Fehr and Falk Wage Rigidity in a Competitive Incomplete Contract Market

1. Fehr and FalkWage Rigidity in a Competitive Incomplete Contract Market Economics 328 Spring 2005

2. 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”

3. Research Question • Standard economic models predict that firms should reduce their worker’s wages when there is unemployment. • There exist numerous survey studies that firms do not cut wages in the face of unemployment. • Firms don’t take advantage of underbidding – offers by unemployed workers to work for less than the firm’s 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?

4. 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

5. 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 firm’s payoff function is the following. Note that this isn’t a standard wage equation. This functional form is used to rule out losses. π = (120 – w)e • The worker’s 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

6. 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 employer’s payoff is (120 – w) and the employee’s 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.

7. 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.

8. 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.

9. Experimental Results • Justifying firm’s 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.

10. Experimental Results • Just because there is a positive relationship between wages and effort doesn’t 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.

11. 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 firm’s profit function which forces the experimenter to run a new set of control sessions.

12. 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.

13. 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.