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C A M E R E R A N D L O E W E N S T E I N

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wage changes in a large financial firm, only 200 of more than 60,000 wage
changes were nominal decreases, but 15% of employees suffered real wage 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 in this volume) demonstrate the pervasiveness of money illusion experimen-
tally (see also Fehr and Tyran 2001) 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 de-
liberately paid above the market-clearing level, which creates an excess supply of
workers and hence, unemployment. But why are wages too high? One interpreta-
tion, “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 moti-
vates them to work hard and economizes on monitoring. Akerlof and Yellen (1990
and in 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 workers repay the gift by working harder
than necessary. They show how gift-exchange can be an equilibrium (given recip-
rocal preferences), and show some of its macroeconomic implications.
In labor economics, gift-exchange is clearly evident in the elegant series of ex-
perimental labor markets described by Fehr and Gächter (2000 and in this vol-
ume). 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 choose low effort. Self-interested workers should shirk, and firms should an-
ticipate this 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 that 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 phe-
nomenon that Frank and Hutchens (1993 and in 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