At work

Unit 6 The firm: Employees, managers, and owners

Introduction

In March 2000, Terri Lawrence was driving her 1996 Ford Explorer SUV near Fort Lauderdale, Florida. ‘All of a sudden, she said, ‘there was this explosion’. One of her tyres had blown out. The Ford Explorer flipped over, and she was badly injured. By the summer of 2000, with similar reports of blowouts and overturned Explorers accumulating, Ford convened a ‘war room’ to deal with the public relations catastrophe. They quickly determined that the Firestone tyres used on most Explorers were at fault. There were no unusual reports of blowouts on Explorers with Goodyear tyres.

In August 2000, in partnership with Ford, Firestone recalled 14.4 million tyres. According to the US National Highway Traffic and Safety Administration, blowouts of the Firestone tyres in question had resulted in crashes that took 271 lives. In the four months following the recall, the market value of Firestone shares on the stock exchange dropped by $9.2 billion, to less than half of their value before the crisis. But the cause of the spate of fatal blowouts remained a mystery.

High-speed stress tests confirmed that there was nothing wrong with the design of the tyres. An inconspicuous clue, however, pointed to ‘the scene of the crime’, if not its motive. On the sidewall of each of the blown-out tyres was a ten-digit tyre code, indicating the particular plant that had produced the tyre and the week of its production. Most of the faulty tyres had been produced at just one of Firestone’s six plants, located in Decatur, Illinois.

For years, the Firestone Decatur plant had been in the news for other reasons. In 1994, the company had imposed a 12-hour shift that rotated between night and day for each worker, replacing the historic 8-hour shift. New hires’ wages were reduced by 30%; vacations for more senior workers were cut by two weeks. On 12 July 1994, the United Rubber Workers union that represented the employees called a strike. The firm immediately hired 2,300 replacement workers, paying them 30% less than wages previously paid. Ten months later, the union called off the strike; returning workers accepted substantial pay cuts, a freeze in their pension benefits, and the 12-hour shifts. Bitterness toward the company and protests continued.

Building tyres at the time was a labour-intensive and skilled occupation. A number of the union workers blamed lack of training and experience among the replacement workers for the tyre blowouts. William Newton, a senior tyre builder in Decatur, reported that he ‘saw a lot of people [working as replacements] who did not know how to build tyres’. But investigators looking at the detailed records of exactly when the faulty tyres were produced were in for a shock—virtually none of them had been produced during the strike, when Firestone was employing the replacement workers. Most of the faulty tyres had been produced by experienced union workers, both before the strike—when Firestone’s pay cuts, 12-hour shift, and other new demands had been announced—and after the defeat of the strike, when the union workers returned.

While it cannot be proven, it seems likely that the permanent workers at the Decatur plant had retaliated against Firestone, devoting less effort to producing safe tyres, or even deliberately sabotaging production. The owners of Firestone discovered that they could indeed impose a 12-hour shift and a 30% pay cut, but they could not ensure that safe tyres would be produced if their employees were angry as a result.

Firestone and Ford are business organizations called firms. Not everyone is employed in a firm. For example, many farmers, carpenters, software developers, and personal trainers work independently, as neither employee nor employer. While some people work for governments and not-for-profit organizations, the majority of people in high-income countries make their living by working in a firm.

Firms are major actors in the economy; we will use this and the next unit to explain how they work. A firm is often referred to as if it were a person—we talk about ‘the price Firestone charges’.

But, while firms are actors—and in some legal systems are treated as if they were individuals—firms are also the stages on which the people who make up the firm act out their sometimes common, but sometimes competing, interests.

The people making up the firm—owners, managers, and employees—are united in their common interest in the firm’s success because all of them would suffer if it were to fail. However, they have conflicting interests about how to distribute the profits from the firm’s success among themselves (wages, managerial salaries, and owners’ profits); they may also disagree about policies (such as conditions of work and managerial perks) and who makes the key decisions (such as whether it was a good idea to impose a 12-hour shift on the Firestone workers in Decatur and cut their vacation times).

To understand the firm, we will model how employers set wages and how employees respond. We have already seen, in earlier units, the importance of work and firms in the economy:

In this unit, we study how the coordination of labour takes place within firms in the modern capitalist economy. We model how wages are determined when there are conflicts of interest between employers and employees, and look at what this means for the sharing of the mutual gains that arise in a firm.

In Unit 7, we will look at the firm as an actor in its relationship with other firms and with its customers.

6.1 Firms, markets, and the division of labour

The economy is made up of people doing different things, for example producing Apple iPhones or making clothing for export. Producing smartphones involves many distinct tasks, done by different employees within the companies that make components for Apple—Toshiba or Sharp in Japan, or Infineon in Germany.

division of labour
The specialization of producers to carry out different tasks in the production process. Also known as: specialization.
firm
A business organization which pays wages and salaries to employ people, and purchases inputs, to produce and market goods and services with the intention of making a profit.

Setting aside the work done in families, in a capitalist economy, the division of labour is coordinated in two major ways—firms and markets.

Among the institutions of modern capitalist economies, the firm rivals the government in importance. John Micklethwait and Adrian Wooldridge explain how this happened.

John Micklethwait and Adrian Wooldridge. 2003. The Company: A Short History of a Revolutionary Idea. New York, NY: Modern Library.

Why do firms work the way they do? For example, why do the owners of the firm hire the workers, rather than the other way around? Randall Kroszner and Louis Putterman summarize this field of economics.

Randall S. Kroszner and Louis Putterman (editors). 2009. The Economic Nature of the Firm: A Reader. Cambridge: Cambridge University Press.

In this unit, we study firms. In the units to follow, we study markets. Herbert Simon, an economist, used the view from Mars to explain why it is important to study both.

Great economists Herbert Simon

Herbert Simon

Trained as a political scientist, Simon’s desire to understand society led him to study both institutions and the human mind—to open the ‘black box’ of motivations that economists had come to take for granted. Herbert ‘Herb’ Simon (1916–2001) was celebrated in the disciplines of computer science, psychology, and, of course, economics, for which he won the Nobel Prize in 1978.

Imagine a visitor approaching Earth from Mars, Simon urged his readers. Looking at Earth through a telescope that revealed social structure, what would our visitor see? Companies might appear as green fields, he suggested, divisions and departments as faint contours within. Connecting these fields, red lines of buying and selling. Within these fields, blue lines of authority, connecting boss and employee, foreman and assembly worker, mentor and mentee.

Traditionally, economists had focused on the market and the competitive setting of prices. But to a visitor from Mars, Simon suggested:

Organizations would be the dominant feature of the landscape. A message sent back home, describing the scene, would speak of ‘large green areas interconnected by red lines.’ It would not likely speak of ‘a network of red lines connecting green spots’.1

A firm, he pointed out, is not simply an agent, shifting to match supply and demand. It is composed of individuals, whose needs and desires might conflict. Simon asked: In what ways could these differences be resolved? When would an individual shift from contract work (a ‘sale’ of a particular, predefined task) to an employment relation? An employment relation where a boss dictates the task after the sale is the relationship at the heart of a firm.

When the desired task is easy to specify in a contract, Simon explained that we could view this as simply work-for-hire. But high uncertainty (the employer not knowing in advance what needs to be done) would make it impossible to specify in a contract what the worker was to do and, in this case, the result would be an employer–employee relation that is characteristic of the firm.2

This early work showcased two of Simon’s lasting interests—the complexity of economic relations, where one might sell an obligation that was incompletely described, and the role of uncertainty in changing the nature of decision making. His argument demonstrated the emergence of the ‘boss’.

Understanding how contract work turns into employment helps us understand a particular relationship between two members of an organization. We have yet to explain the firm as a whole—the Martian’s green fields.

For Simon, the study of markets needed to be supplemented—even supplanted—by institutions and governments better equipped to handle uncertainty and rapid change. These alternative ‘authority mechanisms’ draw on partially understood aspects of the human psyche: loyalty, group identification, and creative satisfaction.

By the time of his death in 2001, Simon had seen many of his ideas reach the mainstream. Behavioural economics has roots in his attempts to build economic theories that reflect empirical data. Simon’s view from Mars shows that economics could not be a self-contained science; an economist needs to be both a mathematician—working with decision sets and utilities—and a social psychologist—reasoning about the motivations of human relationships.

The coordination of work

The way that labour is coordinated within firms is different to coordination through markets:

The prices that motivate and constrain people’s actions in a market are the result of the actions of thousands or millions of individuals, not a decision by someone in authority. Although the government can tax and regulate private property, the idea of private property specifically limits the things a government or anyone else can do with your possessions.

These two books describe the property rights, authority structures, and market interactions that characterize the modern capitalist firm.

  • Henry Hansmann. 2000. The Ownership of Enterprise. Cambridge, MA: Belknap Press.
  • Oliver E. Williamson. 1985. The Economic Institutions of Capitalism. New York, NY: Collier Macmillan.

In a firm, by contrast, owners or their managers direct the activities of their employees, who may number in the thousands or even millions. The managers of Walmart, the world’s largest retailer, decide on the activities of 2.2 million employees, a larger number of people than any army in world history before the nineteenth century. Walmart is an exceptionally large firm, but it is not exceptional in that it brings together a large number of people who work in a way coordinated (by the management) to make profits.

Like any organization, firms have a decision-making process and ways of imposing their decisions on the people in it. When we say that ‘Fiat outsourced its component production’ or ‘the firm sets a price of €11,200’, we mean that the decision-making process in the firm resulted in these actions.

Figure 6.1 shows a simplified picture of the firm’s actors and decision-making structure.

The firm’s actors and its decision-making and information structures.

Figure 6.1 The firm’s actors and its decision-making and information structures.

Owners decide long-term strategies

The owners, through their board of directors, decide the long-term strategies of the firm concerning how, what, and where to produce. They then direct the manager(s) to implement these decisions.

Figure 6.1a The owners, through their board of directors, decide the long-term strategies of the firm concerning how, what, and where to produce. They then direct the manager(s) to implement these decisions.

Managers assign workers

Each manager assigns workers to the tasks required for these decisions to be implemented and attempts to ensure that the assignments are carried out.

Figure 6.1b Each manager assigns workers to the tasks required for these decisions to be implemented and attempts to ensure that the assignments are carried out.

Flows of information

The green arrows represent flows of information. The upward green arrows are dashed lines because workers often know things that managers do not, and managers often know things that owners do not.

Figure 6.1c The green arrows represent flows of information. The upward green arrows are dashed lines because workers often know things that managers do not, and managers often know things that owners do not.

asymmetric information
Information that is relevant to the parties in an economic interaction, but is known by some but not by others. See also: adverse selection, moral hazard.

The dashed upward green arrows represent a problem of asymmetric information between levels in the firm’s hierarchy (owners and managers, managers and workers). Since owners or managers do not always know what their subordinates know or do, not all of their directions or commands (grey downward arrows) are necessarily carried out.

This relationship between the firm and its employees contrasts with the firm’s relationship with its customers, which we study in the next unit. The bakery firm cannot text its customers to tell them to ‘Show up at 8 a.m. and purchase two loaves of bread at the price of €1 each’. The firm could tempt its customers with a special offer, but unlike the relationship with its employees, it cannot require them to show up. When you buy or sell something, it is generally voluntary. In buying or selling, you respond to prices, not orders. The firm is different; it is defined by having a decision-making structure in which some people have power over others.

6.2 Power relations within the firm

Karl Marx, a philosopher and political theorist in the nineteenth century, was also interested in the power relations in a firm. He concluded that conflict between employers and workers was inevitable. Buying and selling goods in an open market is a transaction between equals—nobody is in a position to order anyone else to buy or sell. In the labour market, in which owners of capital are buyers and workers are the sellers, the appearance of freedom and equality was, to Marx, an illusion.

