Near rationality in wage setting

This study argues that it is interesting to examine near rational behaviour in the context of an efficiency wage model, where there are positive if decreasing returns to increasing the wage beyond the efficient level. Previous research has found it difficult to distinguish between efficiency wage and bargaining models, which have similar empirical predictions. But unions are a priori more likely to develop in environments in which the technology favours efficiency wage payments. This makes it interesting to investigate what it costs the firm to deviate from the efficiency wage. If it does not cost a lot, firms may give in to union demands. This study derives expressions for the wage deviation and for the associated profit loss. For illustrative purposes, these are calibrated for UK, US and Indian manufacturing, taking a plausible parameterization of the effort-wage function and using available estimates of the wage and employment elasticities of output. While there is evidence of positive effort returns to wages in the UK and India, the results are consistent with wage bargaining pushing the wage above the efficient level. The associated profit loss is considerably larger in the UK than in India. In contrast, US firms pay wages that are insignificantly different from the efficiency wage.