Andrea Wieland
4/10/03
Efficiency Wages
The theory of efficiency wages says that it is logical for some firms to pay wages
that are above the market wage. The reasoning behind this theory states that productivity
can be related to wages. In other words, in some cases the mere fact that workers are
paid more can make them more productive. This means that the total productivity curve
at some points can be upward sloping.
Of course after some point the curve
will flatten out. By drawing a line
from the origin you can find the
elasticity of a specific point. This
makes it easier to determine what
point will be most efficient.
The most efficient elasticity equals one. Point x that is the point tangent to the origin and
closest to the output axis has the elasticity of one. Looking at the total product curve you
see that the wage increase from point y to x is very small compared to the increase in
output. It is also easy to notice that if you make the large wage increase from point x to z
the output increase is very small in comparison. Therefore the most efficient point is
point x regardless if the supply and demand equilibrium point is below x. Of course if
the supply and demand equilibrium is above point x then the efficiency wage doesn’t
matter, because you will have to pay above the efficiency wage in order to attract
workers. There are examples of possible efficiency wages in practice and there are also
critics to the approach. Now we will look at why wages would increase workers
productivity.
Andrea Wieland
4/10/03
There are four good reasons why efficiency wages would increase productivity.
Five reasons wages and productivity have a positive relation
1. It makes nutrition more affordable.
2. Some workers will be afraid to loose such high wages if their performance
doesn’t meet expectations.
3. The employer gets a choice of the cream of the crop.
4. Saves the employer the cost of high turnover rates.
5. Sociology of the work place
First studies have shown that workers who are undernourished are less productive than
workers that have adequate nutrition. It only makes sense that a more healthy person will
perform better and call off less. The economist John Strauss did research in an African
country Sierra Leone. A ten percent increase in caloric intake among farm workers in
Sierra Leone increases productivity by about 3.4 percentage points. 1
Second efficiency wages can be used to lower the monitoring cost. Economist
recognize this possibility as an example of moral hazard—the tendency of people to
behave inappropriately when their behavior is imperfectly monitored. 2 In the fast food
business it has been proven that worker who work for the corporation get paid more than
workers who work for local franchise stores. This could imply that a local franchise has
lower monitoring cost and therefore doesn’t need to pay higher wages. Whereas a
corporation restaurant has more cost in supervising a store that is farther away and
therefore find that it’s cheaper to pay the workers more instead of paying the monitoring
cost. Other businesses have high monitoring cost and find it easier to just hirer workers
at a higher wage and let employees know that poor workers will be fired.
1
John Strauss, “Does Better Nutrition Raise Farm Productivity?” Journal of Political Economy 94 (April
1986): 297-320
2
Gregory N. Mankiw Macroeconomics Worth Publisher New York 2003
Andrea Wieland
4/10/03
Sometimes hiring people at a higher wage will attract workers who are more
productive who have a higher reservation wage. Some people might feel that the job is
less strenuous than another job paying the same wage. Therefore what worker wouldn’t
want to switch jobs? As the employee gets a more productive worker the worker gets to
work at a job where they can be less productive. If a firm reduces its wage, the best
employees may take jobs elsewhere, leaving the firm with inferior employees who have
fewer alternative opportunities. Economist recognize this unfavorable sorting as an
example of adverse selection—the tendency of people with more information (in this
case, the workers, who know their own outside opportunities) to self-select in a way that
disadvantages people with less information (the firm). 3 Efficiency wages allow
employers to pick the cream of the crop from surplus of workers.
Turn over cost can be very high for employers. Employers have to pay the cost of
loss of productivity while searching for a new employee, plus the cost of finding a new
employee and training the new employee. Why would any employee leave a company
when they knew that they wouldn’t get paid as much anywhere else?
The Sociology of the work force deals mostly with a social issue and not an
economic issue. It states that people will have good feelings about their work and
employer and therefore work harder. It seems unlikely that an entire firm would work
more productively.
Some workers will just feel good about the high wages and work the same.All of
these things can be demonstrated in the first use of efficiency wages. Henry Ford
revolutionized the car industry with the use of the first continuous assembly line.
