Abstract: Recent studies found evidence for nominal wage rigidity during periods of relatively high nominal GDP growth. It has been argued, however, that in an environment with low nominal GDP growth, when nominal wage cuts become customary, workers’ opposition to nominal cuts would erode and, hence, firms would no longer hesitate to reduce nominal pay. If this argument is valid nominal wage rigidity is largely irrelevant because in a high-growth environment there is little need to cut nominal pay while in a low-growth environment the necessary cuts would occur. To examine this argument we use data from Switzerland where nominal GDP growth has been very low for many years in the 1990s. We find that the rigidity of nominal wages is a robust phenomenon that does not vanish in a low growth environment. In addition, it constitutes a considerable obstacle to real wage adjustments. In the absence of downward nominal rigidity, real wages would indeed be quite responsive to unemployment. Moreover, the wage sweep-ups caused by nominal rigidity are strongly correlated with unemployment suggesting that downward rigidity of nominal wages indeed contributes to unemployment.

Economists have written extensively on this question, often focusing on various types of incentive pay contracts aimed at eliciting greater effort from employees. This theoretical research identifies features of employment relationships that limit the effectiveness of simple piece-rate incentive pay plans and that force managers to consider other forms of incentive pay. In addition, managers introduce other human resource management practices, concerning employee training, hiring criteria, teamwork, job design, and employee hierarchies, that are aimed at eliciting optimal performance (see reviews in Gibbons, 1998; Gibbons and Waldman, 1999; Lazear, 1999; Murphy, 1999; and Prendergast, 1999). Still, without empirical evidence on businesses ’ human resource practices, it will remain an open question whether the theories proposed in “personnel economics [are] real or merely a series of clever models proposed by abstract thinkers who have little contact with reality ” (Lazear, 1999). In this study, we describe a new research approach – an approach we label “insider econometrics ” – that is aimed at producing empirical estimates of the value of alternative human resource management practices. This “insider ” approach goes deep

of the process) for helpful comments. 1 Behavioral economics increases the explanatory power of economics by providing it with more realistic psychological foundations. This book consists of representative recent articles in behavioral economics. 1 This chapter is intended to provide an introduction to the approach and methods of behavioral economics, and to some of its major findings, applications, and promising new directions. It also seeks to fill some unavoidable gaps in the chapters ’ coverage of topics. What Behavioral Economics Tries To Do At the core of behavioral economics is the conviction that increasing the realism of the psychological underpinnings of economic analysis will improve economics on its own terms--generating theoretical insights, making better predictions of field phenomena, and suggesting better policy. This conviction does not imply a wholesale rejection of the neoclassical approach to economics based on utility maximization, equilibrium, and efficiency. The neoclassical approach is useful because it provides economists with a theoretical framework that can be applied to almost any form of economic (and even non-economic) behavior, and it makes refutable predictions. Many of these predictions are tested in the chapters of this book, and rejections of those predictions suggest new theories. Most of the papers modify one or two assumptions in standard theory in the direction of greater psychological realism. Often these departures are not radical at all because they relax simplifying assumptions that are not central to the economic approach. For example, there is nothing in core neoclassical theory that specifies that people should not care about fairness, that they should weight risky outcomes in a linear fashion, or that they must discount the future exponentially at a constant rate. 2 Other assumptions simply acknowledge human limits on 1 Since it is a book of advances, many of the seminal articles which influenced those collected here are not included, but are noted below and are widely reprinted elsewhere.

We analyze a unique data set detailing the financial activities of a drug-selling street gang on a monthly basis over a four-year period in the recent past. The data, originally compiled by the gang leader to aid in managing the organization, contain detailed information on both the sources of revenues (e.g. drug sales, extortion) and expenditures (e.g costs of drugs sold, weapons, tribute to the central gang organization, wages paid to various levels of the gang). Street-level drug dealing appears to be less lucrative than is generally thought. We estimate the average wage in the organization to rise from roughly $6 per hour to $11 per hour over the time period studied. The distribution of wages, however, is extremely skewed. Gang leaders earn far more than they could in the legitimate sector, but the actual street-level dealers appear to earn less than the minimum wage throughout most of our sample, in spite of the substantial risks associated with such activities (the annual violent death rate in our sample is 0.07). There is some evidence consistent both with compensating differentials and efficiency wages. The markup on drugs suggests that the gang has substantial local market power. Gang wars appear to have an important strategic component: violence on another gang’s turf shifts demand away from that area. The gang we observe responds to such attacks by pricing below marginal cost, suggesting

ibrant public securities markets rely on complex systems of supporting institutions that promote the governance of publicly traded companies. Corporate governance structures serve: 1) to ensure that minority shareholders receive reliable

