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A Theory of Wage Dynamics

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  • Milton Harris
  • Bengt Holmstrom

Abstract

A dynamic, equilibrium model of long term (implicit) labour contracts under incomplete but symmetric information is developed. Workers are assumed to be risk averse and of unknown ability or productivity. Risk neutral firms learn, as do workers, about each worker's productivity by observing the worker's output over time. It is shown that equilibrium contracts provide for wages which never decline with age and increase only when the worker's market value increases above his current wage. In addition to characterizing the equilibrium wage contract, we also derive some of its implications for the behaviour of aggregate wages across various groups of workers. These implications explain some findings in the recent empirical literature on age-earnings profiles. In particular our model can explain why earnings may be positively related to experience even after controlling for productivity, as some empirical studies have indicated.
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Suggested Citation

  • Milton Harris & Bengt Holmstrom, 1981. "A Theory of Wage Dynamics," Discussion Papers 488, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    • Handle: RePEc:nwu:cmsems:488
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    References listed on IDEAS

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    1. Smith Freeman, 1977. "Wage Trends as Performance Displays Productive Potential: A Model and Application to Academic Early Retirement," Bell Journal of Economics, The RAND Corporation, vol. 8(2), pages 419-443, Autumn.
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    3. Jacob A. Mincer, 1974. "Schooling, Experience, and Earnings," NBER Books, National Bureau of Economic Research, Inc, number minc74-1.
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    5. Holmstrom, Bengt, 1981. "Contractual Models of the Labor Market," American Economic Review, American Economic Association, vol. 71(2), pages 308-313, May.
    6. Prescott, Edward C & Visscher, Michael, 1980. "Organization Capital," Journal of Political Economy, University of Chicago Press, vol. 88(3), pages 446-461, June.
    7. Martin Neil Baily, 1974. "Wages and Employment under Uncertain Demand," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 41(1), pages 37-50.
    8. Fama, Eugene F, 1980. "Agency Problems and the Theory of the Firm," Journal of Political Economy, University of Chicago Press, vol. 88(2), pages 288-307, April.
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