Lecture 4: Wage Productivity Model

• We continue to explore the issue of coexistence of wage rigidity and unemployment/surplus labour.
• The analysis is in a general context and does not assume any special relevance to the urban sector. Now we
consider a set of models known as “efficiency wage” theories of wage rigidity and unemployment and
“collusive models” of unemployment.
• In efficiency wage models employers prefer not to lower wages despite the existence of surplus labour and
in collusive models of unemployment workers refuse to undercut one another even in the presence of open
unemployment
• The efficiency wage theories of unemployment originated with the works of Leibenstein (1975b; 1958)
which assumed that in poor countries higher wages lead to higher productivity. We will also consider
whether wage-productivity model can explain disguised unemployment and surplus labour.
• Wage rigidity, one of the key factors behind dualism in backward economies, is also a cause of labour
market fragmentation in general and of unemployment.
• We considered labour turnover model and now we consider wage-productivity model.
• The basic axiom of wage-productivity model is that workers’ productivity
is positively related to their level of consumption.
• It is to be noted that such a positive relation exists only at low levels of
consumption, and this is true in the context of less developed economies.
• Also assume that the link between wages and consumption is also fairly
stable, that is a higher wage leads to higher consumption.
• This can also be true in LDCs, as their level of consumption is already
very low. Combining both axioms above implies that workers’
productivity depends on wages.
• Assume that output depends, not on the hours of labour, but on the number of
efficiency units of labour used and that the number of efficiency units that worker
can produce is a function of the wage the worker receives.
• Suppose that each worker is working for a fixed number of hours; let it be one hour.
Let ‘h’ be the total number of efficiency units produced by each worker and ‘w’ be
the wage rate.
• Hence we can write
h =h(w), h′(w) > 0
Figure: Relation between wage and productivity

• It is reasonable to assume h =h(w), h′(w) > 0 has

the shape illustrated in Figure.
• The figure suggests that when the level of
consumption is very low, increase in the
consumption have a sharp effect on productivity
and the effect becomes less pronounced at higher
levels of consumption.
• The important point is that beyond a certain wage,
the function h, is concave.
• Total output, X, depends on the number of efficiency units used. Capital is ignored as it is a short
run model.
X =f(nh(w)) f ′ > 0, f ′′ < 0 where n is the number of workers

• First we consider a partial equilibrium problem. A single employer is deciding on the number of
workers n to employ and what wage to pay w.

• Employer’s objective is to maximise profit π, which is equal to

π =f(nh(w))−nw where wage w is given in real terms.
• Suppose 𝑤
෥ is the prevailing reservation wage or the supply price of labour. This means that at
wage level lower than 𝑤
෥ no workers will ready to supply labour power.
• It is to be noted that 𝑤
෥ can be the prevailing market wage or if there is no proper labour
market and workers are willing to work for any wage above subsistence level, then 𝑤
෥ will be
the subsistence wage.
• The employer’s problem is

𝐦𝐚𝐱 𝝅 𝒏, 𝒘 = f 𝒏𝒉 𝒘 - nw
𝒏, 𝒘
෥
Subject to w≥ 𝒘
• In the standard theory, where employer has the freedom to offer any wage equal or above 𝒘,
෥ he
෥
would opt for the lowest, namely 𝒘.
• But in the present context a higher wage also provides higher number of efficiency units from each
hour of labour of each worker. This suggests that the inequality constraint cannot be converted into
equality as in other problems.
• We workout the solution to the above problem in two steps. Consider the above maximisation
problem without any constraint on wage.
• Then maximisation of profit yields the following first-order conditions
f′(nh(w))h(w) − w = 0 ……. (1) (FOC with respect to n)
f′(nh(w))h′(w) − 1 = 0 ……… (2) (FOC with respect to w)

𝒉 𝒘 𝒘 𝟏
The above first order conditions imply the following = 𝒉′ 𝒘 (𝑜𝑟) = …………(3)
𝒘 𝒉 𝒘 𝒉′ 𝒘
The first order conditions can be interpreted in many ways.
𝒉 𝒘 ′ 𝒉 𝒘
• Note that left hand side of the equation (3); =𝒉 𝒘 ; is the slope of the
𝒘 𝒘

straight line through origin at 𝒘∗ and this gives the number of efficiency units per unit
of wage.
• The right-hand side shows the slope of the 𝒉 𝒘 curve or the marginal increase in the
efficiency unit due to a small increase in wage.
• At wage rate lower than 𝒘∗ each unit increase in the wage produces more efficiency
units than the increase in wage and therefore it is profitable to increase the wage rate till
the wage 𝒘∗ .
• Beyond the wage w∗ the increase in the efficiency units is less than the increase in the
wage, and therefore it is profitable for the firm to reduce the wage to 𝒘∗
 Figure: Wage and productivity

• Let 𝒘 = 𝒘∗ be the solution to the (7), then

w∗ is known as efficiency wage.
• In the figure the tangential point of the line
through the origin with the wage-efficiency
curve represents 𝒘∗ .

