What a Difference an Assumption Makes: Effort Discretion, Economic Theory, and Public Policy

Abstract:     
Research in the analytics of efficiency wage and x-efficiency theories is one of the focal points of behavioral economics. A fundamental assumption to these theories is that of effort discretion-that individuals have some control over both the quality and quantity dimensions of the effort they put into the production process. Conventional economic theory assumes that effort is maximized given the firm's production function and is therefore not a variable. Introducing the behavioral assumption of effort variability into the objective function of the individual and the firm has real implication on understanding the microeconomics of firm behavior and public policy. Special and critical attention is paid to the contributions of Leibenstein and Akerlof and extensions to their modelling and analysis based on efficiency wage and x-efficiency theories. The introduction of effort discretion as a choice variable has an impact on the economic narrative dealing with the determination of employment, real wages, productivity, unit cost, and competitiveness. This behavioral model allows for multiple equilibria with regard to wage-effort-productivity relationship. There need not be one unit-cost-maximizing wage and involuntary unemployment need not be the product of high real wages. The model also suggests that key casual determinants of the degree of x-efficiency are real wages and working conditions. The existence of effort discretion provides individuals with a wide array of choices with regard to how firms and economies evolve.

Keywords: Efficiency Wage, X-efficiency, Behavioral economics, Effort discretion, Production function, Akerlof, Leibenstein

JEL Classification: J22, J24, L23

Accepted Paper Series