Wage Determination and Labour Market Dynamics

This assignment delves into the complexities of wage determination within the Australian labor market. Students are tasked with examining the interplay between wages, productivity, and unemployment, drawing upon theoretical frameworks such as efficiency wage theory and gravity models. The assignment encourages critical analysis of empirical evidence and research papers to understand the factors influencing wage levels in Australia.

Running head: EFFECTITIVENESS OF PAY FOR PERFORMANCE
Effectiveness of Pay for Performance
Name of the Student
Name of the University
Author note

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Introduction
Wage is the remuneration given to the employees. Wage provides incentives to the
workers to work. The equilibrium wage in the labor market is determined from the forces of
labor supply and labor demand. When employers without any pressure from regulatory body sets
a wage above the equilibrium wage then the wage is called efficiency wage (Weiss 2014). The
efficiency wage theory explains a positive relationship between wage and work effort or
performance of workers. The theory suggests firms should offer wage above the wage that clears
market. When a high wage is offered then workers become more responsible toward their jobs
which in turn increases their loyalty and reduces shirking behavior on the part of employees.
Premium wages increases integrity in the work place. All these contribute to increasing
productivity and increases profit. A low level of wage or wages just equal to market clearing
level increases dissatisfaction among the employees. This negative attitude hampers productivity
and increases turnover rate among the employees (Dunlop and Segrave 2016). Another
important theory that explains relationship between labor supply and wage is the theory of
backward bending labor supply curve. According to this theory motivation for work effort
increases in line with wage only up to the certain point. After that critical threshold limit labor
supply falls even when wage increases. This is because workers give more preference to leisure
than work effort.
The research essay analyzes theoretical framework of both the concept and then attempts
to evaluate it based on empirical evidences from existing economic literature.

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Economic literature on theoretical framework
The theory of efficiency wage
There are several reasons for which labor market always experiences some unemployment. The
commonly discussed factors for some persistent unemployment include minimum wage
legislation, people looking for new jobs and bargaining by labor union. Above all, another reason
for having a situation of labor surplus is suggested by the theory of efficiency wage (DiGabriele
and Ojo 2017). This theory is in support of the fact that a more efficient operation is ensured by
the firm when it keep wages above the market equilibrium wage. The resulted profitability
encourages firm to offer a high wage to the existing workers even when surplus labors are
present in the economy. Minimum wage, labor union bargaining and efficiency wage all end up
with unemployment because of wages above the equilibrium level. However there is difference
between efficiency wage and the former two model. In the first two cases regulatory bodies and
union restricts firm to lower the wage from set minimum level. With efficiency wage theory such
constraints are not needed as firms are better off from paying a high wage. The rationale is that
profitability of firms’ increases with high wage as it enhances efficiency (Razzak 2015).
There are several theories of efficiency wage each explaining positive association
between wage and worker efficiency from a different aspect.
Workers Health: It is the simplest form of efficiency wage theory. It describes a direct link
between wages offered and health of the workers. When workers receive high remuneration they
can afford a nutritious diet. The healthy diet make workers healthier and increases productivity.
Employers may prefer to pay high wage and retain a healthier and productive pool of workforce

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than to pay a low wage and have workers suffering from poor health condition (Moore and
Viscusi 2014).
This explanation of efficiency wage is not much relevant for workers in rich countries. In
these countries most of the workers get enough payment to afford a healthy diet. Here it is not a
major concern for firm that paying wage equal to market clearing wage can affect health of the
workers in any means. This theory finds more relevance in for workers in poor countries where a
slight rise in income brings significance difference to workers health. As a result unemployment
is found to be high in developing and underdeveloped nation (Mankiw 2014). For example, most
firms in Africa is in fear that a wage cut can adversely affect their workers’ health and
productivity.
Worker Turnover Model: Efficiency wage theory based on the worker turnover points towards
the relationship between worker turnover and wage received. Workers quit their jobs for several
reasons. These include finding suitable jobs in some other firms, to shift and settle in some other
side of the country, in order to quit labor force and such others (Weiss 2014). The frequency with
which worker turnover likely to occur in an industry that might depend on the incentives workers
receive in their existing jobs. Depending on work incentives they can perform a cost benefit
analysis for whether to stay or leave the industry. When incentives are higher than cost of
quitting a job is also higher. With a high and secure payment workers tend to leave their jobs
less. Therefore, by paying a high wage the firm can retain its worker and turnover is minimized.
High turnover is a reason of concern for firms. It generally entails greater cost to the
firms to hire new workers and train them for their job responsibility. Even after training, the
newly trained workers lag behind the experienced workers in terms of productivity (Faia,