He reasoned that employers did not buy the employees’ work, because this cannot be purchased. Instead, the wage allowed the employer to rent the worker and to command workers inside the firm. Workers were not inclined to disobey because they might lose their jobs and join the ‘reserve army’ of the unemployed (the phrase that Marx used in his 1867 work, Capital). Marx thought that the power wielded by employers over workers was a core defect of capitalism.

Capital, Marx’s most famous work, is long and covers many subjects, but you can use a searchable archive to find the passages you need.

Karl Marx. (1867) 1906. Capital: A Critique of Political Economy. New York, NY: Random House.

Great economists Karl Marx

John Mayall, public domain, via Wikimedia Commons

Adam Smith, writing at the birth of capitalism in the eighteenth century, was to become its most famous advocate. Karl Marx (1818–1883), who watched capitalism mature in the industrial towns of England, was to become its most famous critic.

Born in Prussia (now part of Germany), he distinguished himself only by his rebelliousness as a student at a Jesuit high school. In 1842, he became a writer and editor for the Rheinische Zeitung, a liberal newspaper, which was later closed by the government. After this, he moved to Paris and met Friedrich Engels, with whom he collaborated in writing The Communist Manifesto (1848). Marx then moved to London in 1849. At first, Marx and his wife Jenny lived in poverty. He earned money by writing about political events in Europe for the New York Tribune.

Marx saw capitalism as just the latest in a succession of economic arrangements in which people have lived since prehistory. Inequality was not unique to capitalism, he observed—slavery, feudalism, and most other economic systems had shared this feature—but capitalism also generated perpetual change and growth in output.3

He was the first economist to understand why the capitalist economy was the most dynamic in human history. Perpetual change arose, Marx observed, because capitalists could survive only by introducing new technologies and products, finding ways of lowering costs, and by reinvesting their profits into businesses that would perpetually grow.

Marx also had influential views on history, politics, and sociology. He thought that history was decisively shaped by the interactions between scarcity, technological progress, and economic institutions, and that political conflicts arose from conflicts about the distribution of income and the organization of these institutions. He thought that capitalism, by organizing production and allocation in anonymous markets, created atomized individuals instead of integrated communities.

In recent years, economists have returned to themes in Marx’s work to help explain economic crises. These themes include the firm as an arena of conflict and of the exercise of power (this unit), the role of technological progress (Unit 1), and the problems created by inequality (Unit 5).

The writer George Bernard Shaw (1856–1950) joked that ‘if all economists were laid end to end, they would not reach a conclusion.’

This is funny, but not entirely true.

Read the ‘When economists agree’ box to see how Marx and Chicago economist, Ronald Coase—two economists from different centuries and political orientations—came up with similar ways of understanding the power relations between employers and their employees.

When economists agree Coase and Marx on the firm and its employees

In the nineteenth century, Marx had contrasted the way that buyers and sellers interact on a market, voluntarily engaging in trade, with how the firm is organized as a top–down structure, one in which employers issue orders and workers follow them. He called markets ‘a very Eden of the innate rights of man’, but described firms as ‘exploit[ing] labour-power to the greatest possible extent.’

When Ronald Coase died in 2013, he was described by Forbes magazine as ‘the greatest of the many great University of Chicago economists’. The motto of Forbes is ‘The capitalist tool’, and the University of Chicago has a reputation as the centre of conservative economic thinking.

Yet, like Marx, Coase stressed the central role of authority in the firm’s contractual relations:

Note the character of the contract into which an [employee] enters that is employed within a firm … for certain remuneration [the employee] agrees to obey the directions of the entrepreneur.4

Coase founded the study of the firm as both a stage and an actor. In The Nature of the Firm he wrote:

If a workman moves from department Y to department X, he does not go because of a change in relative prices but because he is ordered to do so … the distinguishing mark of the firm is the suppression of the price mechanism.5

Coase sought to understand why firms exist at all, quoting his contemporary D. H. Robertson’s description of them as ‘islands of conscious power in this ocean of unconscious cooperation’.6

Coase pointed out that the firm in a capitalist economy is a miniature, privately owned, centrally planned economy. Its top–down decision-making structure resembles the centralized direction of production in entire economies that took place in many Communist countries (and in the US and the UK during the Second World War).7

Both Marx and Coase based their thinking on careful empirical observation, and they arrived at a similar understanding of the hierarchy of the firm. They disagreed, however, on the consequences of what they observed—Coase thought that the hierarchy of the firm was a cost-reducing way to do business; Marx thought that the coercive authority of the boss over the worker limited the employee’s freedom. Over this, they disagreed. But they also advanced economics with a common idea.

How economists learn from data Managers exert power

These three investigations, published as books, show the effect of the power that managers and owners exert.

  • In Nickel and Dimed: On (Not) Getting By in America, Barbara Ehrenreich worked undercover for minimum wage in motels and restaurants to see how America’s poor live.8
  • In Hard Work: Life in Low-pay Britain, Polly Toynbee, a British journalist, had previously done the same in the UK in 2003, taking jobs such as call centre employee and home care worker.9
  • In Labor and Monopoly Capital: The Degradation of Work in the Twentieth Century, Harry Braverman and Paul Sweezy provide a history of what they call the ‘deskilling’ process, and suggest how dumbing down jobs is a strategy for maximizing the employer’s profits.10

Contracts and relationships

contract
A legal document or understanding that specifies a set of actions that parties to the contract must undertake.

The difference between market interactions and relationships within firms is clear when we consider the differing kinds of written and unwritten contracts that form the basis of exchange.

A sale contract for a car transfers ownership, meaning that the new owner can now use the car and exclude others from its use. A rental contract on an apartment does not transfer ownership of the apartment (which would include the right to sell it); instead it gives the tenant a limited set of rights over the apartment, including the right to exclude others (including the landlord) from its use.

wage labour
A system in which producers are paid for the time they work for their employers.

Under a wage labour contract, an employee gives the employer the right to direct him or her to be at work at specific times, and to accept the authority of the employer over the use of his or her time while at work.

The employer does not own the employee as a result of this contract. If the employer did, the employee would be called a slave. We might say that the employer has ‘rented’ the employee for part of the day. To summarize:

Exercise 6.1 The structure of an organization

In Figure 6.1, we showed the actors and decision-making structure of a typical firm.

  1. How might the actors and decision-making structure of three organizations, Google, Wikipedia, and a family farm compare with this?
  2. Draw an organizational structure chart in the style of Figure 6.1 to represent each of these entities.

Question 6.1 Choose the correct answer(s)

Which of the following statements are true?

  • A labour contract transfers ownership of the employee from the employee to the employer.
  • According to Herbert Simon, a visitor approaching Earth from Mars with a telescope that reveals social structure would see a network of red lines (market exchanges) connecting green spots (firms and consumers).
  • In a labour contract, one side of the contract has the power to issue orders to the other side, but this power is absent from a sale contract.
  • A firm is a structure that involves decentralization of power to the employees.
  • That would be slavery. A labour contract grants the firm the authority to direct the activities of the employee during specific times.
  • Herbert Simon reported the converse—highlighting the importance of the firms (green) and the lines of authority within them, rather than the exchange activities of buying and selling.
  • A labour contract gives the employer the authority to direct the activities of the employee, whereas a sale contract transfers property rights and does not bind the parties to further actions.
  • Firms represent a concentration of economic power in the hands of the owners and managers.

6.3 Other people’s money: The separation of ownership and control

The firm’s profits legally belong to the people who own the firm’s assets, including its capital goods. The firm’s owners direct the other members of the firm to take actions that contribute to the firm’s profits. This, in turn, will increase the value of the firm’s assets and improve the owners’ wealth.

There are thus two aspects of ownership of a firm:

residual claimant
The person who receives the income left over from a firm or other project after the payment of all contractual costs (for example the cost of hiring workers and paying taxes).

Profit is the residual. It is what’s left of the revenues after these payments. The owners claim it, which is why they are called residual claimants. Managers and employees are not residual claimants (unless they have some share in the ownership of the firm).

This division of revenue has an important implication. If the firm’s revenues increase because managers or employees do their jobs well, the owners will benefit, but the managers and employees will not (unless they receive a promotion, bonus, or salary increase). This is one reason we consider the firm as a stage, one on which not all the actors have the same interests.

Owners delegate control to managers

share
A part of the assets of a firm that may be traded. It gives the holder a right to receive a proportion of a firm’s profit and to benefit when the firm’s assets become more valuable. Also known as: common stock.

In large corporations, there are typically many owners. Most of them play no part in the firm’s management. The owners of the firm are the individuals and institutions (such as pension funds) that own the shares issued by the firm. By issuing shares to the general public, a company can raise capital to finance its growth, leaving strategic and operational decisions to a relatively small group of specialized managers.

These decisions include what, where, and how to produce the firm’s output, or how much to pay employees and managers. The senior management of a firm is also responsible for deciding how much of the firm’s profits are distributed to shareholders in the form of dividends, and how much is retained to finance growth. The owners benefit from the firm’s growth because they own part of the value of the firm, which increases as the firm grows.

separation of ownership and control
The attribute of some firms by which managers are a separate group from the owners.

When managers decide on the use of other people’s funds, this is referred to as the separation of ownership and control.

The separation of ownership and control results in a potential conflict of interest.

Conflict of interest between owners and managers

The decisions of managers affect profits, and profits decide the incomes of the owners. But the interests of owners and managers will be in conflict because managers’ salaries and bonuses are paid from profits that would otherwise go to the owners. There are many things that managers can do to raise their pay at the expense of profits. For example, in firms listed on the stock market, managers’ pay rises and falls with the firm’s stock market performance over a period as short as a quarter or a year; there are many ways managers can boost the firm’s short-term stock market performance but damage the firm’s profitability in the long run.

Managers are in day-to-day control of the firm’s assets and they may choose to take actions that benefit themselves, at the expense of the owners. An example is where managers seek to increase their own power and prestige through empire-building, even if that is not in the interests of shareholders.

Even sole owners of firms are not required to maximize their profits. Restaurant owners can choose menus they personally like, or waiters who are their friends. But, unlike managers, when they lose profits as a result, the cost comes directly out of their own pockets.

Although Adam Smith had not seen the modern firm, he observed the tendency of senior managers to serve their own interests rather than those of shareholders. He said this about the managers of what were then called joint-stock companies:

[B]eing the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a [firm managed by its owners] frequently watch over their own … Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. (The Wealth of Nations, 1776)

Aligning the interests of owners and managers

There are many ways that owners can incentivize managers to serve their interests. One is that they can structure contracts so that managerial compensation depends on the performance of the company’s share price over a lengthy period of time.

Another is that the firm’s board of directors, which represents the firm’s shareholders and typically has a substantial share in the firm (like a representative of a pension fund), can monitor the managers’ performance. The board has the authority to dismiss managers.

free ride
Benefiting from the contributions of others to some cooperative project without contributing oneself.

But although the shareholders, who are the ultimate owners, have the right to replace members of the board, they rarely do so. Shareholders are a large and diverse group that cannot easily coordinate to decide something. Occasionally, however, this free-rider problem is overcome and a shareholder with a large stake in a company may lead or coordinate a shareholder revolt to change or influence the board of directors and senior management.

In spite of the separation of ownership and control, when we model the firm as an actor, we often assume that it maximizes profits. This is a simplification, but a reasonable one for many purposes:

Question 6.2 Choose the correct answer(s)

Which of the following statements about the separation of ownership and control are true?

