ECON 3341 SMU Relative Wages Efficiency Wages & Unemployment Discussion Questions

  

Assignment 2 : Read CH 13, 16 & 17 and answer the following essay type questions 15 points out of final grade

1. Discuss the pros and cons of efficiency wages as opposed to deferred compensation as compensation systems to deter shirking and encourage work effort. (20 points)

2. Explain the concept of hidden unemployment, or marginal labour force attachment. Discuss the pros and cons of including the hidden unemployed in our unemployment statistics. (20 points)

3. Explain why some job losers find new jobs relatively quickly at wages similar to those in their previous job, while others take longer to become re-employed and often earn much less in their new job. What policies might be implemented for those who experience large losses from job displacement. (20 points)

Assignment 2 : Read CH 13, 16 & 17 and answer the following essay type questions 15 points out of final
grade
1. Discuss the pros and cons of efficiency wages as opposed to deferred compensation as compensation
systems to deter shirking and encourage work effort. (20 points)
2. Explain the concept of hidden unemployment, or marginal labour force attachment. Discuss the pros and
cons of including the hidden unemployed in our unemployment statistics. (20 points)
3. Explain why some job losers find new jobs relatively quickly at wages similar to those in their previous job,
while others take longer to become re-employed and often earn much less in their new job. What policies
might be implemented for those who experience large losses from job displacement. (20 points)
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Prepared by Dr. Amy Peng
Ryerson University
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Discuss why certain compensation arrangements that at first glance
seem inefficient may be optimal mechanisms to align the incentives
of employers and employees or stockholders and management.
Explain why these optimal compensation arrangements may change
over time or differ across different countries or workplaces.
Outline the “new economics of personnel” and to see if it offers
insights into the workplace and human resource practices of
organizations.
Engage in the debate as to whether CEOs are “worth” their often
astronomical pay or essentially “milking” their organization and its
stockholders.
Discuss why mandatory retirement may exist and the implications of
legislatively banning mandatory retirement.
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Agency Theory
The framework applied is the principal agent
problem:
 Deals with the problem of designing an efficient contract
between the principal and the agent when there are
incentives to cheat
 Problems rise with asymmetric information
 Eliciting a “truth-telling” contract
 Examples of such contracts are: collective agreements or
implicit contracts
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Efficiency Wage Theory
 Wages affect productivity
 Wages are being paid according to value of marginal
product of labour
 Emphasizes that subsistence wage is necessary for
basic levels of nutrition, reproduction, and higher
productivity
 The result of higher wages is efficiency gains
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Small differences in the skill input of certain
individuals may get magnified incredibly in the
value of marginal product of the service consumed
by the public or co-workers in certain circumstances
(ex. concert, TV show)
ï‚¡ A small positive effect on each person can
accumulate into a large total effect when the
number of affected persons in the organization is
large (ex. executives, talented individuals)
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ï‚¡
Promotion on the basis of being the best (of several
executives with seemingly equal ability), results in a
huge increase in the salary
 Treated as prize of winning a contest
 Based on capability
 Increases the incentive to perform
 Important to senior persons who have few promotional
opportunities left
 Discourages cooperative behaviour
 Fosters corruption
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ï‚¡
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Inequality of pay is necessary to provide an
incentive to perform well
Too much inequality is not efficient since it:
 Discourages cooperative behaviour and teamwork
 Encourages sabotage
Solution:
 Different pay incentive schemes for different levels within an
organization
 Higher-level managers’ bonuses on the basis of group output
 Separate business units
 External promotion
 Human resources policies to encourage cooperative behaviour
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ï‚¡
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Paying people on the basis of the average
performance of team members
“Free rider” problem
 Large team – little incentive
 Small team – Peer pressure
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Up-or-Out Rules
 Under such rules employees are evaluated usually at a
specified point in their career and either promoted or
terminated (e.g. tenure at universities)
 Appears to be inefficient practice that causes loss of
workers with lower productivity
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Solution
 Using junior non-promoted slots to evaluate new
candidate
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Raiding, Offer-Matching, and the Winner’s Curse
Asymmetric information issues give rise to organizations
engage in raiding other organizations for top talent
 The organization being raided
â–ª Would offer-matching of the outside offer if the person
were truly worth that amount
â–ª Would not match the offer if the person were not worth
that amount.
▪ The raiding organization suffer from the “Winner’s
Curse”
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Piece Rates: workers are paid on the basis of the
output they produce.
ï‚¡ Benefits:
 Workers producing more output
 Systems attracting good workers
 Save on the cost of monitoring
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Drawbacks:
 Harder to monitor output of an individual
 Costly
 Harder to sustain the system if the individual does not have a large
degree of control over the output
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ï‚¡
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Executive pay has increased relative to the
average pay of workers
Executive compensation consists of a base
salary and stock options
Compensation process involves the board of
directors who have an incentive to award
high executive salaries because they are
themselves executives
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ï‚¡
Wages above an individual’s productivity:
 Senior employees
 Wages rise with seniority independently of productivity
 Wage increase and pension accrual for each additional
year of work
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Characteristics:
 Exist only if there is a long-term commitment on the part
of the firm to continue the contracted arrangements
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(a) Deferred Wages Contract Market:
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(b)Spot Market:
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(c) Deferred Wages with Company-Specific Training:
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(d) General Training:
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ï‚¡
Efficiency rationale:
 Increases work honesty and effort
 Reduces the need for constant everyday
monitoring
 Reduces unwanted turnover
 Reduces fixed hiring and training costs
 Discourages bad workers
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ï‚¡
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Assume a worker’s VMP, is $10 per hour
Assume that she is paid according to a
deferred compensation system W = 5 + 0.2T
Assume further that she starts working with
the firm at age 20, and that there is no
discounting.
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Calculate at which age (or how many years
tenure) the workers break even?
1.

