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Public sector pay and private sector wage premiums: testing alternative models * of wage determination Pramila Krishnan WPS/2000-7 May 2000 Correspondence: St Antony’s College, Oxford or and Centre for the Study of African Economies, Department of Economics, University of Oxford, OX1 3UL. Abstract: The paper focuses on a labour market dominated by a public sector where the links between pay and effort are weak, as in many developing countries. This feature is incorporated in an extension of the basic Shapiro-Stiglitz model of shirking in order to explain the co- existence of high wages (in both private and public sectors) and high unemployment. Using data from panel surveys of households and of manufacturing firms, the empirical test attempts to identify why firms in the private sector do not bid down wages but offer a premium over the reservation wage of the marginal worker. The robustness of the premium is tested by controlling for the heterogeneity of workers, and the dispersion in wage offers and reservation wages of workers relative to the marginal worker. The premium appears to be driven by efficiency wage considerations rather than alternatives such as bargaining models and specific investments in workers. Keywords: reservation wages, efficiency wages, matched employee-employer survey, panel data. * I would like to thank Stefan Dercon, Stephen Nickell, Margaret Stevens and Francis Teal for their comments. I would also like to thank the Department of Economics at Addis Ababa University and Arne Bigsten of the University of Gothenburg for providing access to the Urban Household Survey and Taye Mengistae for the data on manufa