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Lechthaler and Merkl 2014). Therefore, it may seem profitable for the firm to pay high wages to
make labor turnover as least as possible.
Adverse Selection Model: Quality of workers depends on wages offered to them. Firms always
give priority in hiring most talented and productive workers from the available labor force. The
firms cannot perfectly asses the quality of workers and hence, uses the scale of wage (Yang
2013). A high wage level attracts better workers pool apply for a job and thus increases quality
of the workforce. When the firm offers a low wage in response to a labor surplus then better
quality workers who are generally more competent than less qualified counterpart may not apply
for the low paid job. When wage becomes an important attribute in determining quality of
applicant then this supports the efficiency wage claim (Stanley 2014).
Shirking Model: The theory of efficiency wage based on worker effort explains the connectivity
between payment of wages and effort given by the workers. In many jobs workers have choices
regarding how much effort to give (Halaby 2014). In this kind of situation firs doubt about
workers loyalty thy monitor workers activity and those not giving enough effort or found
shirking their responsibilities are driven away. However, it is not possible to catch all shirkers as
an immediate instance. Moreover, on part of the firm monitoring in an imperfect and costly
practice. In order to reduce shirking activity firms often decide to pay a high wage. With higher
remuneration workers are more interested to retain their job and therefore try to give maximum
effort (Kwon 2014).
Labor market segmentation and efficiency wage
The theory of labor market segmentation was founded in 50ss of 20th century. The theory
is derived from a number of factors in labor market that demand attention at that time. Job

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securities at different levels and different levels of wage assessment were evident in the labor
market. No uniformity in available opportunities and condition were found to exist (Wilkinson
2013). The practice of discrimination was reflected in the theory of labor market segmentation.
Segmented labor market refers to existence of different sub markets where each faces a
different condition. In each segments there are different economic and social factors with a
different quality. In real world, these segments often overlap with each other and are not clearly
distinguishable. Three basic segments are professional markets, locally regional markets and
branch market. The principal explanation of labor market segmentation lies in the existence of a
dual economy. In the dual economy there is one central and one peripheral sector. The central
sector is considered as a privileged sector and workers receive a high remuneration in central
than in the peripheral sector (Altmann et al. 2013). The dual markets works on grounds of lower
and higher income sectors in economic stock, the prevailing wage levels draws a possibility of
changing ranking position, higher stability of workers associated in jobs with a high salary and
absence of full mobility between sectors.
Based on above characteristics there are two broad sectors in the labor market primary or
internal sector and secondary or external sector. An ordinary labor cannot access to primary
sector as the positions here are determined following seniority of principals. The higher positions
are determined by high qualification and this corresponds to high salary of worker. The
secondary sector means real world labor market where supply of labor matches with demand and
workers receive only market clearing wage. As there are no incentives for additional work effort
room exists for improving knowledge and skill base of workers.
The labor market segmentation theory explains low wages in secondary sectors of labor
market and poor work condition and hence high turnover. This provide foundation to the theory

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of efficiency wage. The theory holds for both internal and external sector of labor market. For
the secondary sector high wages increases job security and hence productivity (Cahuc, Carcillo,
and Zylberberg 2014). In the external sector as well companies value the positive association
between high wage and high productivity.
The theory of backward bending labor supply curve
Labor supply curve shows the association between quantities of labor supplied and wage
rate. The positive relation between wage and labor supply does not always hold as assumed in an
ideal situation. In real world, supply curve bends backward with a rising wage rate. When wage
changes then there are effects namely substitution effect and income effect. An increase in wage
raises income of the workers. With the increased income worker can purchase more items
including leisure. This is income effect of an increases in wage. The increased wage means a
higher opportunity cost of leisure (Greenwood 2016). It tends the workers to substitute leisure
with work effort. This is substitution effect of wage increase. The final effect on labor supply
depends on magnitude of substitution and income effect.
Figure 1: Income and substitution effect of a change in wage

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(Source: Mankiw 2014).
In figure 1, the horizontal axis measures labor supply (from right to left) and leisure (from left to
right). The vertical axis measures labor income. At an initial wage rate of W0, the available work
hours is OT and corresponding money income in OM0. At this wage rate the individual worker is
in equilibrium at point R. At this point, the worker supplies L0T hours of labor and enjoys OL0 of
leisure hours. With an increase in wage rate leisure income constraint rotates pivotally and
becomes TM1. The equilibrium now shifted to H with a low labor hours L1T and high choice of
leisure OL1. The substitution effect tends to increase labor supply from L0T to L2T. However, the
income effect tends to decrease work effort from L2T to L1T. The income effect dominates
because of a greater magnitude and hence reduces work effort.
Figure 2: Backward bending labor supply curve

