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The Efficient Wage and Its Challenges

The Efficient Wage and Its Challenges Economy Near Us (XXVI)

The standard Economics states that the gross nominal wage which is consistent (that is, non-contradictory) with the criterion of economic behaviour of the employer – the gross profit maximization – must be at most at the level of monetary expression of the marginal labour productivity (such a level could be called the optimal-based wage – OBW). Let us presume, for the sake of discussion, that the employer does not wish to exploit the employee, so he does not pay less than the OBW. But what happens if he pays more than the OBW? Here emerges the concept of the efficient wage (EW), that is that gross level of the wage which is higher than the OBW. In the present intervention, I will discuss some issues related to the concept of EW, in the very context of Romanian economy where, quite recently, such a philosophy of remuneration was implemented. 

Demand-side command of economy 

The demand-side command of economy is a policy strategy based on the Keynes-ian economic theory according to which the demand is pushing on supply, not the other way around. The causal circularity between demand and supply (remember that the Chicago School of monetarism stated the inverse causality) and the uselessness of such a reductionism is outside of our interest here, so the demand-side command of economy will be taken as such. So, this hypothesis states that by increasing the aggregate demand (of course, we are talking about the effective demand, that is, about the covered demand), the economy will react by increasing the appropriate supply – namely, through the well-known mechanism of increasing prices when the demand increases, which encourages the supply which, in turn, is increasing, caeteris paribus, with the price increasing. Of course, any component of the aggregate demand could be selected to be increased so the aggregate demand increases. 

WLG model and its requirements? 

In the case of the demand-side command economy, the WLG (wage led growth) model implies that increasing of the aggregate demand will be pushed by the increasing of wages, because wage is a component of private consumption, which is, in turn, a component of the aggregate demand. Leaving aside the fact that the consumption does not increase at the same rate with the wage, but according to the marginal rate of consumption (which is less than 1, and has a concave shape, so it is decelerating with increase), it is also questionable if the consumption increase based on the wage increase will really stimulate the internal supply, because an open economy has the risk that the income will be directed to the external supply, stimulating imports. These two vulnerabilities of the WLG model could be considered as being outside of the governmental control, so are very difficult to manage. Moreover, there is another vulnerability which emerges from the reaction of the employees to the efficient wage. Let us make some assessments in the matter. 

How would the efficient wage work? 

It must be said from the beginning that the EW can only work in very specific conditions, so it is very risky to use it in a WLG model. Since the EW, like any wage, is considered, once granted, as an irreversibly gained right, it is questionable if the employee granted such will increase his/her marginal labour productivity to arrive at optimality from the employer’s perspective, even if that employee knows about the quality of EW regarding the increasing of the wage in case. It is even less likely that the employee will increase his marginal labour productivity when he ignores this issue. So, the EW could work (namely, to increase labour productivity) if and only if it is reversible. In other words, the employee in case must be made aware about this reversibility, that is, about the conditional character of the increase in wages. From a formal point of view, such a case has the nature of a new labour contract between the employer and the employee regarding the introduction of a flexibility in establishing the nominal gross wage – i.e., the maintenance of the increased wage is conditioned by the increase in the labour productivity (in an agreed time horizon) by a given measure. If such a conditionality is violated, then the wage will be reduced at the previous level, which is presumed to be verified by the level of the marginal labour productivity. Being stipulated into the labour contract (that is, acting as a law of the parts), the reversibility (or the conditioned flexibility) of the EW is ensured and, consequently, the adverse effects can be avoided. 

How should the efficient wage be designed? 

From the above mentioned, it can be understood that the EW has a crucial vulnerability when it is used as an incentive to push on the supply in a demand-side command of economy. The worst situation is when, on the one part, the additional income is directed to the external supply and, on the other part, the additional income is considered a gained right, which does not lead to the corresponding increasing of the labour productivity (I do not consider the irresponsible case in which the wage increase is not intended to act as EW but is done simply for reason of populism – as it seems to have recently been the case in Romania). Then, is there a way to design and safely use the EW? I think the answer is affirmative. Two main conditions should be accomplished to this end:

  • the economic condition: as it is well-known (see the standard theory of production), the marginal labour productivity is concavely increasing and higher than average labour productivity until the first inflection point of the logistic shape of the production function, where it reaches its maximum. Between the first inflection point and the second inflection point of the production function curve, the marginal labour productivity is decreasing while the average labour productivity continues to concavely increase (the marginal labour productivity equals the average labour productivity exactly for the second inflection point of the production function curve). The nominal gross wage should be only increased after the production function curve has reached its second inflection point and only by, at most, the difference between the average labour productivity and the marginal labour productivity (I remind to the reader that, after reaching its the second inflection point of the production function curve, the average labour productivity is always higher than the marginal labour productivity);
  • the contractual condition: the contractual condition ensures the reversibility of the actual wage (its return to the level indicated by the marginal labour productivity) if the production function does not reverse its decreasing trend (which comes after reaching its second inflection point). Of course, not reversing the decreasing trend of the production function is a cumulative effect of at least three causes:
  • the Dusenberry effect for insufficient increase in consumption when the income increases;
  • the directing of the increase in consumption demand to the external supply (imports);
  • a belief that the wage increase is already based on the marginal labour productivity increase. 

A compromise solution? 

Why wouldn’t the two parts (employer and employee) agree that the difference between the EW and the actual wage (as described before) should be stored in a special fund (like a pension fund) and be granted to an employee when and only when his/her marginal labour productivity will justify that? But, of course, such a development deserves a separate intervention.

 

 
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OEconomica No. 1, 2016