wage Theories

15 15 16 17 17 17

Recent Empirical Work on Efficiency Wage Models


The Case Studies Approach The Statistical Approach

19 20









We appreciate comments on previous drafts by Bela Balassa, Ravi Kanbur, Ricardo Paredes, Donald Robbins, Philippa Shepherd, Andres Solimano, and Adriaan Verspoor. *


Recently, the design and effectivenessof appropriatedlabor market policiesin the context of structuraladjustmentprogramsin developingcountrieshas receiveda great dealof attention. For the most part, structuraladjustmentprograms seek to permanentlychange relativeprices thereby shiftingresourcesaway from the productionof non-tradedtowards traded goods. Inter-industry factormobility,particularlylabor mobility,is, therefore,of paramountimportancein achievingthis supplyresponse. Rigidityin the wage structurehas been singledoutas an importantfactorpreventingefficient inter-industrylabor mobility, therebycontributingto the persistenceof high unemployment. The segmentationthat characterizesmost developingcountries' labor markets, constrainsthe supply responseto adjustmentpolicies especiallysincethe limitedflexibilityof real wages in theformal sectorslowsthe reallocationof laborand production,and increasesthe burdenof adjustmenton the informalsector. Sincethe formalsector is normallythe producerof traded goods in the economy, wage rigidityin this sectoris a crucialimpedimentto adequatelabor mobilityand henceinhibitsthe supplyresponseto macroeconomicpolicies. From a politicaleconomyperspective,the sluggish supplyresponseand inequitableburdenborne by the informalsector, which is typicallyincreased by the presenceof high unemployment,canonly weakenthe politicalsupportneededfor successful structuraladjustment. To date, policy analysison wage rigidity in the formalsector has emphasizedthe role of distortionsarising fromexogenous(unionandgovernment)intervention'. As a result, it has - within the context of macroeconomicconditionalityand lending- stronglyconcentratedon the need to deregulatelabormarkets. The desireto achievewage flexibilityhas led to policyprescriptionsthat

2 are particularlyforcefulregardingthe limitationof formalwage indexationrules and other features that makethe wage structuremore rigid. In contrast to the conventionalview that wage rigidities are exogenouslyimposed, the alternativeefficiencywagetheoriessuggeststhat observedwagerigiditiesare endogenousto a firm's own optimizingbehavior. These theoriespostulatethat, in the absenceof mictoeconomicpolicies that alter the efficiencywage frontier, the level of real average wages and the pattern of wage differentialsacross sectors will not be affectedby macroeconomicstructural adjustmentpolicies exceptafter a period of high and prolongedunemploymentas firms will be reluctantto reducereal wagesbecauseof the adverseeffectson laborproductivityand, hence, profits. Thus, in the presence imposedlabor marketdistortionswill do little to of efficiencywages, the removal of exogenotasly promotewage flexibilityand, hence, labormobilityand structuraladjustment. Whetherthe removal of exogenouslyimposedlabormarketdistortionsis sufficientto providethe requiredwageflexibility Is a fundamentalpolicy issuesthat remainsto be resolved. This paper reviews the theoretical and empirical literature on efficiencywages. The implicationsof this literature for macroeconomicadjustment in the developing countries is highlighted. The structure of this paper is the following: in section II we briefly describethe generaltenetsof efficiencywage theories. In SectionIII we analyzesome of the policyimplications of efficiencywages for macroeconomicadjustmentin developingcountries. SectionIV suggests some possible implications for human resource development.

Section V reviews the

microfoundations of this approachwhilesectionVI discussesthe empiricalliteratureon the subject, pointingout the lackof appliedresearchaimedat a positive,comprehensivetest of the theory. The paper closeswith a summarypresentedin SectionVII.


Efficiencywage modelsof unemploymentare a familyof conceptuallydistincttheoriesthat, for the most part, seek to offer an explanationof persistentreal wage rigiditiesin the presenceof the involuntaryunemploymentobservedin mosteconomies.Thecentralassumptionof thesetheories is that higher real wages can, throughvariousmechanisms,result in higher laborproductivity. A major implicationof these tieories is that wages, and hence, labor markets, may be unresponsive to typical macroeconomicpolicieswhichseek to lower real wages, changeresourceallocationand reduceopen unemployment. A common tenet in all efficiencywage theories is their focus on the firm's production function. As in standardmicroeconomicmodels, the quantityof output (Q) that a firm produces dependsupon the amountof labormeasuredin efficiencyunits(L), capital(K) and other inputs(I) it employs:


Q = F( L K, I)

Unlikethe standardmicroeconomicmodel,however,the laborinputin the efficiencywage approach is not simplythe physicalnumberof workersemployed(N) but rather a more complexaggregate that also dependson some notionof worker efficiencyor effort (c). Formally,the efficiencyunits of labor can be writtenas (2)

L = L(W, A

wherethe numberof workershiredandthe wage rate paid by the firm (W)will determinethe impact of labor on output.