Workers specialized to the point that it took 5 minutes to learn the task required of them.
3
Gregory N. Mankiw Macroeconomics Worth Publisher New York 2003
Andrea Wieland
4/10/03
This led to a boring work place that almost encouraged worker to call off and quit.
Annual turnover at the ford plant was nearly 370 percent in 1913. In addition, the
absenteeism rate was nearly 10 percent daily. In 1914 the Ford Motor Company decided
to disregard the wage and employment conditions that had been presumably set in the
competitive labor market and unilaterally reduced the length of the workday from 9 to 8
hours and more than doubled the wage from $2.34 to $5.00 per day. By 1915 the
turnover rate had dropped to 16%, the absenteeism rate had dropped to 2.5 percent,
productivity per worker had increased between 40 and 70 percent, and profits had
increased by about 20 percent. 4 The argument could be made that the workers were
getting underpaid according to sufficiency wages because of the disadvantage of the
tediousness of the job. This would lead you to believe that once the wage was raised it
actually reached equilibrium. Maybe people were just beginning to understand that
boredom has a cost just like risk must be paid more than a safe job. There is some
evidence that Inter-Industry wage differentials can be interpreted in different ways.
Some suggest that since most people who leave a job and transfer to another company
usually get paid more this means that the new job pays efficiency wages. Sumner
Slichter (1950) was among the first economist to study the industry wage structure.
Sumner was struck by the magnitude of industry wage differences for comparable
workers. 5 Others argue that the pay difference is due to sticky wages. The evidence for
efficiency wages does say that the wage difference is not due to socioeconomic
background, differences in jobs, or worker characteristics.
4
Daniel M.G. Raff and Lawrence H Summers, “Did Henry Ford pay Efficiency Wages?” Journal of Labor
Economics 5 (October 1987, Part 2): S57-S86
5
Alan B.Krueger and Lawrence H Summers, “Efficiency Wages and the Inter-Industry Wage Structure”
Econometrica, Wol.56, No. 2. (Mar., 1988) : 259-293
Andrea Wieland
4/10/03
Critics would argue the sticky wage theory. Arguing that some employers are in a
time period when they can’t change wages to a hirer place therefore what may appear to
be the labor market equilibrium really isn’t. Other employers are able to move to the
higher place and therefore make higher profits. Another theory is known as the bonding
theory. If one place were hiring a limited number of workers at a higher price workers
would want to buy that job. Something like indentured servitude, or in modern times
possible delayed wages. As we discussed earlier when a job pays for workers education
the worker is the one that pays in the form of lower pay. When the education is increased
the pay is increased. This would suggest at the present time all wages are equal. The
bonding critique, therefore, suggests that efficiency wages models would self-destruct in
the long run. 6 Unfortunately the evidence to support the bonding critique or efficiency
wages is not conclusive.
Others critics argue that efficiency wages causes more unemployment, because of
the high wage. The result of this higherthan-equilibrium wage is a lower rate of
job finding and greater unemployment. 7
As you can see from the supply and
demand diagram the efficiency wage
causes a surplus of workers. Some of
the people who will get the jobs are
people with higher reservation wages
and not the people who would otherwise
6
7
George J Borjas Labor Economics Irwin McGraw-Hill Boston 2000
Gregory N. Mankiw Macroeconomics Worth Publisher New York 2003
Andrea Wieland
4/10/03
get the job. As we mentioned before the there is still a debate about weather interindustry efficiency wages exist. Krueger
believes the stability of the industry wage structure casts doubt on exp lanations of wage
differentials based on the short run immobility of labor or transitory labor demand
shocks. It is unlikely that labor is sufficiently immobile over several decades or even one
decade to allow such large differentials to persist. 8
All in all for whatever reason sometimes raising the wage even if all the other
companies are staying the same can make sense. The logic is there even if the source of
the logic, the economist continue to argue about.
8
Alan B.Krueger and Lawrence H Summers, “Efficiency Wages and the Inter-Industry Wage Structure”
Econometrica, Wol.56, No. 2. (Mar., 1988) : 259-293