Labour Economics

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					Labour Economics

   Dr Hamish Low
      Lecture 3
     Outline: Wage determination
1.   Types of wage contract
2.   Spot Market
3.   Uncertainty and risk sharing
4.   Verifiable output (but hidden actions)
5.   Non-verifiable output (next time)
     1. tournaments
     2. efficiency wages
          Alternative Wage Contracts
  •   Wage per hour worked
  •   Payment per unit produced
  •   Salary (independent of hours worked)
  •   Bonus payments:
      – linked to firm output?
      – firm profit?

Issues:      how much effort do workers put into the job?
             how does a firm ensure it attracts the right workers?
       Spot Market

        wx  p x . MPL

                         p x .MPL3
                         p x . MPL
                         p x .MPL2

• Marginal product is subject to shocks

• Risk averse workers will buy insurance

• Should insurance be “bought” from the (risk
  neutral) firm through the wage contract
• self-insurance through saving / borrowing?

• depends on type of risk: permanent vs

• private market? firms have better
  information than government / insurance
        Harris-Holmstrom (1982)
• Quality of workers is uncertain but is revealed over
  time by performance (no asymmetric information)
• Workers are risk averse, firms risk neutral
• Pay constant wage over life-cycle? Thus insuring
  against turning out to be low productivity worker
• Workers can always earn MPL on the spot market
• Effort is constant
          Wage and MPL Profiles

E  px .MPL 
• When workers learn they are of high ability, they
  will leave and receive spot wage OR firm will
  increase guaranteed wage

• So, firm can only offer partial insurance (because
  of a zero profit condition)

• Wages are immobile downwards
          Implications (cont)
• Firms make profits from workers early in life-
  cycle but lose money later
  – initially paying some workers less than MPL
  – later paying some more than MPL (bad workers)
    and paying the others equal to MPL

• What if firms cannot commit?
  – back to spot wage?

• What if workers know their own ability or
  make choices about effort?
 Who measures marginal product?
• Firm and worker may be unaware of how
  productive worker will be
• Asymmetric information about ability of
• Asymmetric information about effort put in
  by worker
• Output may depend on several people’s
               Hidden types
• Two sorts of contract: piece-rate or time-rate

• Two types of worker: high productivity and low

• Workers will separate
Utility (income?)

                           piece rate workers

                           time rate workers

              Low   High
             Hidden Action
• Risk averse worker, risk neutral firm
• Output (verifiable) y  e  z
• One period only, effort unobservable to the

• First best: firm bears all risk
• Optimal for incentives: worker bears all risk
To what extent should worker wages
  depend on output realisations?

• effectiveness of effort, benefit of inducing extra
• cost to the worker of extra effort
• responsiveness of effort to incentives
• risk aversion
• monitoring technology
• only condition wage on signals which are
  correlated with effort (ie informative ones)
Problems with performance pay

• Multiple tasks

• Time: “ratchett effect”
  – once a “piece rate” has been set, it will not be
    changed (Lincoln Electric Co in US)

• Hierarchies (the principal cannot do all the
• Many types of wage contract other than spot
  wage (MPL)
• Symmetric uncertainty over productivity: partial
  insurance possible if firm is able to commit
• Asymmetric uncertainty over productivity or
   – contracts providing partial insurance, but worker holds
     part of the risk to induce effort
• Next time: output is not verifiable

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