Efficiency Wages, Interfirm Comparison, and Unemployment

Abstract

The paper presents an efficiency wage model where worker effort depends on own wages relative both to wages of other workers in the firm and to similar workers in other firms. First, we show how the Solow conditions are modified if internal comparison effects are at work. Second, we discuss the effect of internal wage comparison on wage inequality within firms. Third, we study unemployment and relative wage determination within a general equilibrium model, and analyze the effect of technological change and various tax policies on equilibrium unemployment and relative wages. Finally, the short-run effects of aggregate demand shocks are analyzed. A popular argument for the existence of involuntary unemployment is that a worker's effort rises with wages, giving employers incentives to set wages above market clearing levels. It is often assumed that the worker's effort is a function of the wage level, with no reference to the size of the wage in comparison with that received by other workers. Yet, such comparisons are likely to influence an individual in his effort choice. If this is the case, then it seems equally likely that workers compare themselves with others, both internal and external to their place of work. This paper contributes to the efficiency wage literature by providing an understanding of wage setting and unemployment determination within a model where workers' efforts depend on their wage relative to both the wages of other workers at the same firm and to the wages of similar workers at other firms.