Labor market ; Monetary policy - United States ; Wages

Chan Guk Huh

English

Research Papers in Economics

FR8SF WEEKLY LETTER
Number 92-45, December 25, 1992
labor Market Structure and
Monetary Policy
Wage earnings comprise about two-thirds of the
total income of individuals in the u.s. economy.
Besides being the primary source of households'
income, the wage rate plays a key role in labor
market adjustment. Wage rate determination and
labor market adjustment also influence the way
the Federal Reserve's monetary policy affects the
economy.
This Weekly Letter explores three alternative
models of demand and supply behavior in the
labor market and the consequences for monetary
policy. If the conventional, competitive market
framework applies, then monetary policy is es-
sentially neutral in terms of affecting real wage
rates and therefore employment in the long run.
But in recent years, two alternative views ofwage
determination have emerged, the bargaining
model and the model of "efficiency wages:' If
these theories more accurately describe the way
the labor market functions, then they suggest that
monetary policy can have long-term impacts.
Competitive labor market
The conventional approach to modeling how
wages are determined uses a competitive market
framework. In a competitive market, no single
participant has a significant impact on the pre-
vailing wage rate-that is, individual workers
and firms take the wage or the price as given.
At any particular wage rate, a profit-seeking firm
hires the number ofworkers for which the last
added worker's contribution (productivity) is ex-
actly matched by the given wage rate. Typically
the net contribution to the firm's output of add-
ing one more worker declines as the number of
workers increases. Consequently, in order for
firms to want to hire more workers the wage
rate must fall, and vice versa.
Individuals decide how much time to devote to
work by balancing their choices of leisure versus
the income received for work. The amount of
work an individual is willing to do increases as
the wage rate rises, unless the wage and, hence,
income reach such a high level that one starts to
value leisure more than income at the margin.
The actual levels of wages and employment are
simultaneously determined by the interaction of
these demand and supply factors. In the com-
petitive model, the market-clearing wage rate
represents the marginal contribution of the last
worker added (or the marginal productivity of
labor). Thus, one is paid for the economic value
of one's contribution. Consequently, workers'
productivity is the key determinant of the wage
obtained in the market. Most economists take
the competitive model as a baseline description
of how the labor market operates.
Empirical findings both support and refute this
view. Some studies that examine economy-wide
aggregate data have found a pattern of close co-
movement between the measur€:s of average
compensation and productivity. However, other
studies that have examined firm level data found
little evidence to support the equality of wages
and marginal productivity. Thus, how representa-
tive the competitive model is of the workings of
an actual labor market appears to be an open
issue.
Bargaining model
An important challenge to the basic price-taking
assumption of the competitive model is the
widely observed labor market practice of wage-
bargaining between employers and labor unions.
In contrast to the passive price-takers of competi-
tive markets, parties in a bargaining process are
strategic players, and factors such as the relative
strength of an employer versus a union play an
important role. As long as firms do not dominate
workers and therefore remain price-takers, the
behavior of the demand for labor described in
the competitive model still best characterizes the
firm's position in the labor market.
On the other hand, the behavior of workers in a
bargaining model differs from that of the compet-
itive case: The aggregate labor supply depends
not on individual decisions, but is collectively
determined by the union. Consequently, the rela-
tive emphasis the union puts on securing a higher
level of employment of union members ratherFRBSF
than a higher wage rate will bias the potential
bargaining outcome. One extreme example is
when a union picks' the wage rate and leaves
the employment decision up to the firm-this is
known as a "right-to-manage" case. Firms in this
case respond very much as they would in the
competitive case, because they take the wage
rate as given and thus simply resort to the de-
mand for labor curve to find an optimal level of
employment. This level of employment, however,
would likely be lower than in the competitive
setting since the wage picked by the union is
likely to be higher than the market determined
wage.
A steady trend of declining labor union member-
ship over recent decades is one development that
has cast doubt on how well the bargaining view
of wage rate determination describes the current
overall U.S. labor market. Unionized labor has
made up about 16 percent of the labor force in
recent years compared to over 30 percent during
the 1960s.
Efficiency wages
Several studies have found substantial interindus-
try wage differentials, even when differences in
worker quality, job attributes, and, in some cases,
unionization were considered. Within the com-
petitive market view, it is hard to reconcile the
case of, say, a maintenance electrician in a de-
partmentstore earning a different wage from a
maintenance electrician in an auto parts com-
pany. In a simple competitive market the wage
differential will be bid away by workers moving
from low-paying to high-paying industries, which
would lead to little variation in compensation for
similar jobs in different industries.
"Efficiency wage" theories propose an explana-
tion of why it might be profitable for some firms
to pay wages above the market-clearing level. If,
for example, the costs of labor turnover are very
high for the firm, it might be profitable to pay a
higher wage to reduce turnover. This view relaxes
the simplifying assumption of the competitive
view that the quality of labor is uniform; it ac-
knowledges the possibility that the productive
effort of a worker may depend on the wage
received.
For example, workers have some discretion over
the pace of work, so they may be able to shirk
some of their responsibilities without being de-
tected. In that case, there is a minimum wage
rate that would give workers the right incentive