We examine the relationship between wages and skill requirements in a sample of over 50,000 managers in 39 companies between 1986 and 1992. The data include an unusually good measure of job requirements and skills that can proxy for human capital. We find that wage inequality increased both within and between firms from 1986 and 1992. Higher returns to our measure of skill accounts for most of the increasing inequality within firms. At the same time, our measure of skill does not explain much of the cross-sectional variance in average wages between employers, and changes in returns to skill do not explain any of the time series increase in betweenfirm variance over time. Finally, we find only weak evidence of any declines in the rigidity of internal wage structures of large employers.

We report the results from a representative survey of human resource managers in 885 Swedish firms. We estimate that during the severe recession of the 1990s, only 1.1 percent of workers took a cut in regular nominal pay. We trace the lack of wage moderation to a combination of exogenous (primarily labor law and collective bargaining contracts) and endogenous factors. Our analysis suggests that (i) endogenous wage rigidity plays an important role in most segments of the labor market, (ii) sources of endogenous wage rigidity differ significantly between the high- and low-end of the labor market, and between large and small firms, and (iii) mechanisms of wage rigidity tend to complement each other. Some of our questions deal with issues in the economics of personnel. We report evidence that job protection tends to reinforce the stigma from long-term unemployment, and that labor market training tends to reduce the same stigma. We show that managers in small organizations have a more negative attitude towards incentive schemes based on relative rewards, and we report evidence suggesting that gender have an impact on attitudes concerning effort and motivation.

Most empirical tests of the many competing theories of wage rigidity use publicly available data on pay rates and employment that reveal little about the institutions and motivations that explain wage behavior. In order to learn more, some economists have analyzed unusual sources of data or have conducted surveys and experiments. Management scientists and organizational psychologists have for

We interpret workers ’ confidence in their own skills as their morale, and investigate the implication of worker overconfidence on the firm’s optimal wage-setting policies. In our model, wage contracts both provide incentives and affect worker morale, by revealing private information of the firm about worker skills. We provide conditions for the non-differentiation wage policy to be profit-maximizing. In numerical examples, worker overconfidence is a necessary condition for the firm to prefer no wage differentiation, so as to preserve some workers ’ morale; the nondifferentiation wage policy itself breeds more worker overconfidence; finally, wage compression is more likely when aggregate productivity is low.

This paper develops and structurally estimates a dynamic model of learning in which a firm can acquire information about a worker’s ability by observing his performance over time. Ability determines both the profitability of a job and the job-dependent distribution of performance outcomes. Different output signals about a worker’s productivity can be generated by the firm by assigning the worker to different jobs. Because of the trade-off between learning and shortrun profit maximization, the firm’s optimal information acquisition strategy is the solution to an experimentation problem (a multi-armed Bandit problem with dependent and independent arms). Under the firm’s optimal employment policy, the worker is assigned to jobs of decreasing degree of informativeness, as measured by the dispersion in posterior beliefs. The purpose of the analysis is to investigate to what extent uncertainty about ability affects the dynamic pattern of a worker’s transition across jobs within a firm, i.e., the timing and job characteristics of a career. To this end the model is structurally estimated using longitudinal data from a single U.S. firm, on the cohorts of managers who enter the firm at the lowest managerial level between 1970 and 1979. Estimation results confirm that a theoretically restricted learning model can succeed in fitting the dynamic profile of the probability of retention and promotion at the major job positions within the firm. The estimated model is then used to compute the firm’s value of information and to evaluate the effect on this value, the pattern of job assignments, and on turnover rates of (i) changes in the discount rate, which reflect changes in market interest rates, and (ii) alternative information structures.