11.5 The labor discipline model: A best-response equilibrium between workers and employers
Even though workers want to be paid as high a wage as possible for as little effort as possible, and employers want to pay workers as low a wage as possible for as much effort as possible, employers and workers come to agreements that involve long-standing contracts between them where both are sufficiently happy that neither wants to leave the contract, as we saw in Figure 10.4.
- labor discipline model
- Employers face a labor discipline problem when they need to give workers an incentive to ensure that they work hard and well. In the labor discipline model, they do this by setting wages that include an economic rent (employment rent), which will be lost if the job is terminated.
- strategic interaction
- A strategic interaction is an interaction in which each actor knows that what they get from the interaction depends on what they do and on what other people do, including how others respond to each person’s action.
The labor discipline model helps us to explain why this is true. It also helps us to answer the following questions: Why do many employers in the fast food industry choose to pay their workers more than the minimum wage? Why do employers spend so much money to track and monitor their workers? Why are some workers paid more than others in the same industry? To answer these questions and develop the labor discipline model, we revisit the example of the Mexican restaurant from Chapter 10.
Chef working in a kitchen.
Imagine you and your friend are preparing for the opening of your restaurant. Before the restaurant opens, you have to hire a chef. You and your friend decide that a chef named Celia is the best match for a position. Now you and Celia have decisions to make.
If you and your partner do not make Celia a profit claimant, you have to decide what wage to offer her as a worker. Celia then must choose how hard to work in response to your wage offer. This is a strategic interaction, meaning the outcomes for Celia and you and your partner are interdependent.
A game between firms and workers
Let’s assume Celia accepts the job. We can then model the principal–agent relationship between you and Celia as a game like the one described in Section 11.3. You and your partner act as the principal; Celia is the agent. We call this game the labor discipline model.
To simplify our model, we will assume that you and your partner control three features of the interaction, all of which are communicated to Celia: 1) the wage, 2) the effort you require, and 3) the level of monitoring. The higher the level of monitoring, the more likely you are to catch her if she is not providing the effort you require (but monitoring Celia is costly). If you believe Celia is exerting less than the required level of effort, you will fire her.
- shirking
- Occurs when a worker does not exert the effort that the employer demands.
We also assume Celia has only two choices when it comes to her effort: working and shirking. If she works, she puts in the effort required by you and your partner. If she shirks, she does not work as hard as you asked her to. If she gets caught shirking, she will get fired. The likelihood of her getting caught depends on the level of monitoring.
How is the game played?
This is a sequential game. The employer goes first, and Celia, the worker, goes second. The steps of the game proceed as follows:
- You and your partner announce a wage, a required level of effort, and a level of monitoring.
- In response, Celia decides either to work or to shirk.
- If Celia works, she will receive the wage and will have to pay the personal cost of working at the required effort.
- If Celia shirks, two things may happen. If she is not caught shirking, then she receives the wage without paying the personal cost of working. If she is caught shirking, then she will be fired and receive her outside option. Whether she is caught shirking is determined partially by the level of monitoring in which the employer has invested and partially by luck.
As with other sequential games, we can draw this game as a game tree, shown in Figure 11.4.
Figure 11.4 Game tree of the payoffs to Celia’s choice to work or shirk. Her outcomes for shirking depend on the chance of her employer catching her shirking.
You and your partner move first by setting the wage, required effort, and level of monitoring
Celia chooses to either work or shirk
Celia gets caught shirking
Celia shirks but keeps her job
The best outcome for Celia in this game is to shirk and not get caught. In that case, she receives the wage without having to subtract her personal cost of working. For you and your partner, the best outcome is that Celia chooses to work. You and your partner then have two ways to incentivize her to work:
- Monitoring: Increasing the extent to which you monitor Celia’s work will reduce her likelihood of shirking, as she does not want to get caught and lose her job.
- Employment rent: The bigger the employment rent, the less likely Celia is to risk losing her job due to shirking, and the more effort she will exert. You can increase her employment rent either by raising her wage or reducing her personal cost of working.
