Efficiency Wages

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21 Aug, 2024

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Efficiency wages refer to the level of wages paid to the employees to retain their skill set and improve the workforce productivity in an organization. The theory states that an increase in wages leads to increased productivity and motivates employees to stay loyal to the firm.

Economist Alfred Marshall introduced the term to imply wage per efficiency labor unit. It is more than the minimum market wage, sometimes even higher, depending on the industry. Firms also offer efficiency wages to employees to avoid shirking, increase loyalty, and attract highly skilled labor.

What are Efficiency Wages?

Efficiency wages can be defined as the wages the firms pay the employees to retain and recruit the best employees and improve their efficiency.
The effectiveness of this theory is debatable, as it's wrong to assume that people are only motivated by money. Many would look for other factors, too, like work environment, career development, etc. Firms should offer these simultaneously to make employees productive and retain them.
Higher wages in the market lead to involuntary unemployment. The Shapiro-Stiglitz model of efficiency wages depicts this accurately.

Efficiency Wages Theory Explained

Efficiency wages theory is used by many firms which believe that remuneration has the power to affect employees positively. Hence, they pay more to recruit and retain the best. This, they believe, will increase profits in the long run.

Pay does matter, but only to an extent. Most employees want other perks too. That is, if an employee has to stay in the same position forever but is guaranteed increments every month, the proportion of employees who would be up for it might be less. This is because employees want career development too. They would want to grow within an organization and climb up the ladder.

Not only this, employees would want a job they enjoy doing. If it's too much pressure or monotonous, or if they don't find the job challenging, some might not be up for it. However, it depends on the employee. Hence, a conducive and developmental atmosphere with higher wages can do the magic.

Why Do Firms Offer Efficiency Wages?

The main principle behind firms offering higher wages is increasing workers' output. Output or productivity is a broad term. So, let's briefly discuss how firms aim to improve productivity.

Minimize employee turnover – Firms do not want their workforce leaving their jobs and looking for work elsewhere, especially if the training and replacement costs are high. Apart from this, the time, effort, and other resources that go into recruiting a candidate and turning them into an employee often discourage companies from letting go of them quickly. In addition, higher wages can make most employees stick to their job.
Reduce shirking – Shirking refers to employees evading their tasks. This might be due to laziness or lack of responsibility and accountability. Higher pay compels employees to give their best for fear of losing their jobs.
Boosts morale – Based on the theory of reciprocity, employees are psychologically compelled to work for higher wages. Furthermore, this reciprocity increases with the salary hike.
Retain trust and loyalty – This aligns with the objective of firms to reduce turnover. But in specific industries, trust and loyalty go beyond holding on to a job. For example, in the jewelry industry, the pay is usually high, as firms have to minimize the chances of theft.
Recruitment of skilled candidates – Higher pay can attract a vast pool of eligible candidates. This allows the management to choose the best candidates among them.

All these factors can improve employee productivity. Besides this, nutritional theories posit that employers pay more to keep their employees healthy and fit for work to be highly efficient. But the proportion of such companies might be significantly less.

Example

Let's look at the example of the Great Resignation in the United States. The mass migration of the workforce from the labor market occurred during the COVID-19 pandemic and the subsequent government aid, which enabled people to reconsider their career options. The construction and infrastructure industry was one of the most heavily struck ones.

An estimated 40% of the existing construction workforce in the United States will retire within the next decade. There is an industry-wide labor shortage, except in the non-residential construction sector. One of the ways to attract an efficient and skilled workforce is to offer efficiency wages. Of course, other perks would be required once recruited. Nevertheless, higher wage levels could, for now, save the day.

The Shapiro-Stiglitz Model

Many economists have contributed to understanding this theory. But the Shapiro-Stiglitz model of efficiency wages is one of the critical approaches. Carl Shapiro and Joseph Stiglitz developed it in 1984. The model describes how wages affect employment patterns. It also provides a mathematical basis for no-shirking conditions and labor market equilibrium.

When a market attains full employment, the fear of losing jobs decreases, and there is a tendency among employees to shirk. If they lose their job, it is easier to get another one since the market has a zero unemployment rate. In this condition, the firm pays more to increase productivity, but that will be of no benefit to the firm because the workers are not afraid of losing their jobs and would still forget.

But when the firm pays more, it must lay off a few employees. This decreases employment. The fear of losing jobs sets in, and the employees are forced to work responsibly. Now, the firm will not be ready to recruit a candidate willing to work for lower than the minimum wage due to the firm's fear of employees shirking. Hence, involuntary unemployment occurs.

Efficiency Wages And Unemployment

Economists argue that efficiency wages lead to involuntary unemployment. Involuntary unemployment is when people are still unemployed despite being ready to work below the minimum market wage.

For example, suppose a company of 250 employees feels that increasing their salary by $100 each will keep them motivated and increase efficiency. But just the net increment would be equal to $25,000. So, to manage the cost, the company decides to lay off employees receiving the least pay. Hence, around 25 employees are laid off, and the company provides their salary to the rest of the workforce in increments.

Now, of course, the company would not be doing this deliberately. But if the management is convinced that higher pay can improve the productivity of those whose performance matter the most, then it would be willing to let go of a few. But even if the workers who are laid off are ready to work for lesser than minimum wages, the company, in most cases, will not be able to have them in the workforce.

Frequently Asked Questions (FAQs)

What is the fundamental tenet of efficiency wages application?

The main principle behind paying employees more is to increase their productivity, trust, and loyalty to their organization. In addition, firms believe that paying more to employees will enhance the company's profits in the long run, as higher wages directly corresponds to higher employee efficiency.

How do efficiency wages cause unemployment?

When firms pay higher wages to specific employees, they do so by laying off a few to manage costs. Later, when people are ready to work for lower wages, firms are skeptical about shirking. The Shapiro-Stiglitz model aptly shows this phenomenon.

What do efficiency wages contribute to?

Economists have long since debated the pros and cons of efficiency wages. Though firms believe higher wages can make employees productive and contribute to the company's growth, not all employees are motivated by money. Also, offering higher wages can lead to unemployment when firms lay off a few and offer their salaries as increments to other workers.