  • When the ownership and control of a firm is separated, the managers become the residual claimants.
  • Managers always work to maximize the firm’s profit.
  • One way to address the problem associated with the separation of ownership and control is to pay the managers a salary that depends on the performance of the firm’s share price.
  • It is effective for shareholders to monitor the performance of the management, in a firm owned by a large number of shareholders.
  • The shareholders are the residual claimants.
  • Managers may choose to take actions that provide benefits for themselves at the expense of the owners.
  • Such performance-related pay is a common method of incentivizing managers to maximize the value of their firm.
  • When there are many shareholders, there is not only a coordination problem but also a free-rider problem, where every shareholder relies on others to do the costly monitoring (and hence too little monitoring is undertaken).

6.4 Other people’s labour

The firm does not only manage ‘other people’s money’; the decision-makers in a firm also decide on the uses to which their employees’ efforts will be put. People participate in firms because they can do better if they are part of the firm than if they were notfor example, if they were self-employed. As in all voluntary economic interactions, there are mutual gains. But just as conflicts arise between owners and managers, there will generally be differences between owners and managers on the one hand, and employees on the other, about how the firm will use the strength, creativity, and other skills of its employees.

A firm’s profits (before the payment of taxes) depend on three things:

Our focus here is how firms seek to minimize the cost of acquiring the necessary labour to produce the goods and services they sell.

The employment contract is incomplete

Hiring employees is different from buying other goods and services. When we buy a shirt or pay someone to mow a lawn, it is clear what we get for our cash. If we don’t get it, we don’t pay; if we have already paid, we can go to court and get our money back.

But a firm cannot write an enforceable employment contract that specifies the exact tasks employees have to perform in order to get paid. This is for three reasons:

To understand the last point, consider a restaurant owner, who would like her staff to serve customers in a pleasant manner. Imagine how difficult it would be for a court to decide whether the owner can withhold wages from a waiter because he had not smiled often enough.

incomplete contract
A contract that does not specify, in an enforceable way, every aspect of the exchange that affects the interests of parties to the exchange (or of others).

An employment contract omits things that both the employees and the business owner care about—how hard and how well the employee will work, and for how long the worker will stay. We call this an incomplete contract. As a result of this contractual incompleteness, paying the lowest possible wage is almost never the firm’s strategy to minimize the cost of acquiring the labour effort it needs.

Exercise 6.2 Incomplete contracts

Think of two or three jobs with which you are familiar, perhaps a teacher, a retail worker, a nurse, or a police officer.

In each case, indicate why the employment contract is necessarily incomplete. What important parts of the person’s job—things that the employer would like to see the employee do or not do—cannot be covered in a contract, or if they are, cannot be enforced?

Why not pay workers piece rates?

piece-rate work
A type of employment in which the worker is paid a fixed amount for each unit of the product made.

Why is it not possible for firms just to pay employees according to how productive they are? For example, paying employees at a clothing factory $2 for each garment they finish. This method of payment, known as piece rate, provides the employee with an incentive to exert effort, because employees take home more pay if they make more garments.

In the late nineteenth century, the pay of more than half of US manufacturing workers was based on their output, but piece rates are not widely used in modern economies. At the turn of the twenty-first century, fewer than 5% of manufacturing workers in the US were paid piece rates and, beyond the manufacturing sector, piece rates are used even less often.11

Why do most of today’s firms not use this simple method to induce high effort from their employees?

gig economy
An economy made up of people performing services matched by means of a computer platform with those paying for the service. Workers are paid for task performance and not per hour, are not legally recognized as employees of the company that owns the platform, and typically receive few if any benefits from the owners other than matching.

An exception is today’s gig economy (see Section 6.12). Consider the case of Uber, Lyft, Deliveroo, and other delivery and transportation services. Unlike modern office and factory work, the job is typically done by a single individual working alone. The nature of the job is easily subject to contract because it is readily determined whether it has been carried out or not.

If piece rates are not practical, then what other method could a firm use to induce high effort from workers? How could the firm provide an incentive to do the job well, even though the worker is paid for time and not output? Just as the owners of the firm protect their interests by linking management pay to the firm’s share price, the manager uses incentives so that employees will work effectively.

Question 6.3 Choose the correct answer(s)

Which of the following statements regarding employment contracts are correct?

  • Employment contracts are incomplete as they can only specify things that both the employees and the business owner care about.
  • The firm is required to state exactly what it needs the employee to do in an employment contract.
  • Employees’ effort levels cannot be the basis of an enforceable contract.
  • The firm needs to specify exactly how much effort employees are expected to put into their jobs.
  • Employment contracts are incomplete as they cannot specify things that both the employees and the business owner care about—how hard and how well the employee will work, and for how long the worker will stay.
  • Due to unforeseen future events, the firm cannot possibly know exactly what it will need the employee to do at the time the contract is signed.
  • This is true—for example, a restaurant owner cannot take an employee to a court to decide whether he can withhold wages because the waiter does not smile often enough.
  • It is impractical or too costly for the firm to observe exactly how much effort each employee puts into their job.

Question 6.4 Choose the correct answer(s)

Which of the following are reasons why employment contracts are incomplete?

  • The firm cannot contract an employee not to leave.
  • The firm cannot specify every eventuality in a contract.
  • The firm is unable to observe exactly how an employee is fulfilling the contract.
  • The contract is unfinished.
  • It may be costly for the firm if the employee leaves, but employees retain the right to do so.
  • Since the firm does not know all the tasks it will require of an employee, the contract is necessarily incomplete.
  • Since effort or the quality of an individual’s work cannot be perfectly monitored and measured, it cannot be specified in the contract.
  • Employment contracts are usually long term. An incomplete contract is not one that is unfinished, but rather one that does not completely specify every relevant aspect of the relationship.

6.5 Why do a good day’s work? Employment rents

There are many reasons why people put in a good day’s work. For many people, doing a good job is its own reward, and doing anything else would contradict their work ethic. Even for those not intrinsically motivated to work hard, feelings of responsibility for other employees or for one’s employer may provide strong work motivation.

For some employees, hard work is the appropriate way to respond to the employer for providing a job with good working conditions. In other cases, firms use performance-related pay to reward hard work. It is sometimes possible to identify teams of workers whose output is readily measured—for example, the percentage of on-time departures for airline staff—and pay a benefit to the whole group, to be divided among team members. These employees have a reason to work hard—they are paid for it.

Fear of losing your job or not being promoted

However, there is another reason to do a good job—the fear of being fired, or of missing the opportunity to be promoted into a position that has higher pay and greater job security.

Laws and practices concerning the termination of employment for cause (that is, because of inadequate or low-quality work, not due to insufficient demand for the firm’s product) differ among countries. In some countries, the owners of the firm have the right to fire a worker whenever they choose, while in others, dismissal is difficult and costly. But, even in these cases, an employee has to fear the consequences of not meeting the standards that the employer sets. If this happened, she might lose her job if lower demand for the firm’s products results in workers being laid off.

Read about the tactics used by some Japanese companies—in a culture of lifetime employment—to get unneeded employees to quit.

Do workers care whether they lose their jobs? They would have no reason to care if they could immediately get another job at the same wage and working conditions. If this is not the case, then there is a cost to losing your job, as well as some benefits from not working.

We list the benefits that would be lost if you lost your job and the costs of working in Figure 6.2.

Benefits of your job (what you would lose if you lost it)
Wage income
Utility you get from your workplace friends and from the social status and psychological benefits from working
Medical insurance (in some countries, this is
tied to your job) or other benefits given by the firm (e.g. housing subsidies,
company car, etc.)
Costs of your job (what you would gain if you lost your job)
Utility from the free time you gain when out of
work (also called the disutility of working)
Disutility from the social and psychological costs of job loss
Unemployment benefit you would get if unemployed and searching for another job
Cost of travel to work minus cost of searching
for a new job
Net cost of job loss = Benefits minus Costs
This is the 'rent' you get from having your job and is called your ‘employment rent’

The net cost of job loss.

Figure 6.2 The net cost of job loss.

employment rent
The economic rent a worker receives when the net value of her job exceeds the net value of her next best alternative (that is, being unemployed). Also known as: cost of job loss.
employment rent
The economic rent a worker receives when the net value of her job exceeds the net value of her next best alternative (that is, being unemployed). Also known as: cost of job loss.

In the final row of the table, we calculate the net cost of job loss. This tells you how much so-called ‘rent’ you gain from being in your job (compared with the next best alternative, which is being unemployed and searching for a new job). This amount, which you would lose if you lost your job, is called your employment rent.

unemployment benefit
A government transfer received by an unemployed person. Also known as: unemployment insurance

People who lose their jobs can typically expect help from family and friends while they are out of work. Also, in many economies, people who lose their jobs receive an unemployment benefit or financial assistance from the government. They may be able to earn a small amount in self-employment or by taking odd jobs.

utility
A numerical indicator of the value that one places on an outcome, such that higher valued outcomes will be chosen over lower valued ones when both are feasible.

In Figure 6.2, we used the concept of utility introduced in Unit 3. We can say that the worker’s utility is increased by the goods and services she can buy with her wage, but reduced by the unpleasantness of going to work and working hard all day—the disutility of work.

Figure 6.3 takes the case of a worker called Maria and puts numbers on the hourly wage, the hourly unemployment benefit (at a level in this example of the equivalent of 50% of the wage for a 35-hour week) and a dollar value that she places as the cost of working for an hour (the disutility of work).

gig economy
An economy made up of people performing services matched by means of a computer platform with those paying for the service. Workers are paid for task performance and not per hour, are not legally recognized as employees of the company that owns the platform, and typically receive few if any benefits from the owners other than matching.

To be specific, we assume Maria spends half her time at work working and the other half on social media. She reckons that working this hard is equivalent to a cost of $2 per hour to her. If she lost her job she would have $6 per hour unemployment benefit and could earn $2 per hour doing gig economy work (see Section 6.12) or doing work of that value around her house.

Benefits of her job (what Maria would lose if she lost it) Example
Wage income ($12 per hour)-unemployment benefit ($6 per hour) while searching for a job 12 - 6 = $6
Costs of her job (what Maria would gain if she lost it)
Disutility of working ($2 per hour) $2
Employment rent = Benefits - Costs $6 - $2 = $4 per hour

Calculating Maria’s employment rent.

Figure 6.3 Calculating Maria’s employment rent.

When Maria thinks about her employment rent, she is forecasting what would happen to her if she were to lose her job. When estimating her employment rent per hour, she has to forecast the likely length of a spell of unemployment, the kind of wage she could expect to get in another job, what the working conditions would be like, and so on.

Employment rent, the wage, and how hard to work

When Maria interacts with her employer, and the employer sets her wage, her employment rent plays a major role. How much Maria stands to lose if she loses her job affects how much effort she exerts on the job; a worker with a high employment rent has a lot to lose if she loses her job and therefore will exert more effort for a given wage. To see how this works, we summarize the determinants of employment rent in Figure 6.4.

Maria’s effort will also depend on the cost to the firm of laying her off. If the laws and customs make firing more costly, then ceteris paribus, Maria will exert less effort. She will exert more effort on the job if the costs to the firm of replacing her are low (as would be the case if she is working in McDonalds).

Read through Figure 6.4, thinking about a specific job and imagining how the changes in benefits and costs of having the job affect the net cost of job loss, and hence, the employment rent, and how hard the employee will work.