In determiningthe contributionof its labor input, the firm must not only be concernedwith the numberof workersit has hired(N), but alsowith the levelof effort that thoseworkersput forth. In most expositionson efficiencywagetheories, the effort levelof workers(laborefficiencyunits) is assumedto increaseeither with the higherwage relativeto some averagewage or with the real wage in terms of consumer prices3 .


both the number of workers hired and the wage rate paid

to those workerswill determinethe impactof laboron output. This labor aggregateis oftengiven the followingfunctionalform (3)

L = e(W, y) N

whereE(W,-y)can be viewedas the functiondeterminingthe effortlevelof the workers. This labor efficiencyfunctionis assumedto be increasingin W (6eI5Wae. >0). The other variable, y, is a vector of parameters,such as, taxes and subsidies,that may also affectthe efficiencyfunction. In the standardcompetitivetheory of the labor market, the wage rate is constantlyadjusted to equateaggregatelabor supplyand demand. The individualfirm takesthe marketclearingwage as exogenouslygiven. That is, the firm is a price taker in the labor market. The optimalpricing decisionby the firm is to equate the valueof a worker's marginalproductto that given wage rate (the marginalvalueof a worker's leisure). Changesin labordemandas a resultof macroeconomic shocks or policies will result in both wage and employmentfluctuations. Unemploymentin this paradigmis voluntaryin the sense that, at the going marketwage, anybodywho wishes to forgo 4 . It is clearthat this model'sdepictionof flexiblewagesand voluntary leisurecan findemployment

unemploymentis too simplistica descriptionof observedwage and employmentpatterns. Further, this model is, in many ways, unrealisticregardingthe actual dynamicsof the wage/employment adjustment.

5 To add realism, earlier models attemptedto address the lack of adjustmentof wages and labormobilityby assertingthat real wagesare rigid and fixedabovethe marketclearingequilibrium level. Unionand governmentinterventionhas been consideredthe basic forcewhichpreventwages from clearingthelabor market. Underthe assumptionof rigid wages,unemploymentis involuntary and, of course, inefficient. Thesemodels,however,have been heavilycriticizedfor their inability to explainand rationallyjustify the mechanismthat kept wagesrigid. There is littleto explainwhy workersseekingemploymentshouldnot be able to find a job by offeringto work at a lower wage. In efficiencywage models,giventhe positive relationshipbetweenwages and productivity (the efficiencyfunction),firmnswill no longer view the wage rate as an exogenousparameter,but rather will choosean optimalwage as a result of their profit maximizingbehavior.Given that a higher wage will producehigher laborproductivity,differentwage rates will, for the samnephysical amountof labor, purchasedifferentamountsof laborefficiency. The optimalbehaviorof the firm is to choosea wage that minimizesthe averagecostper unit of efficiencylabor notper physicalunit of labor as in the standardtheory. This part of the firms problemcan be formallywrittenas


Min w

W (W, y)

Assumingthe firm does not facea bindinglaborsupplyconstraint,the first order conditionsfor this problem is


5e(W,y) - W E,1 W, y) 'E(W, Y)2


6 Rearranging,the first order conditioncan be writtenas (6)

W Cp4W, y)


e(W, y)

whichcan be solvedfor the optimalefficiencywage (W). This first order conditiongives the well known "Solow"resultthat, at the optimalwage, the elasticityof effort with respectto the efficiency wage is unity. Once the firm has determinedthat "efficiency"wage rate, they will hire as many workers and other inputsrequiredto producethe optimal,profit maximizinglevel of output. This second stageof the firm's optimizationproblemcan be written as (7)

Max P F(e(W, y)N, K, 1)- WN - rK - ql,

wherethe first order conditionsto this problemare simply (8)


y) - W = 0

PfR - r = 0 Pf,-q

= 0

As usual, the firm's optimalstrategyis to employinputsuntiltheir marginalproductis equalto the real input price5 .

Remarkably,the determinationof the efficiencywage dependsonly on the characteristicsof the efficiencyfunctionand not on the demandor supplyconditionsin the market. Further, if at the optimalefficiencywage labor supply exceeds labor demand there will be persistent involuntary


unemployment. If an unemployedworker shouldoffer to work for less than the efflciencywage, his offer of employmentwould be refused. This behavioron the part of the firm is optimal. Since laborefficiencyis tied to thewage rate, a fall in thewage rate wouldreduceworkerproductivityand hencethe profit rate of the firm. Underthe assumptionof perfectcompetitionin the outputmarket, at the optimalefficiencywage the firm is just breakingeven by employingthe marginalworker. Thus, at a lower wage the firm would,paradoxically,be makinga loss. To summarize,underthe efficiencywagehypothesis,the optimizingbehaviorof the firm can be viewedas a two stage optimizationproblem. In the first stage, the firm choosesa wage that minimizesthe average cost of an efficiencyunit of labor. The second stage of the firm's optimizationproblemconsistsof choosingthe profitmaximizinglevelof inputsgiventhe efficiency wage, output prices and other inputprices. An importantimplicationis that firms will react to macroeconomicsshocksby alteringemployment,not wages.