not to shirk. Thus, paying a higher wage would
encourage workers to put forth their full effort,
since they would have more to lose if they were
caught shirking and then dismissed. Different
industries might be subject to the monitoring
problem in varying degrees and consequently
might have different levels of optimal wages.
Hence, interindustry wage differentials are to
be expected across various industries.
This view is not without criticism. in theory, it
is possible to devise a payment mechanism that
can overcome most of the problems raised by
proponents of the "efficiency wage" explanation.
For example, instead of paying a higher wage to
prevent shirking, deferring part of the employee's
compensation until later in the employee's tenure
would have the same effect. This arrangement
would reduce the inclination for the worker to
shirk by making the cost of getting fired higher
in terms of the lost future compensation. At the
same time, an employer would have ample op-
portunity to monitor the rea! effort of workers
over time. Thus, the apparent ease with which
the shirking problem can be overcome casts
some doubt on the importance of its role in
wage determination (see Katz 1986).
Implications for monetary policy
Theories are necessarily caricatures of the actual
workings of markets; therefore, no single view
can be expected to encompass all of the features
of how the labor market actually works or how
wages are set in practice. Instead, each theory is
likely to contain an element of truth. Knowing
which factors dominate is important. For exam-
ple, different theories of the labor market have
different implications for the effects of monetary
policy in the short run as well as in the long run.
According to the classical and traditional Keynes-
ian macroeconomic views, an increase in the
money supply will not have much effect on the
level of employment and output in the long run,
because the labor market isassumed to behave
according to the competitive labor market model
in the long run. The main difference between the
classical and the traditional Keynesian views is
the rate at which both real wages and employ-
ment adjust to an increase in money supply. In
the classical view, real wages and employment
adjust almost immediately; in the traditionalKeynesian view, real wages adjust relatively
slowly, because of labor contracts, and conse-
quently a money supply increase would raise
employment in the short run.
However, in the wage-bargaining and efficiency
wage labor market models, the effects of an in-
crease in the money supply could be long-lasting.
Blanchard and Summers' (1986) explanation of
the persistent high unemployment in Europe dur-
ing the 1980s provides a rationale for long-run
effects of a money supply change when the bar-
gaining model dominates. According to their
explanation, the employed are "insiders" who
are mainly concerned with maintaining their
employed status and act accordingly in wage-
bargaining with,their employers. Now consider
an increase in the money supply, which leads
firms to hire more workers, so that they can in-
crease output to meet the resulting temporary
increase in aggregate demand. According to
this model, the newly employed, who are now
"insiders" will exert influence over subsequent
bargaining to secure their "insider" status.
Hence, the status of the employed becomes self-
sustaining, and a policy action, like an increase
in the money supply, might actually lead to a
long-run increase in employment.
Though not as clearly developed as the previous
bargaining mode! example, an increase in the
money supply and subsequent increase in the ag-
gregate demand may increase output in the long
run in the efficiency wage labor market model
when price levels are slow to adjust in the short
run. The overall wage level would be Dushed UD
due to an increase in the firm's dema~d for ad-'
ditional workers in the labor market. The higher
wages and the commensurate increase in work-
ers' efforts may lead to higher productivity in the
long run.
These examples illustrate the need to know more
about the structure of labor markets, since such
insight could contribute to better understanding
the mechanism that transfers monetary policy
actions to real economic activity.
Chan Guk Huh
Economist
References
Blanchard, Olivier J.t and Lawrence H. Summers.
1986. "Hysteresis and the European Unemploy-
ment Problem:'NBER Macroeconomic Annual,
pp. 15-78.
Katz, Lawrence F. 1986. "Efficiency Wage Theories:
A Partial Evaluation:' NBER rV1acroeconomics
Annual, pp. 235-276.
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to theeditor or to the author...• Free copies of Federal Reserve publications can be
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92-22
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92-38
92-39
92-40
92-41
92-42
92-43
92-44
The Silicon Valley Economy
EMU and the ECB
Perspective on California
Commercial Aerospace: Risks and Prospects
Low Inflation and Central Bank Independence
First Quarter Results: Good News, Bad News
Are Big U.S. Banks Big Enough?
What's Happening to Southern California?
Money, Credit, and M2
Pegging, Floating, and Price Stability: Lessons from Taiwan
Budget Rules and Monetary Union in Europe
The Slow Recovery
Ejido Reform and the NAFTA
The Dollar: Short-Run Volatility and Long-Run Adjustment
The European Currency Crisis
Southern California Banking Blues
Would a New Monetary Aggregate Improve Policy?
Interest Rate Risk and Bank Capital Standards
NAFTA and u.s. Banking
A Note of Caution on Early Bank Closure
Where's the Recovery?
Diamonds and Water: A Paradox Revisited
Sluggish Money Growth: japan's Recent Experience
Sherwood-Call
Walsh
Sherwood-Call
Cromwell
Parry
Trenholme/Neuberger
Furlong
Sherwood-Call
juddlTrehan
Moreno
Glick/Hutchison
Throop
Schmidt/Gruben
Throop
Glick/Hutchison
Zimmerman
Motley
Neuberger
Laderman/Moreno
Levonian
Cromwell/Trenholme
Schmidt
Moreno/Kim
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974-2246, Fax (415) 974-3341.~ 1%\ 'S~U! ueaqi\os lll!M TV '!1' Jaded papA:J8J uo palU!Jd OZl176 \I) 'O:>SPUI?J:J UI?S lOLL X08 ·O·d O)S!)UOJj UOS JO ~U08 aAJaSa~ IOJapa:J ~uaw~Jodaa 4)JOaSa~ Index to Recent Issues of FRBSF Weekly Letter

Efficiency Wage Theories: A Partial Evaluation:'

Hysteresis and the European Unemployment Problem:'NBER Macroeconomic Annual,

Labor market structure and monetary policy

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Labor market structure and monetary policy

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