Current job conditions improve
- You have better chance of promotion in this job
- The relationship with your colleagues improves
- Your medical insurance gets better
- The job becomes more pleasant, so disutility is lower
The quality of the best alternative job declines
- Wages in the job you want to get are cut
- You expect conditions in the best alternative job to get worse
- There are fewer chances of gig work
- The cost of travelling to another job goes up
The cost of leaving your current job rises
- Unemployment benefit per hour is cut
- Unemployment benefit will be paid for a shorter time
- The social stigma of unemployment is higher
-It will take longer than before to get a new job
- There are fewer good jobs available
The best alternative to your current job is relatively worse
You have a higher cost of job loss
Current employment rent is higher
You exert more effort for a given wage

Determinants of the employment rent in a specific job.

Figure 6.4 Determinants of the employment rent in a specific job.

How can employment rents be measured?

Even confining attention to the loss in wages, the cost is high. But how do we measure how high it is?

natural experiment
An empirical study exploiting naturally occurring statistical controls in which researchers do not have the ability to assign participants to treatment and control groups, as is the case in conventional experiments. Instead, differences in law, policy, weather, or other events can offer the opportunity to analyse populations as if they had been part of an experiment. The validity of such studies depends on the premise that the assignment of subjects to the naturally occurring treatment and control groups can be plausibly argued to be random.

How economists learn from data How large are employment rents?

Setting aside the undoubtedly large but hard-to-measure psychological and social cost of losing one’s job, estimating the cost of job loss (the size of the employment rent) is not simple.

Can we compare the economic situation of workers currently employed with the economic situation of unemployed people? No, because the unemployed are a different group of people, with different abilities and skills. Even if they were employed, they would be likely (on average) to earn less than people who currently have jobs.

An entire firm closing, or a mass layoff of workers, provides a natural experiment that can help. We could look at the earnings of workers before and after they lost their jobs during a major employment cutback. When a factory closes because the parent company has decided to relocate production to some other part of the world, for example, virtually all workers lose their jobs, not just the workers who were most likely to lose their jobs through poor performance.1213

Louis Jacobson, Robert Lalonde, and Daniel Sullivan used such a natural experiment to estimate the cost of job loss. They studied experienced (not recently hired) full-time workers hit by mass layoffs in the US state of Pennsylvania in 1982. In 2014 dollars, those displaced had been averaging $50,000 in earnings in 1979. Those who were fortunate enough to find another job in less than three months took jobs that paid a lot less, averaging only $35,000—being laid off meant that their earnings declined by $15,000.14

Four years later, they were still making $13,300 less than similar workers who had been making the same initial wage, but whose firms did not lay off their workers. In the five years that followed their layoff, they lost the equivalent of an entire year’s earnings.

Many, of course, did not find work at all. They suffered even greater costs.

The year 1982 was not a good time to be looking for work in Pennsylvania, but similar estimates (from the US state of Connecticut between 1993 and 2004, for example) suggest that, even in better times, employment rents are large enough that workers would worry about losing them.

When workers receive employment rents, they are being paid more than in their next best alternative (being unemployed and looking for a job or, eventually, working for a different company). How does this benefit employers? Because the employee has something to lose, owners and managers can exert power over workers. The threat can be implicit or explicit, but it will make the worker perform in ways that she would not choose unless this was the case.

Question 6.5 Choose the correct answer(s)

Which of the following statements regarding employment rents are correct?

  • Higher employment rents make workers more likely to quit their jobs.
  • They are the costs you have to pay for your employment.
  • It equals the wage you receive in your employment.
  • Employers can use high employment rents to exert power over employees.
  • Workers would lose their employment rent if they quit. Therefore, higher rents make workers less likely to quit.
  • They are the economic rents of employment, which is the net cost of job loss if the next-best alternative is unemployment.
  • It is the net cost of job loss, which is not only the difference between the wage you receive in employment (minus the disutility of work) and the unemployment benefit, but also includes benefits such as firm-specific assets, medical insurance (if available), and the social status of being employed.
  • Employers can use the implicit threat of being fired to make the worker perform in ways that he would not choose unless he had something to lose.

Question 6.6 Choose the correct answer(s)

In which of the following employment situations would the employment rent be high, ceteris paribus?

  • in a job that provides many benefits, such as housing and medical insurance
  • in an economic boom, when the ratio of jobseekers to vacancies is low
  • when the worker is paid a high salary because she is a qualified accountant and there is a shortage of accountancy skills
  • when the worker is paid a high salary because the firm’s customers know and trust her
  • If the employee loses the job, all these benefits would be lost, so the economic rent from employment is high.
  • The cost of job loss is low because it would be easy to find another job. Therefore, the economic rent is low.
  • A qualified accountant will easily find another job at a similar salary, so the economic rent is low.
  • This worker is paid a high salary because there are aspects of her work that are specifically related to the firm and that will not be of value in other firms where she might work if she leaves. Other firms would pay a lower salary (at least initially) so the economic rent is high.

6.6 Work and wages: The labour discipline model

When the cost of job loss (the employment rent) is large, workers will be willing to work harder in order to reduce the likelihood of losing the job. Holding constant other ways that it might influence the employment rent, a firm can increase the cost of job loss—and therefore the effort exerted by its employees—by raising wages. We refer to ‘effort’ as if it were a single thing, but of course what the firm needs to make profits is many dimensions of what an employee may do on the job, including physical effort, care, and not engaging in the kinds of vindictive sabotage that may have occurred in the Firestone plant in Decatur, Illinois.

game
A model of strategic interaction that describes the players, the feasible strategies, the information that the players have, and their payoffs. See also: game theory.

We now represent this social interaction in the firm as a game played by the owners (through their managers) and the employees.

As with other models, we ignore some aspects of their interaction to focus on what is important, following the principle that sometimes we see more by looking at less.

On the stage of the firm, the cast of characters is just the owner (the employer) and a single worker, Maria. The game is sequential (one of them chooses first, like the ultimatum game that we saw in Section 3.2 of Unit 3) and is repeated in each period of employment. Here is the order of play:

  1. The employer chooses a wage: This is based on his knowledge of how employees like Maria respond to higher or lower wages, and informs employees that they will be employed in subsequent periods at the same wage—as long as they work hard enough.
  2. Maria chooses a level of work effort: This is in response to the wage offered, taking into account the costs of losing her job if she does not provide enough effort.

The payoff for the employer is the profit. The greater Maria’s effort, the more goods or services she will produce, and the more profit he will make. Maria’s payoff is her net valuation of the wage she receives, taking into account the effort she has expended.

Nash equilibrium
A set of strategies, one for each player in the game, such that each player’s strategy is a best response to the strategies chosen by everyone else.

If Maria chooses her work effort as a best response to the employer’s offer, and the employer chooses the wage that maximizes his profit given that Maria responds the way she does, their strategies are a Nash equilibrium.

Employers typically hire work supervisors and may install surveillance equipment to keep watch over their employees, increasing the likelihood that the management will find out if a worker is not working hard and well. Here we will ignore these extra costs and just assume that the employer occasionally gets some information on how hard or well an employee is working. This is not enough to implement a piece-rate contract, but more than enough to fire a worker if the news is not good. Maria knows that the chance of the employer getting bad news decreases the harder she works.

To decide on the wage to set, the employer needs to know how the employee’s work effort will respond to higher wages. We will consider Maria’s decision first.

The employee’s best response

Maria’s effort can vary between zero and one. We can think of this as the proportion of each hour that she spends working diligently (the rest of the time she is not working). An effort level of 0.5 indicates she is spending half the working day on non-work-related activities, such as checking Facebook, shopping online, or just staring out of the window.

reservation wage
What an employee would get in alternative employment, or from an unemployment benefit or other support, were he or she not employed in his or her current job.
disutility of effort
The degree to which doing some task (effort) is unpleasant.

We will assume that Maria’s reservation wage is $6. Even if she put in no work whatsoever (and so endured no disutility of effort, spending all day on Facebook and daydreaming), her job at a $6 wage would be no better than being without work. Therefore, she would not care one way or the other if her job ended. Her best response to a wage of $6 would be zero effort.

If Maria receives an unemployment benefit or income from any of these sources, it will partially offset the lost wage income. Let us suppose that, while Maria remains unemployed, she will receive a benefit equivalent to being paid $6 an hour for a 35-hour week. This is her reservation wageit is always available to her, so she would be indifferent between having a job that paid $6 an hour, and not working.

What if she were paid a higher wage?

For Maria, effort has a cost (the disutility of work) and a benefit (it increases the likelihood of her keeping the job, and the employment rent). In her choice of effort, she needs to find a balance between these two.

A higher wage increases the employment rent and hence the benefit from effort, so it will lead her to choose a higher level of effort. Maria’s best response (the effort she chooses) will increase with the level of the wage chosen by the employer.

worker’s best response function (to wage)
The optimal amount of work that a worker chooses to perform for each wage that the employer may offer.

Figure 6.5 shows the effort Maria chooses for each level of the wage, referred to as her best response curve, or worker’s best response function. (Just like the production functions in Unit 4, it shows how one variable, in this case effort, depends on another, the wage.) Maria’s best response to a wage offer depends on how long she would expect to be unemployed before getting a new job if she were to lose her job. We assume this is 10 months (roughly 44 weeks), as was typical among OECD countries in 2016.

Maria’s best response to the wage. Point J refers to the information in Figure 6.3 (wage = $12, effort = 0.5).

Figure 6.5 Maria’s best response to the wage. Point J refers to the information in Figure 6.3 (wage = $12, effort = 0.5).

Effort per hour

Effort per hour, measured on the vertical axis, varies between zero and one.

Figure 6.5a Effort per hour, measured on the vertical axis, varies between zero and one.

The relationship between effort and the wage

If Maria is paid $6, she does not care if she loses her job because $6 is her reservation wage. This is why she provides no effort at a $6 wage. If she is paid more, she provides more effort.

Figure 6.5b If Maria is paid $6, she does not care if she loses her job because $6 is her reservation wage. This is why she provides no effort at a $6 wage. If she is paid more, she provides more effort.

The worker’s best response

The upward-sloping curve shows how much effort she puts in for each value of the hourly wage on the horizontal axis.

Figure 6.5c The upward-sloping curve shows how much effort she puts in for each value of the hourly wage on the horizontal axis.

The effect of a wage increases when effort is low

When the wage is low, the best response curve is steep—a small wage increase raises effort by a substantial amount.

Figure 6.5d When the wage is low, the best response curve is steep—a small wage increase raises effort by a substantial amount.

Diminishing marginal returns

At higher levels of wages, however, increases in wages have a smaller effect on effort.

Figure 6.5e At higher levels of wages, however, increases in wages have a smaller effect on effort.

The employer’s feasible set

The best response curve is the frontier of the employer’s feasible set of combinations of wages and effort that it gets from its employees.

Figure 6.5f The best response curve is the frontier of the employer’s feasible set of combinations of wages and effort that it gets from its employees.

The employer’s MRT

The slope of the best response curve is the employer’s marginal rate of transformation of higher wages into more worker effort.

Figure 6.5g The slope of the best response curve is the employer’s marginal rate of transformation of higher wages into more worker effort.

Point J in Figure 6.5 represents the situation in Figure 6.3, as discussed at the end of the previous section. Maria’s reservation wage is $6, she is paid $12, and chooses effort of 0.5.

The best response curve is concave, meaning that it becomes flatter as the wage and the effort level increase. This is because, as the level of effort approaches the maximum possible level, the disutility of effort becomes greater. In this case, it takes a larger employment rent (and hence a higher wage) to get effort from the employee.

Seen from the standpoint of the owner or the employer, the best response curve shows how paying higher wages can elicit higher effort, but with diminishing marginal returns. In other words, the higher the initial wage, the smaller the increase in effort and output the employer gets from an extra $1 per hour in wages.