The basic efriciency wage theory examined in the previous section, has three central macroeconomicimplications:first, there is an equilibrium"natural"level of open unemployment, which differs among labor force groups and cannotbe affectedby demand managementpolicies; second, wnen reducingthe level of production-- and to the extent that other firm's wages are perceivedas given -- the typical firm will resort tc laying off labor instead of reducing wages, thereby introducinga significantwage inertia and an overshootingof open unemployment';and third, wages do not respondto clear the labor market, and are not responsiveto macroeconomic policiesand microeconomicderegulation.As discussedbelow, theseimplicationsare of paramount importancein the contextof macroeconomicadjustmentpolicies. The likely presence of real wage rigidity raises fundamentalquestions regarding the effectivenessof macroeconomicpoliciesand the extent to which the supplyresponse needed for adjustmentwill be forthcoming.The conventionalview assumesthat macroeconomic policies-- such as those emphasizingdemandrestrictionsvia fiscaland/or monetarypoliciesto controlinflationor exchangerate policies aimed at raisingthe relativeprice of traded goods -- reducenominalwage increasesandtherebyloweringreal wages. The reductionof real wages involvesboth an absorption component-- aimedat reducingthe real domesticaggregatedemand--and a switchingcomponent- intendedto changerelativewagesbetweentraded goodsand non-tradedgoodsto achievea higher inter-industrylabor mobilitv and a subsequentrestructuringof production. These policies rely heavilyon the "transitory"natureof the increased unemploymentinducedin order to "discipline" the labor market. Realwage flexibilityis a necessaryconditionto attainmacroeconomicadjustment. Although

9 often complicatedby labor market regulations,the labor reallocationbetween tradable and non7 For reallocation zradableindustriesis the fundamentalingredientto achievestructuraladjustment.

to take place, wages in terms of traded goods -- and real consumptionwages -- must decline in responseto a nominaldevaluation. If tie price of non-tradedgoods remainsunaffecteddue to the use of appropriateabsorption-reducing policies(restrictivefiscaland monetarypolicies),the relative real productionwage of tradedgoods versusnon-tradedgoodswill decline. Becauseof the change in relativeprices, labor will flow from the non-tradableto the tradableindustryand thereby allow productionof traded goods to increase relativeto non-tradedgoods. If wages are relativelyrigid, chancesare that the process of labor reallocationwill not take place and the economywill be dominatedonly by the recessionaryshock associatedwith the mix of expenditurereducing and expenditureswitchingpolicies. The presence of formal mechanismsof wage indexationhas been usually mentionedas a deterrentof the wage flexibilityneededfor structuraladjustment.' In particular,the dynamicrole of minimumwages in pushingthe entire wage structure(and inflation)up has been pointedout as 9. The implicationsfrom the a crucial mechanismcreatingwage rigidity in developingcountries

viewpointof policy makingare straightforward:institutionsand regulationswhicl, introducewage rigidity in the economymust be eliminated. Contraryto this conventionalview, if real wages are rigid due to the role playedby factors endogenousto the firm, such as the existenceof efficiencywages, then the successof demand policiesin achievingstabilizationand adjustmentwill dependon the stabilityof the efficiencywage frontierunderlyingthe processof wagedetermination.The efficiencywage frontieris nothingmore than the positive relationshipbetweenwages and labor productivity(effort) derived from utility maximizationon the part of the workers. If this frontier is very stable then it is likelythat the


increaseduncmploymentcaused by demand restrictingpolicieswill have a much more moderate effect on real wages. Changesin demandand unemploymentassociatedwith structuraladjustment are likelyto exert very littleeffect on the efficiencywage frontierand, hence, on the "optimal"real wage as determinedby firms. If firms are not willingto reducereal wages becauseof the implied drop in labor productivity,taxationand subsidizationpoliciesaimed at affectingworker behavior wouldbe the most advisablepolicies. The stabilityof the efficiencywage frontieris a crucialaspect of the policy implicationsof the theory. The basic element determiningthe degree of wage flexibility in response to macroeconomicadjustmentpolicies is the extent to which a consistent and invariant causal relationshipbetweenwagesandeffortprevails. If this relationshipis stable,thenthe efficiencywage hypothesishas importantpolicy implications;conventionalmacroeconomicadjustmentpolicieswill need to be complementedwith microeconomicpolicies (i.e. taxation,subsidization,etc.) to assure the successof the adjustmentpolicies(in termsof wage flexibility and supplyresponse)withoutthe creationof high and persistentunemployment.If on the contrary,this stabilityis rather limited,any policy implicationswill basicallydependuponthe dynamicsof the forcesdriving the changesin the efficiencywages relationship. The efficiencywage frameworkprovidesimportantinsightsfor someobservedlabormarket phenomena. For instance, this approachimplies that the equilibriumwage is compatiblewith equilibriuminvoluntaryunemploymentassociatedto the wage premiumpaid by firms.'" In fact, a standardresult of efficiencywage models is that the equilibriumlevel of wages may exceed the "competitive"wage (the wage that equateslaborsupplyand demand). Moreover,in the contextof efficiencywage models(articularly the adverseselectiontheorydiscussedbelow),workersoffering servicesat a lower wage rate are unableto drivethe wage downand to expandemployment". The