Set W = VMP; that is, 5 + 0.2T = 10, or T = 25
Solve for the mandatory retirement age
2.

45 + 25 =70
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3. Overpayment or Underpayment
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Researchers observed that workers actually
preferred the rising wage profiles
ï‚¡ They regard them as forced saving
ï‚¡ They get satisfaction for anticipating future
consumption
ï‚¡ Individuals seemed to give up current wages in
return for future wages
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Rationales:
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To enable deferred wages
As a result the expected present value of the wage stream is equal to the
expected present value of the productivity stream to the firm
Gives finality to the existing contractual arrangement
Efficient compensation rule
Opens up promotion and employment opportunities for younger workers
Creates a greater degree of certainty about the date of retirement
For employers: facilitate planning for new stuffing requirements, pension
obligations, and medical expenditures
For workers: encourages pre-retirement planning
Reduces the cost of monitoring of older workers
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Human rights issues (a form of age discrimination)
If one is able, wants to continue, and capable of
working productively, they will still not be able to do
so (efficiency-loss)
ï‚¡ Improving the viability of public and private
pensions
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Some theoretical predictions:
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Changing the age earning profile to coincide with
productivity (higher wages for younger workers and lower
wages for older workers)
Possible changes of deferred wages systems
Possible Increase in the monitoring and evaluation of
workers
Reduction in the employment opportunities for younger
workers
Reduction in training
More difficult forecasting and planning
Possible redesigning of jobs to accommodate older workers
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Agency and Efficient Wage Theories
Economics of Superstars
Salaries as Tournament Prizes
Inequality in Pay
Up-or-Out Rule: Drawbacks and Resolution
Piece Rates: Positives and Negatives
Executive Compensation
Deferred Wages: Characteristics and Rationale
Mandatory Retirement: Rationales, Impact, and
Causes
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Prepared by Dr. Amy Peng
Ryerson University
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Explain how unemployment and the unemployment rate are defined
and measured.
Explain why the measurement of unemployment is often controversial,
and describe alternative measures that can be used.
Summarize the salient features of Canada’s unemployment experience
and how it compares to those of other developed countries.
Define the labour force participation rate and the employment rate,
and explain why these measures are often used in addition to the
unemployment rate to provide a complete picture of the state of the
labour market.
Explain the meaning of the incidence and duration of unemployment
and describe how each contributes to the extent of unemployment.
Describe the dynamic nature of the Canadian labour market and explain
the implications of this feature for understanding movements in
unemployment.
© 2017 McGraw-Hill Education Ltd.
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ï‚¡
Unemployment:
 Those who are not currently employed and who indicate by
their behaviour that they want to work at the prevailing wages
and working conditions
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Labour Force Survey (LFS):
 Conducted monthly by Statistics Canada
 People categorized as unemployed if they did not work but
were actively searching for work
 People categorized as employed if they did any work for a pay
 Employed plus unemployed make the labour force
 Unemployment rate is defined as the number of unemployed
divided by the labour force
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1929: The Great Depression unemployment rate soared to 20%.
During the World War II the unemployment rate fell.
In the recession periods of 1957–58, 1974–75, and 1981–82 the
unemployment rate increased.
After a brief economic slowdown in 2001, the Canadian
economy experienced strong growth in the first part of the 21st
century. By 2006, the unemployment rate had fallen to 6.0
percent, its lowest level since the early 1970s.
The global financial crisis that began in 2008 resulted in a deep
recession in many countries. Canada’s economic downturn was
less severe but the unemployment rate rose to 8.3 percent in
2009.
Since 2009, Canada’s unemployment rate has gradually
declined.
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ï‚¡
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Unemployment rate is used to measure the
aggregate labour market activity and the degree
that the labour force is utilized
The employment and labour force participation
rates focus on the fraction of the working age
population that are employed and in the labour
force respectively
Unemployment rate measures the fraction of the
labour force that is out of work and searching for a
job
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In the 1950s, unemployment rates were higher in
the U.S than those in Australia and Japan
With the first OPEC oil shock in 1973,
unemployment rose in a few European countries
During the 1990s further increases in
unemployment took place in France, Germany, and
Italy
Since 2000, unemployment rates have remained
low in English speaking countries
The worldwide financial crisis and the associated
2008-09 recession resulted in dramatically higher
unemployment in many advanced economies.
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ï‚¡
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Individuals may be without work and yet they desire to
work but are not classified as unemployed
