Efficiency wage

Efficiency wage is an economic theory proposing that employers may benefit from paying wages above market-clearing levels because higher pay increases worker productivity, reduces turnover, and improves employee quality. Carl Shapiro and Joseph Stiglitz formalized the theoretical foundation in their 1984 paper "Equilibrium Unemployment as a Worker Discipline Device," published in the American Economic Review. The theory helps explain why wages remain rigid during recessions and why involuntary unemployment persists even in competitive labor markets.

Historical background

The concept that higher wages might increase rather than decrease profitability has earlier roots. Alfred Marshall noted in his 1890 "Principles of Economics" that well-paid workers often produce more efficiently. However, the formal theoretical development occurred much later.

Henry Ford's introduction of the five-dollar day in January 1914 provides a celebrated historical example.^[1] Ford Motor Company doubled wages from approximately $2.34 to $5.00 per day. Worker turnover dropped dramatically from 370% annually to below 40%. Productivity rose substantially, and absenteeism declined. Daniel Raff and Lawrence Summers analyzed this episode in 1987, concluding the evidence supported efficiency wage interpretations.

Robert Solow's 1979 article "Another Possible Source of Wage Stickiness" in the Journal of Macroeconomics contributed early theoretical foundations. George Akerlof and Janet Yellen developed the "fair wage-effort hypothesis" in their 1990 Quarterly Journal of Economics paper, extending the theory to incorporate fairness considerations.

Theoretical mechanisms

The shirking model

Shapiro and Stiglitz developed the most influential formalization. Their model assumes employers cannot perfectly monitor worker effort. Employees choose between working diligently and shirking. If caught shirking, workers face termination.

The key insight: punishment severity depends on the wage premium above alternative employment options. Workers earning wages close to their outside opportunities face minimal losses from dismissal. Higher wages create greater incentive to avoid shirking because job loss becomes more costly.

In equilibrium, all firms pay efficiency wages, so fired workers rejoin the unemployment pool. Unemployment itself becomes a worker discipline device. Fear of joining the unemployed motivates effort. This mechanism implies involuntary unemployment exists even in equilibrium.

Turnover reduction

Training new workers involves substantial costs. Search expenses, productivity losses during learning periods, and direct training investments can exceed several months' wages. Higher compensation reduces quit rates, allowing employers to recover training investments.

Industries with significant firm-specific skills show particular interest in retention. Professional services firms, technology companies, and manufacturers with complex production processes benefit disproportionately from reduced turnover.

Adverse selection

Above-market wages attract higher-quality applicants. Workers have private information about their own abilities and productivity. Offering premium pay encourages better candidates to apply because they know they can meet higher expectations. This selection effect improves average workforce quality.

The mechanism resembles insurance markets where low premiums attract high-risk customers. Analogously, low wages may attract only workers unable to obtain better offers elsewhere.

Gift exchange

Akerlof proposed that workers reciprocate generous wages with above-minimum effort. This sociological perspective emphasizes workplace norms and fairness perceptions rather than purely monetary calculations. Experimental evidence from laboratory gift exchange games supports the existence of reciprocal behavior, though field evidence remains more mixed.

Macroeconomic implications

Wage rigidity

Efficiency wage theory explains why nominal wages rarely fall during recessions. Cutting wages reduces effort provision, increases turnover, and lowers applicant quality. The productivity losses may exceed wage savings. Employers prefer layoffs to wage cuts, accepting unemployment rather than reduced efficiency.

This rigidity has Keynesian implications. Wages that cannot adjust downward prevent labor market clearing. Involuntary unemployment emerges not from market imperfections but from optimal firm behavior. Traditional policy prescriptions focused on wage flexibility miss the underlying efficiency logic.

Unemployment persistence

The theory predicts positive unemployment in equilibrium. No individual firm wishes to lower wages because doing so would harm its own workforce quality and effort. Collectively, all firms paying efficiency wages create unemployment that disciplines workers. This unemployment is involuntary because jobless workers would accept prevailing wages but cannot find positions.

Empirical evidence

Industry wage differentials provide indirect support. Workers with similar observable characteristics earn persistently different wages across industries. Krueger and Summers (1988) documented substantial inter-industry wage differences unexplained by compensating differentials or worker sorting.

Direct tests face identification challenges. Observing higher wages and productivity together does not establish causation. Firms might pay higher wages to inherently more productive workers. Experimental approaches have produced mixed results. Some find efficiency wage effects in specific contexts while others suggest effects are modest or context-dependent.

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References

• Shapiro, C. & Stiglitz, J.E. (1984). "Equilibrium Unemployment as a Worker Discipline Device." American Economic Review, 74(3), 433-444.
• Akerlof, G.A. & Yellen, J.L. (1990). "The Fair Wage-Effort Hypothesis and Unemployment." Quarterly Journal of Economics, 105(2), 255-283.
• Raff, D.M.G. & Summers, L.H. (1987). "Did Henry Ford Pay Efficiency Wages?" Journal of Labor Economics, 5(4), S57-S86.
• Solow, R.M. (1979). "Another Possible Source of Wage Stickiness." Journal of Macroeconomics, 1(1), 79-82.

Footnotes

[1] Ford's five-dollar day included both wages and profit-sharing components. Workers had to meet residency and behavioral requirements to receive the full amount. Nevertheless, the dramatic wage increase and subsequent productivity gains made this case central to efficiency wage discussions.