Efficiency wage model:
Efficiency wage models are developed with the input of imperfect information where the participation constraint of employees are slack because of informational problems or others like limited liability constraints. The basic issue raised in these concerns with, why there is unemployment. A dominant view is unemployment arises because wages need to be above the market clearing level in order to give incentives to workers. In fact, it is the combination of unemployment and high wages that make more attractive for workers.
Such a configuration materialise because,
i) unlike other forms of capital, human being can choose their levels of effort; and
ii) it is costly for firms to determine how much effort workers are exerting.
Consider a situation where all workers come receive the market wage and there is no unemployment. In such an eventuality, the worse thing that can happen to a worker is that she will be fired and instantaneously rehired. There is therefore no penalty for exerting effort ('shirking'). To induce workers not to shirk, firm pays above-market wages. So job loss impose penalty. The problem is, if one firm pays above-market wages, then other will follow the suit. When such a situation prevails, the incentive not to shirk disappears.
However, the unemployment results since wages are above the natural equilibrium level and unemployment creates its own penalty for shirking. Let us see the how these models present the problems. Suppose a firm pays markets clearing wage w* and the workers shirk. When they are caught for shirking and are fired (dismissed), they get hired elsewhere for the same wage w*. Thus, the threat of being fired is not a cost to a worker and she has no incentive to be productive. To induce the worker for not shirking, a firm must offer higher wage. In such an arrangement, once a worker is fired and gets hired by another firm, she receives only the market clearing wage w*. Thus, when the difference between shirking and non-shirking wages is substantial, it induces the workers to be productive. The wage at which no shirking occurs is the efficiency wage.
If shirking prevails in all the firms, every one of these is paying wages we, that is greater than w*. Does such a feature therefore indicate that worker will shirk even with higher wages? You may think yes, because they will be hired at a higher wage by other firms if they get fired. However, you may be wrong. Why? See that all firms are offering wages higher than w*. As wages are higher, the demand for labour is lower than that of the market clearing So, when a worker is fired even with an incentive-based wage, she may remain unemployed on some time internal. Shirking in the labour market is shown in Figure. It can be seen that with no shirking, the demand for labour (DL) intersects the supply of labour (SL) to give market clearing wage W* and full employment of labour L*. With shirking, however, individual firms are willing to pay more than W*, which we may call no shirking wages (NSC). The NSC curve shows the minimum wage to be given to worker in order not to shirk with NSC. The equilibrium wage will be determined at w,, and labour employment will be Le. As the NSC 1 curve depicts, the lowest wage that firms can pay to avoid shirking, will not exceed the labour supply curve. So there will be always some unemployment in equilibrium.
