Federal Reserve

Yellen's No. 1 theory: The badly paid don't work hard

Joshua Roberts | Bloomberg | Getty Images

President Barack Obama's choice of Janet Yellen to head the Federal Reserve was surely bolstered by the fact that her concerns about unemployment outweigh her concerns about inflation. It must have gratified him, then, to learn that her most famous theory attempts to pinpoint the specific cause behind unemployment.

Co-written with her husband, Nobel-winning economist George Akerlof, Yellen's most widely cited paper is borne out of a simple premise: "if people do not get what they think they deserve, they get angry." Yellen and Akerlof go on to argue that workers who receive less than what they perceive to be a fair wage will purposely work less hard as a way to take revenge on their employer. And the worse they are paid, the less hard they will work. Or, as the paper puts it, "workers proportionally withdraw effort as their actual wage falls short of their fair wage."

In the 1990 paper, the economists christen their theory "the fair wage-effort hypothesis," and go on to explain why the phenomenon could explain unemployment.

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But before that is elucidated, it is important to understand that under the admittedly "rudimentary model" used by these economists, unemployment is a bit of a riddle. After all, if the cost of hiring a worker is greater than the value that worker adds, then firms will hire no one.

In that scenario, "the demand for labor is zero, and the unemployment rate is unity," (meaning one, or 100 percent). On the other hand, if there is unemployment, then a given firm could "set its wage at any level." In that case, a given firm would choose a wage that maximizes value—and once they do so, "every firm should hire an infinite amount of labor," which would solve the problem of unemployment.

However, Akerlof and Yellen submit that since people do better work when paid more, firms pay workers a wage that workers consider fair. And since this "fair wage" is higher than the "market-clearing wage" that would lead to an "excess demand for labor," unemployment results. In this way, "this hypothesis explains the existence of unemployment," the economists declare.

That paper, entitled "The Fair-Wage Effort Hypothesis and Unemployment," has been cited in more than 300 academic articles, and has had a huge impact on the field of economics. "It's a very influential paper," said economics professor John Burger of Loyola University Maryland, who cited it in a recent paper of his own.

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However, one aspect of the theory has been broadly disputed. While Akerlof and Yellen submit that "people work less hard if they are paid less than they deserve but not harder if they receive more than they deserve," a now more widely accepted theory called "efficiency wage theory" holds that paying people more does, in fact, increase their productivity. This provides an alternate reason why firms pay workers more than the "market-clearing wages" that would lead to full employment.

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The fair wage-effort hypothesis "is a precursor to the efficiency wage literature," said Stanford economics professor Kathryn Shaw. "It had an influence, although the work on efficiency wage theory has had a bigger influence."

Either way, no one doubts the influence of the theory devised by Yellen and her husband. "We're building knowledge slowly, and this is a big contribution," Burger said.

So what does the argument tell us about how Yellen would direct Federal Reserve policy?

"She is on the side that there are serious impediments in the labor market," Burger said. For Yellen, "the labor market won't create full employment by itself. And if you believe that there are serious impediments to full employment, that gives you the case for an active policy that stimulates the economy to drive the unemployment rate down."

Of course, whether Yellen will actually be able to decrease unemployment through stimulative policies remains an open question— and not merely an academic one.

—By CNBC's Alex Rosenberg. Follow him on Twitter: @CNBCAlex.

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