Question

Efficiency wages are defined as wages that are intentionally above market rates. This practice is sometimes cited within the macroeconomics literature as a basis for sticky wages in the short run. One explanation for efficiency wages derives from incomplete information. In a world of complete information, firms could structure compensation contracts to directly reward high effort and punish low effort. However, in a world of incomplete information, monitoring is difficult and costly.

Consider a worker that must make a choice between putting in high effort on the job and putting in low effort on the job (a.k.a. shirking). If the worker puts in high effort, he/she keeps the jobwith certainty and earns w. If the worker puts in low effort (shirks), then he/she earns G, the gain from shirking. The probability that the firm catches the worker shirking is f, in which case the worker is fired, and he/she must take a new job at the market wage m. If the firm does not catch the worker shirking, then he/she continues to earn w.

(a) Construct an extensive-form representation of this game where the firm makes the first move by offering a wage w.

(b) Write down the payoff to the worker from putting in high effort and the expected payoff to the worker from shirking.

(c) What incentive compatibility constraint must be met for the worker to choose to put in high effort?

(d) Describe the relationship between the firm’s optimal choice of w and G, all else equal.

(e) Describe the relationship between the firm’s optimal choice of w and f, all else equal.

Answer 1