Fehr and Falk Wage Rigidity in a Competitive Incomplete Contract Market

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Fehr and FalkWage Rigidity in a Competitive
Incomplete Contract Market

• Economics 328
• Spring 2005

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The Golden Rule . . .What comes around goes
around!

• The traditional version is Do unto others as you
  would have them do unto you.
• The golden rule of how people behave appears to
  be Do unto others as they have done unto you.
• This helps us understand many economic phenomena
  that traditional theory cannot easily explain.
• Gifts from charities
• Tipping
• Bargaining
• Wages above market levels
• Understanding this golden rule helps understand
  why evolution favored home sapiens over home
  economicus

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Research Question

• Standard economic models predict that firms
  should reduce their workers wages when there is
  unemployment.
• There exist numerous survey studies that firms do
  not cut wages in the face of unemployment.
• Firms dont take advantage of underbidding
  offers by unemployed workers to work for less
  than the firms going wage.
• Surveys indicate that this failure to cut wages
  is driven by fears that workers morale will be
  hurt.
• Workers will see the firm as hostile and
  perceive the wage cut as an insult.
• Worker will not work to their full capabilities.
• In an environment that promotes convergence to
  the competitive equilibrium will a combination
  of incomplete contracts and reciprocity between
  employers and employees prevent convergence

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Experimental Design

• Fehr and Falk conducted a total of 6 double oral
  auction markets. Each market had 7 firms and 11
  workers.
• Given that each firm can only employ one worker
  all of the surplus should go to the firms due to
  their market power.
• Bids had to be improving but prices are allowed
  to cross. In other words a firm can bid a wage
  higher than the lowest requested wage.
• Allows a firm to do a favor for a worker
• Should never be used according to standard theory
• Workers were never told the identity of the firm
  they had been matched with (or vice versa).
• Reciprocity vs. reputation

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Experimental Design

• After a firm and worker have agreed on a wage
  the worker selects an effort level e. Because
  the employer cannot specify the level of e when
  it sets the wage the employment contract is
  incomplete.
• The firms payoff function is the following.
  Note that this isnt a standard wage equation.
  This functional form is used to rule out losses.
• p (120 w)e
• The workers payoff is given by the following
  function with costs drawn from Table 1. Notice
  that effort only benefits the firm not the
  worker.
• U w c(e) - 20

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Experimental Design

• In the treatment sessions the worker set the
  effort level.
• The theoretical prediction is that workers should
  always choose the minimum possible effort.
  Anticipating this firms should therefore take
  the entire surplus for themselves.
• The possibility of positive reciprocity implies
  that the firm might give the worker some of the
  surplus in exchange for an effort level higher
  than the minimum.
• In control treatments the workers were not able
  to set the effort level.
• The employers payoff is (120 w) and the
  employees payoff is (20 w).
• The theoretical prediction is unchanged by not
  allowing workers to set e.
• Any scope for reciprocity is removed although
  fairness concerns could still conceivably affect
  wages.

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Experimental Results

• Even in the control sessions the average wage is
  well above the equilibrium prediction of w 20.
  The average wage decreases slightly over time.
• Wages are uniformly higher in the treatment
  sessions roughly double wages in the control
  sessions and are rising with experience. As
  such there is no reason to believe wages would
  converge to the theoretical equilibrium with
  greater experience.

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Experimental Results

• One possibility is that the high wages in the
  treatment are driven by worker solidarity. The
  presence of massive underbidding rules this out.
• Similar underbidding does not occur in the
  control sessions.
• The occurrence of underbidding indicates that
  firms are willingly paying high wages they
  could hire workers for less but choose not to do
  so.
• Survey data indicates that in reality firms
  almost always reject offers from underbidding
  workers.

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Experimental Results

• Justifying firms decisions to pay higher than
  necessary wages there is a strong positive
  relationship between wages and effort levels.
• There is a fraction of the workers (10 of 44) who
  always return the minimum possible effort.
  Almost all other workers have strong positive
  correlation between the wage they receive and the
  effort they exert.
• The relationship between wage and effort is
  statistically significant even controlling for
  individual effects and two-sided censoring.
• There is no strong relationship between the
  wage-effort equation and experience.

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Experimental Results

• Just because there is a positive relationship
  between wages and effort doesnt mean that
  offering high wages is profit maximizing for
  firms. The higher effort levels need to more
  than compensate the firm for paying a higher
  wage. As indicated in the figure to the right
  firms clearly benefit by setting higher wages.
• If anything the average wages are slightly too
  low.
• This result indicates that the refusal to accept
  underbids is not driven by concerns for equity
  but instead is a rational profit-maximizing
  choice.

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Experimental Results

• The positive wage-effort relationship in the
  preceding experiments is driven by positive
  reciprocity. Fehr and Falk ran an additional set
  of experiments designed to determine if negative
  reciprocity could also lead to higher wages and a
  positive relationship between wages and efforts.
• The cost function shown below makes choosing the
  highest effort money maximizing for workers.
  This is equivalent to a setting where the firm
  can closely monitor workers.
• There is a small change in the firms profit
  function which forces the experimenter to run a
  new set of control sessions.

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Experimental Results

• Although not quite as strong as the positive
  reciprocity result the ability to set efforts
  clearly leads to higher wages.
• Once again there is a strong positive
  relationship between wages and efforts.
• Wages decline over time in the control sessions
  but are stable in the treatment sessions.

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Conclusions

• We have spent a great deal of time studying the
  nature of fairness. This can seem very
  abstract but as demonstrated in this paper can
  have important practical consequences.
• The presence of a strong positive relationship
  between wages and effort due to positive
  reciprocity implies that labor markets will
  generally not converge to the competitive
  equilibrium.
• The standard result in economics is that the
  competitive equilibrium is efficient. In these
  markets the competitive equilibrium is
  inefficient. By generating higher effort levels
  positive reciprocity in increasing total surplus.
  This is not a zero-sum game. It is possible
  for employers and employees to work together and
  increase the size of the pie to be split.