During recession where few jobs are available, the
phenomenon of the discouraged worker appears
Discouraged workers are not employed and yet are not
seeking work because they think that no work is
available
The number of discouraged workers increases during a
recession
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Labour Market Stocks and Flows:
ï‚¡ Flows that occur each month between the labour force
of employed, unemployed, and not in the labour force
ï‚¡ On average every month 235,000 unemployed workers
obtain jobs
ï‚¡ 190,000 workers lost or left jobs and joined the pool of
job searchers
ï‚¡ Average net monthly flow was 45,000
ï‚¡ The probability of an unemployed worker becoming
employed is 0.22
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The average net monthly flow is
235,000 – 190,000 =45,000 from U to E.
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Incidence and Duration of Unemployment:
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The incidence of unemployment: is the proportion of
individuals who become unemployed in any period
The duration of unemployment: is the length of time spent in
the unemployment state before obtaining employment or
leaving the labour force
Incidence: measures the probability of a member of the
group becoming unemployed
Duration: measures the length of time the individual can be
expected to remain unemployed
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Incidence and Duration of Unemployment:
Incidence of unemployment: measured as a fraction
of labour force
ï‚¡ Amount of unemployed is affected by both
incidence and duration
ï‚¡ UR = I (incidence) X D (duration)
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The data collected to date leads to the following conclusions:
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The labour force is highly dynamic
About half the flow into unemployment is due to individuals
losing their jobs
Even in 2010 (a time of above-normal unemployment) the
average duration of unemployment was approximately three
months, with only about one-fifth of all unemployment spells
lasting more than six months.
The age groups with highest unemployment rate have lowest
duration, but the highest incidence of unemployment
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Unemployment rate is widely used as an economic
indicator of:
Aggregate state of the economy
Tightness/Looseness of the labour market
Measure of the amount of unutilized labour supply
Increasing in periods of low or negative economic
growth
Measures the extent of hardship in an economy,
region, or time period
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Unemployment definition and measures
Canadian experience: history of events
Hidden unemployment: timing, causes, and
consequences
ï‚¡ Labour market stock and flows followed by
statistics
ï‚¡ Incidence and duration of unemployment plus
research findings
ï‚¡ Unemployment rates as a summary statistic
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Causes and Consequences
Prepared by Dr. Amy Peng
Ryerson University
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Explain how imperfect information can lead to a labour
market equilibrium in which unemployed workers and
unfilled job vacancies co-exist.
2. Discuss and assess evidence on how technological change,
especially the growing use of the Internet, is affecting job
search and the matching of unemployed workers and
unfilled job vacancies.
3. Explain how shifts in the structure of product demand can
be a source of unemployment in the labour market.
4. Summarize empirical findings on job displacement and its
consequences.
1.
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5.
6.
7.
Describe leading models of worker and employer behaviour
that give rise to employers paying above-market wages,
thus, resulting in a labour market equilibrium with
unemployed workers.
Explain the rationale for publicly provided unemployment
insurance, and the ways that unemployment insurance may
influence labour supply and unemployment.
Summarize the empirical evidence on the relationship
between unemployment insurance and labour supply and
unemployment.
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The minimum wage laws
Institutional factors such as unions or large public
sector
Demand factors
Seasonal unemployment
Frictional unemployment associated with normal
turnover of the work force
Sectoral shifts causing structural unemployment:
Time lag in finding a job
High unemployment insurance
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Search Unemployment:
ï‚¡ Job search associated with imperfect information causes
delays
ï‚¡ Job search involves costs and benefits
ï‚¡ Expected benefits have to be weighted against the expected
costs
ï‚¡ The condition of optimal search is a stopping rule: a
minimum acceptable requirements (wage, benefits, working
conditions, etc.) is chosen and the search is executed until
the job that meets the acceptable requirements is found
 More specifically…
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Employees continue to search until expected marginal
benefit equal expected marginal cost
ï‚¡ Benefits and costs of search are likely to be related to the
amount of time devoted to a job search
ï‚¡ Marginal cost is rising with the amount of job search
undertaken
ï‚¡ Optimal amount of a search will maximize the difference
between B and C (see the diagram on the next page)
ï‚¡ The difference is maximized when expected marginal
benefit equals expected marginal cost at Se (see the diagram on
ï‚¡
the next page)
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Implications of imperfect information
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Generally workers and firms will stop their search activities
prior to being fully informed due to diminishing returns to
information acquisition and also increasing costs of
information acquisition. As a result:

