Wednesday, November 16, 2016

For class session tomorrow to begin our discussion about reputations and deferred compensation.

The graph below was taken from the paper Why Is Their Mandatory Retirement?  This paper is from 1979 and the labor market was quite different then.  In particular the model assumes that the employee works for the same employer for the entire working life of the employee.

In the graph, W* is the wage that is actually paid, W tilde is the reservation wage (what the employee could earn elsewhere), and V* is the marginal value product.   That the lines are straight is simply to make the graph more readable.  It is more reasonable to imagine time variation of these curves that coincides with human capital accumulation over the working life and then later some deterioration in skill due to aging  But even with the straight lines that Lazear uses, we should note the slope.  That W* is steeper than W tilde connotes a seniority premium to the actual wage.  That W tilde is upward sloping suggests that with experience some of the human capital accumulation is general human capital that has value when working elsewhere.  Recall in class we talke about a simple model where a  person's output depends on human capital, ability, and effort.  After some age (perhaps 55 or so) the person slows down (ability declines) and that trumps the human capital accumulation part.  Where the peak is surely depends on the individual and the nature of the work the person does.  Also note that at some age, the reservation wage reflects more the value of leisure than the productivity in some other job.

Likewise, the marginal value product curve is probably humped, with a peak somewhere in mid career.  I think that is more realistic, though there is no doubt that the graph below is cleaner to look at.  Economics modeling says to look at the simplest possible model that illustrates the points the author wants to make.  So Lazear's graph wins over  a more realistic alternative.

Finally, as the picture is drawn, the employee does not want to retire at T because W*(T) > W tilde (T).  So in Lazear's model mandatory retirement (which is no longer legal) gets the separation of the worker from the firm to happen when it should.  Absent mandatory retirement there needs to be some other mechanism to encourage separation (perhaps certain types of pensions will do this) or one can't rely on seniority premiums as much as one could when mandatory retirement was legal.

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