What determines the effort you put in at work? It probably has something to do with what you get paid. So answer this question for yourself: “If I were paid $5,000 more per year, how much harder would I be willing to work?” What if it was $10,000 more? Would your answer change? Economists and employers are also thinking about this question and using models to set the wages they offer.
Welcome to the sixth week of Econ 101. Chapter 6 of the Core Econ textbook “Economy, Society, and Public Policy” explores the structure of large companies in a capitalist economy. These firms serve as “stages” for interactions between workers, bosses and shareholders.
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Key takeaways
One of the key components of a capitalist economy are firms, businesses that:
- Hire people as workers and pay them wages in exchange for their labor
- Buy inputs to produce and market goods and services
- Aim to make a profit.
Unlike markets, where buyers and sellers voluntarily and equally engage in trade, employers have concentrated power to issue orders and demand workers follow them.
Despite their very different views on capitalism, conservative University of Chicago economist Ronald Coase and “The Communist Manifesto” author Karl Marx arrived at a similar understanding of the authoritarian power structure within firms. Walmart, for example, employs millions of people, all organized within a top-down hierarchy.
Bosses give orders to employees and decide whether to promote or fire them based on the amount of effort they put into their work. Employee effort is an important metric for determining how much profit firms can make, but it’s also expensive and difficult — sometimes impossible — to quantify.
Management and workers alike stand to benefit from entering a labor contract. But the relationship can get tense, because company owners often want to pay less and get more out of their employees. Workers, on the other hand, want higher wages for less effort.
The employer’s goal isn’t to get every employee to love their work, but to like it enough that they will do a good job and won’t leave. That’s why employers often offer higher wages — not out of generosity, but for motivation. It’s also meant to make the next best alternative — unemployment — less desirable.
Sometimes employers will let workers go if they think that they can find new workers who will be more productive. Even the threat of this can push current workers to put in more effort. This is especially true during recessions, when unemployment rates go up along with the cost of losing one’s job. Economist Edward Lazear found evidence of this when observing increases in worker productivity at one large company during the financial crisis of 2008. He and his co-authors found that increase was more due to increased effort by existing workers than the result of hiring more skilled workers.
We can calculate the cost of a job loss by subtracting what an employee would make if they lost their job, including nonwage benefits and the costs of starting a new job, from what they’d make if they stayed employed. Economists call this figure “employment rent.”
Take the hypothetical example of a worker named Maria who makes $24 per hour, a total of $36,960, if she worked 35 hours a week for 44 weeks. If she lost her job and spent those same weeks unemployed, she’d only make $18,018 from unemployment benefits for the same time period.
Her economic rent, the benefit she receives from keeping her job, is the difference of those two numbers: $18,942.
The more money someone makes, the greater their economic rent.
If Maria’s wages were $48 per hour, her economic rent would total $55,902, almost triple what it was at $24 per hour.
But employment rent can change even when wages remain flat. During a recession, you might expect to be out of work for a longer time, which would drive employment rent up. At the start of the COVID-19 pandemic, the federal government offered an additional $600 a week on top of state unemployment benefits, driving employment rent down.
The Federal Reserve Bank of New York surveys people about their expectations for reservation wages, the minimum salary they would accept to change jobs. That number reached a new high of $73,667 in November. However, as the chart below shows, the salary people expected depended on their employment status. People who didn’t currently have a job said they’d accept a salary that’s $27,000 less than what people with a job would take.
The upward trend in reservation wages, 2014 to 2022
Were an employer to offer a wage equal to the reservation wage, there’d be no incentive for the worker to put in any effort. But offering the highest possible wage may not be ideal either, because there are limits to how much effort that a worker can exert. As workers approach peak effort, employers experience diminishing marginal returns. In other words, employers get less bang for their buck.
Important definitions
- Reservation wage: what you can expect to get instead of your hourly wage, while unemployed
- Employment rent: the cost of a job loss, or the excess value between the benefit an employee receives from their job and their next best alternative
- Labor discipline model: a model that explains how employers set wages so that employees receive employment rent, which provides workers an incentive to work hard in order to avoid job termination
David Brancaccio’s thoughts on Chapter 6
The chapter reminds us of an ugly truth: From a company’s point of view, unemployment is a good thing. When the jobless rate is high, the reservation wage falls. Paychecks also tend to fall, with more unemployed people willing to accept less pay to take a job. The United States has been close to what economists call “full employment,” and employers have had to pay more to recruit people.
More from Marketplace
Want to learn more about the dynamics between employees and employers? Check out these Marketplace stories to see how the principles in Chapter 6 play out in the real world.
- The salary games some employers play
- Companies still say they can’t find enough workers. What’s going on?
- This is not your grandpa’s union
- A rule that could upend the gig economy
Next week
In Chapter 7, we’ll learn about supply and demand and the “magic of the markets.”
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This course was written and edited by Ellen Rolfes, Erica Phillips, Tony Wagner and David Brancaccio. It was originally published in February 2023 and updated in November 2024.
Revisit previous lessons:
- Chapter 1: The relationship between capitalism and income inequality
- Chapter 2: Game theory and rational decision making
- Chapter 3: How policymakers and economists assess fairness and efficiency
- Chapter 4: Finding balance between work and leisure (like an economist)
- Chapter 5: What is an “economic rent” and how does it influence working conditions?