Questions: Wage Setting and Labor Market Equilibrium

Question 1

A manufacturing firm pays its workers 20% above the market-clearing wage, even though many unemployed workers would accept jobs at the lower market rate. What is the most likely economic explanation?

• A. The firm is legally required by sectoral wage agreements or minimum wage laws
• B. The firm pays efficiency wages: the higher wage raises worker productivity (reducing shirking and turnover) enough to offset the higher cost
• C. The firm faces a monopsony labor market and must pay above-market wages to attract workers from a distant competitor
• D. Workers have unionized and successfully extracted rents from the firm through collective bargaining

Answer: (B)

Efficiency wage theory explains why profit-maximizing firms voluntarily pay above market-clearing wages. Higher wages reduce shirking (workers fear losing a premium wage they cannot find elsewhere), reduce costly turnover, and attract higher-quality applicants. If these productivity gains outweigh the higher wage cost, the firm maximizes profit by paying above-market. Crucially, this creates equilibrium unemployment: the firm does not lower wages to hire the unemployed workers even though those workers would accept lower pay, because doing so would harm productivity. The unemployment is the side effect of the firm's profit-maximizing choice.

Question 2

When the actual unemployment rate falls well below the NAIRU, what does wage-setting theory predict will happen next?

• A. Real wages remain stable because firms have pricing power that offsets workers' stronger bargaining position
• B. Nominal wages accelerate because workers' outside options improve, strengthening their bargaining power and pushing wages above what the price-setting curve can sustain without inflation
• C. Firms substitute capital for labor, reducing employment back to the NAIRU without any change in wages or prices
• D. The price-setting curve shifts upward to accommodate higher wages, maintaining equilibrium without inflation

Answer: (B)

When unemployment falls below the NAIRU, workers' bargaining position strengthens — they can threaten to leave and find work quickly. This tilts the wage-setting curve outcome toward higher wages. If wages rise above the level consistent with the price-setting curve (firms' markup over costs), firms raise prices to protect margins, which reduces real wages and triggers further nominal wage demands — the wage-price spiral. This is why the NAIRU is the rate at which inflation is stable: below it, wages push above the sustainable level and inflation accelerates.

Question 3

Unemployment can persist in macroeconomic equilibrium even without minimum wage laws or union contracts, as a result of firms' voluntary wage-setting decisions.

• T. True
• F. False

Answer: True

Efficiency wage theory demonstrates exactly this: a firm maximizing profits may choose to pay above market-clearing wages to raise worker productivity. This creates a surplus of labor (workers who want jobs at that wage but can't find them) as an equilibrium outcome — not a disequilibrium to be corrected. The unemployment is intentional and sustained: firms don't cut wages to hire the unemployed because doing so would reduce the productivity benefits. This is one reason the labor market clears differently than a goods market, where excess supply typically drives prices down to equilibrium.

Question 4

In the insider-outsider model, persistently high unemployment eventually resolves because firms eventually replace expensive insiders with the unemployed outsiders who are willing to work for lower wages.

• T. True
• F. False

Answer: False

The insider-outsider model predicts persistent wage rigidity precisely because outsiders are not perfect substitutes for insiders. Insiders have firm-specific skills and, crucially, can credibly threaten to withdraw cooperation during new worker training — making replacement costly. Insiders bargain to maintain wages that exclude outsiders from employment, and since insiders bear no cost from outsider unemployment, they have no incentive to accept wage cuts. This creates hysteresis: a period of high unemployment (say, from a recession) can permanently raise the NAIRU because insiders entrench high wages that prevent the unemployed from rejoining the workforce.

Question 5

Explain why unemployment serves a 'disciplinary function' in the efficiency wage model, and what would happen to worker effort and wages if unemployment fell to zero.

Model answer: In the efficiency wage model, workers are tempted to shirk because effort is costly and monitoring is imperfect. The threat of job loss disciplines this: if unemployed workers abound and wages are above market-clearing, losing a job is genuinely costly — the worker faces a spell of unemployment before finding another position, likely at a lower wage. The larger the unemployment pool and the higher the efficiency wage premium, the more costly job loss becomes, and the harder workers work to avoid it. If unemployment fell to zero, job loss would carry no penalty — a fired worker could immediately find equivalent work elsewhere. The disciplinary threat would evaporate, and firms would need to either accept lower productivity, increase costly monitoring, or raise wages further to restore the deterrent — potentially triggering an inflationary wage spiral.

This is why efficiency wage models predict a stable, non-zero equilibrium unemployment rate: too low and the discipline effect collapses, too high and the premium needed to retain workers becomes unsustainable.