The effect of firm profit on fairness perceptions, wages and employee effort

This study investigates whether firm profit trend influences employees' perceptions of what constitutes a fair wage and thus affects the relation between wages and employee effort. It extends prior research that attempts to explain the empirical finding that wages do not fall to market clearing levels. One potential explanation is the gift exchange model (Akerlof 1982, 1984), which assumes that firms maximize profits by taking into consideration social norms such as fairness and reciprocation. By paying higher wages, firms motivate employees to provide effort above the level enforceable under their employment contract.;Consistent with this model, my experimental results show that workers provided more effort when they were paid higher wages even though there was no ex post reward for doing so. As a result, firms that paid higher wages generally earned higher net profit. Moreover, profit trend influenced the relation between wages and effort. Specifically, controlling for wages, workers provided higher effort when firm profit had decreased compared to when firm profit had increased, even though workers' financial incentives were unchanged by the firm's profit trend. Finally, workers' responses to firm profit trend were asymmetric. Workers behaved as if they expected to share in firm profit increases but did not expect to share in firm profit decreases.;These findings are consistent with field data showing that wage increases are associated with productivity increases and that wages and firm profit are positively correlated. The results suggest that firms can benefit from taking into account social norms when designing employment contracts. To the extent that social norms help create self-enforcing implicit contracts, they are especially important in environments where it is difficult to tie rewards to performance. The results also have potential implications for earnings management. In particular, if reported profit indirectly affects firms' wage costs and labor productivity, firms may be motivated to manage their earnings reports.