∗ 𝒘
Note that at wage level 𝒘 , the cost of efficiency units, is minimised
𝒉 𝒘
• As the employer’s actual problem is to maximise profit subject to the constraint
that 𝑤 ≥ 𝑤.
෥
෥ <𝑤 ∗ , then 𝑤 ∗ is feasible and that is precisely the wage paid.
• If 𝑤
• If 𝑤 ∗ < 𝑤
෥ , then 𝑤 ∗ is not feasible and then the employer maximises profit by
giving a feasible wage close to 𝑤 ∗ . And in this case the employer gives wage
equal to 𝑤
෥.
• We can show that by giving a wage close to w∗ , which is feasible, profit is maximised.
Note that the profit function can be rewritten as follows
𝒘
𝝅 𝒏, 𝒘 = f 𝒏𝒉 𝒘 - nh 𝒘
𝒉 𝒘

• Suppose that initial wage and employment are at 𝒘 and 𝒏 and 𝑤 > 𝑤 ∗ .
ෝ , which is still above 𝑤 ∗ .
• Consider a lowering of 𝑤 to 𝑤
𝑤ෝ 𝑤
• It is clear from the figure that ෝ
< . Let 𝑛′ be such that 𝑛′ ℎ 𝑤
ෝ = 𝑛ℎ 𝑤 .
ℎ 𝑤 ℎ 𝑤

• Clearly 𝝅 𝑛′ , 𝑤
ෝ = 𝝅 𝒏, 𝒘 . Hence, if 𝑤 > 𝑤 ∗ , the employer can always do better by
lowering w and suitably amending n.
• This implies that the optimal wage, w, depends on the supply price of labour, 𝑤
෥ , in the
෥ = max 𝑤 ∗ , 𝑤
following way: 𝑤 = 𝑤 𝑤 ෥
 ෥ the optimal n
Once 𝒘 is chosen, n is determined by inserting 𝒘 in (5). Because 𝒘 is a function of 𝒘,
෥ as well. As long as 𝒘
must be a function of 𝒘 ෥ < 𝒘, ෥ ≥ 𝒘∗, ∂n/∂ 𝒘
෥ and if 𝒘
n does not respond to 𝒘 ෥
< 0.
Thus ෥
n = n(𝒘)
The above equation can be illustrated using a figure, which is a kind of demand curve for labour,
depicting labour demand curve corresponding to every reservation wage rate.
The reservation wage need not always equal to the actual wage. For instance if the reservation wage
is 𝒘𝟏 , the actual wage is 𝒘∗ .
This means that though the employer can get workers at lower wage 𝒘𝟏 , the employer prefers to pay
them the higher wage 𝒘∗ .
This completes the partial equilibrium analysis. The above model can explain the existence of wage
rigidities and involuntary unemployment.
Graphical depiction of equations
෥ = max 𝒘∗ , 𝒘
𝒘=𝒘 𝒘 ෥ and
෥
n = n(𝒘)
• In analysing the behaviour of a single employer, we have determined the wage an
employer would pay, given a fixed reservation wage.
• The purpose of the market equilibrium analysis is to show what the reservation wage will
be, and therefore, what the actual wage will be paid.
• Suppose for simplicity that there are 𝒍 identical employers each like the one described
above.
• Then aggregate demand for labour, 𝑵𝑫 for each reservation wage is given by
෪
𝑵𝑫 = 𝒍𝐧 𝑾
• Assume that aggregate labour supply, N is positively related to the supply price of labour,
we have
෪ , 𝑵′ 𝑾
𝑵=𝑵 𝑾 ෪ ≥𝟎
 • S be the supply schedule. If workers take their wage to be fixed at
Figure: Labour Market equilibrium ෝ , then they together supply N(𝒘
𝒘 ෝ ) units of labour. If the wage rate
𝒘 ෝ ) = ℓn(𝒘
ෝ is greater than 𝒘∗ , then N(𝒘 ෝ)

• Now consider an alternative supply schedule, S′. In this case

supply exceeds the demand at 𝒘∗ , that N(𝒘∗ ) > ℓn(𝒘∗ )
• In this case 𝒘∗ is the actual wage paid in the market and
reservation wage 𝒘∗∗ is less than efficiency wage and equilibrium
is characterised by involuntary unemployment equal to
N(𝒘∗ )−ℓn(𝒘∗ ).
• In this case demand equals supply of labour, and the 𝒘
ෝ is the
equilibrium reservation wage and also the actual wage paid.
• The model can explain the existence of involuntary unemployment in LDCs.
• As the function h(w) can be different for different kind of jobs, can result in different
efficiency wage rates 𝒘∗ . Thus the model is also able to explain existence of wage
dispersion.
Surplus Labour and efficiency wage