The best-response equilibrium and the no-shirking wage
- best response
- Given an action by another person, the action selected by doing the best you can is called the best response to the other’s action.
- no-shirking wage
- The wage that is just sufficient to motivate a worker to provide effort at the level specified by their employer.
- incentive-compatibility constraint
- The incentive-compatibility constraint (ICC) describes the limits on the outcomes that a first mover in a sequential game may achieve by showing how a second mover will respond to each of the choices that the first mover might make.
The best-response equilibrium of this game is for you and your partner to offer Celia her no-shirking wage and for Celia to choose to work and not shirk. The no-shirking wage is the lowest wage at which Celia will always choose to work instead of shirking. It is the wage where the employment rent is just high enough for the risk of getting caught shirking to no longer be worth losing the job, making working her best response to the wage offered. The no-shirking wage is therefore also the incentive compatibility constraint, as you know that offering her a wage any lower would result in her shirking.
Everyday Economics 11.8
This article from the satirical newspaper The Onion highlights the basic goal for many workers in this game, which is to determine the minimum amount of effort required so as not to be considered shirking by their boss or employer. In thinking about jobs you’ve had, did you do the same thing?
Offering the no-shirking wage is also the best response for you and your partner, because you are paying Celia the lowest amount that will still motivate her to work at the effort you require. If you raise the wage any higher, your profits will decrease.
In our model, Celia’s no-shirking wage depends on two things: 1) the net benefit of her outside option, and 2) her personal cost of working.
- reservation wage
- The reservation wage is the lowest wage a worker is willing to accept to take up a new job. It is the wage available in the worker’s next-best job option (the outside option). For workers whose next-best option is unemployment, the reservation wage takes into account the wages they expect to receive when they find a new job as well as any income received while unemployed.
- participation constraint
- Each member of an interaction must receive at least their outside option in order to participate in the interaction.
At the absolute minimum, you cannot pay her less than the net benefit of her outside option, which is also known as Celia’s reservation wage. It is the absolute minimum she will accept for a job.
However, if you pay Celia a wage just above her reservation wage, she will shirk because the personal cost of working decreases the net benefit of the job. If her wage does not compensate for that cost, she will be worse off than if she had remained unemployed. Her best response in that case is to take the job and shirk.
Knowing this, you and your partner offer a wage that is equal to the value of her outside option plus her personal cost of working. This wage is her participation constraint, or the absolute minimum she requires in order to take the job and put in any effort at all. If the employment contract were complete, and you could perfectly and costlessly monitor Celia’s effort, her participation constraint wage would be sufficient to motivate her to work instead of shirk.
Because effort cannot be part of an employment contract, and because you cannot perfectly monitor her effort, Celia’s best response at the participation constraint wage is still to shirk. At that wage, she’s no better off than she would be if she lost her job. So long as there is some chance she could shirk and keep the job (such a chance always exists), shirking remains her best response.
This clip from the 1999 comedy Office Space illustrates the dilemma facing workers as a result of their not being profit claimants. In the clip, Peter, the main character, explains to the two consultants interviewing him why he shirks. He points out that, even if he works hard and the firm “ships a few extra units,” his pay will not go up at all. He is unmotivated to work hard because he does not have a direct incentive to do so. He wants to work just hard enough to avoid being fired and not to be hassled by his bosses.
You therefore need to give Celia further incentives to work instead of shirking—by itself, the participation constraint is not enough to discourage shirking. In other words, for you and your partner, doing the best you can means offering Celia a wage equal to her outside option plus her personal cost of working plus a large enough employment rent to ensure that working is preferred not only to her outside option, but also to taking the job and shirking.
Figure 11.5 models this scenario for a typical worker and employer. At the bottom of panel (A) in red is the net benefit of the worker’s outside option. Above that, in green, is their personal cost of work, which they must be compensated for if they are going to exert any effort at all. The wage equal to the outside option plus the personal cost of working is the worker’s participation constraint. Because effort increases with employment rent, the employer needs to adjust wages accordingly until the effort is where they need it. Whatever wage leads to the required effort is the no-shirking wage, which is the incentive compatibility constraint.
