Why Pay Workers More? An Economist’s Guide to Efficiency Wages

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An Economist’s Guide Efficiency Wages

The term “efficiency wages” or “efficiency earnings” was first introduced by influential economist Alfred Marshall (1842-1924) to represent a unit of labor based upon the relationship between wage and efficiency. According to Marshall, the theory behind efficiency wages would require that employers pay based upon output or efficiency, meaning that more efficient workers would be paid more than less efficient workers which would render the employer theoretically indifferent towards workers of ranging efficiencies.

Today, the term has taken on a different meaning.

The modern use of the term efficiency wage is in reference to the hypothesis that wages in some markets are not always based upon the process of market-clearing, which requires that supply be equal to demand. Market clearing wage, for instance, is the wage or pay scale at which the quantity of labor is equal to the demand or need for labor. It is when this supply equals demand that the market is cleared of all excess.

Efficiency Wage Theory

In economic theory, market clearing presents the most efficient process. But the idea behind efficiency wage theory is that it may ultimately benefit a firm or company to pay laborers a wage that is higher than their marginal revenue product.  That is to say that there is incentive for companies to pay their employees more than the market clearing or equilibrium wage.

Why Pay More?

In theory, perfect wage equilibrium presents the ideal state for a market.

But in reality, there are other influential factors that affect an employer’s determination of wages.  A company may be incentivized to pay their workers more in order to benefit in other areas such as increased productivity or a reduction in costs associated with turnover. There are several theories surrounding why employers may choose to pay above the market clearing wage, which include:

  • Avoiding shirking: By raising the cost of being fired, employers discourage shirking, or doing less work than agreed.  
  • Minimizing turnover: The costs of turnover are plenty. In general, it is expensive to hire and train replacement workers. Paying above market-clearing wages can encourage worker loyalty and reduce a worker’s desire to leave or look for employment elsewhere.
  • Sociological benefits: Higher wages can encourage higher morale, which in turn can raise group output norms.
  • Increasing selection: Companies offering higher wages will generally attract more job candidates, which will improve their applicant pool. This can be especially profitable when the position requires skill or experience.

Simply put, labor productivity is positively correlated to wage in these efficiency wage models, which provides simply explanation of why employers would sway from paying market clearing wage.

By contrast, consider models in which the wage is equal to labor productivity in equilibrium, or models in which wages are set to reduce the likelihood of unionization (union threat models). In these, productivity is not a function of the wage.

Other Economics Resources:

Be sure to check out the full glossary of economic terms for more great articles and resources.