The best response curve is the frontier of the feasible set of combinations of wages and effort the firm can get from its employees, and the slope of the frontier is the marginal rate of transformation of wages into effort.

Why not pay the lowest wage?

The lowest wage the firm could set for Maria would be the reservation wage, $6, where the best response curve hits the horizontal axis and effort is zero. We can see that the firm would never offer the lowest wage possible, because she would not exert any effort at work.

We have drawn the best response function in Figure 6.5, under the assumption that unemployment is expected to last ten months. If the expected duration were to change, the best response function would change too. If economic conditions worsened, increasing unemployment duration, Maria’s employment rent would be higher. For any wage, her best response would be to exert a higher level of effort than that shown in Figure 6.5.

Question 6.7 Choose the correct answer(s)

Figure 6.5 depicted Maria’s best response curve when the expected duration of unemployment was 10 months. Which of the following statements are correct?

  • If the expected unemployment duration increased to 11 months, Maria’s best response to a wage of $12 would be an effort level above 0.5.
  • If the unemployment benefit were reduced, then Maria’s reservation wage would be higher than $6.
  • Over the range of wages shown in the figure, Maria would never exert the maximum possible effort per hour.
  • Increasing effort from 0.5 to 0.6 requires a bigger wage increase than increasing effort from 0.8 to 0.9.
  • Maria’s best response to a wage of $12 is 0.5, when expected unemployment duration is 10 months. If duration increases to 11 months, the cost of job loss is higher, so Maria will work harder for the same wage.
  • If the unemployment benefit were reduced, then the reservation wage would fall below $6.
  • The maximum level of effort would not be provided over the wage range shown.
  • When effort is lower, a smaller wage rise is required to increase it by 0.1.

6.7 Wages, effort, and profits in the labour discipline model

Maria is not in the situation that Angela faced when Bruno could order her to work at the point of a gun. Maria has bargaining power because she can always walk away—an option that, initially, Angela did not have.

Maria chooses how hard she works. But the employer can determine the conditions under which she makes that choice. The owners and managers know that they cannot get Maria to provide more effort than is given by the best response curve shown in Figure 6.5. The fact that the best response curve slopes upwards means that employers face a trade-off. They can only get more effort by paying higher wages.

Firms maximize profits by minimizing costs of production

To maximize their profits, firms want to minimize the costs of production. In particular, they want to pay the lowest possible price for inputs. A company purchasing oil for use in the production process will look for the supplier that can provide it at the lowest price per litre, or equivalently, supply the most oil per dollar. Likewise, Maria provides an input to production, and her employer would like to purchase it at the lowest price. But this does not mean paying the lowest possible wage. We already know that, if he paid the reservation wage, workers might show up (they wouldn’t care one way or the other), but they would not work if they did.

The wage, w, is the cost to the employer of an hour of a worker’s time. But what matters for production is not how many hours Maria provides, but how many units of effort—effort is the input to the production process. If Maria chooses to provide 0.5 units of effort per hour and her hourly wage is w, the cost to the employer of a unit of effort is 2w. In general, if she provides e units of effort per hour, the cost of a unit of effort is w/e.

So, to maximize profits, the employer should find a feasible combination of effort and wage that minimizes the cost per unit of effort, w/e.

efficiency unit
A unit of effort is sometimes called an efficiency unit.

Another way to say the same thing is that the employer should maximize the number of units of effort (sometimes called efficiency units) that he gets per dollar of wage cost, e/w.

The firm’s isocost curves for effort

The upward-sloping straight line in Figure 6.6 joins together a set of points that have the same ratio of effort to wages, e/w. If the wage is $10 per hour and a worker provides 0.45 units of effort per hour, the employer gets 0.045 efficiency units per dollar. Equivalently, a unit of effort costs $10/0.45 = $22.2. The employer would be indifferent between this situation and one in which the wage is $20 with an effort of 0.9—the cost of effort is exactly the same at all points on the line.

We will call this an isocost line for effort. These lines join points that have identical effects on the employer’s costs. We can also think of it as an indifference curve for the employer.

The employer’s indifference curves: Isocost curves for effort.

Figure 6.6 The employer’s indifference curves: Isocost curves for effort.

An isocost line for effort

If w = $10 and e = 0.45, e/w = 0.045. At every point on this line, the ratio of effort to wages is the same. The cost of a unit of effort is w/e = $22.22.

Figure 6.6a If w = $10 and e = 0.45, e/w = 0.045. At every point on this line, the ratio of effort to wages is the same. The cost of a unit of effort is w/e = $22.22.

The slope of the isocost line

The line slopes upward because a higher effort level must be accompanied by a higher wage for the e/w ratio to remain unchanged. The slope is equal to e/w = 0.045, the number of units of effort per dollar.

Figure 6.6b The line slopes upward because a higher effort level must be accompanied by a higher wage for the e/w ratio to remain unchanged. The slope is equal to e/w = 0.045, the number of units of effort per dollar.

Other isocost lines

On an isocost line, the slope is e/w, but the cost of effort is w/e. The steeper line has a lower cost of effort, and the flatter line has a higher cost of effort.

Figure 6.6c On an isocost line, the slope is e/w, but the cost of effort is w/e. The steeper line has a lower cost of effort, and the flatter line has a higher cost of effort.

Some lines are better for the employer than others

A steeper line means lower cost of effort and hence higher profits for the employer. On the steepest isocost line, he gets 0.7 units of effort for a wage of $10 (at B), so the cost of effort is $10/0.7 = $14.29 per unit. On the middle line he only gets 0.45 units of effort at this wage, so the cost of effort is $22.22 and profits are lower.

Figure 6.6d A steeper line means lower cost of effort and hence higher profits for the employer. On the steepest isocost line, he gets 0.7 units of effort for a wage of $10 (at B), so the cost of effort is $10/0.7 = $14.29 per unit. On the middle line he only gets 0.45 units of effort at this wage, so the cost of effort is $22.22 and profits are lower.

The slope is the MRS

The employer is indifferent between points on an isocost line. Like other indifference curves, the slope of the effort isocost line is the marginal rate of substitution—the rate at which the employer is willing to increase wages to get higher effort.

Figure 6.6e The employer is indifferent between points on an isocost line. Like other indifference curves, the slope of the effort isocost line is the marginal rate of substitution—the rate at which the employer is willing to increase wages to get higher effort.

Question 6.8 Choose the correct answer(s)

Consider isocost lines drawn on a graph with hourly wage on the horizontal axis and effort per hour on the vertical axis. Which of the following statements is correct?

  • Isocost lines intersect the horizontal axis at the reservation wage.
  • For an isocost line with a slope of 0.07, the cost of a unit of effort is $14.3.
  • The slope of the isocost line is the employer’s marginal rate of transformation of higher wages into worker effort.
  • Steeper isocost lines represent higher cost per unit of effort.
  • Isocost lines go through the origin (zero wage, zero cost).
  • The slope of the isocost lines represents the units of effort per dollar of wage cost, which is the inverse of the cost per unit of effort. The cost of a unit of effort is therefore 1/0.07 = $14.3.
  • The slope of the isocost lines is the employer’s marginal rate of substitution, which is the rate at which the employer is willing to increase wages to get higher effort.
  • The slope of the isocost lines represents the units of effort per dollar of wage cost. Steeper isocosts therefore mean more units of effort per dollar of wage cost, or equivalently, a lower cost per unit of effort.

To minimize costs, the employer will seek to reach the steepest isocost line for effort, where the cost of a unit of effort is lowest. (Remember, steeper isocost lines mean that a given increase in the wage will result in a larger increase in effort.) But the employer lacks the ability to dictate how much effort Maria puts in to her work, and so has to pick some point on Maria’s best response curve.

tangency
When two curves share one point in common but do not cross. The tangent to a curve at a given point is a straight line that touches the curve at that point but does not cross it.

The best the employer can do is to set the wage at $12 on the isocost line that is tangent to Maria’s best response curve (point A). Use the analysis in Figure 6.7 to see how the employer sets the wage.

The firm sets the ‘efficiency’ wage

The employer sets the wage to minimize the cost of effort.

Figure 6.7 The employer sets the wage to minimize the cost of effort.

Minimizing the cost of effort

To maximize profits, the employer wants to obtain effort at the lowest cost, and will seek to get onto the steepest isocost line possible. But, without the ability to dictate the level of effort, the employer must pick some point on the worker’s best response curve.

Figure 6.7a To maximize profits, the employer wants to obtain effort at the lowest cost, and will seek to get onto the steepest isocost line possible. But, without the ability to dictate the level of effort, the employer must pick some point on the worker’s best response curve.

C is not the best the employer can do

Could choosing a point such as C be optimal? No. It is clear that, by paying more, the employer will benefit from a lower wage–effort ratio, because effort will increase more than proportionally to the wage.

Figure 6.7b Could choosing a point such as C be optimal? No. It is clear that, by paying more, the employer will benefit from a lower wage–effort ratio, because effort will increase more than proportionally to the wage.

Point A is the best the employer can do

The best the employer can do is the isocost line that is just touching (tangent to) the worker’s best response curve.

Figure 6.7c The best the employer can do is the isocost line that is just touching (tangent to) the worker’s best response curve.

MRS = MRT

At this point, the marginal rate of substitution (the slope of the isocost line for effort) is equal to the marginal rate of transformation of higher wages into greater effort (the slope of the best response function).

Figure 6.7d At this point, the marginal rate of substitution (the slope of the isocost line for effort) is equal to the marginal rate of transformation of higher wages into greater effort (the slope of the best response function).

Point B

Points on steeper isocosts, such as Point B, would have lower costs for the employer but are infeasible.

Figure 6.7e Points on steeper isocosts, such as Point B, would have lower costs for the employer but are infeasible.

Minimum feasible costs

Therefore, $12 is the hourly wage that the employer should set to minimize costs and maximize profits.

Figure 6.7f Therefore, $12 is the hourly wage that the employer should set to minimize costs and maximize profits.

In Figure 6.7, the employer will choose point A, offering a wage of $12 per hour to hire Maria, who will exert effort of 0.5. The employer cannot do better than this point—any point with lower costs, for example, point B, is infeasible.

marginal rate of substitution (MRS)
The trade-off that a person is willing to make between two goods. At any point, this is the slope of the indifference curve. See also: marginal rate of transformation.
marginal rate of transformation (MRT)
The quantity of some good that must be sacrificed to acquire one additional unit of another good. At any point, it is the slope of the feasible frontier. See also: marginal rate of substitution.

The employer minimizes costs and maximizes profit at the point where the employer’s MRS (the slope of the indifference curve or isocost line) equals the MRT (the slope of the best response curve, which is the employer’s feasible frontier). This balances the trade-off the employer is willing to make between wages and effort against the trade-off the employer is constrained to make by Maria’s response.

constrained choice problem
This problem is about how we can do the best for ourselves, given our preferences and constraints, and when the things we value are scarce. See also: constrained optimization problem.

This is a constrained choice problem, similar to the one in Unit 4. There, individuals maximizing utility chose working hours where MRS = MRT, and the slope of their indifference curve equalled the slope of the feasible frontier determined by the production technology.

efficiency wages
The payment an employer makes that is higher than an employee’s reservation wage, so as to motivate the employee to provide more effort on the job than he or she would otherwise choose to make. See also: labour discipline model, employment rent.

When wages are set by the employer in this manner, they are sometimes called efficiency wages because the employer is recognizing that what matters for profits is e/w—the efficiency units per dollar of wage costs—rather than how much an hour of work costs.

labour discipline model
A model that explains how employers set wages so that employees receive an economic rent (called employment rent), which provides workers an incentive to work hard in order to avoid job termination. See also: employment rent, efficiency wages.