11 firm's profit maximizingwage may exceed the opportunitycost of redundantlabor, but lowering wageswouldentaila greaterlossassociatedto the reductionof productivityand the "averagequality" of workersthan would be gainedfrom the reductionof per-workerwst. The empiricaltestingof the efficiencywage theory is crucial to further assess its policy implications. The macroeconomicconsequencesof efflciencywages have to be a crucial aspectof the empiricalanalysis. As discussedbelow,empiricalstudiesuntilnow have only providedindirect tests on the relevanceof the theory. In general, no applicationhas been done to the case of developingcountries. The need for a more structuraltest standsout, whichcouldbe based on the major macroeconomicimplicationsof the theory. Given the positive effects that structural adjustmentpotentiallyhas for future growth prospects and the role efficiency wages have in achieving this adjustment, there are three fundamentalmacroeconomicimplicationsimportantto an empiricalevaluationof the validityof efficiencywages in developingcountries.First, observedwage changeswill not depend upon the level of unemployment,although it can be explained by the rate of change in unemployment. Second, wages are responsiveto changesin the consumerpricesbut not to the price of the output producedby the firm. Third, employmen;levelsdo not respondto the real price of other inputs, but only real labor compensation. The applicationof efficiencywage theoriesto developingcountriesfaces the problem of segmentation.As we shall discuss,the standardempiricalanalysisbasedon wagedifferentials,does not usuallyaccount for the structuralcharacteristicsof the labor market, whichis in turn a factor affectingwage setting at firm level. However,efficiencywages can be aa explanationfor the between,for example,a formalsectorwhereefficiency existenceof dual labormarkets(segmentation 2 , thus settlinga clear challengefor designingany wages prevailand a neoclassicalinformalsector)"

12 empiricaltest. Other problemsinvolvedin designingan empiricalteston theefficiencywagestheory for developingcountriesis that it cannot be simply extendedto the informal sector, which is 3 . However,in following characterizedby the presenceof quasi-voluntary("wait")unemployment"

other empirical studies on the observed wage performancein developingcountries, the role of efficiencywages is consistentwith the relativewage rigidityof formalsector laborcosts"4 The conceptof wageswhich is relevantto empiricallyanalyzethe likelyimportantrole of efficiencywages in developingcountriesconstitutesa crucial issue. The presenceof wage rigidity in the formalsector,whichis usuallyassociatedto eitherthe presenceof endogenousor exogenously createdindexation,has notbeen substantiated,Studieswhichhave concludedthat severedropin real wages has takenplace in developingcountriesoughtto be examinedwith care. First, an important problem is whetherthe observedflexibilityin wages refers to averagewages or to some specific sector or industry. In fact, wages can be very flexible in the aggregate if, for instance,some informalactivitiesor governmentwagesare included,but still rigid in the formalsectorproducing tradablegoods. Second,the presenceof wage rigidityis an issuethat involvesrelativewages. For instance,wages may drop in both the tradableand the non-tradablesector, but the relativedecline may not be sufficientto producesubstantiallabormobility. Third, wagesare most likelyirrelevant indicatorswhenexaminingthe issue of rigidity versusflexibility,as compensatingchangesin nonwage labor costs can introducesubstantialrigidity in total labor costs -- the relevantvariablewhen analyzingemploymentand productiondecisions.



The efficiencywage hypothesisalso has some importantimplicationsfor human resource development. For the purposesof this analysis,the latterconceptis madeequivalentto increments to human capital. Adequateinvestmentin human capital,througheither schoolingor general and specific formal training, is among the necessary conditionsfor sustainablelong term economy growth. As notedearlier, in the efficiencywage paradigmoutputis dependentnot onlyon physical amountsof capitaland labor, but also on worker effort or quality. Given that the investmentin educationandtrainingis theprimarymeansby whichworkersandfirms can augmenthumancapital, efficiencywagestheory has implicationsregardinglong term economicdevelopment. TIis is an important,but largelyunexploredtopicthat deservesfurther research. For now, however,we can only attemptto sketchsome of the possibleimplications.Efficiencywages affect humanresourcedevelopmentdirectlyin two possibleways: throughit impacton formaleducation and through it impact on training. As discussion in section I suggests, the higher level of unemploymentimpliedby efficiencywages may result in a reductionin expectedlabor earnings, particularlyfor skilledworkersin the formalsector. Therefore,one would expecta declinein the averagerate of return to investmentsin schoolingon the part of theseworkers. Moreover, insofar as someof the unemployedformalsectorworkersmay seekemploymentin the informalsector,thus driving wages in that sectordown, the expectedearningsin the informalsectormay also be lower. Lowerexpectedearningsis importantfor humanresourcedevelopmentbecauseit impliesan overall decline in the private rate of return and in the investmentsin educations. Again, this impactmay be moreimportantfor highereducationthan for primaryeducationsinceit is mainlythe skilledwork force that is affected by efficiencywage unemployment. The policy implicationis that large

14 governmentsubsidyto educationin general, and higher educationin particular, may be needed. Efficiencywages, as explained in section IV under the turnover model, by raising the opportunitycost of leisure and by making existing efficiency wage jobs more attractive than alternativeemployment,may resultin a lowerlaborturnoverin efficiencywage firms. Firms, faced with a more stablework force, may be willingto investmore resourcesin general training. The standardhuman capitaltheory predictsthat generaltrainingwould financedby workers, insteadof firms, giventhat it raises the labor productivityin the firm andelsewhere. With lowerturnoverthe firm's would have a longer pay back periodand it is less likelythat worker will acquireskills and then seek employmentelsewhere. In addition,workersmay be willingto pay more of the training costs especiallywith regards to specific training. This impliesthat there may be less need for govermnentsubsidiesfor generaltraining. In sum, efficiencywagesmay implythe possibilityfor the governmentto shift resourcesfrom generaltrainingto education.