• A sector is charectrised by surplus labour if it is possible to remove a fraction of

the labour force without causing any reduction in output.
• Such a situation is also described as one having “disguised unemployment”
because part of the employed population is redundant, though not visibly so.
• It has been claimed by many (not without others contesting it) that surplus labour
is widespread in overpopulated backward economies.
• However, the persistence of surplus labour is a puzzle to economists, and a
number of explanations have been suggested.
 Existence of surplus labour

• One explanation provided is that for a large number labours in the LDCs, marginal
productivity is zero or near zero, and therefore removing them from the production
does not reduce the output.
• However, this approach raises questions about the rationality of both employer and
labourers. In the case of family farm, why do they work so much if their effort is not
adding anything to output.
• In this context, Sen (1966, 1975) showed that zero marginal productivity of labour is
neither necessary nor sufficient for the existence of surplus labour.
• We demonstrate this argument using a simplified version of Sen’s(1975) model.
• Consider a family farm with 𝒏ഥ working members. Output, Q, depends on the hours of labour used. If x
denotes the number of hours that each member works, we have
ഥx
𝑸=𝒇 𝒏 𝒇′ > 𝟎, 𝒇′′ < 𝟎
• Let the cost of each hour of labour is expressed in terms of the output and fixed at c.
• Assume that family objective is to maximise total production, net of leisure cost, they will work up to the
ഥx = c
point where 𝒇 𝒏
• Let the x that solves this be denoted by 𝐱ത
• Suppose that 𝑋 ∗ is the maximum number of hours a person can work. Then surplus labour exists if 𝐱ത < x∗
• Define n∗ such that = n∗ x∗ = 𝒏
ഥ 𝐱ത. This means that if farm had n∗ members and each of them is working
x∗ hours, then f′(n∗ x∗ ) = c.
• This implies that 𝐱ത < x∗ , 𝒏
ഥ >n∗ . Therefore, out of the 𝒏 ഥ − n∗ were
ഥ working family members, if 𝒏
withdrawn, this would result in each member working 𝐱ത − x∗ hours more.
• Since n∗ x∗ = 𝒏
ഥ 𝐱ത, f (x∗ n∗ ) = f (ഥ
𝒏 𝐱ത), implying output remains undiminished.
• However, the above argument hinges on the assumption of constancy of cost of
leisure.
• Though the model is logical, its use of rather restrictive assumption compels us to
search for other explanations.
• Now we consider the efficiency wage hypothesis to explain the existence of surplus
labour.
• It is possible that withdrawal of some workers would increase the wage rate of
remaining workers. Higher wage can increase their productivity, which in turn
prevent the output from falling.
• Unfortunately, we will show that this argument is not tenable.
 Efficiency wage and Surplus Labour

• Consider the market equilibrium model with efficiency wage. Let 𝒘∗ be the optimum
wage.
• Let N(𝒘∗ ) and ℓ n(𝒘∗ ) be the supply and demand for labour at wage 𝒘∗ .
• Let N(𝒘∗) > ℓ ln(𝒘∗), indicating that there is unemployment, which is open.
• However, we are concerned with a context where there is no excess supply of labour.
So we assume, for simplicity, that labour supply curve is completely inelastic that is
N(w) = N ∀ w.
• Assume that supply curve is vertical through E in the previous figure. Then 𝒘
ෝ is the
equilibrium wage because ℓ ln (𝒘
ෝ ) = N.
 ഥ (< N) remains behind.
• Suppose now a part of the labour force is withdrawn and 𝑵
• Now the new equilibrium wage 𝑾 is greater than 𝒘.
ෝ
• Given that productivity is positively related to the wage rate, h(w) must rise.
• Now the question is whether this increased productivity is sufficient to keep the
total output at the same level. The answer is no.
• Since 𝑾 > 𝒘 ෝ are greater than 𝒘∗ , it follows from the shape of
ෝ and both 𝑾 and 𝒘

𝑾 ෢
𝑾
the h(·) that > ෢
𝒉𝑾 𝒉 𝑾

𝒘
• In equilibrium n and w must be such that f′(nh(w))=
𝒉 𝒘
Let the initial and new equilibrium n be denoted by 𝒏ෝ and 𝒏ഥ respectively, that is, 𝒏ෝ =
𝒘) and 𝒏ഥ = n (ഥ
n(ෝ 𝒘).
• The above two equations imply that
𝒇′ 𝒏
ഥ𝒉 𝒘
ഥ > 𝒇′ 𝒏
ෝ𝒉 𝒘
ෝ

Since f′′< 0, this implies that 𝒏

ഥ𝒉 𝒘
ഥ <𝒏
ෝ𝒉 𝒘
ෝ
• Therefore, 𝒇′ 𝒏
ഥ𝒉 𝒘
ഥ < 𝒇′ 𝒏
ෝ𝒉 𝒘
ෝ that is output after withdrawal of labour is
smaller.
• Since all functional forms were unspecified, it follows that surplus labour cannot
be explained using the axiom that productivity depends on consumption.