Unit 6 - The Firm: Owners, Management, Employment

6.6 Work and wages: The labour discipline model

• When employment rent / cost of job loss is large, workers will be willing to work harder in order to reduce the likelihood of losing the job

• Firms can increase the cost of job loss and thus effort exerted by employees by raising wages

• Employers choose wage; Worker chooses a level of work effort

• The greater the effort, the more the worker produces, the more profit

• If a worker chooses work effort as a best response to the employer’s offer, and employer chooses the wage that maximizes his profit = strategies are Nash Equilibrium

  • Nash Equilibrium - a set of strategies, one for each player in the game, such that each player’s strategy is a best response to the strategies chosen by everyone else

Employee’s best response

• Effort can vary between zero or one, proportion can be each hour spent working versus each hour not working

• Could still be paid for just sitting there

• Effort has a cost—disutility of work—and a benefit—increases the likelihood of her keeping the job and the employment rent

• Maria’s higher wage increases the benefits from effort, so the best response will increase with the level of the wage chosen by employer

• worker’s best response function (to wage) - optimal amount of work that a worker chooses to perform for each wage that the employer may offer

• MRT = slope of feasible set

• disutility of effort becomes greater as level of effort approaches the maximum possible level (diminishing returns), higher wage could get more

• the higher the initial wage, the smaller the increase in effort and output the employer gets from an extra $1 per hour in wages

• for any wage, best response is to exert a higher level of effort

• the lowest wage possible (0) is not in the feasible set, cuz then Maria would not work

6.7 Wages, effort, and profits in the labour discipline model

• Maria has bargaining power - can walk away

• Workers can choose how hard they work

• the trade off employers face is having more effort for higher wages

• to maximize profits, firms want to minimize the costs of production, including the input employees bring, but not the lowest possible wage or the simple reservation wage

• cost of a unit of effort is wage over units of effort per hour

• feasible combination of effort and wage that minimizes the cost of unit per effort

• maximize number of units of effort (sometimes called efficiency units) that the employer gets

• isocost effort line - sort of like an indifference curve for the employer, all combinations of wage and units of effort per hour that the employer is indifferent to, it is constant

• isocost line is effort over wage, reciprocal of cost of effort

• slope of effort isocost line = MRS: the rate at which the employer is willing to increase wages to get higher effort

• will seek the steepest isocost line for effort, but has to pick some point on the best response curve

• thus 12$ is the hourly wage the employer should set to minimize costs and maximize profits

• minimize cost and maximize profit at MRS = MRT

• constrained choice problem

• efficiency wages - the payment an employer makes that is higher than an employee’s reservation wage so as to motivate the employee to provide more effort on the job than he or she would otherwise choose to make

• labour discipline model - a model that explains how employers set wages so that employees receive an economic rent (called employment rent), which provides workers an incentive to work hard in order to avoid job termination

  • Equilibrium - best response strategies result in Nash equilibrium

  • rent - receives an employment rent that she might lose if she slacked off

  • power - fear of losing economic rent means employer has some power over her, having her act in ways she would not do without threat of job loss, profits of employer

Involuntary unemployment

• in the labour discipline model, there must always be involuntary unemployment

  • involuntary unemployment - the state of being out of work but preferring to have a job at the wages and working conditions that otherwise identical employed workers have

• looking for work basically

• In equilibrium, both wages and involuntary unemployment have to be high enough to ensure that there is enough employment rent for workers to put in effort