Labor Productivity in the
A Consideration of the Firm’s Death Rate
Small Business Economics
14: 149–155, 2000.
2000 Kluwer Academic Publishers. Printed in the Netherlands.
ABSTRACT. It is inappropriate to equate the “representa-
tive firm” with the typical firm, particularly for economies
which consist of small enterprises where a large number of
jobs are created or disappear as establishments are born or die.
If workers care about the job disappearance risk, their utility
and effort offered will be influenced by the death rate of firms.
This paper sets out an efficiency-wage model and takes the
probability of the firm’s closure into account. By extension,
it is shown that equilibrium labor productivity is plausibly
procyclical under certain circumstances, which is consistent
with the stylized facts observed in many countries.
In many countries, small businesses make up a
large proportion among all businesses. For
instance, roughly 85% of companies in the U.S.
employ fewer than 20 people,
and Japan and Italy
have the highest percentage of small enterprises
among the OECD countries. In an oft-cited book
on labor demand theory, Hamermesh (1993, p.
137) states that, “huge changes occur in the
number of jobs as establishments are born or die
. . . It does . . . demonstrate that it is incorrect to
equate the ‘representative firm’ to the typical
firm.” Moreover, consideration of heterogeneous
firms is particularly important for economies
during economic transitions, e.g., the impact of
firms’ birth and death rates during the Asian
financial crisis (from 1997 to 1998).
Imagine that workers consider the risk of job
disappearance as an unpleasant firm character-
other things being equal, a higher plant
death rate lowers workers’ utility. The effect of a
firm’s closure rate on worker utility is analogous
in concept to the theory of compensating wage
differentials (Rosen, 1974). The reasons why
worker utility will be lowered by an increase in
the probability of a firm’s closure can be attrib-
uted to the following: first, the likelihood of a
worker searching for a better job could plausibly
increase with the current firm’s closure rate. The
greater chance to undertake a job search, which
involves both explicit and implicit costs, might
deteriorate a worker’s utility at the current job.
Second, from the psychological point of view, a
worker’s mood and social pressure might be
influenced by the possibility of his job disap-
pearing. Third, a higher probability of firm closure
could have an adverse impact on workers’ outlook
for the future. For example, losing a job results
in some kind of stigma on his record. Therefore,
taking into account a firm’s death rate affects one’s
effort at work through the utility obtained.
To my knowledge, the efficiency-wage theory
is the first that takes workers’ effective effort into
consideration and has been regarded as a powerful
model to explain the existence of involuntary
unemployment caused by market failure. How-
ever, this theory generally leads to the counter-
cyclical prediction of labor productivity and real
wage, which is inconsistent with Okun’s Law
(Akerlof and Yellen, 1986). To explain the well-
known procyclicality observed in the U.S.
(Kydland and Prescott, 1982; Caballero and
Lyons, 1992) and other industrialized countries
(Grodon, 1987), Akerlof and Yellen (1986)
combine the efficiency-wage model and implicit
contract theory, while Chatterji and Sparks (1991)
construct an imperfect monitoring model with an
endogenous performance standard for work effort.
Final version accepted on December 1, 1999
Department of Economics,
National Central University,