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Efficiency Wage Models of Unemployment An important question considered in this essay is why do labour markets not clear when involuntary unemployed people are willing to work at less than the going rate? Surely cutting wages would be profitable to the firm? Business cycles are characterised by involuntary unemployment. In the presence of involuntary unemployment, firms may find it unprofitable to cut wages. The efficiency wage hypothesis describes how the productivity of workers depends on the real wage paid. Firstly, lets consider a perfectly competitive market where firms can hire as many workers as they like. To maximise profits the firm will pay a real wage that reflects the effort of its workers, this minimising labour cost per efficiency unit. Unemployed people would prefer to work at this real wage or lower but because a wage cut would discourage current employees, reducing their productivity, then firms do not hire people at...

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