Extension of Policy Analysis

To extend this model further, let us now consider a slight change in the assumptions. First assume that the minimum wage is already in place and firms are hiring $L_1$ workers. The no-shirking requirment was derived from the utilities that a potential employee would get from working hard, from working and shirking, or from pursuing other alternatives. Thus an exogenous change in those other alternatives will have an effect on the model. Consider the welfare policy changes of 1996 that included new limits placed on benefits. This decrease in welfare benefits causes the cost of shirking for an employee to increase because there is a smaller safety net if he loses his job. Therefore, from the point of view of the firm, the no shirking condition has shifted down. The firm must pay a lower wage to guarantee that its employees do not shirk because they have more of an incentive to hold on to their job. This is shown graphically in figure 6 as we move from No Shirk(1) to No Shirk(2). This is accompanied by a similiar shift in marginal cost from $MC_L$ to $MC_L'.$ Firms are now subject to two constraints when determining the number of employees to hire, $w_{min}$ and No Shirk(2). Since they are still profit maximizing, the firm will be able to attain a higher level of profits which is indicated by the shift from Iso(1) to Iso(2). The wage remains at $w_{min}$, but employment has increased to $L_2$. Thus, not only did an increase in the minimum wage increase employment, but limiting welfare benefits increased employment and firm's profits! Though employment has increased and the firms are happy making larger profits, what about the welfare of the work force? Consider the following equation,

$$V^A = \bar{w} + \frac{sV^N + (1-s)V^A}{(1+r)}.$$ (6)

$V^A$ represents the utility that a person would receive from leaving his present employer and pursuing other alternatives. Since welfare benefits have decreased, the $\bar{w}$ term must be lower than before, representing a lower utility from not working. The variable $s$, which is the probability of success in finding a new job, has risen with the higher level of employment in the economy. The change in $V^A$ is ambiguous and is dependent on the utility one gains from working productively. One must then pose the question, is society better off overall? The answer seems to be in the trade off between the welfare of those with jobs versus those that still are not fortunate enough to find work. Employment in the economy has risen, and those that are working are getting paid higher wages, but those that are unemployed are getting hurt by lower welfare benefits. Thus the debate over the amount of welfare support continues and the efficiency wage model has shown that the implications of such policies can lead to mixed results.