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Does Fairness Prevent MarketClearing? : An Experimental

Investigation By Fehr, Kirchsteiger

and Riedl (1993)

Presented By Preetha Rajan

Econ 776Experimental Economics

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The Aim

The aim of this paper by Fehr etal. was to test in the context of a

competitive experimental market,the validity of the fair-wage effort

hypothesis.

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The Fair Wage - Effort Hypothesis

The postulates of the fair-wage hypothesis, as put-forthby Akerlof (1982) and Akerlof and Yellen (1988, 1990)are:

• The fairness oriented behaviour of workers may lead to

involuntary unemployment.• There exists a positive relationship between work

effort and wages. Because of this relationship, it maybe profitable for employers to pay wages above themarket-clearing level.

• Further, wage increases raise workers’ effort levelseven in the absence of any increase in the penalty forshirking.

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The Design of the Experiment

 The experiment consisted of two stagesconstituting one period. Twelve periods in eachsession. Four sessions in total.

 Before each session, all subjects picked a card – card with S - worker, card with B - employer.

 First stage was a one sided oral auction withemployers as bidders, making wage proposals

with no opportunity to choose the worker withwhom they traded, since every worker couldaccept every offer. Stage one ended if the workeraccepted an offered wage p, concluding a binding

contract with the employer

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Continued

 The second stage involved workers choosingtheir effort with their choice being revealed

only to the employer. There were no sanctions

associated with this choice.

 Workers and employers were located in

different rooms. The transmission of wage

price and effort levels took place through

telephone. Wage price messages were public

knowledge. The effort choices were coded and

known only to the two parties involved.

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Continued  Monetary effort costs for workers – given by

increasing function m=m(e), m(emin)=0

 emin is the minimum effort level with zero effortcosts. The m(e) schedule is the same for allworkers.

 u j = p j-c-m(e j) is the total monetary pay-off ofworker j with wage p j, effort level e j andmonetary cost of providing one unit of labourtime c

 πi = (υ-pi)ei is the payoff of employer i whoseworker chose effort ei. The expression υei is suchthat one unit of effort produces υ units of outputwhich is sold for a price of one.

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Hypotheses used to test the fair wage-

effort hypothesis

 Hypothesis one: Effort level is increasing in thewage.

 Hypothesis one is tested by fitting a regressione= α + β.p +μ – hypothesis not rejected if β is greater

than zero  To account for behavioural differences among

workers with regard to the fairness notion, dummyvariables di are used for workers to run the followingregression : e= Σγidi + βp + μ - Wald statistic is usedto test the null hypothesis (pertaining to testing thesignificance of behavioural differences of workers)that all estimated γi are equal to the estimated α co-efficient

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Continued

 Period Dummy variables pt added to account forthe possibility that effort varies systematicallyacross periods – takes a value 1 if relevant

observation made in period t and value zero ifotherwise. The following regression equation isrun - e= Σθtpt + βp + μ – Wald statistic is used totest the null hypothesis that all θt are equal to the

estimated α co-efficient  Hypothesis two states that the average wages in

the experiment are considerably greater than themarket clearing wage

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Continued

 Hypothesis 2 tested using variable “r”, which

is the “average relative overpayment” -

r = (p0  – c – τ)/ (υ-c) – hypothesis 2 is true if r

is considerably greater than zero and has no

tendency to converge to zero

 Hypothesis three states that the average

effort per period is above emin 

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Experimental Results

 Experimental Results rather favourable forthe fair wage-effort hypothesis

 The average relative overpayment was 0.42 – 

employers gave workers 42% of surplus – despite there being more workers than jobs

 The average effort chosen by workers was 0.4

- this was 4 times the level predicted bystandard theory

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Continued

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Continued

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Continued

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Continued

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Interpretations and Conclusions

 Employers on making wage offers took intoaccount that effort level of workers dependedon the wage

 Employers’ hope that fairness considerationsinduce workers to choose a high effort inresponse to high wages has been justified

 Reputation formation is unlikely to be a

driving force behind deviation from standardprediction

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