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(Source: Mankiw 2014).
Literature on empirical evidences
In the previous section two important theories related to labor market are discussed with
their theoretical foundation. The efficiency wage theory posits that paying wage above market
determined wage increases efficiency of workers and hence in the interest of employers to pay a
high wage. The backward bending labor supply curve in contrast oppose this fact. It indicates
increasing wage beyond a critical level reduces work effort as workers prefer leisure hours to
labor. Any conclusion regarding what is actually happening in the labor market needs support
from empirical evidences. In this section the existing literatures based on real world phenomenon
are reviewed to find support or opposition of these two theories.
The efficiency wage hypothesis is always been an interesting area of research. One such
important thesis attempts to find answer to two important questions using time series data. The
first question is whether payment of wage above market equilibrium level increases output of the
industry by increasing labor productivity. Another related aspect is to find out whether there is a
positive association between such a wage rate and level of unemployment (Chand 2016). In
order to test efficiency wage hypothesis Solow residual approach is used. The empirical data
used is that on shares of labor and capital and then directly using them by incorporating it in the
production function. Regression of industry productivity on wage and unemployment captures
the effect of wage and unemployment on productivity and industry. The literature often suggests
a weak evidence in favor of hypothesis of efficiency wage in Australia. The estimated elasticity
of output with respect to wage is very small when estimated empirically. Also, the result suggest
insignificant association between unemployment and wage level. Studies on existing literature
suggest two probable factors behind this results in Australia (McLachlan 2013). The reason for

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weak association between unemployment and output is former is directly linked with business
cycle fluctuation. Therefore it seems to be unlikely to obtain favorable result of output elasticity
in respect of unemployment (Kifle 2014). In Australia, the scope for making efficiency wage
was restricted for two factors during 1980 and 1990s. The wage was restrained highly after the
phase of recession in 1982. During this time, development of non-wage allowances and
increased benefit of superannuation were more of a focus than to increase real wages in the
industry. In the labor market a workplace agreements were build they encouraged a wage
increase only after achieving a productivity gain. Therefore, little tendency is found to exist to
set wage outside this agreements or beyond equilibrium level.
Some evidences are found about the existence of efficiency wage in reference to
prediction of Solow about high wages result in higher productivity or higher output. The relation
between unemployment and output gained little support from literature (Supriadi 2017).
Evidences from Australia support the fact that involuntary unemployment is to some extents
supported by efficiency wage hypothesis.
Analysis of industry sample data for the period 1984 to 2000 revealed that elasticity of
output with respect efficiency wage ranges between 0.03 and 0.42. The corresponding range of
output elasticity is 0.34 to 0.61 for firms in countries such as US, UK and Spain respectively.
Different explanations have given by different commenters in order to account comparatively
small estimated magnitude in Australia. One simple explanation can be data manipulation.
Average industry data from all industries except fishing, forestry and agricultural sector are
utilized in studies (Yang 2013). It may be the case that efficiency wage is not taken for
consideration not all but in some industries. As a result at times of aggregation of data, the effect
of efficiency wage is averaged giving a small effect of efficiency wage.

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Another explanation is the time taken of evaluation. From 1984 to 2000, payment of
efficiency wage in Australian industries were limited because of relation system of Australian
industry. The sample period is viewed as three distinct phases one from 1984 to middle of 1987,
when wage was restricted. The second phase ranged from mid-1987 to 991. During this phase
wages were realized to be increases only after generation of efficiency. In the last or third phase,
fixing of wage in a decentralized manner and agreement in workplace were encouraged. All the
three phases do not contain same result. Regression taking three separate time period yielded
different results depending on industry regulation and system.
Previous studies on evidences of Australian macroeconomic indicators indicate two
possibilities. It turns out that real wages in neo classical models are either harmful or do not
matter for Keynesian model because of sticky nature of nominal wages. Increase in real wage is
considered harmful because it increases production cost. In some non-competitive market model,
wages do not have any significant influence unless wages enter in the model as shock variable.
In efficiency wage model, role of real wage is different as that in Keynesian, neo-
classical or imperfectly competitive market models. In theoretical models, there is dual function
of real wage. From theoretical perspective, wages are considered as a cause of productivity as
well as unemployment.
There is concern regarding how much wage to offer employees in government sector in
order to ensure optimum level of effort on part of the employees. There is lack of motivation
among public sector employees than that for private sector employees even in response to high
wage incentive. Pay scheme based on performance is malfunctioned in government sector.
Therefore, literature on theory of efficiency wage and public sector motivation are considered.
The workings of Jeannette Taylor and Ranald Taylor show result of model build to examine the

