With identical workers, this cannot be an equilibrium because capital constraints do not allow all workers to operate in the preferred capital-intensive sector. An increase in the capital-rental rate would be needed to ration the consequent excess demand for capital. This rise in the rental rate of capital shifts both wage-effort offer lines downward. Both the initial rotation and the shift downward worsen the terms of the low-wage low-effort contract and it follows that the final equilibrium selects a lower worker indifference curve for the representative worker.
The negative income effect that shifts the contracts to a lower indifference curve will also cause lower wages and higher effort in both sectors provided that both leisure and the consumption goods are “normal”. There is also a substitution effect that tends to drive the contracts in opposite directions; the low effort-low wage contract shifts in favor of lower effort and lower wages, and the high effort-high wage contracts shift in favor of higher wages and higher effort. Thus a rise in the relative price of the capital-intensive good makes workers worse off and increases income inequality. Keep in mind that the workers are indifferent between the two contracts and there is no ‘real’ inequality in the model. The principle message is that the wage-effort offer curve twists, as shown in Figure 2.4. We do find this kind of twisting in the 1970s.
Figure 2.4: Twisting of the Market Wage-Effort Offer Curve
The model presented above can easily be amended to allow for variation in workers’ attitude towards effort. This change has little impact on our empirical work since we are studying the demand side of the labor market wage-effort offer curve, not the choices that workers make from among the offered contracts. In a model with heterogeneous preferences, materialistic workers who have a relative preference for goods over leisure would take the high-effort high-wage jobs while humanistic workers who prefer leisure would take the low-effort low-wage work. Heterogeneity in labor supply doesn’t affect much how we study the demand side of the market, but this form of heterogeneity is important from a policy standpoint. The twisting of the offer curve caused by declines in the relative price of labor-intensive goods may have an adverse affect on the utility level of the humanists but a favorable effect on the materialists. In other words the welfare effects of changes in economic fundamentals such as relative prices may vary across groups of workers.
However, heterogeneity in ability is a serious problem for our empirical analysis. If the ability to operate expensive machinery varies across individuals, it is possible to have the more able receiving high wages for low effort in the capital-intensive sectors while the less-able work hard for low pay in the labor-intensive sectors. This would seriously affect our attempts to uncover the offer curve from observed contracts. We do partially allow for this by including in the empirical analysis measures of education.
This subsection discusses the effect of technological change on the wage-effort offer curve. The debate regarding the increase in inequality in the United States has focused on two culprits: globalization and technological change. We have shown that globalization taking the form of price declines for labor-intensive goods twists the wage-effort offer curve. It is an unfortunate but familiar outcome that technological change can have almost the same effect. We would have liked in this paper to have made a substantial effort to try to disentangle technological effects from globalization effects but that task requires direct indicators of both technological change and globalization. When we occasionally slip into interpreting a certain twist of the wage-effort offer curve as a globalization effect or a technological effect, we do so loosely and based on information not contained in this paper.