A labour market characterized by imperfect information
will not clear instantaneously

Dispersion of wage rates will occur even in a labour
market with homogeneous workers and jobs

Case of dynamic monopsony
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ï‚¡
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Julia just graduated from college and is
looking for a first job.
There are three types of jobs:
 The best jobs pay $2400 a month.
 “Not as good” jobs pay $2200 a month.
 The worst type of job pays $2000 a month.
 The probability of each type of job offered is one-
third.
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ï‚¡
Julia must now decide what to do once she
gets an offer
 The expected value of a future offer is $2200 a
month (average of $2000, $2200, and $2400 a
month).
 She won’t accept a job offer unless it pays at least
$2200 a month.
 2/3 is the hazard rate.
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Expected benefit of job search
Expected duration of a job
Age: younger workers’ unemployment duration is lower
ï‚¡ Institutional mechanisms of information dissemination
ï‚¡ Internet accessibility
ï‚¡ Number of employers with available job vacancies
ï‚¡ Rate at which employers offer jobs
ï‚¡ Value of leisure
ï‚¡ Social and labour market policies
ï‚¡ Employment insurance
ï‚¡ Pensions
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ï‚¡
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Use of the Internet by workers to scout for jobs and by
employers to find and select applicants has increased at
a rapid rate
Extensive empirical research on estimating formal
models of search behaviour
The dramatic growth in the use of online methods to
advertise and search for jobs has also attracted research
interest.
Technological advances is likely to improve the search
and matching process.
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Unemployment would increase in periods of major
structural adjustment
High employment growth across industries is associated
with periods of high unemployment
Some industries are more cyclically sensitive than
others
Economic shocks have more severe consequences for
unemployment
Economic dislocation causes displacement of older and
less educated workers
Unemployed workers relocate due to regional sectoral
shifts in Canada
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Earnings losses from permanent job loss are very
large for workers with prior stable labour force
attachment.
ï‚¡ A major part of the earnings loss arises from reemployment at wages substantially below their predisplacement levels.
ï‚¡ These substantial losses appear to be long lasting.
ï‚¡ Older displaced workers are less likely to become reemployed than their younger counterparts.
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Alternative approaches
ï‚¡ Implicit Contracts
ï‚¡ Efficiency Wages
ï‚¡ Insider-Outsider Theories
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Deals with issues that arise when firms and workers are
engaged in a continuing employment relationship
Seeks to explain phenomena such as rigid wages and
the use of quantity adjustments
Based on the view that employment behaviour reflects
risk-sharing between employers and employees
Difference in attitudes toward risk between employers
and employees provide the basis for both parties to
benefit from a risk sharing arrangement
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ï‚¡

