Efficiency Wages – explained in simple words


The term efficiency wages describes a labor market theory that tries to explain the real-world observation of wage development. Although the economy fluctuates considerably over time, real wages do not change with the same ups and downs as a pure supply and demand analysis would imply. A possible explanation for this phenomenon is proposed by the efficiency wage theory.

It is important to understand that efficiency wages are initiated by employers and voluntarily set higher than required. Why would companies pay more than they need? The reason is simple: Paying higher wages may increase worker productivity. For a company it might be a worse strategy employing e.g. 100 workers at an hourly pay of 10 dollars comparing it to contracting 80 workers at an hourly wage of 12.5 dollars. Although it would result in the same final labor cost for the company, the efficiency wage theory suggests that the better paid 80 workers are more productive and thus a company opts to pay a higher wage.

The example already gives a hint at the main implication of the efficiency wage theory: There will be involuntary unemployment. Since companies pay higher wages than they would need to, there will be individuals willing to work, but won’t find a job. If the model is analyzed in detail, it can be shown that wages and unemployment depend on unemployment benefits and the level of competitiveness of firms. The higher unemployment benefits are, the lower unemployment will be. A high level of competitiveness of companies implies lower levels of unemployment.

What are the reasons for an increase in productivity if wages rise? There are 5 commonly assumed explanations:

  1. Health: The higher compensation an employee receives, the better food, medication, medical treatments etc. he or she can afford.
  2. Low Turnover Costs: The higher the wage, the easier it is for a company to keep its current workforce and prevent costly frequent changes of employees.
  3. Higher discipline: If wages a set higher, workers have “more to lose”, that means they are more willing to work harder in order to keep their job (compare also with the “No-shirking model”).
  4. Better applicants: If the wage is high, the chances are higher to obtain highly qualified workers.
  5. Reciprocity: Simply means that by treating employees nicely they will in return treat their company well by working harder.

As a result, companies pay higher efficiency wages and through their wage setting process, a certain level of unemployment follows necessarily. A similar theory trying to explain relatively stable wages and comparatively high fluctuations in employment is put forward in a trade union model.



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Dr. E.

Dr. E. has a PhD in Financial Economics and loves giving advice about finances. His mantra is, if you can avoid fees, you win!

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