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relationship between wage and public sector motivation (Taylor and Taylor 2012). The analysis
has taken consideration 15 countries that include Australia, Great Britain and United States.
Comparative research designed between private and public sector employees indicates that
government employees are less motivated by monetary reward. Most studies find insignificant
relationship between motivation level of these employees and high rate of wages. Employees
having post in high organization level are driven more by service and altruistic motive than those
posted at low organization level. These factors are more motivating than wages in these sectors.
Findings of this paper indicates that in New Zealand and Australia public sector wages
exceed market wages slightly. The elasticity of work effort with respect to wages in 0.21 in
Australia. This implies when wages increases by 1% then effort level increases by .21%. The
estimated elasticity of public sector motivation of in respect to work effort is 0.61. The
implication of this is that 1% change in work effort is associate with a 0.61% increase in public
sector motivation. The elasticity of public sector motivation with respect to work effort is
greater than elasticity of work effort with respect to efficiency wage (de Linde Leonard and
Stanley 2015). This signifies that public sector motivation plays a more important role in
increasing work effort than wages.
The results of this paper can be summarized as follows. First, there are gap between
wages in public and private sector. Second, a positive relation is found to exist between wage
level and effort. This implies importance of wage for many government employees (Heid and
Larch 2016). However, a high a positive value of elasticity of PSM and work effort give
confirmation to the fact that PSM in important in reshaping worker effort.
A study is conducted on Australian industry for the period 1965 to 2007 to trace the
effect of real wage on labor productivity. The interrelationship is tested using Granger-causality

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and co-integration. Focus is also given on testing structural breaks during this time. The paper
posit theoretical argument of efficiency wage that with high wage rate opportunity cost of job
loss increases and enhances work effort. The paper made an investigation based of empirical
evidence to find the impact of real wage and inflation on productivity and work effort of the
workers. The paper finds presence of a structural break in 1985 (Kumar, Webber, and Perry
2012). The wage elasticity of productivity lies between 0.5 and 0.8. The result symbolizes that a
one percent increase in wages in manufacturing sector increases productivity ranging from 0.5 to
0.8. These findings support presence of efficiency wage hypothesis in Australian industry. The
granger causality test in the paper has estimated a bi directional causality between productivity
and real wages (Nguyen Van 2016).
Studies are designed to identify selection of efficient contract between subjective
performance pay for motivating workers and subjective performance pay. The result reveals that
subjective performance pay is a cheaper means of increasing productivity than paying a high
wage to the workers (Katz 2012). The use of subjective pay is limited because of incentive to
breach contract. Paying bonus is a credible means of increasing wage rate. In optimal contract,
bonus has a positive correlation with wages. The empirical result shows that high turnover costs
are found in occupation where a low wage is paid. High wage is associated with a low turnover
rate. Similar is the result for bonus payment.
Conclusion
The essay aims at finding the relation between pay and performance for business
organization. Efficiency wage refers to a wage that is above the wage as determined by the
forces of labor supply and labor demand. The efficiency wage is named so as firms find rationale
in providing a wage above market clearing wage. There are different theoretical model that

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explains efficiency wage from a different perspective. The basic models are shirking model,
adverse selection model, and worker turnover model. In the shirking model, a high wage is paid
to reduce the shirking behavior of workers. Turnover of experienced workers is costly for firm.
Greater incentive in the form of high wages help the firms to retain its experienced workers. A
high wage premium attracts better quality job applicants and enhances performances of business
organization. For poor countries another concern is worker health. In rich countries this is not a
major concern as most workers receive wages sufficient enough to afford a healthy diet. One
opposing theory to this is the back ward bending labor supply theory. Labor supply curve is
backward bending at after a critical threshold workers prefer leisure more than giving extra work
effort. Here, work effort do not increases even when wage increases. Based on the theoretical
assertion literatures have made to support the theory with empirical evidences. The data for
Australian labor market from 1984 ad 2000 shows weak evidences of efficiency wage for the
relevant period. One reason is that there during that time implication of efficiency wage was
restrained in Australia given the industrial system. Another study on Australian labor market
from 1965 to 2007 reveals that output elasticity of wage increases from 0.5 to 0.8. The
relationship between pay and performance is also evaluated for public sector employees as well.
The result signifies the fact that public sector motivation is a more influencing factor for work
effort than wages. Literature also supports the claim that high payment of total wages reduces
worker turnover. Therefore, conclusion can be drawn in favor of efficiency wage as in all the
literature a positive elasticity is obtained.

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