What has the labour discipline model told us?

Exercise 6.3 The employer sets the wage

Would any of the following affect Maria’s best response curve or the firm’s isocost lines for effort in Figure 6.7? If so, explain how.

  1. The government decides to increase childcare subsidies for working parents but not for those unemployed. Assume Maria has a child and is eligible for the subsidy.
  2. Demand for the firm’s output rises as celebrities endorse the good.
  3. Improved technology makes Maria’s job easier.

Question 6.9 Choose the correct answer(s)

Figure 6.7 depicts the efficiency wage equilibrium of a worker and a firm. According to this figure:

  • Along the isocost line tangent to the best response curve, doubling of the per-hour effort from 0.45 to 0.90 would lead to an increased profit for the firm.
  • The slope of each isocost line is the number of units of effort per dollar.
  • At the equilibrium point, the marginal rate of transformation on the isocost line equals the marginal rate of substitution on the worker’s best response curve.
  • Points C and A both represent Nash equilibria because they are on the best response curve.
  • Along the isocost line, doubling effort requires doubling the wage. The cost of effort would not change, so profit would not change either.
  • Isocost lines have a constant ratio of effort to wage, e/w. Since e is on the vertical axis, and w is on the horizontal axis, the slope is e/w, which is the number of units of effort per dollar.
  • At the equilibrium point, the marginal rate of substitution between higher wage cost and higher effort on the isocost line equals the marginal rate of transformation of higher wages into greater effort on the worker’s best response curve.
  • At point C, the worker’s choice of effort is a best response if the employer chooses this wage. But the employer would not be doing the best he could, given the worker’s strategy for choosing effort, so it is not a Nash equilibrium.

6.8 Why there is always involuntary unemployment

When we think about the implications of the labour discipline model for the whole economy, it tells us something else, which may at first seem surprising:

involuntary unemployment
A person who is seeking work, and willing to accept a job at the going wage for people of their level of skill and experience, but unable to secure employment is involuntarily employed.

There must always be involuntary unemployment.

Being unemployed involuntarily means not having a job, although you would be willing to work at the wage that other workers like you are receiving.

In developing our model, we assumed that Maria could expect to be unemployed for ten months before receiving another wage offer at the same level. But the model implies that there must be an extended period of unemployment.

To see why, try to imagine an equilibrium in the game between Maria and her employer, in which the employer pays her a wage of $12 per hour and, if she loses her job, she could immediately find another at the same wage. In that case, Maria’s employment rent would be zero. She would be indifferent between keeping the job and losing it. Therefore, her best response would be an effort level of zero. But this could not be an equilibrium—the employer would not pay $12 an hour to someone who did no work.

Now imagine there were plenty of jobs available in the economy at $12 per hour and no one was unemployed. Immediately, you can see that this situation could not last. Employers would offer higher wages, say an extra $4 per hour, to ensure that their workers had something to lose and would therefore work hard. But, after offering higher wages, they would not be able to offer as many jobs. Workers who lost their jobs would no longer be able to find new ones easily. Jobs would be scarce, and it might take weeks or months to find another. The economy would move to a new equilibrium with higher wages and involuntary unemployment. Employees would be earning $16 an hour and those who lost their jobs would be willing to accept another at $16, but they would not immediately be able to find one.

In equilibrium, both wages and involuntary unemployment have to be high enough to ensure that there is enough employment rent for workers to put in effort.

Unemployment is an important concern for voters, and so for the policymakers who represent them. We can use this model to see how policies that governments pursue to alter the level of unemployment, or to provide income to unemployed workers, will affect the profits of firms and the effort level of their employees.

6.9 Putting the model to work: Owners, employees, and public policy

Until now we have considered how the employer chooses a point on the best response function. But changes in economic conditions or public policies can shift the entire best response function, moving it to the right (or up) or to the left (or down).

The worker’s incentive to choose a high level of effort depends on how much she has to lose (the employment rent), but also the likelihood of losing it. The position of the best response function depends on:

If there are changes in any of these factors, the best response curve will shift. Public policy can affect the position of the best response function.

Unemployment affects the wage firms set

Imagine how an increase in the unemployment rate affects the best response curve. When unemployment is high, workers who lose their jobs can expect a longer spell of unemployment. Recall that unemployment benefits (including support from family and friends) are limited, so the longer the expected spell of unemployment, the lower the level of the unemployment benefit per hour (or per week) of lost work. An increase in the duration of a spell of unemployment has two effects:

Figure 6.8 shows the effects on the best response curve of a rise in unemployment, and also of a rise in unemployment benefits.

The best response curve depends on the level of unemployment and the unemployment benefit.

Figure 6.8 The best response curve depends on the level of unemployment and the unemployment benefit.

The status quo

The position of the best response curve depends on the reservation wage. It crosses the horizontal axis at this point.

Figure 6.8a The position of the best response curve depends on the reservation wage. It crosses the horizontal axis at this point.

The effect of unemployment benefits

A rise in the unemployment benefit increases the reservation wage and shifts the worker’s best response curve to the right.

Figure 6.8b A rise in the unemployment benefit increases the reservation wage and shifts the worker’s best response curve to the right.

An increase in unemployment

If unemployment rises, the expected duration of unemployment increases. Therefore, the worker’s reservation wage falls, and the best response curve shifts to the left.

Figure 6.8c If unemployment rises, the expected duration of unemployment increases. Therefore, the worker’s reservation wage falls, and the best response curve shifts to the left.

Effort changes for each wage

For a given hourly wage, say $18, workers put in different levels of effort when the levels of unemployment or unemployment benefit change.

Figure 6.8d For a given hourly wage, say $18, workers put in different levels of effort when the levels of unemployment or unemployment benefit change.

Economic policies affect the wage firms set

A rise in the level of unemployment shifts the best response curve to the left:

A rise in unemployment benefits shifts the best response curve to the right, so it has the opposite effects.

Economic policies can alter both the size of the unemployment benefit and the extent of unemployment (and hence the duration of a spell of unemployment). These policies are often controversial.

Exercise 6.4 Effort and wages

Suppose that, with the status quo best response curve in Figure 6.8, the firm chooses the wage to minimize the cost of effort, and the worker’s best response is an effort level of 0.6. If unemployment rose:

  1. Would effort be higher or lower than 0.6 if the firm did not change the wage?
  2. How would the firm change the wage if it wanted to keep the effort level at 0.6?
  3. How would the wage change if the firm minimized the cost of effort at the new unemployment level?

How economists learn from data Workers speed up when the economy slows down

The idea that employment rents are an incentive for employees to work harder is illustrated in a study by Edward Lazear (an economic advisor to former US President George W. Bush) and his co-authors. They investigated a single firm during the global financial crisis, to see how the managers and workers reacted to the turbulent economic conditions. The firm specialized in technology-based services—such as insurance-claims processing, computer-based test grading, and technical call centres—and operated in 12 US states. The nature of the work made it easy for the firm’s management to track the workers’ productivity, which is a measure of worker effort.

It also allowed Lazear and his colleagues to use the firm’s data from 2006–2010 to analyse the effect on worker productivity of the worst recession since the Great Depression.

When unemployment rose, workers could expect a longer spell of unemployment if they lost their jobs. Firms did not use their increased bargaining power to lower wages as they could have, fearing their employees’ reaction.

Lazear and his co-authors found that, in this firm, productivity increased dramatically as unemployment rose during the financial crisis. One possible explanation is that average productivity increased because management fired the least productive members of the workforce. But Lazear found that the effect was more due to workers putting in extra effort. The severity of the recession raised the workers’ employment rent for any given wage, and they were therefore willing to work harder. We would predict from our model that the best response curve would have shifted to the left as a result of the recession. This meant that (unless employers lowered wages substantially) workers would work harder. Apparently, this is what happened.15

Our model shows that employers could have cut wages, while sustaining an employment rent sufficient to motivate hard work. An earlier recession provided another insight that helps to explain their reluctance to reduce wages in the crisis. Truman Bewley, an economist, was puzzled when he saw only a handful of firms in the northeast of the US cutting wages during the recession of the early 1990s. Most firms, like the one Lazear’s team studied, did not cut their wages at all.

Bewley interviewed more than 300 employers, labour leaders, business consultants, and careers advisors in the northeast of the US. He found that employers chose not to cut wages because they thought it would hurt employee morale, reducing productivity and leading to problems of hiring and retention. They thought it would ultimately cost the employer more than the money they would save in wages.16

Exercise 6.5 Lazear’s results

Use the best response diagram to sketch the results found by Lazear and co-authors in their study of a firm during the global financial crisis.

  1. Draw a best response curve for each of the following years and explain what it illustrates: (a) the precrisis period (2006) (b) the crisis years (2007–8) (c) the postcrisis year (2009) Assume that the employer did not adjust wages.
  2. Is there a reason why a firm might not cut wages during a recession? Think about the research of Truman Bewley and the experimental evidence about reciprocity in Unit 4.

Question 6.10 Choose the correct answer(s)

Which of the following statements are true?

  • If unemployment benefits are increased, the minimum cost of a unit of effort for the employer will rise.
  • If the wage doesn’t change, employees will work harder in periods of high unemployment.
  • If workers continue to receive benefits however long they remain unemployed, an increase in the level of unemployment will have no effect on the best response curve.
  • If an employee’s disutility of effort increases, the reservation wage will rise.
  • An increase in unemployment benefits shifts the best response curve to the right. The employer will no longer be able to reach the isocost line tangent to the original best response curve, so the cost of effort must rise.
  • In periods of high unemployment, the cost of job loss is higher. At any given wage level, employees will choose higher effort to reduce the chance of losing their jobs.
  • In this case, an increase in the level of unemployment would not affect the reservation wage, but it would increase the cost of job loss, so the best response curve will change.
  • At the reservation wage, the employee is indifferent between employment and unemployment, and would exert no effort. A change in the disutility of effort would therefore have no effect.

6.10 Why do employers pay employment rents to their workers?

When a firm is deciding on how to run its plant, it looks for the lowest cost available as we saw in Section 6.7. If we were to observe a firm paying 0.15 euros per kilowatt hour of electricity when it could be purchased for 0.11 euros, we would conclude that, for some reason, the firm was not minimizing its costs and therefore could not be maximizing its profits. It would be throwing away money.

When workers receive employment rents, they value having their jobs more than their next best alternative (being unemployed and searching for and eventually taking some other job). This means that the employer is paying more than the minimum that would induce the worker to prefer taking the job over remaining unemployed.

Isn’t this just a gift from employer to worker? How does this benefit employers?

We have explained one reason:

There are other ways that paying a rent to the worker contributes to the profits of the firm.

What, then, is the difference between labour and kilowatt hours, or office furniture, or any of the other non-labour inputs of the firm, or any of the other goods or services for which no firm would ever pay more than the minimum? The answer is simple—for electricity, all that matters is that the good or service is delivered to the firm.

But for the firm, making a profit is not as simple as getting the worker to show up for work, as Firestone Tire and Rubber Company discovered when the strikers at Decatur returned to work. Because the labour contract is incomplete, as we have seen in Section 6.4, the worker must also be motivated to work hard, and stay with the firm.

Question 6.11 Choose the correct answer(s)

Which of the following are correct explanations of why, when purchasing electricity, the firm will always seek the cheapest provider, but it will not pay an employee the lowest amount that would motivate the worker to accept the job?