This section presents a summary review of the five main different type of theories that provide the microfoundations of efficiency wages'5

By pinpointing alternative aspects of the

employmentdecision at the level of the firm, these theories aim at providing a rationale for the basic postulate that higher wages do convey higher productivity implying that the wage is not given to the firm by the prevailing labor market equilibrium. Nutritional Theories The first approach to incorporateefficiency wage behavior is known as the nutritional model. It basically emphasized the connectionbetween wages, nutrition and productivity'6 . This model was aimed primarily at explaining the link between wages and productivity for agriculture workers in developing countries. The central focus is the connection between higher wages and a worker's health. The productivity of workers, it is assumed, can be sufficiently increased by better nutrition that the cost to the employer of the higher payment to workers is outweighed by their increased output. This implies that workers should receive a minimum subsistencewage to allow them to meet their nutritiopal needs and thus be more productive. However, in most economies, particularly in the industrial sectors, the link between wages and worker health is not likely to be important because wages far exceed subsistence levels. Consequently, the nutritional model is not considered relevant in this case and emphasis has been placed on the other links between wages and productivity. Shirking Theories In shirking theories of efficiency wages the basic premise is that workers can choose to work or shirk."7 If they shirk, there is some chance that they will be caught and immediately fired. If there is no unemployment (above and beyond structural or natural unemployment) and all workers

16 are paid the ongoing market wage, there is no cost to shirking. If a worker gets fired, he/she can easily find another job at the same wage. To increase the cost of shirking, employers pay a higher than market wage, with the resulting unemployment acting as a disciplinary device on workers. Hence, these models predict that increases in the wage will raise the cost of job loss, reduce shirking and thus will raise productivity. The optimal policy for the firm, in addition to adopting an announced policy of random monitoring and dismissal of workers found shirking, would be to pay a wage in excess of the opportunity cost of labor (what the worker would get if he were fired). In the aggregate, average wages and labor productivity would rise and employment would fall.18 Turnover Theories This set of theories has a similar rationale but generally emphasizes the effect of wages above the market-clearing level on the costs associated with high labor turnover.'9 These turnover costs generally consist of direct costs incurred in the hiring and training of new workers, as well as the indirect cost of lost production as these new workers take some time to achieve their full potential. Workers are less likely to quit if either the relative wage or the level of unemployment is high. di turnover model has been one of the most popular versions of efficiency wage theories. In choosing a wage, the firm faces an important tradeoff. A lower wage will have the benefit of reducing the total direct labor costs for the firm, but will increase turnover cost as more workers quit and have to be replaced. This is because the lower the firm's wage is relative to the average wage in the economy the higher the quit rate. Higher levels of unemployment, however, tend to discourage workers from quitting. Given that high turnover is associated with the loss of firm-specific skills and a decline in labor productivity, we once again have the prediction that a high relative wage and/or a high level of unemployment will increase productivity. This time, however, the benefits to the firm result from the effects of reduced turnover costs.

17 Sociological Theories Another justification for efficiency wage behavior can be provided on what has been called "sociological" grounds.2 0 A firm may attempt to raise the effort level of its workers by paying them a wage above what they could obtain outside the firm, on the implicit condition that workers will reciprocate by working harder.

In this model, workers compare their wage with what is

regarded as a "fair wage". The latter may depend, in similarity to other efficiency wage models, on the outside wage and the unemployment rate. In that case, we also have prediction that an increase in the relative wage and/or the unemployment rate will boosts productivity at the level of the firm. This time, however, productivity increases by making grateful workers feel that they must reciprocate their good treatment with higher work effort. Adverse Selection Theories An additional rationalization for efficiency wages is offered in terms of adverse selection.2 ' The basic argument here is that the wage rate is a signal to attract a specific type of worker, labor is viewed as a heterogenous input differing by quality. Therefore, firms raise wages in order to attract a larger and "better" pool of suitable applicants.

Hence, given that no one, except the

applicantthemselves, knows about these difference in quality, firms pay high relative wages to attract more and better applicant and thus achieve higher levels of productivity. Critique of Efficiency Wage Theories The most fundamental critique to the efficiency wage approach is the bonding argument.22 This argument suggests that efficiency wages are unnecessary because firms do use different disciplinary devices --such as seniority wage systems and pension schemes -- based on an implicit performance bond which is waived if the worker does not perform satisfactorily.23 In other words, this argument implies that the rents associated with efficiency wages are deferred to the future

18 thereby forcing worker to remain with the firm and avoid shirking. However, it has been pointed out that explicit bonding arrangement would be difficult since imperfect capital markets would not enable workers to obtain cash to post a bond or pay an employment fee.24 In addition, is also argued that the bonding system creates a moral hazard problem on the part of the firm since nothing would prevent, once the bond is posted, the firm from cashing the bond and firing the worker on the grounds that he/she was shirking.2 5



Empiricaltestingof efficiencywages theoriesis still in its infancy. 26 To date, there have been two distinct empiricalapproachesto the testingof the efficiencywage hypothesis. The first approach explores, on the basis of case studies, the central relationshipbetween wages and productivity.While strikingat the heart of the efficiencywage hypothesis,this approachhas yet to be rigorouslypursuedand has yielded mostlyanecdotalevidence. The secondapproachexamines wagedifferentialsacrosseither industries,firmsand/oroccupations.For the mostpart thisempirical research has centered on statisticallyexamining the role played by industry and labor force characteristicson inter-industrywage differentials. Given that a portion of the observed wage differentialsis systematicallyleft unexplainedby the economicvariables,this residualis attributed to the role playedby efficiencywages27.

