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Mathematics & Economics
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Efficiency Wage Model: Background of the Efficiency Wage Model (Essay Sample)


The topic should be Efficiency wage.
Theory Paper: 200 points
You will choose one of the six tutorial topics (Efficiency Wages, Optimal Monetary Policy, Neoclassical Model, Adaptive Expectations/Rational Expectations, Solow Model, or Endogenous Growth Model) and write a four-five page paper that covers the primary components of the model. The paper should cover two main sections. The first section should describe how the model works, how solutions are derived, and the background of the model. The second section should be an application. You will find this part by going to the economics literature and looking at how these models are used in research. You only need to include one application. Please be very careful to cite appropriately.


Efficiency Wage Model
Background of the Efficiency Wage Model
The idea that as unemployment increases the wage decreases does not always hold as is the case with efficiency wages. The efficiency wage model highlights that increasing wages can result in improved productivity (Wu and Ho 36). This implies that firms may recoup the higher wage costs sine there is increased retention and improved labor productivity. The efficiency wage models that focus on monitoring workers highlight that paying higher salaries make slacking a more expensive action, because if caught shirking there is loss of salary.
The simplified models of efficiency wages highlight that a worker can choose the level of effort he or she wants to develop, which directly affects their productivity. The worker’s effort is influenced by the salary they receive. The company does not perfectly observe the degree of compliance of each worker because of asymmetric information. Thus, the firm must incentivize the worker's effort, offering a salary higher than what it would offer to encourage their effort, while a wage cut can lead to a decrease in productivity, and an increase in the unit cost of production. The level effort grows more than proportionately for low wages, and the opposite occurs for higher wages, mostly because a salary increase offers fewer incentives to put effort.
Assuming there are two actors the workers and the firms, workers can be employed and doing their job, unemployed, or employed but shirking or slacking. Workers seek to maximize utilities and firms maximize profits. When workers are shirking they are unproductive, while utility is the difference between the wages and effort. The point at which the cost per effective unit of work is minimal and the company maximizes profits by minimizing the cost per effective work unit is the preferred position
Shapiro and Stiglitz Model – efficiency wages
An important generalization of the efficiency wage model is developed by Shapiro and Stiglitz (1984) is that wages fluctuate within the economic cycle, whereby efficiency wages are allowed to vary. The basis of Shapiro and Stiglitz's model (1984) is the firms monitor efforts, albeit imperfectly (Wu, and Ho 36). Thus, the wages should be such that the effort that workers apply is consistent with the possibility that they may be detected in the absence of their obligation. The firms monitor their employees’ efforts, and when they detect a worker who is slacking and not doing well they get fired. The workers, for their part, they must decide how much effort they apply and this will depend on the salary, monitoring and labor market conditions (Navarra and Tortia 714). When there is a high unemployment, the risk to the employee of applying little effort is high, and as the unemployment falls, it will be more difficult to incentivize the workers’ effort.
The main assumptions of the Shapiro and Stiglitz Model are that there are: large number of firms, large number of workers, and the workers maximize their expected utility, and the model is studied on continuous time, focusing on the steady state results. The problem of consumers and behavior of the firm are considered in analyzing the model.
There are other key elements of the model as it is as

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