  • A rent provides a power motivation for the employee to work hard and well.
  • There are many competitors supplying electricity, but this is not the case for labour.
  • Electricity (or equivalent forms of power) represent a larger share of the firm’s costs than does labour.
  • Paying the employee more makes it more likely that she will remain with the firm.
  • This is the definition of the employment rent that forms part of the employment contract.
  • There are many competing suppliers of labour, but the firm will always pay above the reservation wage; among the suppliers of electricity, however many there are, the firm will seek the lowest cost provider.
  • Cost minimization could justify why the firm seeks the cheapest electricity provider, but does not explain why it does not pay the employee their reservation wage. If a firm was seeking to minimize costs, they would want to pay their employees as little as possible.
  • By raising the cost of job loss, the employment rent paid by the employer makes it more likely the employee will stay at the firm.

6.11 Another kind of business organization: Cooperative firms

worker-owned cooperative
A form of business in which a substantial fraction of the capital goods are owned by employees rather than being owned by those who are not involved in production in the firm; worker-owners typically elect a manager to make day to day decisons.
cooperative firm
A firm that is mostly or entirely owned by its workers, who hire and fire the managers.

Even in capitalist economies, some business organizations have an entirely different structure to the one we have been analysing—their workers are the owners of the capital goods and other assets of the company, and they select managers who run the company on a day-to-day basis. This form of business organization is called a worker-owned cooperative or cooperative firm.

During the twentieth century, worker-owned plywood producers successfully competed with traditional capitalist firms in the US.

John Pencavel. 2002. Worker Participation: Lessons from the Worker Co-ops of the Pacific Northwest. New York, NY: Russell Sage Foundation Publications.

The knowledge-based economy is creating new forms of firms, neither capitalist nor worker-owned.

Tim O’Reilly and Eric S. Raymond. 2001. The Cathedral & the Bazaar: Musings on Linux and Open Source by an Accidental Revolutionary. Sebastopol, CA: O’Reilly.

One well-known example of a cooperative is the British retailer John Lewis Partnership, founded in 1864 and held in trust for its employees since 1950. Every employee is a partner, and employee councils elect five out of seven members of the company board. The benefits for employees (pension, paid holidays, long-service sabbaticals, and social activities) are generous, and the business’s profits are shared out as a bonus, calculated as a percentage of each person’s salary every year. John Lewis has been one of the UK’s most consistently successful retail businesses.

Cooperatives have fewer supervisors

Worker-owned cooperatives are hierarchically organized, like conventional firms, but the directives issued from the top of the hierarchy come from people who owe their jobs to the worker-owners. Other than this, the main differences between conventional firms and worker-owned cooperatives are that the cooperatives need fewer supervisors and other management personnel to ensure that the worker-owners work hard and well. Fellow worker-owners will not tolerate a shirking worker because the shirker is reducing the profit share of the other workers. Reduced need for supervision is among the reasons that worker-owned cooperatives produce at least as much per hour (if not more) than their conventional counterparts.

There are typically fewer inequalities in wages and salaries within the company in worker-owned cooperatives than in conventional firms, for example between managers and production workers. And worker-owned cooperatives tend not to lay off workers when the economy goes into recession, offering their worker-owners a kind of insurance (often they cut back on the hours of all workers rather than terminating the employment of some).

Case studies show that, in those unusual companies owned primarily by the workers themselves, work is done more intensely with less supervision. There have been many attempts to establish other types of business organization throughout recent history, but borrowing the funds to start and sustain worker-owned companies is often difficult because, as we will see in Unit 9, banks are often reluctant to lend funds (except at high interest rates) to people who are not wealthy.

Exercise 6.6 A worker-owned cooperative

In Figure 6.1 we showed the actors and decision-making structure of a typical firm.

  1. How do the actors and decision-making structure of John Lewis Partnership differ from that of a typical firm?
  2. Redraw Figure 6.1 to illustrate your answer to Question 1.

Question 6.12 Choose the correct answer(s)

Which of the following statements regarding a cooperative firm such as John Lewis are correct?

  • The firm is owned by shareholders, some of whom are employees.
  • Workers typically exert more effort, despite having less supervision.
  • During a downturn, the firm tends to reduce working hours for all workers, rather than fire some workers.
  • Profits are not paid out to the owners but retained within the firm for future investment.
  • The firm is owned by the employees, every one of whom is a partner.
  • This is true in a cooperative firm, where fellow worker-owners do not tolerate a shirking colleague.
  • This is true in a cooperative firm, where the effects of a downturn are shared among the worker-owners.
  • A significant proportion of the profits is retained for future investment, while the rest is shared out as a bonus between the employees, who are the owners.

Exercise 6.7 Using Excel: Who owns the firms?

In this unit, we learned that owners are at the top of the ownership structure of a ‘typical’ firm, with managers in the middle and employees at the bottom of the hierarchy. We will now look at the characteristics of firm owners in different countries.

The data you will be using is from the World Bank’s Enterprise Surveys, which collect information about characteristics of firms around the world and the business environment they face.

Download the firm ownership data. There are four variables related to ownership:

  • proportion of private domestic ownership in a firm
  • percentage of firms with at least 10% of foreign ownership
  • percentage of firms with at least 10% of government/state ownership
  • percentage of firms with legal status of sole proprietorship (these firms are not a legally separate entity from their owner, and cannot sell shares to raise funds for the business)
  1. Choose two countries in the dataset and filter the data so that only the entries with ‘All’ for the variable ‘Subgroup Level’ are visible. For each country, plot a column chart showing these four variables, with percentages on the vertical axis and sector (manufacturing or services) on the horizontal axis. Make sure to include a legend and label the axes appropriately. (If your chosen country has more than one year of available data, plot a separate column chart for each year). For help on how to filter the data and draw a column chart, go back to Exercise 1.3 in Unit 1.
  2. The variable ‘Subgroup’ shows the same four variables, but for different subsectors, firm sizes, regions within a country, exporting behaviour, and gender of the top manager. Choose one subgroup and plot a separate column chart for each country, showing these four variables, with percentages on the vertical axis and the variable ‘Subgroup Level’ (containing the name of each subgroup) on the horizontal axis.
  3. Suggest some explanations for any similarities or differences in firm ownership across countries and/or time that you observe in your charts from Questions 1 and 2. (You may find it helpful to research the institutions and policies related to business activity in your chosen countries.)

Great economists John Stuart Mill

The Popular Science Monthly

John Stuart Mill (1806–1873) was one of the most important philosophers and economists of the nineteenth century. His book, On Liberty (1859),17 parallels Adam Smith’s Wealth of Nations in advocating limits on governmental powers, and is still an influential argument in favour of individual freedom and privacy.

Mill thought that the structure of the typical firm was an affront to freedom and individual autonomy. In The Principles of Political Economy (1848), Mill described the relationship between firm owners and workers as an unnatural one:

To work at the bidding and for the profit of another, without any interest in the work … is not, even when wages are high, a satisfactory state to human beings of educated intelligence …

Attributing the conventional employer–employee relationship to the poor education of the working class, he predicted that the spread of education, and the political empowerment of working people, would change this situation:

The relation of masters and work-people will be gradually superseded by partnership … perhaps finally in all, association of labourers among themselves.18

Exercise 6.8 Was Mill wrong?

Why do you think Mill’s vision of a postcapitalist economy of worker-owned cooperatives has not yet occurred?

6.12 Another kind of business organization: The gig economy

gig economy
An economy made up of people performing services matched by means of a computer platform with those paying for the service. Workers are paid for task performance and not per hour, are not legally recognized as employees of the company that owns the platform, and typically receive few if any benefits from the owners other than matching.

A ‘gig’ for a musician or comedian is a single appearance for which they will be paid not by the hour, but an agreed sum for the performance. The gig economy is not about jokes and tunes, however; it refers to the combined activities of Uber or Lyft drivers, TaskRabbits, Upworkers, Mechanical Turkers, and others who transport people and goods, home-assemble online purchased furniture, and perform other well-defined tasks for which they are paid a fixed rate.

Gig workers do their jobs independently, not as members of a team, and gain access to their ‘gigs’ by means of a two-sided digital platform that connects those who will pay for the work, and those who perform it.

The gig economy provides an illuminating contrast with the model of labour discipline studied in this unit. The key difference is that there is no labour discipline problem because the tasks performed are sufficiently well-defined that a virtually complete contract is possible—if you want to go from your hotel to the airport, your Lyft driver does not get paid. If you hire someone to assemble your flat-packed furniture, the TaskRabbit worker who was putting it together does not make any money until it is put together properly.

An important feature of the gig economy is that the only way that workers can get gigs is through the platforms owned by a few firms—for example Uber and Lyft for taxi services, TaskRabbit for tasks around the home, or Mechanical Turk for small administrative jobs. This means that those performing the gigs have no real bargaining power—if a TaskRabbit worker objects to the terms, there will always be another Tasker to do the job. The worker who refused the job will be unlikely to find better gigs on that platform.

The digital platform that allows those who need a gig performed to connect to those performing the gigs makes substantial mutual benefits possible by putting together gig workers—who have free time and the skills, a vehicle, or other equipment required—with those willing to pay for a completed gig. But because there are few platforms and many gig workers, they typically receive very little pay for often difficult and onerous work.

A result is that gig performers in this economy face extraordinary economic insecurity—they are not guaranteed a fixed schedule of hours and pay, nor do they receive health insurance benefits, maternity leave, holiday pay, or pension contributions through their employer.

Why does TaskRabbit, for example, not pay enough for gigs so that the Taskers receive an employment rent, as would be the case in the typical office or plant described by the labour discipline model? The answer is that they do not need to pay more than the gig worker’s next best alternative. They do not need to motivate the worker to do the job—if it is not done, the worker will not be paid. A result is that the gig economy can often produce services at a lower cost and price than are available from conventional firms.

The gig economy affects employees in conventional firms

The gig economy is a small portion even of those high-income economies where, for example, ride services like Uber and Lyft have competed successfully against conventional taxi firms.

It has at least three effects on employees working in conventional firms:

6.13 Principals and agents: Interactions under incomplete contracts

In the relationship between Maria and her employer, Maria’s work effort matters to both parties but is not covered by the employment contract. This leads to the existence of employment rents. If they had been able to write a complete contract, the situation would have been quite different. The employer could have offered her an enforceable contract, specifying both the wage and the exact level of effort she should provide, and if these terms were acceptable to her, she would have agreed and worked as required. To maximize profit, the employer would have chosen a contract that was only just acceptable, so Maria would not have earned any rents.

This example is not unusual. In practice, all employment relationships are governed by incomplete contracts. Employment contracts often do not even bother to mention that the worker should work hard and well. By contrast, the way we have described the gig economy means that a gig worker does not have an employment contract with a firm. The nature of work in the gig economy is the subject of legal battles in many countries.

Why are contracts incomplete?

Thinking about some examples of economic interactions, we can see that there are several reasons for the absence of a complete contract:

Principal–agent models

principal–agent relationship
This is an asymmetrical relationship in which one party (the principal) benefits from some action or attribute of the other party (the agent) about which the principal’s information is not sufficient to enforce in a complete contract. See also: incomplete contract. Also known as: principal–agent problem.

In the case of Maria and her employer, the employer is called the principal. The employer would like to offer Maria, the agent, an employment contract and she wants the job, but the amount of effort she will provide cannot be specified in the contract because it is not verifiable. The relationship between the two actors within the firm is an example of a principal–agent relationship.

Our model of Maria’s employment is an example of a principal–agent model, in which an action taken by the agent is ‘hidden’ from the principal, or ‘unobservable’.

hidden attributes (problem of)
This occurs when some attribute of the person engaging in an exchange (or the product or service being provided) is not known to the other parties. Example: an individual purchasing health insurance knows her own health status, but the insurance company does not. Also known as: adverse selection. See also: hidden actions (problem of).