Despitethe use of sophisticatedeconometricsand data

requirements,this approachhas tended to produce only an indirecttest and is thus subject to criticism. 28 These studies Most availableempiricalstudiesdeal with the case of industrialcountries.

have, therefore,notbeen able to capturethe particularitiesof labormarketsin developingcountries. In particular,they seldomaccountfor the role of segmentation,the differentaccessof firms to the formalcapitalmarkets,and the differentcoverageof industrialand other regulations,that are often foundin developingcountries. Thesefactorsmaybe cruciallylinkedto observedwagedifferentials. Therefore, accountingfor the industryand labor force characteristicsmay not be enough, being necessaryto includethe structuralcharacteristicsof the labor marketinto the analysis. The Case StudiesApDroach As notedearlier, the positiverelationshipgoingfromwagesto productivityis at the heart of


the efficiencywage hypothesis. Empiricalresearch on this direct link, however, has been very limited. The findingsof two well knowncase studies- the StanfordLinearAcceleratorCenterand 29 the Ford Motor Company- have suggestedthe existenceof efficiencywages.

In 1975,managementat the StanfordLinearAcceleratorCenterindicatedthat it wouldreduce its work force by 10 percent. To avoid the layoff, workers respondedto this announcementby volunteeringto take a 10 percentcut in wages. Management,implicitlyappealingto the adverse selectionmodelof efficiencywageshighlightedabove, rejectedthis offer on the groundsthat lower wageswould result in a reductionin the qualityof the work force ("the best workerswouldquit"). The other case study examinesthe relationshipbetweenemployeecompensation,output and profitsof Ford Motor Companybefore and after the introductionof the "five dollar day" in 1914. In January of 1914, the workingday at Ford was decreasedfrom 9 to 8 hours and the minimum daily pay was increased from $2.34 to $5.00. Followingthe pay increase, turnover declined significantlyand productivityis estimatedto have increasedbetween30 and 70 percent. In spite of a higher wage bill, profitsat Ford continuedto increase. The study suggeststhat productivityand profits respondedin a mannerconsistentwith the efficiencywage hypothesis. Thesetwo casestudiesby themselves,however,are notsufficientevidenceof thewidespread 30 To supportthe broader claim that efficiency applicationof efficiencywages. wages play a role

in macroeconomicfluctuations,evidenceof a wage-productivity link in manydifferentsectorsof the economyis needed. iTh Statistical ADorAach

Persistentinterindustrywage differentialshave alwaysbeen a puzzleto economists. Researchon the efficiencywage hypothesishas, therefore,mainlyconcentratedon the examination 3" The standardcompetitivelabor market model of occupationaland industrialwage differentials.

21 suggests that persistent industry wage premiums can only occur if there are industry-related

differencesin laborqualityor otheraspectsof workthat requirecompensatingdifferences. Further, transitoryindustrywage differencesmay be explainedby changesin labordemandacross sectorsin conjunctionwith imperfectlabor mobility. These transitionaldifferences,however,cannotpersist over the long run. Any test examiningthemmust be basedon longitudinaldata with sufficienttime horizonto accountfor those transitionaldifferences. Under ths efficiencywage hypothesis,on the otherhand, if the relationshipbetweenwages and productivity(the efficiencyfrontier)differsacrossindustries,then the optimalwage will differ. This impliesthat workerswith identicalcharacteristicswill be paid differentlydependingon their industry affiliation. Thus unlike the standard model, these wage differentialsreflect industry characteristicsthat do not require compensatingdifferentials. So far, empirical results reached in the standard statisticalexercisesdo not support the hypothesisthat firms are wage takers, but rather supportsome type of efficiencywage behavior. In the case of industrialeconomies,and after controllingfor all possiblerelevantvariables-- such as schoolingyears, seniority,occupationalandgeographicalcharacteristics-- a substantialproportion 32 of wage disparities remains unexplained.

More sophisticatedempirical studies have proxied

compensatingdifferentialsto accountfor theirrole in explaininginter-industrywagegaps, in addition to the other more standardexplanatoryvariables.33

They still observe significant,stable and

unexplainedwage differentialsacross industries. Yet other empiricalstudieshave used a special cohort samplesurveyand a versionof the turnovermodelto test the explanatorypower of standard economic variables, reporting the inability of the model to compleielyexplain observed wage differentials3 4 .

