Labor Subsidies and Just-Cause Employment Laws in an Efficiency Wage Model

Abstract

Efficiency wage models differ from standard labor market models in that wages do not necessarily clear markets. Wages act as devices to encourage work effort or, more generally, to increase productivity. Firms set their wages above the market clearing level and there is involuntary unemployment. There are several reasons firms set wages high. One is that this may increase employee morale and so lead to greater effort, as observed by Solow [12]. Salop notes that high wages may reduce labor turnover and so allow the firms to avoid turnover costs [10]. High wages may also reduce the workers' incentive to shirk on the job if shirking increases the chance of losing an attractive position; see Shapiro and Stiglitz [11].' Akerlof and Yellen give examples of other motivations for efficiency wages [1]. This article uses a shirking model to discuss optimal government policies. Economists have placed little emphasis on government policies in such models. Shapiro and Stiglitz do discuss employment subsidies and unemployment benefits [11].2 An employment subsidy or a reduction in unemployment compensation increases employment. In their basic model, as in most shirking models, a suboptimal employment level is the main distortion. So the two policies can increase efficiency.3 If firms choose minimum acceptable effort levels to ask of their workers, as in this paper, there is a second distortion. Both the employment and the effort levels are too low to be optimal. Employment subsidies still lead to greater employment but also lead to a reduction in effort. These policies reduce one distortion while making the other more severe. The net effect on efficiency is ambiguous. Section II presents the model. Section III considers the welfare effects of unemployment compensation, two subsidies, and just-cause employment laws. These two subsidies are wagerate subsidies (paid based on the total wage bill) and employment subsidies (paid per worker