In short, a hidden action problem occurs when there is a conflict of interest, between a principal and an agent, over some action that may be taken by the agent, and this action cannot be subjected to a complete contract.

Incomplete contracts are the rule, not the exception, in the economy

Using the lens of the principal–agent relationship, we can see many other ways in which we interact in the economy and society without a complete contract:

The table in Figure 6.9 identifies the principals and agents in the examples from this section.

Principal Agent Action that is hidden, and not covered in the contract
Employer Employee Quality and quantity of work
Banker Borrower Repayment of loan, prudent conduct
Owner Manager Maximization of owners’ profits
Landlord Tenant Care of the apartment
Insurance company Insured Prudent behavior
Parents Teacher/doctor Quality of teaching and care
Parents Children Care in old age

Figure 6.9 Hidden action problems.

Emile Durkheim (1858–1917), the founder of modern sociology, observed that ‘not everything in the contract is contractual.’ There is usually something that matters to at least one of the parties that cannot be written down in an enforceable contract.

Exercise 6.9 Principal–agent relationships

For each of the following examples, explain who is the principal, who is the agent, and what aspects of their interaction are of interest to each and are not covered by a complete contract.

  1. A company hires a security guard to protect its premises at night.
  2. A charity wants to commission research to find out as much as possible about a new virus.

Question 6.13 Choose the correct answer(s)

Which of the following statements correctly identify who is the principal and who is the agent?

  • In a public limited company, the managers are the principals and the shareholders are the agents.
  • In a contract between a football club and its star player, the club is the principal and the player is the agent.
  • In an Airbnb contract, the owner and the traveller are both principals and agents.
  • In a contract to buy an essay from an online provider, the essay writer is the principal and the student is the agent.
  • The shareholders do not have the information to verify whether the managers are working in their interest. Therefore, the shareholders are the principals and the managers are the agents.
  • The club is not guaranteed to receive the returns worthy of the hundreds of thousands of pounds a week paid to its star player.
  • The quality of the room rented is not guaranteed, and in this case the traveller is the principal and the owner is the agent. But the care of the room is also not guaranteed, in which case the owner is the principal and the traveller is the agent.
  • The student does not know whether the essay bought will bring him the top grade. Therefore, the student is the principal and the essay writer is the agent.

Question 6.14 Choose the correct answer(s)

Which of the following are measures that can reduce principal–agent problems?

  • paying part of the chief executive’s bonus as company shares rather than cash
  • a black box in the car that measures the speed of the driver
  • travellers who submit an insurance claim must pay the first £100 of the amount claimed out of pocket (the insurer will not reimburse this £100)
  • increasing the number of workers in a factory
  • This is a measure to realign the interests of the chief executive with those of the shareholders.
  • This is a measure to reduce the moral hazard of drivers, who may drive more recklessly if they have car insurance.
  • This is a measure to reduce the moral hazard of travellers who have travel insurance from being more careless with their luggage.
  • This makes monitoring more difficult and worsens the principal–agent problem.

6.14 Conclusion

division of labour
The specialization of producers to carry out different tasks in the production process. Also known as: specialization.
principal–agent relationship
This is an asymmetrical relationship in which one party (the principal) benefits from some action or attribute of the other party (the agent) about which the principal’s information is not sufficient to enforce in a complete contract. See also: incomplete contract. Also known as: principal–agent problem.

In a capitalist economy, the division of labour is coordinated both by markets (which contribute to the decentralization of power) and by firms (which concentrate power in the hands of owners). To understand the role of the firm, we view it not only as an actor, but also a stage on which owners, managers and employees interact in principal–agent relationships.

separation of ownership and control
The attribute of some firms by which managers are a separate group from the owners.
hidden attributes (problem of)
This occurs when some attribute of the person engaging in an exchange (or the product or service being provided) is not known to the other parties. Example: an individual purchasing health insurance knows her own health status, but the insurance company does not. Also known as: adverse selection. See also: hidden actions (problem of).
incomplete contract
A contract that does not specify, in an enforceable way, every aspect of the exchange that affects the interests of parties to the exchange (or of others).
reservation wage
What an employee would get in alternative employment, or from an unemployment benefit or other support, were he or she not employed in his or her current job.
employment rent
The economic rent a worker receives when the net value of her job exceeds the net value of her next best alternative (that is, being unemployed). Also known as: cost of job loss.

While the separation of ownership and control makes it possible for the objectives of owners and managers to diverge, incentive schemes may help align interests. The problem of hidden actions becomes especially evident in the worker–employer relationship, characterized by incomplete contracts. These arising due to the fact that employees’ effort is neither perfectly observable nor verifiable, and their tasks depend on unforeseeable future events. It is this contractual incompleteness that causes the wages offered to workers to be above their reservation wage, giving rise to an employment rent that incentivizes them to exert effort.

labour discipline model
A model that explains how employers set wages so that employees receive an economic rent (called employment rent), which provides workers an incentive to work hard in order to avoid job termination. See also: employment rent, efficiency wages.

Drawing on our game theory and constrained choice tools, we have developed the labour discipline model to study the worker–employer interaction as a sequential, repeated game where the employer offers a wage and the worker responds by choosing the amount of effort she exerts:

worker’s best response function (to wage)
The optimal amount of work that a worker chooses to perform for each wage that the employer may offer.
employment rent
The economic rent a worker receives when the net value of her job exceeds the net value of her next best alternative (that is, being unemployed). Also known as: cost of job loss.
disutility of effort
The degree to which doing some task (effort) is unpleasant.
marginal rate of transformation (MRT)
The quantity of some good that must be sacrificed to acquire one additional unit of another good. At any point, it is the slope of the feasible frontier. See also: marginal rate of substitution.
isocost line
A line that represents all combinations that cost a given total amount.
efficiency unit
A unit of effort is sometimes called an efficiency unit.
marginal rate of substitution (MRS)
The trade-off that a person is willing to make between two goods. At any point, this is the slope of the indifference curve. See also: marginal rate of transformation.
Worker Employer
The worker’s best response function shows the optimal level of effort the worker chooses to exert at a given wage. It slopes upward because a higher wage increases the cost of job loss, inducing the worker to put in more effort. It is concave because the disutility of effort is greater at higher effort levels, causing diminishing marginal returns to wages. Its slope is the marginal rate of transformation (MRT) of wages into effort. Isocost lines can be seen as indifference curves. They join the set of points with the same ratio of effort to wages, which the employer seeks to maximize in order to minimize the wage cost per efficiency unit. A steeper isocost line represents a lower cost of effort. The slope of an isocost represents the rate at which the employer is willing to increase wages to get higher effort (the MRS).
Optimal Choice: MRT = MRS

The labour discipline model.

Figure 6.10 The labour discipline model.

efficiency wages
The payment an employer makes that is higher than an employee’s reservation wage, so as to motivate the employee to provide more effort on the job than he or she would otherwise choose to make. See also: labour discipline model, employment rent.
involuntary unemployment
A person who is seeking work, and willing to accept a job at the going wage for people of their level of skill and experience, but unable to secure employment is involuntarily employed.

The point of tangency represents a Nash equilibrium, and wages set this way are known as efficiency wages. The main implication for the broader economy is that there is always involuntary unemployment in equilibrium. We can analyse the effects of public policies by considering how these affect the worker’s best response function.

worker-owned cooperative
A form of business in which a substantial fraction of the capital goods are owned by employees rather than being owned by those who are not involved in production in the firm; worker-owners typically elect a manager to make day to day decisons.
gig economy
An economy made up of people performing services matched by means of a computer platform with those paying for the service. Workers are paid for task performance and not per hour, are not legally recognized as employees of the company that owns the platform, and typically receive few if any benefits from the owners other than matching.

We have also looked at worker-owned cooperatives, where typically less supervision is necessary, and considered the implications of the modern gig economy, including for people currently working as employees in firms.

6.15 Doing Economics: Measuring management practices

In Section 6.1, we discussed the top-down decision-making structure in most firms, which involves managers directing the activities of their employees to implement the long-term strategies decided by owners. We might expect that firms where employees and production processes are managed well will be more productive than poorly-managed firms. However, defining and quantifying ‘good’ management practices is a challenge.

In Doing Economics Empirical Project 6, we look at some ways to measure the quality of a firm’s management practices, and make comparisons across countries, industries, and types of firms, and discuss possible explanations for the patterns we observe.

Go to Doing Economics Empirical Project 6 to work on this project.

Learning objectives

In this project you will:

  • explain how survey data is collected, and describe measures that can increase the reliability and validity of survey data
  • use column charts and box and whisker plots to compare distributions
  • calculate conditional means for one or more conditions, and compare them on a bar chart
  • construct confidence intervals and use them to assess statistical significance
  • evaluate the usefulness and limitations of survey data for determining causality.

6.16 References

  1. Herbert A. Simon. 1991. ‘Organizations and Markets’. Journal of Economic Perspectives 5 (2): pp. 25–44. 

  2. Herbert A. Simon. 1951. ‘A Formal Theory of the Employment Relationship’. Econometrica 19 (3). 

  3. Karl Marx. (1848) 2010. The Communist Manifesto. Edited by Friedrich Engels. London: Arcturus Publishing. 

  4. Ronald H. Coase. 1937. ‘The Nature of the Firm’. Economica 4 (16): pp. 386–405. 

  5. Ronald H. Coase. 1937. ‘The Nature of the Firm’. Economica 4 (16): pp. 386–405. 

  6. D. Robertson. 1923. The Control of Industry. Hitchen: Nisbet. 

  7. Ronald H. Coase. 1992. ‘The Institutional Structure of Production’. American Economic Review 82 (4): pp. 713–719. 

  8. Barbara Ehrenreich. 2011. Nickel and Dimed: On (Not) Getting By in America. New York, NY: St. Martin’s Press. 

  9. Polly Toynbee. 2003. Hard Work: Life in Low-pay Britain. London: Bloomsbury Publishing. 

  10. Harry Braverman and Paul M. Sweezy. 1975. Labor and Monopoly Capital: The Degradation of Work in the Twentieth Century. 2nd ed. New York, NY: Monthly Review Press. 

  11. Susan Helper, Morris Kleiner, and Yingchun Wang. 2010. ‘Analyzing Compensation Methods in Manufacturing: Piece Rates, Time Rates, or Gain-Sharing?’. NBER Working Papers No. 16540, National Bureau of Economic Research, Inc. 

  12. Lori G. Kletzer. 1998. ‘Job Displacement’. Journal of Economic Perspectives 12 (1): pp. 115–136. 

  13. Kenneth A. Couch and Dana W. Placzek. 2010. ‘Earnings Losses of Displaced Workers Revisited’. American Economic Review 100 (1): pp. 572–589. 

  14. Louis Jacobson, Robert J. Lalonde, and Daniel G. Sullivan. 1993. ‘Earnings Losses of Displaced Workers’. The American Economic Review 83 (4): pp. 685–709. 

  15. Edward P. Lazear, Kathryn L. Shaw, and Christopher Stanton. 2016. ‘Making Do with Less: Working Harder during Recessions’. Journal of Labor Economics 34 (S1 Part 2): pp. 333–360. 

  16. Truman F. Bewley. 1999. Why Wages Don’t Fall during a Recession. Cambridge, MA: Harvard University Press. 

  17. John Stuart Mill. (1859) 2002. On Liberty. Mineola, NY: Dover Publications. 

  18. John Stuart Mill. (1848) 1994. Principles of Political Economy. New York: Oxford University Press.