There are four majorconclusionsof studiesthat have used the statisticalapproachto test the

22 efficiencywage theory. First, there exist substantialwagedifferentialsamongindustries,evenafter correctingfor skills, age, gender,job characteristics,compensatingdifferentials,unionizationand otherdemographicfactors. Second, the rankingof industriesaccordingto wage paid has remained fairly constantthroughoutlong periods of time. Third, wage differentialsthroughoutindustrial branchesfor severalcountriesappearto be remarkablysimilarand large wage differentialspersist at various levels of disaggregation. Four, the degree of unionizationor the existence of compensatingdifferentialsdoes not appear having a central role in explaininginter-industry differentials. The existenceof unexplainedwage differentialsis, however,more a rejectionof the market competitionhypothesis,than an acceptanceof the efficiencywages. Nonetheless,the conclusionsreached in the existingempiricalliteratureare consistentwith the predictionsof the efficiencywage hypothesis. With regard to developingcountries, studies on wage differentialshave been scarce and aimed at more general analysesof industrialpatterns." Studies based on wage settingfunctions have been carried out in the context of analyzingthe contributionof general human capital to earnings rather than that of studyingwage differentialsalong the lines of the efficiencywage theory.36

There has been only one study directly applying an efficiency wage model to a

developingcountry." That studyexaminedwagesin the manufacturingsectorof Sao Paulofinding that theestimatedwagedifferentialsin Brazilwere large,statisticallysignificantandhighlycorrelated with wage differentialsobservedin some of the industrialcountries. The study used a two-stage estimationprocedureto examinethe firm and industrycorrelatesof interfirmwagedifferentials. In the first stage firm level earningfunctionswere estimated. In the secondstage,predictedfirm-level wages for observationallyequivalentworkerswere regressedonto firm and industrycharacteristics. The regression controlled for differencesin capital intensityat the firm level, size, industry

23 concentration,percent multinationaland modernityof technology.Althoughrecognizingthat wage differentialsmay be partly explainedby industrydifferencesin humancapital,the studyconcludes that the strong link between firm concentrationand high wages suggests that efficiency wage considerationsare an importantdeterminantof wage premium. Researchat the World Bankhas toucheduponthe industrialwage structurein a limitedway and not in the directionof examiningrelativewage rigiditydeterminedby exogenousor endogenous forces. An exceptionis the recent Bankstudyon the modernsector of Cote d'Ivoire.3 8 That study foundthat industrialrestructuringandentryof new smallerfirmsexplainedthe occurrenceof a large drop in employmentand a sharpdecline in the rate of return to human capitalin the Cote d'lvoire. The studyshowedthat wages,in the aggregatedrop, by less than disaggregatedwagedata (measured across industries). The conclusionof the study impliesthat there is relative wage rigidity in the formalsector of large enterprises,supportingthe idea that adjustrnentwould requirehigher labor mobilityfrom large to smallfirms. Alongsimilarlines, two other recentBank studieshave shown that wages in the formalsector of four Latin Americaneconomiesare relativelymore rigid than 3 9 These studiesinvestigatedthe consequencesin those in the informalsector. terms of adjustment,

and the implicationsin terms of deregulationof the labor market. In not of these studies is the probableorigin of that relativerigidityin efficiencywageswas explored. Testingthe empiricalpredictionsof the efficiencywagehypothesisis still at an early stage. The examinationof the direct linkbetweenwages and productivityis limitedto a few case studies. The rest of the empirical work concentrateson industry wage differentialsand it has been overwhelminglyappliedto the case of industrialcountries. Thesedifferentials,however,are neither necessarynor sufficientconditionsfor the existenceof efficiencywages. Wage differencesacross industriescan arise as a resultof compensatingdifferentialsor unobservablespecifichumancapital.



Efficiencywagesprovidea very plausibleexplanationto severalempiricalphenomena.The implicationsof efficiencywages are particularlyimportantfor the discussionof macroeconomic adjustmentprogramsbecausethe resultingendogenouswage rigiditywill inhibitthe requiredlabor market response, leading to a limited supplyresponse in the adjustingsectors of the economy. However, empirical testing has not yet provided a definite answer on the underlyingstructural causality. This paper has suggestedthat a more structuraltestingof the hypothesishas to be based upon its major macroeconomicimplicationsin terms of the responseof wages to unemployment, consumerprices and other factorprices. The implicationsof the efficiencywages theory are particularlyimportantfor developing countries. Labor market segmentationand persistentunemploymentcan be better analyzedand understoodthroughthe applicationof efficiencywagestheoriesto the impactof adjustmentpolicies. This undoubtedlycalls for specificempiricalanalysis. Moreparticularly,the issueof wage rigidity must be addressedmore comprehensively,includingdisaggregationacross economicsectors and considerationof the non-wagecost componentof labor costs. In general, there is an enormous potentialto enrichpolicy recommendations by applyingthe efficiencywage approachto Developing Countries.

