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cuts over a 10-year period, and in many years more than half of wage increases were real
declines. It appears that employees don t seem to mind if their real wage falls as long as their
nominal wage does not fall. Shafir, Diamond, and Tversky (1997 and this volume) demonstrate
the pervasiveness of money illusion experimentally and sketch ways to model it.
Labor economics
A central puzzle in macroeconomics is involuntary unemployment-- why can some
people not find work (beyond frictions of switching jobs, or a natural rate of unemployment)? A
popular account of unemployment posits that wages are deliberately paid above the market-
clearing level, which creates an excess supply of workers and hence, unemployment. But why are
wages too high? One interpretation, "efficiency wage theory," is that paying workers more than
they deserve is necessary to ensure that they have something to lose if they are fired, which
motivates them to work hard and economizes on monitoring. Akerlof and Yellen (1990 and this
volume) have a different interpretation: Human instincts to reciprocate transform the employer-
worker relation into a "gift-exchange". Employers pay more than they have to as a gift; and
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workers repay the gift by working harder than necessary. They show how gift-exchange can be an
equilibrium (given reciprocal preferences), and show some of its macroeconomic implications.
In labor economics, gift-exchange is clearly evident in the elegant series of experimental
labor markets described by Fehr and Gachter (2000, and this volume). In their experiments there
is an excess supply of workers. Firms offer wages; workers who take the jobs then choose a level
of effort, which is costly to the workers and valuable to the firms. To make the experiments
interesting, firms and workers can enforce wages, but not effort levels. Since workers and firms
are matched anonymously for just one period, and do not learn each other s identities, there is no
way for either side to build reputations or for firms to punish workers who chose low effort.
Self-interested workers should shirk, and firms should anticipate that and pay a low wage. In fact,
firms deliberately pay high wages as gifts, and workers choose higher effort levels when they
take higher-wage jobs. The strong correlation between wages and effort is stable over time.
Other chapters in this section explore different types of departures from the standard
assumptions that are made about labor supply. For example, standard life-cycle theory assumes
that, if people can borrow, they should prefer wage profiles which maximize the present value of
lifetime wages. Holding total wage payments constant, and assuming a positive real rate of
interest, present value maximization implies that workers should prefer declining wage profiles
over increasing ones. In fact, most wage profiles are clearly rising over time, a phenomenon
which Frank and Hutchens (1993, and this volume) show cannot be explained by changes in
marginal productivity. Rather, workers derive utility from positive changes in consumption, but
have self-control problems that would prevent them from saving for later consumption if wages
were front-loaded in the life-cycle. In addition, workers seem to derive positive utility from
increasing wage profiles, per se, perhaps because rising wages are a source of self-esteem; the
desire for increasing payments is much weaker for non-wage income (see Loewenstein &
Sicherman, 1991).
The standard life-cycle account of labor supply also implies that workers should
intertemporally substitute labor and leisure based on the wage rate they face and the value they
place on leisure at different points in time. If wage fluctuations are temporary, workers should
work long hours when wages are high and short hours when wages are low. However, because
changes in wages are often persisting, and because work hours are generally fixed in the short-
run, it is in practice typically difficult to tell whether workers are substituting intertemporally
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(though see Mulligan, 1998). Camerer et al. (1997, and this volume) studied labor supply of cab
drivers in New York City (NYC). Cab drives represent a useful source of data for examining
intertemporal substitution because drivers rent their cabs for a half-day and their work hours are
flexible (they can quit early, and often do), and wages fluctuate daily because of changes in
weather, day-of-the-week effects, and so forth. Their study was inspired by an alternative to the
substitution hypothesis: Many drivers say they set a daily income target, and quit when they
reach that target (in behavioral economics language, they isolate their daily decision and are
averse to losing relative to an income target). Drivers who target daily will drive longer hours on
low-wage days, and quit early on high-wage days. This behavior is exactly the opposite of
intertemporal substitution. Camerer et al (1997, and this volume) found that data from three
samples of inexperienced drivers support the daily targeting prediction. But experienced drivers
do not have negative elasiticies, either because target-minded drivers earn less and self-select out
of the sample of experienced drives, or drivers learn over time to substitute rather than target.
Perhaps the simplest prediction of labor economics is that the supply of labor should be
upward sloping in response to a transitory increase in wage. Gneezy and Rustichini (this
volume) document one situation in which this is not the case. They hired students to perform a
boring task and either paid them a low piece-rate, a moderately high piece-rate, or no piece-rate
at all. The surprising finding was that individuals in the low piece-rate condition produces the
lowest "output" levels. Paying subjects, they argued, caused subjects to think of themselves as
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