Reasons for workers being more risk-averse than
employers:
1. The main workers assets—human capital—not
diversifiable (to reduce risk)
2. Sorting according to innate risk preferences
â–ª
â–ª
Entrepreneurs are mostly risk-neutral and risk-lovers
Employees (wage earners) are mostly risk-averse
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Other related issues:
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Moral Hazard
 Individuals can influence the risk against which
they are insured
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Adverse Selection
 Insurer cannot observe the risk that a particular
insuree presents
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The firms provide insurance only to its own
employees, thus avoiding adverse selection
problem
ï‚¡ The firm controls the probability of income loss due
to layoff or wage/hour reduction, thus avoiding the
moral hazard problem
ï‚¡ Implicit contract theory applies to situations in
which there is a long-term attachment between the
firm and its workers
ï‚¡ Symmetric vs. asymmetric information
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ï‚¡
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Base case without implicit contracts
N0 workers attached to the firm and the value of
leisure is k
Supply is perfectly elastic
In the good state N0 workers are employed, earning
Wa
In the bad state, Nb workers are employed, earning
Wb
Earning variability is reduced with implicit contracts
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In the good state, employment will be at N0
at a wage of W*
In the bad state, employment will be higher
at Nb* and wages at W*
For workers it represents reduction in the risk
Firms are paying lower wages
Firms and workers are better off with risksharing
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Contract provides a rigid wage, independent of the
state that is realized
Layoffs may occur in weak states of demand
The contract wage W* is lower than the market
clearing wage in the good state
Both parties benefit from a risk sharing
arrangement
Optimal contact reduces income uncertainty
The contract represents tradeoff between risk
sharing and production efficiency
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Firms choosing to pay wages above market clearing
level
Enhance worker productivity
Improve worker morale
Discourage shrinking and absenteeism
Reduce turnover
Discourage unionization
Workers who eat better work harder
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Output of rice is given by Q = F(eL)
Efficiency, e, depends on wage paid e =e(W)
Firm’s profit is given by
Π = (F(eL) x L) – WL = g(W; L) – WL
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If the firm reduces labour costs by paying a
lower wage, these labour savings may be
offset by a drop in labour productivity, so that
the lower wage actually reduces profits.
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 Productivity increases only slowly at first when
wage is increasing
 Only when workers reach a certain threshold, we
see an increase in efficiency
 Diminishing returns take over
 Higher wages beyond some point will have a
small impact on productivity
 Firm maximizing profits (minimizing costs) at
Q/W
 Optimum occurs at W* at the tangency where
profits are maximized
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Another explanation of wage inflexibility and unemployment
Persistent unemployment typically focuses on the wage
determination process—wages may not adjust quickly to
eliminate excess supply of labour
ï‚¡ Wage setting is determined by bargaining between the
employer and its existing work force (the “insider”)
 The unemployed (the “outsider”) has little influence on the
outcome
 It’s costly to the firm to replace some of the existing workers
 Increased bargaining power of the “insider” to raise wages,
given the excess supply of labour, the “outsider”
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Economic Rationale for UI:
ï‚¡ UI: provide workers with protection against
the risk of income loss due to unemployment
ï‚¡ Affects the incidence and duration of
unemployment by altering the incentives
facing workers and firms
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The effect of unemployment insurance on the incidence
and duration of unemployment:
UI affects the incidence and duration of search by
altering the costs and benefits of the job search
For the employed, the increase in benefit rate makes
the job search more attractive, hence increasing the
incidence of unemployment
For the unemployed, more generous UI lowers the costs
of a job search, increasing the duration of job search
and, hence increasing the unemployment rate
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The effect of unemployment insurance on the
incidence and duration of unemployment:
More generous UI decreases the weeks worked
Higher benefits could also alter the behaviour of
those who are not eligible for UI by accepting jobs
quickly in order to qualify for subsequent UI benefits
The impact on the labour force participation
Repeated users
Regional extended benefits
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Canada’s UI system was established in 1940
Dramatic changes to these key features of
the UI act were made in 1971–1972.
In 1996, the Unemployment Insurance
program was renamed Employment
Insurance (EI), and several key parameters
were changed. And further refinement was
made in 2000.
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Some features of the current EI program
 55 percent replacement rate for all beneficiaries
 Individuals working 15 or 50 hours per week
accumulated the same credit toward UI eligibility
 The EI program currently distinguishes among
three types of claimants:
â–ª Frequent claimants
â–ª Long-tenured workers
â–ª Occasional claimants (all others).
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For the unemployed who are eligible for benefits ,
UI has both a moral hazard effect and a liquidity
constraint effect.
UI benefits lengthen unemployment spells.
UI benefits and durations may depend on prior work
experience.
When UI benefits are exhausted, there is often a
“spike” in the probability of leaving unemployment.
UI affects job search behaviour.
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Income-Leisure Model Predictions
Empirical research evidences
 A more generous EI benefit structure is to
increase unemployment.
â–ª
â–ª
â–ª
â–ª
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Kuhn and Riddell (2010)
Repeat use of UI
The regional extended benefit structure
The 1996 changes of UI program
Optimal EI design must strike a balance
between these social costs and benefits.
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Causes and consequences of unemployment
Optimal search and the factors
Sectoral shifts, unemployment, and institutional
rigidities
Displaced workers
Implicit contracts and their features
Efficiency wages and influences
UI rationale and its effects on unemployment
The effect of unemployment insurance on labour
supply
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