25 FOOTNOTES 1. This has been, for example, the main focus of studies on the labor market in Argentina, Colombia,Chile, Peru, thePhilippinesandothercountries.See, Lopez(1987),Riveros(1990),CoxEdwards(1987), Riveros& Saxchez(1987),Suarez (1987)and World Bank (1988). See also the collectionof studiesin Mazumdar 1 (1990). For a generalreview on this issue, see Fallon & Riveros(1990). Formal modelsanalyzingrigiditiescreatedby exogenouslyintroduceddistortions are presentedin Edwards(1989).Edwards& Cox-Edwards(1990)and Lopez& Riveros(1990a,b). 2. Despiteits infancy,there are severalexcellentsurvey articles written on the efficiencywage hypothesis. These articlescover in greater detailthe materialpresent in this sectionof the paper. See, for example,Carmichael(1990),Fisher (1989),Katz (1986)and Yellen(1984). 3. The basic assumptionwouldbe that effort increasesaccordingto a non-linearrelationship. 4. Unemploymentin this approachcan also be of a transitionalnature, associatedto a sluggishreal wage adjustmentin responseto demandfluctuations. 5. An alternativeapproachwouldbe to use a conditionalprofitfunction. In a first stage, the firm maximizesprofits with respectto all other inputsand outputlevelsconditionalon e(W,,)N. In the secondstage the firm would solve the followingproblem: MaW N,W

-1(eN1,; .- WW

sbjec toa e- e(W.y)

The firstorder conditionsfor thisproblemcan be solvedsimultaneously to arrive at the Solowresult presentedin Equation6. 6. The importantwork of Summers(1988),has pointedthe existenceof this coordinationproblem associatedto the informationavailableto the firm. 7. This pointhas been madeby Edwards(1988), 8. See, for instance, Holland(1988), Prachowny(1980), Zandamela(1988), Gros (1986), and Williamson (1985). 9. See Paldamand Riveros (1989). 10. See Stiglitz(1987),Yellen(1984),and Solow(1979). 11. A model which points out the main characteristicsof the relationshipbetweeninsiders and outsidersto the firm is presentedby Lindbeck& Snower(1986a, 1986b) 12. See, for example,Jones (1985)and Bulowand Summers(1986). 13. See Hall (1975),Harberger(1971)and Lopezand Riveros(1990a). 14. Lopez and Riveros (1990a, 1990b).

26 15. In additionto the five theories explained below, a sixth rationale for the efficiencywage approach is the 'Union Threat" model (Dickens, 1986). In this variant, high wages are paid to prevent the formationof militantUnions. Again, this model points to the role of economicand institutionalfactors and its empiricalimplicationsare basicallythe sameas the other four versions. 16. SeeLeibenstein(1957),Mirrless(1975), Blissand Stern (1978)and Dasguptaand Ray (1986, 1987). 17. For a reviewof analysisof this versionsee, Calvo(1979),Stiglitzand Shapiro(1984),Bowles (1981).and Stoft (1982). 18. See also Foster & Wan (1984)who providean explanationon the shirkingissuebased on the principalagentproblem. 19. See, for example,Stiglitz(1974),and Salop(1979). 20. See, for example,Akerlof (1982). 21. See, for example,Weiss(1980). 22. This has been advancedby Lazear (1981) 23. See Fisher (1989). 24. The argumentwas originallydevelopedby Shapiroand Stiglitz. See also, Dickens,Katz and Lang(1986). 25. See Fisher (1989). Carmichael(1985)indicatesthat the moral hazardmay not be serious,but Shapiro & Stiglitz (1984) note that it is the seriousnessof this problem which explains why performancebonds are rarely observedin the real world. 26. In particular, no study has attempted to use a general model to positively test the main implicationsof the efficiencywage hypothesisas against,for instance,the ones derived from the conventionalneoclassicaltheory. 27. Fisher (1989)presentsa criticalreviewof studiesthat haveundertakena direct evaluationon the existence of a relationshipbetweenwages and productivity. See Raff & Summers(1987) for a specificcase study on laborcompensationand introductionof an efficiencywage. 28. The exception,of course, is the limitedbodyof work concentratingon the nutritionalmodelof efficiencywages. See, for example,Dasguptaand Ray (1987). 29. Weiss (1980) recounts the story of the StanfordLinear Acceleratorcenter without directly appealingto the efficiencywage hypothesis.RaffandSummers(1987)studiedthe Ford case looking for evidenceof efficiencywages.

27 30. In contrastto the positivewage productivity,Leonard(1987)looksfor a negativerelationship betweenlevel of supervisionand wages impliedby the shirkingapproachto efficiencywages. He findslittle connectionbetweenthe two. His result, however,have been criticizedbecausehis data sourceis not specifiedand it coversonly one industry. 31. See Dickensand Katz, (1987, 1988), Murphyand Topel (1988) and Kruegerand Summers (1988a, 1988b). 32. See Katz (1986),Dickens and Katz (1987), and Murphyand Topel (1987).Raffand Summers have studieda specificcase on labor compensationand introductionof an efficiencywage. 33. See, Kreugerand Summers(1988) 34. Beaudry(1989). Campbell(1989),on the basis of an aggregatewage settingmodel, has also studiedthe hypothesisof wage rigidityin Franceand Canada. His findingsalso supportthe validity of the efficiencywage hypothesis. 35. See, for instance,the study by Salazar-Carrillo(1982)analyzingthe structureof manufacturing wagesfor a sampleof Latin Americaneconomies,describingtheirbasicfeatureswith regardto both distributionand explanatoryfactors. 36. See Fields (1980),Riveros(1990), Uthoff(1983),and Corbo and Stelcner(1983). 37. See Robbins(1989). 38. See Levy & Newman(1989). 39. See Lopez & Riveros (1990a,b).


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