Pareto Inefficiency of Market Economies: Search and Efficiency Wage Models

Stiglitz, Joseph E.; Greenwald, Bruce C.

In the earlier work, it was shown that market equilibrium with competition, in contexts in which all markets clear, but in which there was imperfect information or incomplete markets would not, in general, be Pareto efficient. Here those results are expanded to incorporate equilibria in which firms are wage setters rather than wage takers, where they set their wage to take into account efficiency wage considerations and where they may set the wage at a level where markets do not clear. This provides a more accurate characterization of labor markets than is provided by the standard perfect information, market-clearing model. It should be clear that similar results obtain in other contexts-in labor, product, and capital markets-in which wages, prices, and interest rates affect market behavior, for instance by conveying information. Though efficiency may indeed entail unemployment, credit rationing, or prices exceeding marginal costs of production, there is no presumption that the extent of rationing, and the level of wages, prices, and interest rates in the market equilibrium are efficient.



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American Economic Review

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April 25, 2013