Fairness in the Labour Market – A Survey of Experimental Results

In this chapter we provide a selective survey of experiments to investigate the potential of social motivations in explaining labour market phenomena. We argue that laboratory experiments are a useful instrument to explore issues in labour market theory and personnel economics. Our starting point is the observation that employment relations are frequently governed by incomplete contracts. We show that the norm of reciprocity that leads to gift exchanges is an effective contract enforcement device under conditions of contractual incompleteness. We then present evidence that gift exchange can explain various labour market phenomena that are puzzles from the viewpoint of standard economic theory. Further issues in the related field of personnel economics that have by now been subjected to an experimental scrutiny concern characteristics of the employment relation and the issues of motivation and incentives systems. We conclude by pointing out the complementary nature of experiments to more conventional methods of data gathering. * Support by the Swiss National Science Foundation under the project no. 1214-05100.97 and the EU-TMR project ENDEAR (FMRX CT98-0238) is gratefully acknowledged. Armin Falk, Manfred Königstein, Dorothea Kübler, Christian Thöni and the participants of the GEW Meeting in Meissen in October 1998 provided very helpful comments. GÄCHTER AND FEHR: Fairness in the Labour Market 1 1. The comparative advantage of experiments in labour market research Is the labour market best described as any other neo-classical market, like the market for groceries, or is the labour market substantially different? Much of research in labour economics has such a question in its background. As an example, take the issue of noncompensating wage differentials. There is a huge empirical literature on the question of whether observed wage differentials reflect merely a compensation for working conditions, skills, etc., or whether they contain elements of true rents. Clearly, the existence of true rents, i.e., non-compensating differentials, is in sharp conflict with the neo-classical view of the labour market. As a second example, take the question of whether real and/or nominal wages are rigid, which is also a central topic in macroeconomics. Sticky wages are held responsible for involuntary unemployment, real effects of monetary policy, and business cycle fluctuations. The important question therefore is: Are wages rigid because of some outside intervention – a possibility that is fully compatible with a neo-classical view of the labour market – or are there endogenous reasons for wage rigidities? A further topic that is in particular studied in the related field of personnel economics (see Lazear 1995, 1998, 1999) concerns the characteristics of employment relationships and the issue of the proper motivation of employees. What are the economic consequences of the fact that most employment relations are contractually incomplete, long-term and take place mostly in non-anonymous environments? How can employees be induced to provide a satisfactory work effort? How do various incentive schemes work that were devised to overcome the motivation problem? This paper surveys the results of many experiments that were designed to answer these questions. There are, however, various ways how one can test the issues raised in the previous paragraph. Let us illustrate these possibilities with the help of an example that figures prominently in this survey. One important theory of wage determination is the so-called “gift exchange version” of efficiency wage theory (Akerlof 1982; Akerlof and Yellen 1990). This theory is based on lots of sociological and psychological research which supports the conclusion that the labour relation can often be characterised in terms of a “gift exchange” between workers and firms: firms voluntarily pay their workers above the next best alternative and workers respond with above-minimum work effort. Such behaviour can result in sticky wages and involuntary unemployment. A first possibility to evaluate such an argument is to conduct survey studies and to interview personnel managers and other labour market participants about the determinants of their wage policy. Bewley (1999) is a particularly elaborate survey study (but see also Kahneman, Knetsch and Thaler 1986; Blinder and Choi 1990; Agell and Lundborg 1995; Campbell and Kamlani 1997). A finding of these studies is, for example, that personnel managers actually point to the importance of generosity and work morale in a way that is consistent with the gift-exchange version of efficiency wage theory. A second possibility is to conduct case studies. A recent example is Burks (1999) who argues that gift exchange motivations are important in the motor freight industry. Third, the most common possibility for economists is to perform econometric analyses of naturally occurring field data. For example, Krueger and Summers (1988), who, among others, found econometric evidence of non-compensating wage differentials, speculated that they may be explained by fair wageeffort or gift exchange considerations. All three methods have their strengths and weaknesses. Economists are often not very fond of survey methods because they prefer revealed rather than reported behaviour. Case GÄCHTER AND FEHR: Fairness in the Labour Market 2 studies tend to be ‘special cases’ and it may be hard to generalise from them. Econometric studies with field data often lack appropriate data. And so on. The issues we want to investigate in this paper are very hard, if not impossible, to study with field data. For example, we will demonstrate the power of gift exchanges as an explanation for various labour market phenomena. How can we assess the relative impact of gift exchanges if we observe successful cooperation in a naturally occurring employment relationship? The survey results, if we trust them, probably offer some hints. However, in real world contracting relationships there are always various intervening factors and motivations inextricably present at the same time. In a strict sense, therefore, survey studies and case studies, as well as field data, can only produce evidence that is consistent with a particular theory, but other theories may be consistent with the same outcome as well. In addition, for many of these issues, all these problems are intensified by a lack of appropriate field data. How can we unambiguously measure a gift-exchange relationship that rests on reciprocal preferences? How can we measure “wage flexibility” and “wage rigidity” and causally link them to gift exchange motivations? Further examples of empirical difficulties are provided by various theories on incentive schemes that depend on data of the utility function that are inherently unobservable to the researcher. The tools of experimental economics offer a way out of these problems. Laboratory methods allow the mapping of a particular model with its assumptions (including preferences) and environmental conditions into an economic situation in which real people have to make real economic decisions that involve monetary payments. (In all experiments that we will discuss in the following, participants received monetary payments according to their decisions.) Moreover, decisions take place under controlled conditions, like, e.g., anonymity. By stripping down an economic situation to its essential features we can – in a nutshell – unambiguously test the behavioural importance of some arguments as an explanation for naturally occurring phenomena. For example, we will demonstrate the occurrence of sticky wages in the laboratory and causally link them to gift exchange considerations. Hence, the decisive comparative advantage of laboratory methods is that one can control the decision situation and thereby exclude various intervening outside factors that plague empirical work on such issues. Moreover, one can test comparative static predictions and (counterfactual) consequences of institutional changes. Sceptics may argue that one cannot learn much from these experiments because (i) stakes are usually “low”, (ii) the students that are the subjects of most experiments lack the experience of most labour market participants and that (iii) the experiments are often artificial and lack context. These are, of course, very serious issues, and experimental economists are very well aware of them. For that reason, a lot of experiments discussed below were conducted to test these objections. However, we can assure the reader already at this place that (i) different stake levels do not lead to strikingly different behaviour; (ii) there are some surprising subject pool effects and that (iii) context and the decision frame matter to some degree in particular in strategically complicated decision situations. Despite the comparative advantages of experimental methods we would like to point out that we view experiments as a complementary method to all other methods of data gathering. After all, experiments can only help to validate an argument. The relevance of laboratory findings has to be evaluated in naturally occurring situations. We believe, however, that the 1 See Cooper, Kagel, Lo and Wei (1999) for an interesting study on interaction effects of subject pool and decision context in a strategically complicated game. See Hey (1991, Part I), Davis and Holt (1993, Chaps. 1 and 9) and Friedman and Sunder (1994) for further methodological discussions. GÄCHTER AND FEHR: Fairness in the Labour Market 3 laboratory findings in many cases support the evidence from the other methods. Together, the different methods may help to improve the behavioural foundations of labour economics (see Agell 1999, Bowles and Gintis 2000, and Kaufman 1999 for many arguments and findings from the other social sciences). In the rest of this survey we will proceed as follows. We set the stage in Section 2 by first discussing the central role of contrac