Productivity, Incentives and Relative Wages

Abstract

The relation between productivity and relative wages is in many ways crucial as to the functioning of the labour market and the wage bargaining system. This is addressed from three angles in the paper. We first present data, which show that there has been a regulation in the Finnish labour market with respect to low-wage employees and low-productivity workers and industries so that the relative wage there clearly exceeds the respective relative productivity. Then, a model is built, which analyses the effects of this kind of regulation and its alleviation in the labour market. The outcome is that such a regulation of the non-skilled sector of the labour market hurts the skilled labour in the form of a lower wage. The possibility to compensate the losers by means of the winners of a deregulation of this type of wage formation is then evaluated. Next, an extended model incorporating efficiency wages, but now with two components of labour, is presented, where the effort of an employee is endogenous and depends on the relative wage rate. This model explains the empirical fact that the relative wages tend to remain unchanged, even though there is a regulation raising the low wages. Finally, we briefly discuss the lesson given by the optimal contract theory on relative wages and their link to productivity.