Figure 11.5 What determines the no-shirking wage?
What determines the no-shirking wage?
The worker’s reservation wage and participation constraint
If the worker is fired, they return to work after a given period
Potential wages the employer could offer the worker
The employer offers wage 1, a low wage
The employer offers wage 3, a high wage
The employer offers wage 2, which is just enough to get the worker to work
The employer satisfies the worker’s incentive compatibility constraint
A worker with a job earns an employment rent at the no-shirking wage
The employment rent for a worker who shirks
Panel (B) of Figure 11.5 shows the same worker’s employment rent if they decide to shirk instead of work. Although they have two months of higher employment rent because they do not have to pay the personal cost of working, they are caught shirking at the end of the second month and are fired. They then have four months of unemployment before getting a similar job. Knowing that their overall employment rent over these six months will be lower if they shirk, this worker will then choose to work.
Like employment rents, outside factors or changing rules of the game can change a worker’s no-shirking wage. For example, Celia’s employment rent will increase if the unemployment rate increases because the value of her outside option will decrease. Assuming her wage and personal cost of working stay the same, the weaker outside option will cause her no-shirking wage to drop as well.
This example helps to explain why, as we saw in the introduction to this chapter, workers tend to work harder during recessions, when unemployment increases. Because most firms do not cut the wages of their workers during recessions, workers see their employment rent increase as their outside option worsens, which incentivizes them to exert more effort.
Everyday Economics 11.9
In many jobs today, it is getting easier for employers to monitor workers’ effort. For example, the “items per minute” of checkout staff can be checked in real time by managers (17 items per minute is the minimum to keep your job at one outlet), and software called a keylogger can record the keystrokes of data-entry workers. Similarly, trip recorders on trucks have been in use for decades and have vastly improved employers’ ability to monitor the actions of truck drivers. When the trip recorders were introduced, companies were able to write contracts based on the speed at which the truck was driven, and to provide drivers other incentives to act in the companies’ interests. Think about jobs at which you or someone you know has worked. How were you monitored while you worked? How did the level or intensity of monitoring affect your effort level? Were there any changes in how you were monitored while at the job? Did you try to find ways to resist monitoring?
In addition to an increased unemployment rate, any of the following will decrease the no-shirking wage an employer must offer a worker if they want the worker to put in sufficient effort:
- less generous unemployment benefits
- lower personal cost of working
- increased monitoring.
The last point explains why employers have an incentive to adopt more and/or better monitoring technologies. So long as the cost of a monitoring technology is less than the benefits to the employer of lower no-shirking wages and increased effort, they will be doing the best they can by investing in it. This technology allows them to claim some of the employment rent from the worker because they now have to pay the worker less. They also get more effort for the wage they pay, illustrating how the principle of mutual exchange and conflicts from exchange can play out in this game. We can think of increased monitoring as a way of making the employment contract closer to a complete contract, because it means that a worker shirking is more likely to get caught and fired.
A mouse jiggler moves a user’s mouse gently to prevent the computer going into sleep mode. Remote workers can use these devices to look like they are logged in and busy even if they are not.
New monitoring technologies have enabled the growth of the gig economy, exemplified by companies like Uber, Lyft, and UpWork, by allowing for the precise definition of tasks. This precision has made it possible to pay gig workers per task rather than per hour, an arrangement that is closer to a complete contract. For example, if a Lyft driver does not finish driving someone to a bar, or a TaskRabbit worker doesn’t properly assemble a piece of Ikea furniture, neither makes a single penny.
Because gig workers are paid only if they complete a task, and monitoring that task is relatively easy, employers only have to pay them just above their participation constraint. This arrangement benefits employers, who make more money from the work done by their workers. But for the gig workers, this arrangement reduces their pay, economic security, and their fallback option, because in many cases these platforms are the only place to get such work.
Characteristics of the best-response equilibrium
What lessons have we learned from the employer–worker game?
- Equilibrium: In the employer–worker game, the employer offers a wage (alongside a level of monitoring) and Celia provides a level of effort in response. Their strategies are a best-response equilibrium.
