BUSINESS CYCLES WITH WORKER MORAL HAZARD

We consider an economy with unemployment, where firms pay efficiency wages due to effort enforcement problems, and face output prices that vary cyclically, between a high and a low level, p(H) and p(L). We show that for a range of p(L)/p(H) < 1, employment and the wage will be cylically rigid, and that this range is greater the shorter H periods are. For lower p(L)/p(H) employment will vary procyclically but then also the wage, and more so the more employment varies. This implies a limited role for efficiency wage theory in explaining employment variations over the business cycle, but a greater role for explaining productivity fluctuations according to 'Okun's law'.