- Shirking is deterred by the employment rent: Celia provides effort because her net benefits of working are higher than the net benefits of unemployment (her reservation wage).
- Power: Because Celia fears losing her job, her employer exercises power over her, getting her to act in ways that she would not do without this threat of job loss. As a result, the employer’s profits increase.
The meaning of work
We have mainly been focusing on the financial costs and benefits of keeping or losing a job. For most people, however, work is far more than just a source of income. In addition to providing other material benefits such as health insurance, it can greatly contribute to a person’s psychological well-being. According to some studies, the amount of income that would compensate typical workers for the loss of social esteem and other costs of being out of work is greater than the income loss itself. Workers’ desire to be treated fairly and with dignity is also both individually and societally important.
Similarly, the cost of losing a job is not just the loss of money and material hardship for most people, though those can certainly be substantial. Getting fired or laid off can also harm one’s health and be socially isolating.
Why, then, are there always some workers in capitalist economies who want to work but cannot find a job? In the next section, we use the models above and the lessons we’ve learned to answer that question.
Exercise 11.8 Effort, no-shirking wage, and labor market conditions
Li works at a marketing firm. Explain how and why each of the following will affect Li’s effort level and no-shirking wage.
- One of the technologies used for monitoring workers at Li’s firm is deemed an invasion of privacy by the government and can no longer be used.
- A few of Li’s co-workers are fired, and she has to take over some of their workload, increasing her personal cost of working.
- Unemployment benefits, which used to last six months, are altered so that they now last only three months.
- The unemployment rate decreases from 5% to 4%.
- Li starts receiving job offers from employers at other marketing firms, some of which she thinks might pay her more than her current employer.
Exercise 11.9 Recession, recovery, and productivity: Lessons from a case study
In a 2016 study, economists Edward Lazear (an economic adviser to former US President George W. Bush), Kathryn L. Shaw, and Christopher Stanton investigated a single firm during the Great Recession in order to understand how the managers and workers reacted to the turbulent economic conditions. The firm specializes in technology-based services such as insurance claims processing, computer-based test grading, and technical call centers. Lazear and his colleagues used the firm’s data from 2006 to 2010 to analyze the effect on labor productivity of the worst recession since the Great Depression.
The researchers found that productivity increased noticeably during 2008 and 2009, as unemployment and the average length of unemployment increased. They also found that the increase in productivity was strongest for branches of the firm located in places that experienced an especially large increase in unemployment. In 2010, as the unemployment rate slowly started to decline, productivity at the firm began to decrease, but was still higher than it had been in 2006 and 2007.
Assuming the wages of the workers at this firm did not change, answer the following questions.
- Why were workers more productive during 2008 and 2009 compared to the prior years?
- Why did worker productivity begin to decrease in 2010?
- Why were workers more productive in 2010 than in 2006 and 2007?
- Draw a diagram like Figure 11.5a for the workers in this firm for 2006, 2008–2009, and 2010 in order to illustrate what changed across these years.
Question 11.7
Which of the following will lower Celia’s no-shirking wage? Choose all that apply.
- Weaker monitoring makes shirking less risky, so the firm must pay a higher no-shirking wage.
- More generous benefits improve the outside option, so the firm must pay a higher no-shirking wage.
- A lower personal cost of working (more enjoyable job) means the firm can pay a lower no-shirking wage.
- A worse outside option (higher unemployment) raises employment rent, allowing a lower no-shirking wage.
Question 11.8
FurnitureInc employees are aware that if they are laid off, it could take several months longer than before to find a new job due to high unemployment rates. Assuming their wage does not change, how does this awareness affect their effort at work?
- Scarcity of jobs increases the effort that workers put in to avoid being laid off, not the opposite.
- High severance packages may reduce fear of job loss, but that is not the scenario described here.
- Fear of long-term unemployment increases the incentive for workers to maintain high effort to avoid job loss.
- Generous unemployment benefits may reduce fear slightly, but workers typically still prefer job security.
